A tale of bitcoins and $500 suits: Will a rising-value currency not be used?

A common objection to bitcoin is that as its value rises, and especially if it is generally expected to keep rising due to its restricted and inelastic production characteristics, “people will never spend bitcoins; they will just hold onto them waiting for the value to go up, and therefore bitcoin cannot succeed as a currency.”

This fallacy commits a number of errors of economic reasoning. For example, it takes one factor, a presumed desire to save bitcoin in the expectation that its exchange value will rise still higher in the future, and treats it as the only factor, even though many others are also in play. It also assumes that all people are the same all the time and that their value scales never change. It treats a person’s entire holding of bitcoin as an indivisible block, or “hoard” (Smaug’s?), ignoring the possibility of marginal decisions about the use of smaller amounts relative to a total balance and specific decision contexts.

Playing directly opposite this supposedly monolithic motivation to hold for the indefinite future is the shift in valuations of a good relative to the value of a given bitcoin holding. As the exchange value per unit rises, the total exchange value of any given holding rises with it. To illustrate how this factor goes directly against the deflationary disuse story, here is a tale of bitcoins and $500 suits.

If Hayek has 100 bitcoins when the bitcoin price is $5, buying one $500 suit would leave him with one suit and no bitcoin. However, the same purchase with bitcoin at $50 would leave him with one suit plus a remaining balance of $4,500 worth of bitcoin. At $500 per bitcoin, he could get the suit and still keep a bitcoin balance worth $49,500. And so the story goes. Finally, at $5,000 per bitcoin, he could buy that same suit and still retain $499,500 worth of bitcoin.

The trade-off Hayek faces between the suit and the proportion of a given bitcoin holding that must be traded to obtain it varies with exchange value. As bitcoin’s exchange value rises (supposedly its fatal flaw as a currency), the cost of the same one suit as a percentage of Hayek’s total bitcoin holding declines, in the foregoing example, from 100% to 10% to 1% to 0.1%, as a direct implication. The choice between buying a suit with 100% of one’s bitcoin balance or with 0.1% of that same bitcoin balance is most dissimilar and it should be clear which of these two conditions is more likely to “stimulate” a retail purchase.

As the value of bitcoin rises, the position of one suit relative to a given unit of bitcoin on a given person’s value scale will tend to change in such a way that the same holder of 100 bitcoins might be increasingly likely, not less, to purchase a suit. This does not mean that other countervailing factors, such as a desire to delay spending in anticipation of a higher future exchange value are not also present. It means that the most oft-cited factor is not the only one and moreover that other important factors point in exactly the opposite direction of the deflationary disuse thesis.

Cross-posted at actiontheory.liberty.me.

"Bitcoin 2014 Panel: History of Money & Lessons for Digital Currencies Today" with time-based outline

Following the Economic Theory of Bitcoin panel on 17 May 2014 at the Bitcoin Foundation Conference in Amsterdam, I also participated in this one-hour panel addressing the history of money and lessons for digital currencies today (my own contributions start at 41:40). The varied topics included lessons from the history of the Netherlands, problems with the deflationary spiral argument, parallels to the early history of the oil industry, competition and types of centralization, historical circulation of multiple monetary metals and relevance for altcoins, and the role and operation of central banks relative to market competition and centralization versus decentralization.

Moderator: Ludwig Siegele (Online Business and Finance Editor, The Economist)

Speakers: Tuur Demeester (Founder, Adamant Research), Konrad Graf (Author & Investment Research Translator), Simon Lelieveldt (Regulatory Consultant, SL Consultancy), Erik Voorhees (Co-Founder, Coinapult)

1) Introductions

00:00–05:50 Introductions by each panelist

2) History of money in Amsterdam (Lelieveldt)

06:10–10:58 Lelieveldt: Amsterdam monetary history; water and community power more outside usual royal vested interests. Amsterdam Exchange Bank cleaned up confusion of many coins in circulation. Guilder was a unit of account without existing as a physical coin anymore, making it a virtual unit of account at the time. Human mind can adapt to and use many different things as currency.

3) Putting the “deflationary spiral” to rest (Voorhees)

10:58–19:07 Hyperdeflationary bitcoin economy hasn’t fallen apart. Opposite: more bitcoins spent when value is rising (wealth effect). Academics cite deflationary spiral as truism, but bitcoin shifts the burden of proof back onto supporters of the idea. Calling the gold standard “rigid” was a justification for control. Increasing the number of monetary units about as useful as increasing the length of an inch.

4) Parallels from history of the oil industry (Demeester)

19:07–28:18 Invitation to academics to launch altcoins representing their favorite monetary policy. Nothing else as disruptive as bitcoin in the history of money, but parallels with history of oil. Not approved by intellectuals or establishment. New innovations raise customer expectations. Academics may avoid taking bitcoin seriously for fear of ostracism from old paradigm.

5) Centralization, impact of licensing on competition, wealth transfer (general)

28:18–41:40 Multiple panelists and audience: Don’t waste time thinking about what (you think) bankers and others think. Oil and the internet were both fragmented originally, but centralization followed. What about bitcoin? Distinction between market-based centralization and coercive, legally privileged centralization. Wealth transfer, innovation, and social opinion.

6) Was the “gold standard” really the free market money of the old days? (Graf)

41:40–49:52 “Money production” an industry that can be examined ethically. Mining a specific service performed with compensation, but literally creating money “out of thin air” an illicit wealth transfer. Gold arrived at leading position through multiple government interventions. Litecoin as silver a weak metaphor. Question simplistic summary images as representations of actual history. [Here is a more detailed write-up on this topic that I posted after the conference: Gold standards, optionality, and parallel metallic- and crypto-coin circulations (21 May 2014)].

7) Q & A and discussion (general)

49:52–62:00 Central banks and money creation. Money another good in the economy or separate? Bankruptcy helpfully eliminates damaging institutions. New money creation leads to visible effects, but unhelpful for society overall; transfers wealth from some people to others. Trigger events for financial collapse? Dominoes collapse starting with weaker economies, periphery. Watch for rising interest rates.

“Bitcoin 2014 Panel: Economic Theory of Bitcoin” with time-based outline

It was an honor to be among the participants in this panel on 17 May 2014 at the Bitcoin Foundation Conference in Amsterdam. We addressed several issues that tend to recur in discussions of economic theory and bitcoin. The main topics were the regression theorem and bitcoin; bitcoin and the role of units of account and pricing; multiple value standards and the economics of altcoins relative to bitcoin; fractional-reserve banking, lending, and direct versus other-party control; and deflation and fixed versus elastic money supplies. I have added a time-based outline after the embedded video below to facilitate noting and locating particular topics.

Moderator: Jon Matonis (Executive Director, Bitcoin Foundation)

Speakers: Konrad Graf (Author & Investment Research Translator), Robert Sams (Founder, Cryptonomics), Peter Surda (Economist, Economicsofbitcoin.com, Robin Teigland (Associate Professor, Stockholm School of Economics)

1) Introductions, opening comments, and overview

00:00–03:05 Matonis: Introduction of panelists

03:05–07:57 Brief openings by each panelist

07:57–09:06 Economics profession and bitcoin

09:06–11:41 Matonis: Overview of topics

2) Regression theorem and bitcoin

11:41–12:12 Matonis: Introduction of topic

12:12–18:32 Surda: Liquidity, organized markets

18:32–23:16 Graf: Technical versus economic; theory versus history layers

23:16–23:50 Sams: Doubts this is relevant to bitcoin

3) Unit of account, price display, and price intuition

23:50–25:02 Matonis: Introduction of topic

25:02–27:00 Teigland: Depends on who; networks, sub-communities, generation change

27:00–27:23 Matonis: Can bitcoin overcome the existing network effect?

27:23–28:01 Surda: Uncharted area, dollar likely to remain unless deep negative event for it

4) Multiple value standards, room for 300 crytocurrencies

28:01–28:49 Matonis: Introduction of topic

28:49–31:01 Sams: Need distinct specializations; mining costs limit

31:01–32:48 Graf: Strong tendency toward one unit; only other very strong factors could counter

5) Fractional-reserve banking and bitcoin

32:48–33:41 Matonis: Introduction of topic

33:41–38:08 Surda: Money substitutes, transaction costs, price differentials, “reserve” standards

38:08–39:57 Teigland: Other non-traditional financing systems, crowdfunding, P2P lending

39:57–41:34 Sams: FRB based on an illusion, one that cannot be created with bitcoin

41:34–44:12 Graf: Bitcoin allows opt-out from all “trusted” 3^rd, 4^th, 5^th parties. Vote with your mouse.

44:12–46:47 Sams: Who owns what? a pervasive issue; first bitcoin lending likely dollar denominated

6) Deflation, only 21 million units, number of decimal points

46:47–48:37 Matonis: Introduction of topic

48:37–49:46 Teigland: People adapt over time to situations

49:46–53:38 Sams: Deflation arguments misplaced; overheld, underused; other crypto money supplies possible

53:38–55:36 Surda: No need to change the quantity of money, but more to investigate

55:36–58:29 Graf: “Rising-value currency;” any quantity of money will do for society as a whole

58:29–59:26 Sams: Elastic supply could help stabilize exchange rate relative to fixed supply

59:26–59:46 Surda: Unit of account function depends on liquidity not volatility

7) Q&A

59:46–60:55 Q1: Banks allowed to create money; unfair playing field?

60:55–62:28 A1: Sams: 100% reserve banking; taking away private money creation privilege

62:28–62:56 A1b: Teigland: Local alternatives, experimentation

62:56–63:19 Q2: Isn’t buying and holding bitcoins already an investment in all of bitcoin?

63:19–64:06 A2: Sams: To some extent, but could be more with different money supply rule

64:06–65:00 Q3: Fixed rate of supply ignores recent lessons of monetary theory

65:00–65:27 A3: Matonis: Already addressed; Surda: May need to unlearn some of those lessons :-)