On Austrian Economics and Bitcoin
How Bitcoin fits into the Austrian Business Cycle and Monetary Framework
Austrian economics and Bitcoin have been tied together since the very early days of the Bitcoin community, largely because they both draw in a libertarian-leaning audience. In fact, I first became interested in Bitcoin because of my passion for Austrian economics. Since then, Bitcoin and crypto have seen a huge change in their communities, and the prevalence and understanding of Austrian economics has since decreased significantly in crypto circles. As we are now in a time of rapid change and economic panic, much like when Bitcoin came into inception, it is fitting to bring Austrian economics back into the spotlight.
Early Bitcoiners and the Cypherpunks
When I first entered the Bitcoin space in 2014 by joining the Bitcoin Association of Berkeley, now known as Blockchain at Berkeley, many of the people I encountered were drawn to the concept of Bitcoin because of its anti-establishment nature as a decentralized currency. At the time, Bitcoin was seen not only as digital gold but also as peer-to-peer cash, in the sense that startups were mostly building products like micropayments and payment processors for Bitcoin and had hopes that Bitcoin would be used for payment with everyday things like a cup of coffee. Nowadays the digital gold narrative is stronger than the p2p currency narrative, as price volatility, transaction fees, and concerns about deflation have possibly made the goal of becoming a global p2p cash unviable. But this does not mean that the libertarian culture of the Bitcoin community has died; nor does it mean that everyone has given up on the dream of hyperbitcoinization and Bitcoin as p2p cash. New developments like Lightning Network have certain communities hopeful for the p2p cash use case, though the technology itself doesn’t solve the problem of deflationary expectations.
Bitcoin itself was in a long line of other previous attempts at creating a digital currency and was firmly within the ideology of the Cypherpunk Movement. Many Bitcoiners are fully aware that the Genesis Block’s coinbase contained the headline “Chancellor on brink of second bailout for banks.” By including this headline, it was clear that Satoshi released Bitcoin precisely because he had a problem with the existing financial system and corporate welfare. This anti-status quo attitude and the economic design of Bitcoin were potentially influenced by hard money proponents, many of whom belong to the Austrian School of Economics.
Austrian Business Cycle Theory
The Austrian School of Economics is a heterodox school of economics that is based on methodological individualism, the concept that social phenomena result exclusively from the actions and choices of individuals. The school of thought is typically associated with libertarianism and classical liberalism. Although it is typically rejected by mainstream economists who depict it as rejecting mathematics and modeling in economics, the Austrian School actually reflects a diverse set of opinions. Most of the school actually shares quite a bit in common with most of the economics profession, to the extent that one could argue the label “Austrian” no longer has any significant meaning. Yet, there are still certain ideas that are unique to the school of thought, including the heterogeneous nature of capital and Austrian Business Cycle Theory.
Austrian Business Cycle Theory (ABCT) explains why many Austrians view commodity-backed (typically gold-backed) currency as superior to fiat currency. Put in layman’s terms, ABCT claims that excessive inflation of money supply, typically driven by a central bank or the government, results in an artificial boom that ultimately results in its own bust.
This boom is driven by malinvestment, which is investment in the wrong lines of production because of a distortion in price signals. This malinvestment is caused by excessive expansion of credit, often in the form of artificially low interest rates created by the central bank. In a simple example using a discounted cash flow model, one can imagine that with an interest rate set low by central banks rather than one created by an organic market with its natural demand and supply of capital, investments are made that otherwise would not make sense. This is explained excellently by Caitilin Long here. Typically, these failed investments can only be understood retrospectively, as most investors in the moment are deceived by the continued expansion of credit and only discover their investments are unsustainable when the bust begins.
The “bubble” occurs as malinvestment results in an inflation specifically in long term capital goods. Entrepreneurs, in a bid to take advantage of credit expansion and not be outspent by their competitors, borrow money for projects that are actually unprofitable in the medium to long run. Eventually, the bust will occur when banks become risk-averse to the accelerated pace of the boom and consumers re-establish their preferences of consumption and saving at the prevailing interest rates. However, the crisis can be delayed by continuing to pump new credit into the economy, often fueled by the central bank. By delaying the inevitable, the over-leveraging becomes even more severe and thus, the adjustment period becomes more difficult with even more bankruptcies. When the crisis onsets, the economic structure is also adjusted as the recession liquidates the unsustainable investments and capital is re-allocated from the malinvestments to the factors of production that are actually profitable. This bust period is a difficult time for the public, as wages are depressed and unemployment rises when this period of economic adjustment occurs. And as Mises notes, the psychological effect of this all is arguably just as important or even greater than the real-world effects. While society is optimistic and joyous when the boom period occurs, it is equally as or even more despondent and depressed when the recession hits, only to forget this feeling when the boom begins again.
The Austrian View of Money
As mentioned above, ABCT explains why many Austrian economists support an alternative to the existing monetary system, usually proposing the gold standard or free banking as better monetary systems. To understand this, it is important to discuss the Austrian view of money itself, or specifically the Misesian view of money.
Austrians dismiss the idea that money has value because the government gives it value and rather suggest that the value of any given currency has some market-driven provenance. Mises proposed the Regression Theorem, which holds that “no good can be used as a medium of exchange which at the very beginning of its use for this purpose did not have exchange value on account of other employments.” Essentially, this means that money currently has value because it had prior exchange value, which regresses to some origin when it was useful for a purpose other than money. In the case of gold, which generally was globally used as money until the rise of fiat currencies, people valued it for its own sake rather than as a means of exchange during a hypothetical previous age of barter. When governments abandoned the gold standard and moved entirely to fiat money, most prominently with President Nixon’s ending of the Bretton Woods system, fiat currency still regressed to commodity-backed currency and retained its value. However, in the Austrian view, the rise of fiat money meant the ability for the central bank to inflate its currency to any extent it wanted to, thus exacerbating the boom and bust cycle.
Bitcoin as Money
As a technology and an asset that came out of the Global Financial Crisis, Bitcoin “solves this,” as the meme goes. When Bitcoin first came into existence, many Austrian economists derided it as fiat “magic internet money.” However, certain Austrians like Jeffrey Tucker were rather receptive to the idea of cryptocurrency and began to write about how Bitcoin potentially qualifies as sound money and is firmly within the ideology of Mises and Hayek. Inspired by his writings, I myself gave a talk on the subject to the Bitcoin Association of Berkeley in Fall 2015.
Since the very beginning of Bitcoin, notable individuals in the community like the late Hal Finney have discussed the merits of Bitcoin as a reserve currency or asset in a system of free banking, in which banks can issue their own currency. Many Austrians initially criticized Bitcoin, because they felt it came out of nothing and had no use as a commodity in of itself, thus breaking the Regression Theorem and rendering its value baseless. However, Jeffrey Tucker has shown that the value of Bitcoin derives from itself, in the sense that it is both a technology and a currency at the same time. While this was perplexing for many economists, especially those that did not understand the technology, Bitcoin was the first currency to be both a payments solution and unit of currency at the same time. As such, the utility of the blockchain provided it value before it ever became a medium exchange, which was months after its launch, and thus actually confirmed Mises’s Regression Theorem in real life.
It is also interesting to note that the Austrian belief in the gold standard requires governments to institute it, which will likely never happen. Hayek in the 70s came to believe in the denationalization of money, which essentially is the free banking system mentioned above. Bitcoin and cryptocurrencies are likely the first currencies that put this Hayekian ideal into action in the modern era.
Assuming that Bitcoin indeed was adopted as a world reserve currency, this would prevent the artificial distortions of money supply and credit associated with central banking. As a decentralized currency born out of the free market with a decreasing growth of money supply over time, Bitcoin fundamentally fits the characteristics of sound money according to the Austrian School.
Criticisms of Bitcoin as Money
While Bitcoin fits into the Austrian framework quite well, there are many criticisms from other perspectives of Bitcoin becoming a new global currency. These criticisms are largely the same as criticisms of the gold standard, though Bitcoin is even more limited in supply than gold and as such, the issues are likely exacerbated. The most commonly raised problem is that if Bitcoin were to become a reserve currency, its limited supply of 21 million would result in deflation, which is typically seen as economically disastrous by most economists. Deflation is often associated with recessions and poor economic growth. Mainstream economists claim that in an extended deflationary period, demand for goods and services decreases because consumers expect future prices to drop. As demand drops, this has a multiplier effect across the entire economy, thus further depressing it.
Another criticism from mainstream economics reflects the complete opposite view of Austrian economics: having an inflexible supply means the inability to conduct monetary policy and adjust money supply for economic changes. Keynesians argue that money supply should be increased during bad economic circumstances to stimulate aggregate demand. Especially when economies face significant illiquidity, Keynesians take the approach that the central bank should actively lower interest rates and increase money supply to increase investment and consumption. This, of course, in the Austrian perspective contributes to the boom and bust cycle and prevents the liquidations of malinvestments, thus leading to potential larger problems in a future economic cycle. Generally speaking, global central banks have largely followed such a policy; however, they have failed to live up to the flip side of Keynes’s views, which look to the government to adjust fiscal and monetary policies when the economy recovers.
Other economists believe that for a modern economy, money supply should adjust to match changes in production. This viewpoint is put forward by Monetarists, most prominently Milton Friedman, who argued that money supply should grow at a rate commensurate with the growth in productivity. Friedman argued that the inflexibility of the gold standard (and by extension, of Bitcoin) meant there would be no way to counteract deflation and reduced liquidity during recessions. He suggested that the largest reason for the extent of the Great Depression was the failure of the Federal Reserve to act to counteract deflation and the drop in money supply from 1929 to 1933. Meanwhile, the gold standard does not allow the central bank to be flexible with money supply, nor does it allow it to set money supply growth at a consistent rate due to fluctuations in the gold market.
Of course, sound money proponents have responded to these concerns about the concern of deflation. They claim that deflation does not, in of itself, cause investment demand to decrease as the absolute future price levels are not so much important as spreads between sales and costs, which will likely not change much from deflation. Hard-money advocates can also point to the late 19th century in the US, which experienced both deflation and rapid economic growth concurrently, to show that deflation is not actually always negative for the economy. Furthermore, Austrians argue that the inability of central banks to adjust money supply according to their discretion due to a Bitcoin or gold standard is actually a good thing, as it prevents the exacerbation of the boom-bust cycle. In fact, one can even suggest, like Alan Greenspan in one of his early writings, that inflation and deficit spending are actually a scheme for indirect taxation, as central banks can inflate away the debts of their nation and transfer wealth from creditors to debtors.
Bitcoin in a Time of Crisis
In the past Global Financial Crisis and potentially in the current Covid-19 crisis, we can see what Austrians would call failures of the monetary system and the role for Bitcoin as an alternative asset. The previous GFC in 2009 vindicated the Austrian school of thought, while it caught many mainstream economists and Wall Street professionals off-guard. The subprime bubble was directly catalyzed by the Federal Reserve’s easy money policy from 2001 to 2006, as well as poor real estate regulation from the government. Low interest rates resulted in significant malinvestment in the economy. This was particularly concentrated in real estate, because the government both decreased the minimum down payment for a mortgage loan and deliberately tried to expand access to credit to the low-income, despite their unlikelihood of actually being able to pay such debts. Meanwhile, Fannie Mae and Freddie Mac continued to expand their purchases of loans and exacerbated the real estate bubble. All these factors, driven by Federal Reserve’s increase of money supply as the main driver, resulted in the subprime bubble that precipitated the GFC. The failure of mainstream economists to see the signs of an economic bubble brought renewed interest to the Austrian school, even driving certain political movements like the Ron Paul Revolution.
Since the GFC, Austrian economists have been warning of the consequences of global central banking policy, suggesting that quantitative easing and negative interest rates would result in hyperinflation and an even greater financial bubble. Of course, we did not see hyperinflation in the US. However, we have seen a new financial bubble emerge, as stock markets are overvalued, a tech bubble is potentially seeing the beginning of the end, and real estate markets are around their peak. Money markets actually began showing signs of cracking in September 2019, as the volatility and spike of money markets forced the Fed to act and engage in overnight repo operations. These conditions set up the economy for a bust, though the timing was difficult to foresee.
Then came Covid-19 out of left field. The coronavirus has absolutely devastated the global economy, forcing a sudden massive increase in unemployment and likely forcing many small businesses to shut down. It has also led to the largest stimulus bills in history and unprecedented action from the Fed, as we noted previously in Efficent Frontier’s newsletter and blog. So what does this all mean in the context of ABCT and Bitcoin? It may be that the coronavirus is the black swan event that triggers the deleveraging and bust of this cycle. Even if the pandemic were to end in the coming months, perhaps the economic shock from the disease may cause a prolonged major recession, as opposed to the rapid recovery hypothesized by Goldman Sachs.
In the beginning of the article, we discussed the evolution of the perception of Bitcoin from digital p2p cash to digital gold. This is important, because should this perception of Bitcoin as an alternative to gold hold a wider sway over both institutional and retail investors, it may cause capital flight into Bitcoin during a financial panic. As we noted before, interest in Bitcoin has increased since the coronavirus panic and the subsequent policies from the Federal Reserve. Yet, if you do a simple Google search of Bitcoin and coronavirus, you will find two diametrically opposed camps on the effect of coronavirus on Bitcoin’s price, with markedly different sentiments on every other article headline. Although many in the Bitcoin community and the broader finance community remain bullish, it is impossible to predict the trajectory of Bitcoin from here the true net effect of the coronavirus crisis on Bitcoin remains to be seen.
As shown above, Austrian economics and Bitcoin have been connected since the very beginning of Bitcoin’s existence. I myself started my crypto journey in college, when my passion for Austrian economics led me to Bitcoin. Since I entered the space, cryptocurrency markets have changed vastly and the prevalence and understanding of Austrian economics has since decreased. Hopefully this article illuminates the connection between the two and demonstrates the potential value of Bitcoin within the Austrian business cycle framework. As we enter a period plagued by coronavirus and uncertain economic conditions, an understanding of the economy, financial markets and Bitcoin’s role in them may be more important than ever.
