With the price of Bitcoin up from $5K in March to $40K last week, now down to $34k, there is much discussion whether “crypto-currencies” are “money,” a new asset class – or what exactly? Looking at its fundamentals, my answer is that – at best – it may turn out to be a rare coin, such as the gold Aureo Medallion of Massenzio (of which only two are known to exist), that the Numimatica Ars Classica auction firm sold for 1.3 million Swiss Francs on April 5, 2011.
Start with Satoshi Nakamoto, the ingenuous person (or group) who designed the basic blocks upon which Bitcoin is built. Among the assumptions he made, the goal being to replace “trust” in present financial exchange system, were the following: 1). That changes in the money supply need to be rule-based, not discretionary. 2). The historical record of all transactions needs to be publicly available and thus broadly verifiable; 3). There is no centralized authority that changes the rules and could enforce them.
Executing the extremely complex algorithm the “mining” of Bitcoins, requires according to Canada’s Energy Regulator (CER) an estimated 71.12 terrawatt-hours per year globally — equal to 11 per cent of the electricity generated in Canada in 2016, an average Bitcoin transaction uses more electricity than a Canadian home does in a month. This is why operations are up North in Quebec: Both cheap electricity and cold, needing less AC to cool the computers. Still, if the technology could replace “trust” in governments, central banks, and financial intermediaries sustained by armies of bureaucrats, economists and political appointees, these costs may be negligible.
It cannot.
The assumptions are reminders of those underlying the rigid “monetary rule” theory associated with the late Milton Friedman - one that in his later years he discarded repeatedly, and most notably in a Financial Times interview in 2003, stating that “'The use of quantity of money as a target has not been a success… 'I'm not sure I would as of today push it as hard as I once did.” (7 June 2003), and when commenting on Japan’s Central Bank policy in December 1997 in the Wall Street Journal: “Judged by monetary growth, they were too little too late, raising monetary growth from 1.5% per year in the prior 31/2 years to only 3.25% in the next 21/2.” The implication is that if you want prosperity, money supply must sometimes grow at different rates.
The flaw in Nakamoto’s ingenuous construct, as well as in younger Friedman’s model, is that the “trust” people want in a currency is not a matter of a fixed rule, but that it is being used reliably for shorter and longer term contractual agreements. Contracts – not logical constructs - are the basis on which the expansion of commercial societies depends. The evidence is sharp and clear that the greater the volatility of the unit of account, the less contractual arrangements are made. Although societies with deeper financial markets can adjust to this volatility by inventing a wide variety of derivatives to overcome it, this makes financial transactions more expensive, and, at times not feasible; drastically reducing prosperity and, at times, bringing political havoc (as I document in my books referenced in the endnote).
To sustain “trust” in the unit of account, volatility must be mitigated – and this requires an “elastic money supply.” The supply responds to changes in the volume of commercial transactions – though must be anchored so as to prevent wild and abrupt changes. If the Bretton Woods agreement did not eliminate two important clauses – it would have been a system that was designed to achieve just that. The clauses required that countries with trade surpluses “commit” to expand domestically and liberalize imports. Otherwise, these countries with prolonged trade surpluses would be penalized by limiting purchases of their exports. Another clause provided for occasional, one-time devaluations once a “fundamental disequilibrium” was identified. Even when adopted in Europe for a short while in the 1950s, these clauses were never acted upon.
It is easy to show that you do not need then, any sophisticated technology to stabilize currencies and sustain trust. After all, there are many "moneys" in circulation, both domestic and others foreign. We have $100, $10 and $5 bills, quarters and dimes too, and an array of foreign currencies circulating. Yet U.S. denominations stay in fixed relation one to the other, whereas others fluctuate in the +/- 50% range, one relative to the another.
Ask then: Why can the $10 bill always be exchanged for 40 quarters, whereas it varies daily in terms of how many foreign units it can be exchanged for? After all, the demand for the $10 bills and quarters fluctuates. With the move to digital exchanges the demand for paper and metal currencies have been dropping at differing rates. Yet the value of quarters relative to $10 bill does not change: As fewer coins are being used, they get returned to the central bank, which perhaps sell them as scrap metal, issuing $10 dollar bills instead, or, depending on velocities, perhaps nothing.
This same process can work for any two currencies of two different countries. If people decide that they intend to spend less in the U.S., they show up at a bank or brokerage house and ask to exchange their unwanted U.S. dollars for, say, Euros. The Fed notices that the demand for the U.S. dollar decreased, so it absorbs the unwanted U.S. dollars by selling U.S. denominated bonds on the open market (or sells Euros or Euro denominated bonds).
The exchange rate between the two currency spheres stays stable - just as the "exchange rate" between the two U.S. denominations do. Technically, the value of the Euro to the U.S. dollar can be as easily fixed as the value of the one U.S. denomination relative to another. The answer to the key question - “Why do so” - takes us where the Bitcoin model started: confidence in sustaining the values of contractual agreement.
Yet – and this the flaw in rigid monetary rules and in Bitcoin’s chances of being “money” - as political and legal institutions stabilize, incentives for expanding commercial transactions do so too. The expansion requires elasticity in the money supply so as to sustain the unit of account in which the contracts were set. You cannot expand commerce with contracts set in Bitcoins valued $5K in March and $40K in January. Commerce suffers if exchange rates go up and down 50% one relative to another as the Euro and Canadian dollar have done during the last few years.
This recognition of the link between stable exchange rates and expansion of commerce – both requiring law and order (whose achievement over the long haul have always and everywhere required political negotiations, compromise and civil discourse – not guillotines) - is missing in the international monetary system today. It is one reason for the financial havoc surrounding us, and for the large expansion of the financial sector, draining bright brains from other sectors. Contracts are shorter; companies pay substantial insurance fees and derivative contracts are in the trillions, so designed that companies would stay closer to their line of business and avoid exchange-rate troubles. And investors have been losing substantial amounts by holding bonds in unexpectedly devalued currencies, which are a consequence of bad governance.
Briefly: Bitcoins’ inventors have offered a valuable service by bringing fundamentals of money in focus: Why constraining money supply matters, and also – with their two other assumptions – why we need accountability and transparency in monetary affairs. Its founders made one basic mistake, however: Rigid models do not fit commercial societies. Bitcoin’s supply is fixed, it cannot be changed, and as such cannot serve as “money” in an expanding commercial society.
However, Bitcoins are scarce and its founders have been pioneers in the crypto-currency sphere. This may give them collector item value – as some Ancient Roman coins have. The greater eventual value in the Bitcoin venture may be the block-chain technology behind it that will help ensure accountability in a range of commercial activities, substituting for a range of intermediaries.
