Tuesday, June 7, 2011

BitCoin. Thoughts on QE

A friend recently turned me on to the existence of bitcoin.

The gist of it is cypher solid peer-to-peer electronic cash system. The creation of money is fixed in its algorithm and is fixed to 21 million units in time. It has grown in visibility of late and the economy it represents is on the order of 6.5 million USD. It seems it used for 'official' purposes (mostly development) and of course many illicit activities such as the drug trade.

Peer-to-peer, CPU creation

The creation of money happens in random places by just 'running' your computer. yeah, it is 'free' money. However the algo is such that a regular computer will take a couple of years to create a unit, so the gold rush is passed essentially.

The peer to peer feature means there is no clearance, no banks, just a trusted network. The original paper by nakamoto is interesting in that it predicts that the system cannot be hacked unless 'a majority of CPUs' is in the hands of a malicious entity, making it, on the surface of things and for the time being, quite robust to hacking.

Fixed money amount: deflation

From an economic standpoint, the main feature of the system is that the amount of unit this system can create is capped at 21million units. This means that as the economy it represents grows, the nominal prices will go down. Kind of like a gold system. This is an NO-GO crippling feature as it induces deflation.

Deflation is bad mkey?

Deflation is bad, because it induces hoarding. Hoarding is simply, not buying things today because the things tomorrow will cost less in cash. This slows down economic activity. Inflation (when it is mild) has the opposite effect, people need to move their cash today as it will be worth less in real good tomorrow. This stimulates the economy and is the basis for most QE approaches. The deflation spiral is well documented from the great depression for example. The purpose of money is not money in and on itself but rather to get 'people working' so this is a monstrosity from a strict monetary standpoint and confines bitcoin to "nice toy model to learn from regarding features of electronic money".

More precisely, this means bitcoin, will thrive as a parallel system but cannot be the basis for a global system with the basic algo. There is always the possibility that the algo is changed I guess.

Debt-Deflation is worse

Of course this money is not born as debt, but rather as free lottery. Money as debt has many irking features, such as the fact that the banking system leverages a tax on money it creates out of thin air. However a debt deflation is worse because the burden of the debt, the debt payments, stay at a nominal value fixed in time while your income in real terms decreases. This is a double whammy that our system of 'fiat money as debt" have (ours). This system does not suffer from that.

Ponzi nature a plus for adoption

The ponzi nature of this scheme is evident: the early adopters will see the value of their 'cash' increase by doing nothing but recruiting other people into the network. The interesting bit is that it turns said early adopters into rabid evangelists as they are quite literally talking their wallet up. Many e-cash schemes suffer from a chicken and egg problem of getting the currency in usage in the first place. Governments collect taxes and that bypasses the problem. Here illicit activity, that wants to escape scrutiny, and the zeal of the early adopters help the promotion and distribution of this money.

Thoughts on QE

Here is the bit that tickles my fancy this morning. Why did they create a fixed amount in the first place. One can argue that the 'marketing' and adoption is working because of that. At the same time that 'fixed' feature is also what destroys the economic value of this system in the mid/short term. It will remain niche (and probably survive and thrive in that niche).

However the way money is created, as pointed out, is by wasting CPU cycles doing nothing. In a way this is VERY close to QE, where money is not created as debt by the banking system for the real economy but created by the FED as "free money".

Of course the discussion there can quickly become emotional. Essentially either you trust your government and you are of the view that this money was created for the good of everyone, reflecting the thought that a government is by and for the people. Or, as certain conservative fringes see it, the government is your enemy and the FED a cabal by private interest and therefore QE is theft.

In reality QE was applied to stabilize prices during crisis (QE1) and avoid the deadly deflation spiral from which bitcoin suffers so much. QE2 is more arguable (I do argue it) and can be seen in various lights, but its 'stimulus' component is evident.

Growing amount aka cypher QE

But the idea that money would be dropped into the system at random times is embraced by most modern economists. It is the 'helicopter' theory. Which was understood quite literally. This is a way to implement such thing. If the amount of money was proportional somehow to the economic activity it represents you would create price stability, a necessary component of a mass money system if it is to stimulate the economy as a whole. But the point remains, that some folks would argue that 'random' distribution of money (or in this case linked to your ability to run computers) is in fact more fair that traditional QE.

Conclusion: more than a nice hack with potential?

All in all I have mixed feelings about this thing. The genius is of course the marketing of it (smart money news flash: CURRENCY APPRECIATES 200,000%) so most people WANT IN. FREE MONEY. Its fixed nature is also its downfall, as a "mass" currency it will induce deflation in its economy which is sustainable as long as the system is niche and parasitical. By parasitical I mean that the activity in it is at the expense of the real economy by avoiding taxes.

Of course there is NO VALUE creation in creating bits of money, running computers is in fact a waste of energy, but that is another topic. I see a nice 'niche/cult' status for such a currency. The capped amount being both its strength and weakness.

Open Source implementation

As an OSS software developer I find the community aspect fascinating, for the good and wrong reasons. That a group of hackers would create such a system under OSS licenses (MIT license in this case) is a testimony to the hacker/cypher world creativity. The greed in the adoption scheme, resembling a ponzi can be a turn off.

I may want to reach out to these kids and see if they have any plan going forward and whether there system is set in stone. Heck! I may want to invest. A new model with monetary base growth, now that the chicken and egg problem has been solved, would go a long way. Very interesting to say the least, it may remain as a 'thought experiment' with real world applications and warrants study as is.


Gavin Andresen said...
This comment has been removed by the author.
Gavin Andresen said...

Is this the deflation-is-bad argument?:

A fixed money supply is bad because if the economy is growing there won't be enough money to go around.
So the cost of money increases.
Which encourages hoarding.
Which decreases investment.
Which depresses economic growth.

If that IS the argument, then it seems to me the system should be self-regulating; if economic growth slows, there will be less (or no) deflation, more investment, etc etc.

Marcf said...

Hey Gavin, Glad I got your attention.

Yes and no. The gold system has proved that you can grow an economy with a fixed money supply and have it thrive. In other words your community will grow in good times and under the umbrella of the larger economy.

The dynamics you describe are VERY context dependent. Any book on the great depression goes over the dynamics and I am sure you are familiar with them. A fixed money supply (gold) is detrimental to the DYNAMICS going on in deflationary times. Essentially on top of the economy slowing you add a deflationary monetary contribution.

In other words, far from being self-regulated it becomes unstable.

In any case, I would be interested in knowing WHY you have opted for a limited supply. I argue that while beneficial in the short run, in the mid-term you are attracting the wrong kind of people (speculators) with little interest in your economic impact. Thoughts?

Marcf said...

And in the mid run you will see panics, violent ones.

Gavin Andresen said...

If I were Satoshi, I would have chosen a small constant rate of inflation (a couple/few percent per year).

But Satoshi probably did the right thing, because the "only ever 21 million" DOES help the bootstrapping problem. And as long as the future money supply is predictable, I think people will adapt and thrive.

I believe in the Wisdom of Crowds and bottom-up spontaneous order a lot mor than I believe in Wise Leaders Steering the Economy.

RE: the gold standard and the depression: I've got some monetary history books in my To Read pile, but I'll channel Russ Roberts and ask: do we really know much? The Great Depression is a data set with one point....

Marcf said...


1/ the point of QE is that it is dynamic. Not set in stone. So no, a 'fixed' rate of inflation doesn't do the trick.

2/ You don't need inflation (although a mild amount is an economic stimulant). In essence you can divide your currency to adapt to growing economics (hereby making early adopter wealthy in nomina). So i believe that your community can stay quite healthy AS LONG AS IT IS SMALL.

3/ You will experience panics. In my yoda voice: oh yes, you will. And then I think you may survive due to your small size and the fact that your currency shows massive volatility, thereby attracting speculation which will provide a steady flow of 'real money'

4/ Lack of convertability may come to bite you but I believe this may not be a bad thing. As long as you have a 'legit" community that uses this instead of barter and you weed out excessive speculation you may be able to sustain a full frontal panic. I just don't know. I think your small size helps you.

5/ If you get big, you will be thrown in jail. Then you can brag about being the new "assange" :)

let's talk

Marcf said...

and since this is my blog and I like to keep things above obvious statements like
"if economic growth slows, there will be less (or no) deflation, " while possibly true in the narrow context of your currency are obviously not true in the 'real' world, in fact it works the other way around. It reveals a deep misunderstanding of basic 101 monetary concepts.

Anonymous said...

The deflation argument doesn't hold up. You think that money needs to be inflationary to get people to want to spend it. You are assuming that money can only be "pushed" through society.

In fact, money can be "pulled" through society as well. Even though my money will be worth more tomorrow, I will spend it, if a seller "pulls" hard enough.

The most obvious example is computer equipment. Why did you EVER buy a computer in the past 20 years, when you KNEW with certainty that it would be cheaper in the future. Answer, because the price became compelling enough that it figuratively pulled the money from your hands. You didn't spend the dollars because the you knew the dollars were "going to be worth less tomorrow" (the inflationary argument). No, you spent the dollars on that computer because the price got "low enough" that it was a good value in your mind.

With Bitcoins, money will be pulled through the system. There are already vendors who welcome, encourage, desire payment in Bitcoins. They will pull the money through the system - through incentives.

Bob said...

It has been proven that Bitcoin is 500 Million Trillion times as valuable as gold.

"Worth it's weight in gold" ? try again!


Stephen said...

There are things that come from bitcoin that do not exist elsewhere.

It is not only a currency but a payment network. The network fee for processing a bitcoin is a fraction of the fee for other payment networks. Just like you pay less at a gas station that is cash-only, you will likely get a discount and pay less when using Bitcoin for ecommerce purchases.

Those who don't have cheap, easy access to credit find the immediate settlement (i.e., about an hour) to be incredibly important.

Think of how Wal-Mart's busiest time is late at night, just minutes before midnight when funds from direct deposit are made available on the first of the month. These people aren't there at midnight for fun, they have been waiting on those funds and the second they arrive they are spent. Bitcoin can have a higher velocity than the banking system allows.

These may be properties that no economists are even thinking about, but those of us on the ground, getting our hands dirty realize that bitcoins are a game changer:

"When you start messing with bitcoins you really get a handle on how stupidly fucking slow normal banks are."

"Nothing like a $49.60 PayPal fee. They need some competition...badly."

"I think I'm done waiting for my bank to credit the 2 tiny deposits Dwolla made a wk ago yesterday. How long does it take to credit 12 cents?"

Marcf said...

Can BTC survive the heist? I don't think so. What was dodgy is now deadly.

Marcf said...

From the bitcoin thread on the forum

Then I'm going to sell whatever bitcoins I have remaining, take it as a life lesson, and count this as a not so fun experimentation with cryptographic currency.

I am then going to focus on making plain old paper dollars and store them in a bank where at least I'll have the full force of society or some central government insurance backing me up - not to mention some recourse to the law in case of any theft.


Mats Henricson said...

USD in a bank deposit seems like a really good advice...