Behavioural Innovations Society
Joining the dots: Bitcoin, blockchain and behaviouralism webinar
On 24 October 2021, the Behavioural Innovations Society hosted behavioural finance pioneer Professor Hersh Shefrin for a discussion over Zoom.
Hersh Shefrin is the Mario L. Belotti Professor of Finance at Santa Clara University. He is one of the pioneers in the behavioral approach to economics and finance. Together with Richard Thaler, he developed an economic theory of self-control, which the Nobel committee emphasized in awarding the 2017 Economics Nobel to Thaler. He is the author of eight books and numerous articles about how behavioural ideas impact real world decisions. In 2009, his book Beyond Greed and Fear was recognized by J.P. Morgan Chase as one of the top ten books published since 2000.
Hersh received his B.Sc. (Hons.) degree from the University of Manitoba, an M.Math degree from the University of Waterloo, and his PhD from the London School of Economics. He also holds an honorary doctorate from the University of Oulu, Finland. He is frequently interviewed by the press, writes a monthly blog post for Forbes, and has intermittently written for The Wall Street Journal, The Huffington Post, and VOX. His Twitter handle is @HershShefrin.
The moderators, Duncan Martin and James Newport, opened the panel by polling the audience on:
· Bitcoin transaction levels
· Bitcoin energy consumption
Attendees on average overestimated Bitcoin transaction levels and estimated power consumption correctly.
Hersh then took us through his presentation. He opened with Satoshi Nakamoto’s “incredible” 2008 paper ”Bitcoin: A peer-to-peer electronic cash system.” In his view, the paper kicked off a revolution in payments technology, reflected in the value of the crypto universe across three domains — activities, assets and infrastructure. This is now estimated at $2.6trn, up from $16bn five years ago (a 257% CAGR). Bitcoin accounts for 92% of that value.
Hersh described the work of his doctoral advisor and mentor at LSE, Frank Hahn. Frank was thinking about the microfoundations of money at that time, in particular transaction costs and the role of information. Two of Hersh’s early publications contributed to the literature on these microfoundations, and these topics were essential for creating the theoretical foundation for analysing the cryptocurrencies we see today. In particular, Nakamoto’s paper was concerned with transaction costs.
Frank posed what has become known as the “Hahn problem:” why are people willing to hold money that has no intrinsic value? This was the central topic of his 1981 book, “Money and Inflation,” which was critically reviewed by Hyman Minsky.
Frank’s work built on earlier research. Hersh mentioned a prior paper by Radford in Economica in 1945 analysing the use of cigarettes as currency in WW2 POW camps. He also referenced a 2012 book by Russ Starr “Why is there money?”
Hersh then transitioned to his second key topic: psychology, and bringing a behavioural perspective to economics.
In his opinion, both Keynes and Minsky were excellent behavioural economists. Keynes in particular uses the word “psychology” a lot. Throughout his works, he talked about optimism, confidence, and sentiment.
Keynes lived through spectacular economic progress, including electrification, and the stock market bubble of the 1920s. The development of that bubble and its reversal after 1929 were basically psychological phenomena.
Hence when Hersh and Richard Thaler started working together in the 1970’s, they were reviving a behavioural tradition rather than starting from scratch. Their most significant work was on self-control, published in 1977. In this paper and those that followed, they elaborated the “planner/doer” model, in which the brain’s cortex was the “planner” and the limbic system the “doer.”
In 2017, by which time both Hersh and Thaler looked a little different, when Thaler received the Nobel prize, Per Stromberg highlighted the work that Hersh and he had done together — the “planner/doer” model. Stromberg felt that the work had “liberated Adam Smith … by resolving the tension between his two great works the “The theory of moral sentiments” and the “The wealth of nations.”
The third topic that Hersh addressed was new payments technologies. Joining the dots again, Hersh pointed out that, like the stock market boom in the 1920s, Bitcoin is heavily electricity dependent.
Hersh walked through some salient statistics, including:
· There are over 1bn credit card transactions per day globally, while Bitcoin’s blockchain handled only 400,000 (0.04%). Ethereum’s ledger handled 1.1m.
· Processing these 400,000 transactions consumed 0.5% of the global electricity supply. In contrast, the clouds run by Google, Facebook, Amazon, Microsoft and Alibaba consumed only 1%.
· So half the power usage of the entire public cloud handles 0.04% of the volume of credit card transactions
· The Achilles heel of Bitcoin is its power consumption. It’s simply not scalable to the kinds of volumes required to displace cards.
Hersh co-wrote a paper in 2018 that established that Bitcoin was priced like a high sentiment beta stock. A high sentiment beta stock can’t serve as an effective store of value.
Hersh then asked the question: is Bitcoin good for anything? By way of analogy, Hersh pointed out that the average citizen of the US state of Massachusetts spent over $2000 per year on the state lottery. Most people find this surprisingly high. It is however indicative that people like certain types of risk. That’s what Bitcoin is attractive for — gambling!
Returning to Minsky, in 2016 Hersh co-edited a book “The global financial crisis and its aftermath.” Hersh authored the chapter on “Assessing the contribution of Hyman Minsky’s perspective to our understanding of economic instability.” He feels that Minsky provided the framework for thinking about financial instability, and while he died in 1995, his work lived on — and was prophetic for the GFC
Minsky’s framework held that were different types of finance: hedge, speculative, and Ponzi. Hedge finance is “what we teach in university.” Speculative and Ponzi financing he referred to as financial innovations which were characteristic of “fringe finance,” roughly synonymous with what today we call “shadow banking.”
Tether is Bitcoin’s cousin, essentially a crypto flavour of shadow banking. Unlike Bitcoin it is in principle backed by dollars. However, Bloomberg reported in 2021 that the extent to which Tether is backed is far from clear. If all the Tethers in circulation were backed one to one with dollars, Tether would be one of the largest banks in the world. Instead it’s an unregulated offshore company, not even a bank.
Hersh then took questions, acknowledging that this is such a new field that he wouldn’t have all the answers.
“How will Blockchain change people’s behaviour?”
The current international system for money transfers through SWIFT is notoriously inefficient. Bitcoin has made it much easier to conduct cross-border transactions. It’s cheaper but also easier to conduct criminal activity.
Blockchain is much more secure, in that it makes transactions immutable. Property rights receive more protection; harder to steal. Blockchain will enable many types of transactions eg buying and selling houses.
Such uses could happen in CeFi (private blockchains, possibly run by Central Banks) or DeFi (decentralised public blockchains).
In general people around the world will have more options than they had before, creating opportunities for different behaviours. Some risks will expand, for example tracking down illicit behaviours.
“Which behavioural aspects of Bitcoin make it so appealing?”
First, the democratising, decentralised aspect. Libertarians, such as Elon Musk, are big fans.
Second, the volatility aspects. Bitcoin provides an opportunity to speculate. In this regard, it is much better than a premium bond! There’s a deep behavioural need to have exposure to “winning big.” The excitement of a random reward, associated with dopamine flows.
“What risks does Bitcoin pose to governments?”
Bitcoin is potentially a competitor to government backed fiat money, and therefore to control exercised by that country’s central bank. Although in the case of El Salvador, Bitcoin is recognized as the coin of the realm, and that country’s government buys and sells Bitcoin, sometimes with a view to impacting its price.
Bitcoin is unbacked, so there’s no systemic risk in the traditional sense. It allows the financing of illegal activities. For example it’s the “coin of realm” for ransomware. Overall it makes crime easier.
Tether is now like a bank. But completely unregulated, based in Caribbean. Only an illusion of backing. Tether can mint as much Tether as it likes. If it fails, it’ll look like a bank run, without deposit insurance.
“Could you speak to the view that “they crypto system is a Trojan horse with a new financial system inside?”
This is partially true. Crypto was designed as a transaction technology but has become a casino. Both are attractive to individual investors. This attractiveness sets the stage for technological diffusion, as crypto technologies compete with their traditional central bank-based counterparts.
Blockchain will change the financial system materially. It’s here to stay.
“How Bitcoin related to Behavioural Finance, and what is its impact on the digital currency system?”
Behavioural finance is about the impact of psychology on the entire financial landscape. Bitcoin is part of that landscape.
Given its appetite for using electricity, Bitcoin has the potential to significantly impact the climate. We need to understand how significant.
Psychology gets us to improperly attach importance to things; to get priorities wrong. So we need to understand that we’re prone to these mis-assessments, and then try to nudge ourselves to getting the priorities right, to be as close to rational as possible.
Duncan and James thanked Hersh for his time and insight and the audience for their interest and questions.
