• Tag Archives bitcoin
  • Why Bitcoin Is Technically an Inflationary Currency—Even Though Its Purchasing Power Is Increasing

    Inflation is commonly defined as “a general increase in prices and fall in the purchasing value of money.” For example, if a six-pack of beers cost $8 last year, but this year the same six-pack costs $16 then the annual inflation rate was 100 percent. This is because the price doubled for the same quality and quantity of beer.

    To put it in perspective, the most famous hyperinflations occurred in Zimbabwe and in Germany. In 2003, Zimbabwe’s monthly inflation rate hit 7.96 x 1010 percent, and in 1923 the German government’s hyperinflation caused the exchange rate to rocket to 4.2 trillion German Marks to one U.S. dollar.

    Using the common definition, Bitcoin is deflationary because Bitcoin’s purchasing power increases over time.

    However, the traditional definition of inflation, according to the British Currency School, was an increase in the supply of money that was unbacked by gold. According to Reinhart and Rogoff’s This Time is Different, governments have been inflating currency over the past 800 years.

    Originally, governments would inflate the currency by debasing gold coins. During the 20th century, government inflation technology advanced to printing presses, and currently, governments are able to inflate the monetary base by digitally creating money by updating internal databases that track fiat money, which is predominately digital.

    Using the traditional definition, Bitcoin is inflationary because the supply of Bitcoin increases over time.

    Gold is considered the ultimate store of value because of one specific characteristic: scarcity. No person or group can will gold into existence. Instead, the supply is controlled by nature. Figure 1 (above) shows the supply of gold has had a stable inflation rate. The creators of Bitcoin designed its inflation rate to mimic gold’s stable inflation rate.

    Figure 2 (below) shows the circulating Bitcoin since its creation in 2009. As the inflation rate decreases, the price for each Bitcoin should increase, ceteris paribus. Bitcoin’s inflation rate was hardcoded into the software that operates Bitcoin. Hardcoding Bitcoin’s inflation is similar to Milton Friedman’s K percent rule that called for an algorithmic and regulated inflation rate that would eliminate human-error and the temptation to manipulate the monetary base for political reasons. However, Bitcoin’s inflation algorithm was designed to make Bitcoin even scarcer than gold.

    There is a fixed amount of 21 million Bitcoin that can be minted, which means that no coins can be minted once this amount is reached. Approximately 80 percent of the total amount of Bitcoin has already been minted. Bitcoin’s algorithmic inflation rate since 2010 is displayed in Figure 3 (below) and is explained in the original white paper written by Satoshi Nakamoto.

    “To compensate for increasing hardware speed and varying interest in running nodes over time, the proof-of-work difficulty is determined by a moving average targeting an average number of blocks per hour,” Nakamoto explained. “If they are generated too fast, the difficulty increases”.

    As of July, the inflation rate of Bitcoin was 4.25 percent. The difficulty re-adjustment makes it impossible to simply mine more Bitcoin by allocating more computer resources to the network. As more people try to mine Bitcoin, the software automatically increases the difficulty of successfully mining a Bitcoin and vice-a-versa.

    Once the inflation rate reaches zero, miners will no longer be able to earn money from minting newly created bitcoins. Instead, transaction fees will have to increase or the number of transactions will have to increase. The last edition of the Crypto Research Report contains an in-depth explanation of how transactions are confirmed on the network and how miners earn income by confirming transactions and minting new coins.

    Although Bitcoin and gold are currently inflationary monies, according to the traditional definition of inflation, their inflation rates are predictable and constantly decreasing. Similar to gold, Bitcoin’s annual inflation rate will eventually reach zero percent.

    According to the mainstream economic definition of inflation, Bitcoin is deflationary because the purchasing power of Bitcoin increases over time. Currently, Bitcoin’s purchasing power is extremely volatile, although, this is expected to stabilize in the long-run. Since Bitcoin’s total supply is fixed, Bitcoin’s purchasing power will continue to grow slowly over time if demand continues to increase.

    Source: Why Bitcoin Is Technically an Inflationary Currency—Even Though Its Purchasing Power Is Increasing – Foundation for Economic Education



  • Bitcoin, Despite All its Problems, Could Revolutionize Property Rights

    Weak or nonexistent property rights lead to low economic productivity. Citizens of countries that do not protect property rights must necessarily spend much energy, thought, and time in an anxious effort to secure what little production they can manage. Many innovations and business models are unfeasible without property rights because they will be destroyed (or, more often, deterred) by one or another form of theft. Even a marginal improvement in access to property rights should drive the economic equilibria of many countries in the direction of wealth creation.

    Because it is decentralized, significantly easier to transport, store, or hide, and—this is crucial to augmenting property rights—significantly more difficult to seize than any traditional asset, Bitcoin delivers a real improvement in property rights at a comparatively modest cost (risk due to price volatility + transaction fees).

    However, Bitcoin is not a better currency (at least not in its current technical implementation). In fact, it probably will never quite be able to compete with centralized solutions in terms of speed and efficiency. Bitcoin is a bank account that is hard to track and hard to seize. The hard-to-track and hard-to-seize features are where the bulk of the real current value (speculation aside) originates.

    Beyond black market applications, Bitcoin has utility and value because most of the world’s population lives in countries that do not uphold property rights.

    The average human on planet Earth lives in serious uncertainty about whether his property will be his tomorrow. (This interactive map is from Index of Economic Freedom published by the Heritage Foundation, click here to play with it)

    What Bitcoin Provides

    1. Provides a last resort store of value—and means of escaping with some assets—for people living in politically unstable or oppressive countries.
    2. Makes people more confident and more likely to be productive by providing a hedge against expropriation, hyper-inflation, theft, divorce (comical but true), and so on—meaning that people can work hard to accumulate wealth, with the confidence that they will be able to keep some portion of it, despite being the victim of some political turmoil or the target of some (in)justice.*
    3. Provides a means to streamline the pervasive and often necessary evasion of taxes, bureaucracy, and regulation in poorly governed countries.**

    *It is important not to underestimate this. Uncertainty discourages people from working hard and taking risks. First world countries owe a significant part of their productivity and wealth to the rule of law and property rights. Any shift in that direction should also increase the amount of economic activity in a country that is normally a dangerous place to be successful.

    **Having done business in China and India, I speak from personal experience when I say that nearly every businessperson and any typical middle-class citizen in these countries is guilty of regularly, or at least occasionally, breaking tax laws, bribery, and so forth, to get by.

    This is not just a third world phenomenon. At one point in my food cart manufacturing days, we worked with two Egyptian food cart partners in New York (they jointly ran several dozen food carts in Manhattan) who—in a bid to report as little income as possible to the IRS, a universal practice among small cash businesses in the city—stored tens of thousands of dollars inside a wall, only to find part of the money eaten by rats several months later (they, of course, only realized what had happened after hotly accusing each other of theft).

    Giving People a Way Out

    It is difficult for those of us living in peaceful Western democracies, and occasionally grumbling about taxes, to understand how front-and-center property rights issues can be.

    Bitcoin provides a last resort for individuals and communities contending with hyper-inflation, capital controls, corrupt courts, extortion, and expropriation of all kinds.

     

    Try selling your small business and leaving Zimbabwe.

    Or take a stroll to the ATM to try and withdraw your hard-earned savings in an attempt to spend them before the currency loses 80 percent of its value.

    It’s no surprise that by October of 2017 (note that articles above are both from 2016) Quartz reported that Bitcoin is breaking all kinds of price records in cash-strapped Zimbabwe.”

    The Bitcoin network, despite its many imperfections, is proving itself as, at least, a moderate improvement in access to property rights and financial freedom for much of humanity.

    Property rights issues cast a shadow that spans the entire income spectrum—whether you are a middle-class entrepreneur in Zimbabwe, who is not legally allowed to leave the country with more than $1000 in cash as the political and economic situation descends into uncertainty, or the world-famous investor Prince Alwaleed.

    Ironically, shortly before being detained indefinitely and very likely expropriated by the despotic Saudi “government,” Prince Alwaleed called Bitcoin an “Enron in the making.”

    Although it’s very possible that Bitcoin’s price has run far ahead of its underlying value (and certainly many of the people bidding it up—including myself on occasion—are speculators, not users), the Prince’s bubble ended up bursting first.

    While people like Prince Alwaleed obviously have access to more traditional methods of evading capital controls and expropriation (offshore banking valued at well over $15 trillion, shell companies, and so on), it is clear that Bitcoin—and perhaps the even-less traceable cryptocurrencies like Monero, Dash, and Zcash—is at minimum a useful new gadget in the offshore banking arsenal.

    Bitcoin is even more useful for criminals (who in all likelihood made up the first critical mass of its users). But they are a rather small market compared to the enormous potential market of law-abiding and semi-law abiding citizens hedging against expropriation, unreasonably high taxes, unfair lawsuits in corrupt courts, capital controls, and so on.

    Obviously, Bitcoin is not a silver bullet—the classic $5 wrench XKCD meme says it all:

    Governments, fair or corrupt, still have plenty of very effective ways of detecting income, collecting taxes, expropriating property, and carrying on all manner of other financial/economic despotism. One cannot live on Bitcoin alone. The government can still take your house, your car, your land, and so on. However, decentralized cryptocurrencies do have the potential to shift the equilibrium noticeably in favor of the individual.

    My own parents were forced to give up all of their possessions when they left the USSR. In fact, they had to pay a fee in order to leave. Had cryptocurrency existed in the 1980s, they would have surely sold their Moscow apartment and other assets for whatever they could get in Bitcoin. In the event, I think they managed to smuggle several thousand dollars worth of gold sewed into the lining of a fur coat.

    [Side note: It was popular among people emigrating from the USSR to have gold dental work installed in a bid to carry out at least something of value… imagine what the USSR would have been like if this was possible.]

    Communist countries are a perfect storm for cryptocurrency—subsidized electricity and zero property rights. Venezuela is the best example.

    However, even China, which is hardly Communist, only allows private citizens to take $50,000/year out of the country. Unsurprisingly there is a general, and well-founded, anxiety among wealthy Chinese that the government will take away what they have earned. Chinese money has been a huge driver of Bitcoin’s price.

    Even banning Bitcoin-RMB exchanges cannot stop the outflow completely.

    Valuation

    IWhen reckoning the long term (years, not months) market cap potential of Bitcoin and other competing cryptos, it is important to consider not just its black market use cases or its competition with gold (gold has ~$7T market cap) and offshore banking ($15–30T market cap), but also the new value it may create if it proves, in the long term, to be a better mousetrap for individuals in their struggles with corrupt and ineffective governments/social structures everywhere.

    Not only does Bitcoin create value by providing a new, albeit imperfect, way to secure existing wealth, it will likely encourage the creation of new wealth by individuals living under otherwise discouraging political regimes. Even governments may trend toward better behavior as they find themselves forced to contend with Bitcoin. I can’t make any price predictions—there is still no certainty that cryptocurrencies will stand the test of time and scale—but the next decade of the cryptocurrency industry’s growth should be interesting to watch.

    Disclosure: I have been holding BTC and some other cryptos on and off since some time after India withdrew large cash notes from circulation—which got me thinking along the lines above.

    Reprinted from Medium.


    Michael Dubrovsky

    Michael Dubrovsky is a libertarian-leaning systems engineer interested in science, entrepreneurship, history, and economics. He was the co-founder of several startups—most notably MOVE Systems—and has experience establishing manufacturing operations both in China and the American Midwest. Michael is currently working on a cryptocurrency mining protocol project and planning to begin graduate studies in Materials Science. You can find more of his blog posts on Medium, where he applies meandering first principles analysis to a range of topics from woodworking to Net Neutrality.

    This article was originally published on FEE.org. Read the original article.



  • How a Bitcoin System is Like and Unlike a Gold Standard

    Many commentators have compared Bitcoin to gold as an investment asset. “Can Bitcoin Be Gold 2.0,” asks a portfolio analyst. “Bitcoin is increasingly set to replace gold as a hedge against uncertainty,” suggests a Cointelegraph reporter.

    Economists, by contrast, are more interested in considering how a monetary system based on Bitcoin compares to a gold-standard monetary system. In a noteworthy journal article published in 2015, George Selgin characterized Bitcoin as a “synthetic commodity money.” Monetary historian Warren Weber in 2016 released an interesting Bank of Canada working paper entitled “A Bitcoin Standard: Lessons from the Gold Standard,” which analyzes a hypothetical international Bitcoin-based monetary system on the supposition that “the Bitcoin standard would closely resemble the gold standard” of the pre-WWI era. More recently, University of Chicago economist John Cochrane in a blog post has characterized Bitcoin as “an electronic version of gold.”

    In what important respects are the Bitcoin system and a gold standard similar? In what other important respects are they different?

    Similarities and Differences

    Bitcoin is similar to a gold standard in at least two ways. (1) Both Bitcoin and gold are stateless, so either can provide an international base money that is not the creature of any national central bank or finance ministry. (2) Both provide a base money that is reliably limited in quantity (this is the grounding for Selgin’s characterization), unlike a fiat money that a central bank can create in any quantity it likes, “out of thin air.”

    Bitcoin and the gold standard are obviously different in other ways. Gold is a tangible physical commodity; bitcoin is a purely digital asset. This difference is not important for the customer’s experience in paying them out, as ownership of (or a claim to) either asset can be transferred online, or in person by phone app or card.

    The “front ends” of payments are basically the same nowadays. The “back ends” can be different. Gold payments can go peer-to-peer without third-party involvement only when a physical coin or bar is handed over. Electronic gold payments require a trusted vault-keeping intermediary. Bitcoin payments operate on a distributed ledger and can go peer-to-peer electronically without the help of a financial institution. In practice, however, many Bitcoin transactions use the services of commercial storage and exchange providers like Coinbase.

    The most important difference between Bitcoin and gold lies in their contrasting supply and demand mechanisms, which give them very different degrees of purchasing power stability. The stock of gold above ground is slowly augmented each year by gold mines around the world, at a rate that responds to, and stabilizes, the purchasing power of gold. Commodity (non-monetary) demands also respond to the price of gold and dampen movements in its value. The rate of Bitcoin creation, by contrast, is entirely programmed. It does not respond to its purchasing power, and there are no commodity demands.

    Difference in Supply Mechanisms

    Let’s consider supply in more detail. Secularly, annual production of gold has been a small percentage (typically 1% to 4%) of the existing stock, but not zero. Because the absorption of gold by non-monetary uses from which it is not recoverable (like tooth fillings that will go into graves and stay there, but unlike jewelry) is small, the total stock of gold grows over time. Historically this has produced a near-zero secular rate of inflation in gold standard countries.

    The number of BTC in circulation was programmed to expand at 4.0 percent in 2017, but the expansion rate is programmed to fall progressively in the future and to reach zero in 2140. At that point, assuming that real demand to hold BTC grows merely at the same rate as real GDP, Bitcoin would exhibit mild secular growth in its purchasing power, or equivalently we would see mild deflation in BTC-denominated prices of goods and services. (Warren Weber’s paper similarly derives this result.) This kind of growth-driven deflation is benign, but the difference is small in real economic welfare consequences between a money stock that steadily grows 3% per year and one that grows 0%.

    The key difference in the supply mechanisms is in the induced variation in the rate of production of monetary gold in response to its purchasing power, by contrast to the non-variation in BTC. A rise in the purchasing power of BTC does not provoke any change in the quantity of BTC in the short run or in the long run. In Econ 101 language, the supply curve for BTC is always vertical. (The supply curve is, however, programmed to shift to the right over time, ever more slowly, until it stops at 21 million units).

    By contrast, a non-transitory rise in the purchasing power of gold brings about some small increase in the quantity of monetary gold in the short run by incentivizing owners of non-monetary gold items (jewelry and candlesticks) to melt some of them down and monetize them (assuming open mints) in response to the rising opportunity cost of holding them and to the owners’ increased wealth. The short-run supply curve is not vertical. Still more importantly, this rise will bring about a much larger increase in the longer run by incentivizing owners of gold mines to increase their output. The “long-run stock supply curve” for monetary gold is fairly flat. (I walk through the stock-flow supply dynamics in greater detail in chapter 2 of my monetary theory text.) The purchasing power of gold is mean-reverting over the long run, a pattern seen clearly in the historical record.

    Because its quantity is pre-programmed, the stock of BTC is free from supply shocks, unlike that of monetary gold. Supply shocks from gold discoveries under the gold standard were historically small, however. The largest on record was the joint impact of the Californian and Australian gold rushes, which (according to Hugh Rockoff) together created only 6.39 percent annual growth in the world stock of gold during the decade 1849-59, resulting in less than 1.5 percent annual inflation in gold-standard countries over that decade. For reference, the average of decade-averaged annual growth rates over 1839-1919 was about 2.9 percent.

    Predicting Supply

    As a result of the long-run price-elasticity of gold supply combined with the smallness and infrequency of supply shocks, the purchasing power of gold under the classical gold standard was more predictable, especially over 10+ year horizons, than the purchasing power of the post-WWII fiat dollar has been under the Federal Reserve.

    As I have written previously: “Under a gold standard, the price level can be trusted not to wander far over the next 30 years because it is constrained by impersonal market forces. Any sizable price level increase (fall in the purchasing power of gold) caused by a reduced demand to hold gold would reduce the quantity of gold mined, thereby reversing the price level movement. Conversely, any sizable price level decrease (rise in the purchasing power of gold) caused by an increased demand to hold gold would increase the quantity mined, thereby reversing that price level movement.”

    Bitcoin lacks any such supply response. There is no mean-reversion to be expected in the purchasing power of BTC, and thus its purchasing power is much harder to predict at any horizon.

    Describing gold supply, Warren Weber writes: “Changes in the world stock of gold were determined by gold discoveries and the invention of new techniques for extracting gold from gold-bearing ores.” This is not well put. Changes in the world stock of monetary gold come about every year from normal mining. Gold strikes and technical improvements in extraction brought about changes in the growth rate (not the level) of the stock.

    Historically, the changes in the growth rate were not dramatic by comparison to changes in the postwar growth rates of fiat monies. As often as not, the changes in gold stock growth rates were equilibrating, speeding the return of the purchasing power of gold to trend from above trend. As Rockoff noted, some important gold strikes (like the Klondike in the 1890s) and some important technical breakthroughs (like the cyanide process of 1887) were induced by the high purchasing power of gold at the time, which gave added incentive for prospecting and research.

    The phrase from John Cochrane quoted above is part of a sentence that reads in its entirety: “It’s an electronic version of gold, and the price variation should be a warning to economists who long for a return to gold.” From the consideration of the mean reverting character of the purchasing power of gold, by contrast to Bitcoin’s lack of such a character, we can see that the second half of Cochrane’s statement is incorrect.

    The inelastic supply mechanism that produces price variation in Bitcoin should give pause to those who predict that Bitcoin will become a commonly accepted medium of exchange. It says nothing about the purchasing power of gold under a gold standard.

    Reprinted from Alt-M.


    Larry White

    Lawrence H. White is a senior fellow at the Cato Institute, and professor of economics at George Mason University since 2009. An expert on banking and monetary policy, he is the author of The Clash of Economic Ideas (Cambridge University Press, 2012), The Theory of Monetary Institutions (Basil Blackwell, 1999), Free Banking in Britain (2nd ed., Institute of Economic Affairs, 1995), and Competition and Currency (NYU Press, 1989).

    This article was originally published on FEE.org. Read the original article.