3/23/14

Bitcoin is Two Things: Payments and Money

There is an enormous amount being said about Bitcoin these days. Marc Andresson thinks it's worth $50 million. Paul Krugman thinks it's evil. Ben Bernanke thinks it holds long-term promise (or maybe he doesn't). But let's face it, No One Understands Bitcoins:




That said, I think that a lot of confusion could be cleared up if people started differentiating between Bitcoin as a Payments System and Bitcoin as Money. Speaking separately about the two is hard because in the system Satoshi Nakamoto designed, the two aspects of Bitcoin are indivisible—you could even say they are two sides of the same coin—but to fully evaluate the merits of Bitcoin, a bit of coin-bifurcation is essential.  (Some shall be pardon'd, and some pun-ished).


Turns out artistic representations of Bitcoins actually only have one side. But you get the point.


I. Bitcoin as a PAYMENTS SYTEM


First, what is a payments system? Payments are how you move money around, after you have agreed about what counts as money (that's Part II). The simplest type of payment system is the exchange of tokens that represent money, for example dollar bills or gold coins. Unfortunately when you start to accumulate money, exchanging tokens gets difficult. They're annoying to count, annoying to carry, easy to counterfeit, and if someone steals them, they're gone. 

The payments system we use today has evolved gradually and is actually really complicated. We still use tokens for small purchases, but we also use credit cards, debit cards, prepaid cards, checks, ACH transfers, wire transfers, and digital services like Venmo. We use banks to keep track of our money, and lots of intermediaries to help them transfer it.* Every intermediary takes a cut, and that adds up to a lot of money—I unscientifically estimate about $300 billion a year.**

Bitcoin, as many advocates are quick to note, cuts out the middle man. The protocol, which I gather has something to do with solving the Byzantine Generals' problem, allows truly peer-to-peer transfers; no bank, no Mastercard, no dolla dolla bills y'all required. Plus, Bitcoin is anonymous, a feature that could be good or bad depending on how libertarian you are, but that is undeniably nifty. 

Verdict: As a payments system, Bitcoin is really cool. 


II. Bitcoin as MONEY


Now, what is money? That answer is a little more complicated. Economic textbooks say that money is "a medium of exchange, a store of value, and a unit of account." Not a particularly helpful definition, when you dig into it. Here's the big secret about money: it's social construct. The Onion said it best with their headline, "U.S. Economy Grinds to Halt As Nation Realizes Money Just A Symbolic, Mutually Shared Illusion." (H/T Neil Irwin). If you need more convincing, I suggest you read the first three chapters of Felix Martin's "Money, An Unauthorized Biography," available in the US as of March 4, 2014. 

In the past, a lot of people used gold as money, but they could have also used shells or giant stone wheels if they wanted too. They used gold for a few good reasons:
  • Gold is divisible into coins, which don't weigh much and are easy to carry
  • Gold is durable (but still vulnerable to debasement)
  • Gold can be used to make things and therefore has some intrinsic value, so if people stopped accepting gold as payment the metal was collateral
  • Gold is state-independent, not supported by any particular state, so neither empire implosions nor malicious monarchs could capsize the currency
  • Gold quantity grows slowly over time because it is naturally scarce, a property that offered some protection against the scourge of inflation 

Today, a lot of people use dollars as money. There are lots of good reasons to use dollars:
  • Dollars weigh less than gold
  • Dollars are more durable than gold, because they can be easily reprinted  
  • Dollars have some intrinsic value in paper and ink, but less than gold 
  • Dollars are state-dependent, backed by the US and required for US taxes 
  • Dollar quantity is managed by the Federal Reserve, which uses monetary policy to keep the value of the dollar stable

In the future, a lot of people might use Bitcoin as money. There are lots of good reasons to use Bitcoin: 
  • Bitcoins weigh nothing at all  
  • Bitcoins are the most durable, though Y2K 2.0 could take 'em down 
  • Bitcoins have no intrinsic value, and waste no metal, paper, or ink***
  • Bitcoins are state-independent, not supported by any state in particular 
  • Bitcoin quantity grows slowly over time as defined by its mining algorithm 

tl;dr:










So, Bitcoin is the clear winner in Weight and Durability, and Intrinsic Value is negligible enough to discount for all three types of currency. What's more, weight and durability are primarily desirable traits because of money's use in payments, and we've already established that Bitcoin is awesome there. The last two categories are really at the heart of money, and there the winner is not so clear.

At first glance, "independent" in the State Relationship category seems obviously preferable, but remember that money is a social construct, and that society is fickle. Pretend for a minute that the world is a kindergarten playground. Today the kids are using jelly beans as money, but last week it was jolly ranchers, and tomorrow it might be dried boogers. You never know which item to stockpile. Now imagine that the biggest kid in kindergarten only accepts jelly beans, and threatens to beat up anyone who uses anything else. Wouldn't you have a little more faith in that currency?

The US Government is like the big kid in kindergarten: annoying, and a bully, but better for dollar stability in the long run. In the 18th century gold became the world currency primarily due to thousands of years of tradition, but it also actually received a fair amount of state support; perhaps a more accurate moniker would have been "multi-state dependent." Bitcoin however has neither tradition nor a bully to back it up, and its value could tumble tomorrow to another cooler cryptocurrency:

how wow
So this is a real thing 

Quantity, however, is the real kicker. Two hundred years of monetary theory have led to the conclusion, almost universally accepted among economists and central bankers, that you want the money supply to adjust to the business cycle. When business is booming, you want to let the money supply expand to keep prices from falling, but not by too much, to keep irrational exuberance in check. When the economy is dragging its feet, you want to let the money supply contract to keep prices from rising, but not by too much, because that could put the economy in a deflationary spiral, and deflation sucks a lot. Today the Federal Reserve carefully manipulates the banking system to expand and contract with the business cycle, without letting it go too far in either direction. Sometimes they get it wrong, but hey, that's life.

It's ok, cause Zerohedge stole from Fisher
thanks Zerohedge, I stole your graphic 

Gold and Bitcoin, however, don't adjust. The earth does not disembowel ore at a faster clip to oblige the business cycle. There is no macroeconomic reaction function written into Bitcoin's source code, and because of the economy's tendency to adjust to known conditions, such a reaction function is probably impossible to write. Adherence to the gold standard in the 19th and early 20th century did not serve us well, and most scholars agree that it was a major contributor to the Great Depression. (Need more? Here's a concise rundown of the maleffects of deflation by Brad DeLong, an academic article by Ben Bernanke, and a few neo-journalist "wonk" charts. Also H/T^2 Neil Irwin on "Bitcoin Needs a Central Banker").

Bitcoin's inflexibility is all fine and well when only a handful  of techies and speculators are trading it (in fact, that just means more fun for the speculators), but deflation of a full-fledged society-wide currency is no laughing matter. To economists, switching to an inflexible currency like Bitcoin would be kind of like Cold War nuclear militarization. It's dangerous. It's irresponsible. It's just plain M.A.D. This is why economists hate Bitcoin, and why I kind of do too. 

Verdict: As money, Bitcoin is very questionable.

Conclusion


As a payments system, Bitcoin rocks. Right now, the American payments system is a quagmire of legacy protocols and entrenched intermediaries. Many awesome innovators are shaking things up, but, in my opinion, not fast enough. Bitcoin is shining example that the industry should move towards or directly borrow from. 

As money, Bitcoin has some flaws. By now hopefully you can see that the reasons for using a particular type of money are complicated and change over time. In the past, gold made more sense because society was less stable and there were no powerful institutions like US Government that could dependably manage its value. And to be honest, we just didn't know any better. It's possible that in the future we will figure out how to tame the business cycle, or write an algorithm that mimics a central bank. In that case, bring on the Bitcoin. But for now, I'd rather stick with dollars.


Footnotes


*Note that financial institutions fulfill many other functions besides facilitating payments, including providing credit, which is a hugely important part of money that I hardly got to mention here
**Google was not fruitful, so I got $300B by multiplying (US GDP)*(Percentage of debit and credit payments)*(2.5%, the average cost paid by a merchant for a card swipe) + another $50B or so for ATM fees, bank fees, and other costs associated with payments. I'm probably underestimating.
***I'm not counting Bitcoin mining, dollar printing, or gold mining in intrinsic value