Monday, April 8, 2013

Bitcoin is money, Bitcoin is a bubble

[I promise - this is my last Bitcoin post.  I fear it attracts low-quality traffic.  Comments are off.]

Someone in a meeting the other day called my theory of why Bitcoin, a useless commodity, has a nonzero price, the "bubble theory of money."  I like it.  I think it could stick.

When I first came up with this BTM (which is only a slight, slight variation of Carl Menger's theory) and posted it seven years ago, I was genuinely concerned that the global mass mind, or at least the global financial mind, might be hyper-rational and converge spontaneously on the equilibrium solution, perhaps in as little as fifteen minutes.  Resulting in unbelievable global mayhem.  Which would arguably be my fault.  And for which I would certainly be blamed.

Obviously, I had a lot to learn about the global financial mind.  No one in this business has a clue.  Everyone who thinks he has a clue has no clue at all.  The rest get by with about half of one, plus a dab of good taste and a lot of hard work.  If you have money to stash away and enough to hire a pro, find some grizzled old silverback like Cassandra and let his spidey sense do the work.  He doesn't have a clue, but nor do you.

For example, while the BTM is impeccable in theory, it does not tell you, me, or anyone whether Bitcoin is money or Bitcoin is a bubble.  If Bitcoin is money, Bitcoin at $150 is absurdly cheap.  Otherwise, it is hilariously expensive.  Bitcoin will go to zero or infinity - almost certainly the former.  What is the expected value?  Answer unclear - ask again later.

Us feeble-brained humans are uncomfortable with path-dependent outcomes.  We don't want Bitcoin, or anything, to have an arbitrary price determined merely by marginal bid and ask, let alone a multiple equilibrium - we want it to have an underlying value.  Which is a physical property, like weight or orangeness.  When I say that Bitcoin is money and Bitcoin is a bubble, your mind grows nervous, as if forced to contemplate a car that is orange and green.  Sure, it's all waves and particles at the bottom - but, really.  Physics is one thing, accounting is another.

The BTM asserts that money and a bubble are the same thing.  Both are anomalously overvalued assets.  Both obtain their anomalous value from the fact that many people have bought the asset, without any intention to use it, but only to exchange it for some other asset at a later date.  The two can be distinguished only in hindsight.  If it popped, it was a bubble.  If not, money - so far.

In any realistic economy, real or virtual, there is a demand for at least one good which is used as a "store of value," that is, not used or intended to be used by the owner, but owned simply to transfer purchasing power across time.  Nonetheless, the owner holds this good and participates in the market for it.  If many owners standardize on the same good, they affect the market for this good.  We can think of their collective purchasing power as a sort of "energy" that flows into this market.

It turns out that the correct collective strategy in this game is for everyone to standardize on the same asset as a store of value, and for this asset to be one of intrinsically limited quantity.  If the quantity is not limited, as for example in a manufactured good, a stable pool of savers will not increase its price.  If the quantity is limited, as with gold, Bitcoin, etc, the price will increase as savings energy flows in - and, of course, decrease as it flows back out.

There is no way to eradicate this effect from anything like a realistic economy.  There is always at least one bubble.  Ideally, this bubble is stable, and we call it "money."  If you try to spread savings energy across all the goods in the economy, it will stay in storable goods and not in un-storable ones.  It will flee from manufactured goods and end up in rare collectibles.  Finally, it will flee from a broad spectrum of collectible assets and end up in a single standard.  Those who are late in fleeing are, by definition, caught in a bubble which pops - and taste the pain.

You might imagine that investment transactions would neutralize or at least reduce the demand for money.  Not so.  True, instead of holding cash, you can hold a debt - a promise of cash delivered next year.  Your demand for cash, and your impact on the price of cash, is now zero.  However, the economy's demand to save cash is unchanged.  In exchange for that debt, you gave someone else a bunch of cash.  She is now the saver.

Bitcoin is an exceptionally pure test of the BTM, because it has no intrinsic utility.  It is uncomfortably reminiscent of that apex specimen of the South Sea Bubble, "a company for carrying out an undertaking of great advantage, but nobody to know what it is."  One of the problems with the South Sea Bubble - in fact, one of the reasons why South Sea Company stock could not become a new monetary standard - was the inability to define a reason why one security should be the standard, and not another.  There are Bitcoin clones, all more or less worthless.  Bitcoin is a protocol standard, and everyone in our era knows how protocol standards play: winner takes all.

When we define the essential characteristic of "moneyness" as overvaluation, not as currency, we see that commerce in Bitcoin has no direct relevance at all to its price.  If you are spending in Bitcoin, you are not holding it.  All that affects the BTC/USD exchange rate is the order book of the people who hold BTC and are willing to sell it for USD, and vice versa.

Indeed, it is logically possible to imagine an economy in which the medium of saving and the medium of exchange are different assets, and the medium of saving is overvalued but the medium of exchange is not.  This actually happens in seriously mismanaged Third World countries, in which all savings flees to gold or hard currency, and the soft currency is held only for immediate commerce.  Often with an inflation rate of double digits per month.

History has never seen a pure monetary standard like Bitcoin.  It's not only that gold has intrinsic material utility - even fiat currency, though tremendously overvalued by savings energy, has intrinsic value.  Try paying your taxes without it.  Dollars will not become worthless even if Bitcoin becomes the global monetary standard, because dollar-denominated liabilities will remain.  However, considering the price of Bitcoins in this outcome, these debts will become macroeconomically quite easy to pay - an unqualified boon in my opinion.

The dollar is already the global monetary standard - what creates any incentive to switch to Bitcoin?  If the dollar was financially perfect, there would be no such incentive.  The dollar is anything but financially perfect.

Probably the easiest way to see this is to consolidate dollars, Treasury notes, and in fact all securities explicitly or implicitly supported by the US Government - a strong argument could be made that this set now includes both the stock market and the real-estate market - as USG liabilities.  To put it crudely, a dollar is a share of stock in America.  Like a frequent-flier mile (which is also a liability), it confers no explicit rights, but can be redeemed for valuable privileges (especially on April 15).

This set of liabilities is constantly expanding - quite a bit more rapidly than the Bitcoin pool.  In plain English, USG leaks money.  It bleeds, in fact, like a stuck pig.  When we do accounting in a diluting equity like this, the rational way to track our positions is not by the number of shares, but by the percentage of ownership.  If we adopt this "normalized accounting," we see that normalized money is constantly being sucked out of our bank accounts.

Fortunately for those who live in America, normalized accounting also shows us that consumer prices in America are constantly dropping.  Price deflation is the rule.  Consumer price indexes show negligible price changes in non-normalized accounting, not only because they are fudged and rigged, but because prices are set by dollars competing for goods.  Because American spenders have fewer and fewer normalized dollars to spend every year, normalized consumer prices are also dropping.

But the quantity of these normalized dollars is constant, so they have to go somewhere.  Where do they go?  To Asia and to rich people, generally.  If we look at the prices, normalized or not, of the assets that Asians and rich people buy, we see these prices going up.  Rather rapidly.  So, for these people (who hold quite a few dollars), the dollar is a rather poor store of value.

Because it seems unimaginable that USG will repair its hemorrhaging finances, the opportunity exists for a sounder monetary standard to outcompete its notes.  However, it is only an opportunity.

USG, now and for the near-term foreseeable future, can kill Bitcoin dead as a stone by rendering it ineffective as a store of value, simply by using its gargantuan physical force to prohibit exchange of Bitcoin for dollars.  Even a credible threat to shut down the exchanges will result in an enormous demand to flee from Bitcoin, effectively popping the bubble.  If the exchanges are really and truly killed, there will be a billion dollars of Bitcoin market capitalization that has no practical way to escape.  The holders of this Bitcoin will write it off as worthless - like South Sea or Mississippi Company stock.

The best thing about this outcome, from USG's perspective, is that to those who lost money in the Bitcoin bubble, it will seem like their own fault for being such fools.  True, as a result of USG actions, their personal net worth might drop vertiginously in an afternoon.  But it's not that the evil government confiscated their Bitcoins - rather, that the market betrayed them.  As with any bubble that pops.  So, just as 300 years ago, no political resistance can save the bubble.

On the other hand, suppose Bitcoin is money?  At this point, I can guarantee it.  Either USG will kill Bitcoin, which it can and probably will, or Bitcoin will be the new monetary standard.  In this case, Rick Falkvinge's projections are quite conservative.  Simply dividing dollar supply, however defined, by Bitcoin quantity, is an extremely incorrect way to project the USD/BTC exchange rate.  On the other hand, there is no better way.

In a world in which the entire pool of savings energy has moved to Bitcoin, what is a dollar worth?  On the one hand, enormous dollar debts exist.  On the other hand, those debts themselves must be valued as securities in Bitcoin.  As the BTC price increases into the millions, the purchasing power to pay off all the dollar debts - simply by cashing in a few Bitcoins - appears with it.  There are no significant Bitcoin debts, and nor will there be any until the transition has completed.

This is a scenario in which no one wants to hold either dollars, or dollar-denominated debts, because the purchasing power of these assets in Bitcoin is constantly decreasing.  (Note that it is already decreasing - at quite a rapid clip.)  The dollar is now the bubble, and devil take the hindmost.  The savings pool evacuates this bubble, but it does not evacuate evenly or all at once.  Rather, those who get out first (like Rick Falkvinge!) become much wealthier than they were before.  Those who get out last, however, can see a fortune shrink to a pittance.  This is classic hyperinflation.  A currency never hyperinflates by itself - it always hyperinflates relative to some other medium of saving.  There is always a savings pool, and always an overvalued asset.

Tangible assets - stocks and real estate - do better.  Across a monetary transition, a house remains a house.  You can still live in it.  On the other hand, the price of a house or a stock, relative to cash, is determined by interest rates.  Before the reboot, it is determined by USD interest rates.  After the reboot, it is determined by Bitcoin interest rates - which are effectively infinite during the transition, and relatively high even when the savings pool stabilizes.

Why relatively high?  Because they reflect the actual collective time preference of savers and borrowers, rather than the political incentives of Professor Bernanke.  We have no way of knowing what interest rates in a free market would look like - all we know is that ours are way too low, resulting in extreme malinvestment and way way way too much debt.

But the most significant effects of this unlikely, but awesome, transition are politicalRick Falkvinge, who to be frank could be easily mistaken for a goddamn hippie, has only begun to imagine them.  Yes, a world in which governments were subject to ordinary accounting reality, and could not fund themselves by expanding their balance sheets, would be a very different one.

But even more important - money is power.  Today, power remains in the hands of the great fortunes of the early 20th and even 19th centuries - the Carnegies, Rockefellers and Fords, not to mention the many lesser billionaires gathered under their umbrella.  The greatest of these fortunes have of course passed out of individual hands and into those of foundation managers.  As with Obi-Wan, this has not lessened their power at all.

When instead of being determined by whose ancestors cornered oil in 1896, the distribution of great fortunes is determined by who bought Bitcoin when 10K BTC would buy a pizza - really, a no less arbitrary function - we see the balance of wealth, and hence the balance of power, in the hands of very different kinds of people.  What changes this would bring - no one can know.  Probably none, as it will never happen.

Disclosure: I have no Bitcoin.  Which is not because I disdain the great bet - but just because I'm a poor student of history.  But if you have some and think you've learned from UR, I just made a wallet: 12jmAcfRptnP7wkvepXQoYUt5yDsYxHRiZ.  Send me a little and I'll buy my wife a pizza.  Send me a lot and I'll found the resistance.  A luta continua!