Why Crypto shills are shilling for a Shilling Somali style

Cryptocurrencies are the new gold rush. The granddaddy of them all, Bitcoin, reaches new exchange rate highs (in US dollar terms) every day, and the financial and technology press can’t get enough of stories of ICOs (Initial Coin Offerings).

From the perspective of computer science the technology behind them is impressive and fascinating. However, there can’t be many people who get as excited as me reading about advances in the implementation of Bloom Filters or the optimal parallelisation of SHA–256 hash functions. So what gives these things their value?

Bitcoin sprang up out of the Great Financial Collapse. There have been many attempts at electronic cash previously, but Bitcoin made the breakthrough into the big time by appearing at the right time with the first implementation of distributed ledger technology. A bandwagon formed amongst the disillusioned who wanted to swap their government currencies for this new electronic wonder and trade a little in it. At which point the middlemen moved in.

Once the exchanges into US dollars appeared Bitcoin started to spring into life. Whenever you look at Bitcoin websites you’ll note that the prices are usually expressed in USD, not in Bitcoin. The crypto-currencies have more in common with barrels of oil than actual currencies.

This is where the modern money viewpoint comes in. The value of the token derives initially from what you have to do to get it. Bitcoin hands out new bitcoins to ‘miners’ about every 10 minutes. A miner is a computer running the Bitcoin algorithm. Somebody has to make that computer, install it, supply it with Internet and electricity — none of which is really for sale in Bitcoin. So you buy all this stuff with actual money, put it in place to mine Bitcoin, then sell the Bitcoin for actual money.

Consequently, the value of Bitcoin in USD terms ends up being driven by the cost of producing the Bitcoin. Bitcoin is trading on its value as a commodity.

This sort of system is not unique. After the Somali central bank collapsed in 1991, Somali Shilling notes continued to circulate as an exchange medium, but their value in USD terms dropped to 4 cents — which is the price it costs to create a new note.

Bitcoin works in a similar manner, but provides a more interesting experiment, because the cost of production is variable. The more you try to produce, the harder it becomes to produce anything and the more computing power you have to throw at the problem. That means the more USD you have to use to get the equipment and therefore the more USD you will require before you will sell your mined Bitcoins. So as technology productivity improves the system adapts and there is still only one award every 10 minutes.

And of course there are now many cryptocurrencies in existence using the same ‘proof of work’ approach. Bitcoin may have a limit of 21 million tokens, but if you have lots of cryptocurrencies then this fabled ‘inflation control’ mechanism dies in a fallacy of composition. There’s always another coin. So when Bitcoin gets too hard to mine, miners switch to a different token and mine that. At which point Bitcoin reduces its difficulty and the miners switch back.

All of this leads to an interesting dynamic in the marketplaces of these tokens that tends to drive the price of them higher as more equipment is deployed. That then pulls in the pure speculators who drive the price higher still, which then draws in more powerful equipment.

However, reading the financial press you quickly realise there is a chicken and egg question here. Is it the increasing computing power that is driving the price up, or is it the price going up that is driving the increase in computing power? Fortunately the design of Bitcoin allows us to answer that. Every four years there is a Halving Event where the amount of Bitcoin you get every 10 minutes halves. On the 9th July 2016 the 10 minute reward dropped from 25 Bitcoins to 12.5 Bitcoins. The financial press was primed for armageddon in the Bitcoin market. So what actually happened in USD terms?

Here we have a speculative flourish which will have delivered miners a windfall and then dropping back to a persistently higher level as that windfall gets used up.

As ever in a gold rush, it is those selling the shovels that make the money.

What does this mean for Modern Money?

You’ll note that I haven’t mentioned taxes once in this piece so far. So what does Bitcoin mean for the ‘taxes drive currency’ view?

There is a long version of that soundbite. If there is no authority to drive the value of a currency it drops to the commodity value of the token. The authority then becomes whoever has the capacity to issue the commodity token and exchange it for equivalent real work. In terms of Bitcoin and the Somali Shilling the real equipment necessary to create the commodity is only available outside the currency area. So once the underlying real exchange becomes profitable, unsurprisingly somebody ‘mines’ a Bitcoin or prints a note. The effort to do that is then exchanged for equivalent effort from the currency area in a commodity exchange. What is supposed to be a separate currency just becomes a commodity priced in whatever currency you can use to get the creation equipment (usually USD).

It’s pretty clear from the marketing around Bitcoin and the cryptocurrencies in general that the ‘currency area’ they represent is heavily dollarised. You cannot sustain an existence exclusively in Bitcoin. It has been the same in Somalia which is heavily dollarised, one of the world’s biggest users of mobile money in dollars, and gets huge remittances from across the world in US dollars.

So really it is the circulation driving the US dollar that has driven these derivatives. And the last time I looked Trump hadn’t cancelled all the taxes.

Additionally, since the reintroduction of the central bank in Somalia, some enforcement of the 10 year jail term for counterfeiting and the imposition of a small amount of taxation from the new Somali government, the Shilling exchange rate has shifted, with the Financial Times reporting that the Somali Shilling was the worlds best performing currency in 2014, beating even the fabled Bitcoin.

The value of a currency is a function of what somebody has to do to get that currency. So in the case of Bitcoin people have to do work to create it, and therefore the value becomes a function of that work. When the amount of work doubled, the exchange value of Bitcoin moved in relation — much like the UMKC Buckaroo.

But it didn’t move straightaway. There was a period of speculation and consolidation as the new price level was discovered. And some people profited from that. Again the same can be said for the Somali Shilling. After the authorities collapsed it took a while before rates settled, which is hardly surprising given that price information in an ex war zone is somewhat scattered.

The big question, however, is why people would want to exchange real currency for Bitcoin? Probably for the same reason pension funds wanted to own aluminium ingots through the commodity boom — to sell onto the greater fool. Initially Bitcoin was clearly driven by the anarchist and libertarians that lurk in the corners of the tech sector. But once the exchanges got started and the boiler-room tactics were deployed more and more people have been sucked in — scared of missing the next big thing.

Clearly the hot money has arrived this year. The transaction flow is increasingly speculative rather than real, meaning even less stuff is available in the Bitcoin currency zone. With no mechanism to prick the bubble by buying up the hot money, and with built in deflation from lost Bitcoins as well as the regular halving event, the bubble effect is going to be huge.

So not only is enforced taxation required to ensure wide and continuing acceptance of a currency, but you need an active approach to monetary management to neutralise hot money flows and keep prices stable. That ‘strong currency’ doesn’t appear to be quite the boon most in the mainstream believe.

Crypto-currencies are the emodiment of the metallist religion. Somehow currencies, rather than being a tokenised way of recording and settling promises between people, are actually real things you can kick . Their desperate attempts to bang that square peg into a round hole are currently attracting vast amounts of Venture Capital. The good thing is that it kicks off lots of real world simulation experiments that provide interesting data. (10 WilsonCoins to the first person who can spot the ramp opportunities in this design. Hint: mainstream theory has no oligopolies and nobody holds currency for vanity or insurance purposes).

The peer-to-peer transaction limits of Bitcoin are stopping its growth resulting in price rises in the transaction fees. Now those developing the software are looking at creating a hierarchy in the network where ‘supernodes’ handle the clearing for lots of underlying blockchain transactions. Supernodes is probably an unfamiliar term to most of you, but you might know them by their other name.


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