Bitcoins
How it is different from the present money system and what advantages are there on the problem of money.
What is money? Since ages money has been identified mainly by its functionality. It has been basically used as a medium of exchange, as an accounting unit and most importantly as a store of value. Over a period of time, a lot of materials or objects have acted like money. These objects include sea shells, bullions, cattle, etc. In modern times, money is defined as the sum of currency notes and bank liabilities. Bank liabilities include checking and savings deposits. Under the conventional definition, M1 is defined as the measure of money supply which includes all physical money in circulation with the public, demand deposits within the banking system and other deposits with the central bank. M1 is used to measure the most liquid components of the money supply. Only the central bank has the power to create currency, the notes that we carry in our pockets. Banks can, however, create demand deposits.
Apart from the above definition, various other schools of thought give their own definition of money. According to the Austrian school of economic thought, money is the one which acts as the most universal medium of exchange — the most liquid good.
But for the moment let’s stay with the capitalist viewpoint.
2. Historical perspective on money
During the investigations in the intricate affairs of Richard Nixon, the 37th President of the United States, an interesting transaction was uncovered. Mr. Charles G. Rebozo, one of President’s good friend received on his behalf a sum of $100,000 from Mr. Howard Hughes. This considerable sum was claimed and thereafter kept in cash in a safe-deposit box for more than three years before being returned to Mr. Hughes. The curiosity concerning this transaction was not over why anyone should return money to Mr. Hughes. Rather it was why anyone should leave so much money in storage. Left in storage, everyone knew that it lost radically in value — a dollar of 1967 had the purchasing power of only 91 cents in 1969, the year Mr. Rebozo kept the money in storage. A dollar of 1967 was valued only 80 cents — the years when the sum of $100,000 was returned. The impact of this trend would have been compensated if the amount would have earned some form of interest, dividends or perhaps capital gains. [1]
[1] Money: Whence It Came, Where It Went by John Kenneth Galbraith (Ch.1 Pg.1)
This has been the general attitude towards money. Everyone expects it to depreciate in value. In earlier years there was little doubt as to what a man could do once he had money, instead there were doubts on whether he could get that money. In modern times, although the problem of acquiring money remains considerable, the focus has shifted from acquiring money to another uncertainty — once acquired, what will be the acquired wealth actually worth.
In historic times, barter was the preferred mode of trade. As trade by barter became all the more difficult with passing time, other commodities were employed to be used as money. For a commodity to act as money it had to fulfil certain criteria — homogeneity, durability and divisibility. The preferred choice for such a commodity money was metal. Metals, especially precious metals like gold and silver soon started to be used as commodity money. Minted in the form of coins, these metals soon spread throughout the Eastern Mediterranean as well as the Middle East. While the preferred way to complete a transaction was by weighing this coinage, a trusted seal from a chartered mint also worked as a trust factor and eliminated the need for weighing the coinage in most cases. Thus came across the concept of official coinage under the seal of the king of that particular kingdom.
For some thousands of years, money was bullion. As the coins underwent wear and tear, they would either be blankly rejected or be accepted at a discount on the face value. Slowly they vanished from circulation. The stability in the value of the currency was guaranteed by the scarcity of gold and silver. This ancient system of coinage lasted for more than two and a half thousand years. As the use of bullion increased as a metal for jewellery, it increased the demand for the same. This lead to an increase in the value of the bullion coins with respect to other materials. Yet, with money came inflation.
As the scarcity of precious bullion increased, it became all the more difficult for kingdoms to pay for their ever increasing expenses. Although the mint was under their control, the kingdom could not mint coins without bullion. This led these states to debase their coinage. Debasement was done by decreasing the share of bullion in the alloy which was minted into coins. Debasement was also performed by hiding cores of low value within the coin. With the fear of coinage getting totally rejected, debasement was carried out with utmost caution and only when it was required the most. Historic records have proved that during the Punic wars, first long-term inflation was caused by debasement of coinage.
History of money, which for most part refers to the history of commodity money, is mostly a time line of currency debasements and successive monetary reforms. Historical evidence shows that money as a unit of measurement has always corresponded to a well-defined quantity of bullion. Significant deviations from these levels have been detected sooner or later. These changes have been detected and rejected. Also debasement has always led to monetary reforms. Unsurprisingly, this has been a cycle, with the authorities from time to time realizing that there vaults were empty and again they have got tempted to debase the coinage.
As trade and daily transactions increased, the need for verification of the purity of coinage increased. Evidently this led to the innovation of credit money and establishment of banks. A stream of innovations took place for the financial industry as the need for cashless transactions was realized by European states. The simplest of all these innovative ideas was to grant customers credit for later settlement. By reducing the dependence on liquid cash for transactions, investment and consumption decisions were made easy. Then came in the innovative idea of private money — cheques. Since early cheques were backed by real coinage in the vaults of the bank, it did not increase the money supply in the economy. This was true till the time banks kept 100 percent reserves. Although it did not take long for them to breach this confidence the depositors had kept in them. Banks soon started providing overdraft facilities for its niche customers. This was the beginning of fractional reserve banking. This led to increasing the money supply in the economy, much more than what was backed by bullion.
Another innovation for the financial industry was mediaeval letter of exchange, an instruction to a merchant or a banker in another city to pay a specified amount to a third party — much like present day demand draft. Since trading in those times meant transfer of risky shipments across seas, letters of exchange helped in expansion of trade. As bullion got scarce with time, European monetary system started to suffer from lack of innovation.
With the advent of the modern era, another type of credit money emerged — the bank note, or paper money. Bank note had no intrinsic value whatever may be the face value. By early eighteenth century almost all European nations started using paper money. Although this move towards credit money led to increased trade, it also led to situations of infinite inflation. While moderate inflations have been there with the coinage, hyperinflation is an exclusive trait of credit money.
During the 19th century, Peel’s Bank Act, 1844 declared the notes issued by Bank of England as legal tender. What that meant was that taxes had to be paid with the bank notes and also trade need to be carried out with them. But to safeguard against a free run, the Act mentioned a statutory requirement. This requirement stated that 2/3rd of the bank notes in circulation had to be backed by gold in the vaults of the bank. This started a monetary system which was later known as the Gold Standard. The gold standard monetary system provided an automatic market linked mechanism to check government triggered inflation. Further it provided an automatic mechanism to keep the balance of payments of each country in equilibrium.
Although the gold standard was quite capable of maintaining the monetary equilibrium, interventions by governments across the globe created undue problems for the equilibrium. This interventions were caused by governments control over the mint and its power to create the legal tender laws. This ultimately led to development of inflationary banking. Although the equilibrium effect of the gold standard was slowed down by government interventions, it was still present. With the onset of World War I in 1914, the governments who were entrusted to with the task of keeping their monetary promises failed to do so. To fight and survive the catastrophic war, governments around the globe inflated there supply of paper and bank money. So severe was the inflation due to paper money that governments across the globe decided to go off “gold standard”. Apart from the U.S. which entered the war late, and still remained on the gold standard, the world suffered dirty floats, competitive devaluations and the breakdown of international trade and investment. The currencies across the world depreciated immensely with respect to gold and the United States dollar.
After the war ended, the countries tried to get back on the gold standard, but by that time the economic condition of the countries had changed. Their currencies had to be re calibrated with respect to each other for them to go back to gold standard. Hence through the years 1926 — 1931 they shifted to a system known as The Gold Exchange Standard. The gold exchange standard led to two key currencies in the world — United States dollar redeemable into gold and British pound redeemable into United States dollar. Now, as Britain was totally off the gold standard, the equilibrium effect of the gold standard also stopped working. Hence Britain and Europe inflated unchecked and as piles and piles of valueless paper notes got stacked around the globe, it was evident that a slight loss in confidence among the general public in this valueless paper could have serious consequences. This is what exactly happened with the Great depression.
With the great depression, the world was now back to the chaos of World War I. Though United Stated remained on the gold standard for the next two years, it soon left the traditional gold standard and followed a modified form of the gold standard in which only central governments and foreign governments were allowed to redeem dollars into gold. In 1945 the United States congress ratified an international new monetary system called as Bretton Woods. This new system was basically a modified version of the previous Gold Standard exchange system. The only difference was that it made US dollar as the only key currency and removed the British pound from the list. Although it worked, it was nothing new and just bought the financial industry some more time. Now only foreign governments and central banks were allowed to redeem the US dollar for gold.
As the war ended, the United States government went on a never ending inflationary spree. The US was inflating and expanding credit and bank money. Inflation combined with increasing industrial productivity of Japan and Europe led to a continuing balance of payments deficits with the United States. While inflation was rising, the Bretton Woods system failed to check the disequilibrium that occurred. The dollar remained overvalued for almost two decades which forced the European countries to revolt against the United States. They started to redeem the piled up stock of dollars they had, for gold which sent US gold reserves dwindling. Finally to stop the run for gold, on August 15, 1971 President Nixon brought the Bretton Woods system to an end. This severed the last link the currencies had with gold. Now all currencies were fiat money and were and are floating against each other with an ever present threat of unimaginable inflation.
No paper currency has any intrinsic value and the same is true for bank deposits. The former is just printed paper and the latter are just entries in a ledger. Metallic coins do have some intrinsic value related to the metal, but generally it is far less than their face value.
If that is the case then how do they get accepted at their face value for all kinds of transactions? They are accepted so, because of the confidence that people have that they will be able to exchange the paper notes for real goods and other assets whenever they choose to do so. Money as we have discussed earlier derives its value from scarcity in relation to its usefulness. e.g. water when available in plenty is distributed and used without any charge, but when it is required at a place where it is scarce, its value increase from nothing to whatever the seller is willing to sell and the buyer is willing to pay.
This scarcity has to be maintained if the value of money needs to be kept stable. Money’s real value can be measured only in terms of what it will buy. Thus its value varies inversely with the level of prices. If the supply of money increases with production of goods remaining constant in an economy, the value of money decreases. The opposite happens when the money supply decreases while the production of goods is kept constant in an economy.
At present the changes in the quantity of money generally originates with the actions of the central bank, commercial banks or the public. Although the major control rests with the central bank, the actual process takes place in commercial banks. Suppose that an individual deposits j100 of currency into a bank account at his or her local bank. Although the bank is obligated to pay the depositor (or a designated third party) r100 on demand, the bank will probably turn around and lend out most of the R100 — perhaps R80 — to someone else. In this way, new money is created. The original depositor has a demand deposit worth r100 and the new borrower worth R80. To put it another way, the bank has increased the supply of money to R180 on a monetary base of R100. In this case, 20% of the money was retained by the banks with themselves. This 20% is known as the leakage. The inverse of this leakage is known as money multiplier.
The size of the monetary base and the level of leakage constitute the key variables in setting the money supply. The central bank can control the former and strongly influences the latter. Commercial banks must, by national laws, retain a certain proportion of their deposits in reserve, not loaning this money but keeping it either in cash or on deposit with the central bank. The central bank sets the reserve requirement, placing an upper limit on the ability of banks to create credit.
5. Regulatory powers of the central bank
Most central banks have three tools to affect the money supply — determining reserve requirements, discount rate and open market operations.
Firstly, the central bank generally determines reserve requirements. This change in the reserve requirements decreases or increases the the money multiplier and thus contracts or expands the money supply.
The second tool with the central bank is the discount rate. Commercial banks borrow funds from the central bank at the discount rate. Such loans add directly to the monetary supply by increasing the reserves of commercial banks, expanding the money supply. The central bank determines this discount rate. By lowering this discount rate, the central bank makes borrowing more attractive to commercial banks, and by raising it, it discourages such borrowing.
The third tool with the central bank is the open market operations. The open market operations include buying and selling of government securities. When the central bank purchases government securities from institutions, it injects liquidity into the economy and increases the monetary base. When the central bank sells securities, it pulls liquidity out the economy and reduces the monetary base.
With these tools the central bank artificially regulates the supply of money in the economy and hence inflation and deflation keeps on happening.
Bitcoin is a lot of things clubbed into one word. From the view of market interpreters, Bitcoin can be interpreted as a de-centralised clearing mechanism. It is based on its own unit of measurement known as bitcoin (with a lower case “b”). This clearing house uses asymmetric cryptography to prevent fraud and uses the same, in the process of transferring balances. Also within this system, there exists an inelastic production function for supply of currency units. The clearing house combined with an inelastic supply of units allows Bitcoins to be used as a medium of exchange.
The concept of Bitcoins came into picture when someone under the pseudo name of Satoshi Nakamoto published an academic paper describing the Bitcoin digital currency. The paper was published in 2009 and is available in public domain. Subsequently an open source computer program was launched the following year which initiated the peer to peer Bitcoin network. According to the paper, bitcoin is purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.
If we compare the present monetary system with Bitcoins, the technicality of Bitcoins surpasses the present day monetary system by leaps and bounds but still it is simple enough to comprehend. Let us see Bitcoins from a different perspective.
6.1. Socio-political difference
As is obvious, the Bitcoin system is a virtual system and currency. The account number is an encrypted text and is also called the Bitcoin wallet address. The balance associated with the address is also just a number and virtual in nature. Linking both together provides us with the data of how much money does one wallet holds. However, the working of the whole system is based on predetermined rules which are easy to understand, and shared across the Bitcoin network, and all the users interacting through the Bitcoin network. Bitcoin users can, without any doubt, expect that the system will behave according to the predefined rules. The supply of Bitcoins is to increase at a predetermined schedule and as long as the users do not share their private keys with anyone, they, and only they, can control the balance of their account. The rules themselves are purely abstract and based on mathematics. They are ignorant to social conventions, irrespective of their nature. These social conventions can be local or global, political or apolitical, ethical or unethical.
On one hand, this can have a huge impact on liberating the users of Bitcoins from social norms and government control that they disagree with, and at the same time, this exposes them to potential risks linked with the absence of these social norms. If however the users accept the blank and simple rules of Bitcoin as a social norm, that the holder of the private key has exclusive control of the linked balance (i.e., the holder of the private key should have exclusive control of the linked balance), and no other bank is required for their upkeep, the vast majority of the risks associated with social norms disappear.
The fundamental difference in the ethical assessment of Bitcoins is based on the ideology one follows. While Keynesian economists view these features of Bitcoins negatively, Austrians school of economics view its features positively.
6.2. Differences in practical use
Money transfer has traditionally been linked with banks, clearing houses and other intermediaries. What the Bitcoin network brought into existence was a way of transferring money from a person to person with total exclusion of a third trusting party, like the bank, etc. This decentralized nature of the Bitcoin, eliminates the need for the upkeep of transactional networks maintained by for profit companies like VISA, PayPal, etc. No one owns and controls the Bitcoin network. Working on the concept of distributed network, all the participants collectively run the network.
This means that money transfer is quick, has very low or no transaction costs, can be transferred to anyone in the world, from anywhere and without any limits. At present, Bitcoin transactions are instant, though the still need 10 minutes to be embedded into the global ledger (the block chain) and get verified.
The users and the flag bearers of Bitcoins don’t just see it as a cheap way of transferring money from one place to another, but as a voice against monetary tyranny of the state. As against the state controlled supply of money, the Bitcoin money supply is algorithmically capped to a limit. New bitcoins are created by a competitive and mathematically expensive process known as mining. This process rewards the individuals for their services. Every 10 minute a block of transactions is mined. This mining releases a pre-set number of bitcoins in to the economy. This rate of money infusion into the Bitcoin economy has been mathematically fixed. It is also known that this release of bitcoins into the economy is set to decrease geometrically, with 50% reduction every 4 years. Hence, the number of bitcoins will just approach 21 million in number. A possible justification for the above said number is that 21 million matches a 4-year reward halving schedule. 2.1 X 10^15 (the maximum units of Satoshi’s) is close to the maximum capacity of a 64-bit floating point number.
So with the exclusion of state as the authority to increase or decrease money supply, its power to immorally manipulate the currency is severed. Which means, taxes for wars and other misadventures will have to be raised the old fashioned way, not by mere debasement of currency.
Unlike paper money and bank credit, even though it’s virtual in existence, copying of Bitcoin does not increase the amount of Bitcoins, nor does it allow a bitcoin to be spent twice. This is a direct consequence of the public ledger architecture of the Bitcoin network. The ledger needs to be balance, and an attempt to add new Bitcoins in violation of the protocol is detected and rejected automatically.
6.2.4. Providing financial services to the unserved
According to a McKinsey study, there are nearly 2.2 billion people in the world who do not have access to the financial services. Though it may not be possible to provide financial services to all, but with the advent and far reach of mobile technology, it is possible to reach and serve the financially excluded with no extra cost. Though the bitcoin network is based on internet, innovative methods have been developed to extend the bitcoin network to those with access to mobile networks. This can be a daily wage earner in India, or a mine worker in Africa.
Economists have a varied viewpoint about the inelastic supply of bitcoins. While some believe that that it is an advantage the others beg to disagree. An inelastic supply is roughly in line with Friedman’s solution for the optimal quantity of money (Friedman 1969). In a limited supply, bitcoins have no alternative than to appreciate tremendously as the demand for bitcoins increases. The real purchasing power of each coin will increase over time as each coin will be linked a corresponding fraction of nation’s growing production power. If we compare it with the present, we can see that the central bank increases the money supply in the economy according to a country’s production capability. But in the case of a Bitcoin economy (with a capped upper limit on currency units), the only way to capture this increased production value in the currency is by appreciating the currency with respect to the other goods and services. But then that’s the view of the present neoclassical school of economics.
8. Austrian school of Economic Thought
Austrian School of economic thought is of the opinion that an economic phenomena is based on the subjective choices made by individuals. The school has its beginnings in Vienna, during the Austrian empire. The Austrian school can be credited with a number of famous theories, one the most famous ones being the opportunity cost theory. Carl Menger is considered as the founding father of the Austrian school. In his famous book Principles of economics, Menger advances the marginal utility of goods theory. In layman terms that means that something which might be valuable to person A, might not be valuable to person B. He further explained that as the number of good increases, there relative value decreases for an individual.
The Austrian school has a different approach for solving many economic problems. The school discards the quantitative models for reasoning an economic event. Instead it focuses on logical thinking for reasoning out an economic event. For example according to the Austrian school, the determination of prices of goods is based on a subjective evaluation by individuals rather than the equilibrium of supply and demand or say production costs. Similarly, the interest rates are subjective to the decision made by an individual to spend his money now or in future. In other words, according to the school the interest rates are determined by the time preference of borrowers and lenders. Further the school believes that inflation does not affect all goods equally. This is because the prices change according to the perception of the individual towards the good. Moreover the user may have a choice to substitute the product with something else.
If we talk about business cycles, the Austrian school has its own view point about it. According to the Austrian business cycle theory, the cycles are caused by change in interest rates. These interest rates are regulated by the government. Hence with the change in interest rates, mistakes happen in capital allocation. Ultimately the economy goes through recession in order to restore the equilibrium state. So the artificial regulation of interest rates by the government is the main cause of boom and bust phases.
9. Austrian Business cycle theory and Bitcoins
The Austrian Business cycle theory (ABCT) was originally formulated by Mises in 1912. Since then it was subsequently examined and advanced by various Austrian economists. A simplified description of the ABC theory is that the money which gets created due to Fractional Reserve Banking (FRB) and other credit creating financial instruments ultimately leads to a particular structural disequilibrium. This takes away opportunities from those investments which have real value. Instead FRB may create investments that do not have any real profitability. Although it may seem that the economy is booming due to various investments, in reality it is getting stressed due to disequilibrium of capital allocation. Once this artificial infusion of funds diminishes off, reallocation of capital goods takes place towards the equilibrium. This reallocation is followed by contraction of credit in the economy. This is generally the bust or the recession phase. The more the central bank tries to artificially control the interest rates the more severe is the bust phase.
The interesting aspect of this theory is that unlike mainstream economists, who view the boom phase as positive and the bust phase as negative, the Austrians view the boom phase as creating a disequilibrium. On the contrary, the bust phase is viewed as the one fixing that disequilibrium. Consequently the bust phase is seen as a necessary consequence of the boom phase by the Austrians unlike the classical economists who keep trying to evade the bust phase. The Austrians are of the view of prevention of the boom phase. To help achieve that, the Austrian school believes in an inelastic supply of money.
Since the major reason for credit expansion has been fractional reserve banking, the Austrians have always argued for a suppression of the same. However in the present monetary framework, attempting to do something of that sorts is not possible. Another aspect to the solution is that if FRB needs to be remove, that removal should be worldwide. Unless that happens the money supply will remain elastic.
This is where Bitcoins start helping! Bitcoins have a predetermined inelastic supply of money which is in-line with the economic thought of Austrians. As it is a virtual instrument, it is free from legislative boundaries and regulations. Further the biggest advantage is the worldwide implementation. Moreover the fact that no depository is required for safekeeping and verification of bitcoins, there is no need for bank deposits. One more advantage which also helps in eliminating FRB is that Bitcoins have a built in money transaction system. That removes any financial intermediaries required for money transfer. Therefore we can easily say that Fractional reserve banking is unlikely to develop in the Bitcoin economy and hence this may help in the ending the ever increasing supply of money.
Theoretically, the implementation of bitcoins is helping the views of the Austrian school come into existence. Even though it’s not yet money, Bitcoin has passed the thresholds that must be surpassed for anything to function as a medium of exchange. The first of these thresholds is emergence of price (which was originally based on the production cost of the commodity coinage). Second of these thresholds is the emergence of liquidity. Bitcoins being highly liquid easily crosses the second threshold. Third is critical mass of the network effect, where the demand for bitcoins generated only through its liquidity is self-sustaining.
There is no doubt that the Bitcoin network has proved its might and crossed all the obstacles required to make bitcoin as the medium of exchange, but still, bitcoins as money is at a very early stage of evolution. Although the services in the Bitcoin community are maturing, they are still plagued by high levels of uncertainty.
Due to its extremely low transaction costs, a monetary system based on Bitcoin is expected to have a money supply identical to the monetary base, i.e. inelastic. This is in compliance with the Austrian Business Cycle Theory. Bitcoin provides a golden opportunity to switch to an inelastic money supply without any legal reform, and without having to address fractional reserve banking. In this respect, it is superior to both gold and fiat money. Having said that, it is quite possible that bitcoin as itself may wither away but the concept that it has been introduced is here to stay and evolve. On the other hand if it sustains and grows, it will be interesting to see the paradigm shift it may bring to the world.