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Saturday, December 9, 2017

Bitcoin As A Vindication Of Mainstream Monetary Economics

Say what you want about the backers of Bitcoin, they managed to create a currency unit that acts in the insane fashion that matches the way money works in mainstream economic models. For anyone with any attachment to reality, it offers a very good real world explanation why the DSGE approach to economics is inherently useless.

Is Bitcoin a Bubble?

The major question my readers probably have is: is Bitcoin a bubble? My response is straightforward: what do you think?

That said, anyone who wants to short the various crypto-currencies should probably pour themselves a stiff drink, and read between the lines from the following theoretical rant. You need to ask yourself: how prudent is it to short something that has a "fair value" that is arbitrarily large?

I was a junior analyst during the dot-com era. The most reliable road to ruin was to pay attention to what internet analysts had to say. It's a speculative vehicle. Ignore stories; read charts.

What Pins Down The Initial Price Level?

If you are even slightly numerate and look at standard DSGE models (that do not include money in the utility function, see below), you see that that they offer a wonderfully complex characterisation of the relationship between the price level from the initial time period and later time periods. That said, there is absolutely nothing that pins down the initial price level. (The Calvo fairy says that some prices will be set from the previous period, which raises various chicken-and-egg questions.)

(Relative prices like wages/goods prices, are pinned down, even in the first period.)

If we are in standard framework, with one (composite) good and money, there is nothing to pin down the exchange rate between money and that good. We know what the rate of change of the good will be, (the ratio of its price between this period and the next), but that's it.

There's a number of ways to deal with this indeterminacy.
  • The central bank magically sets the price level. In other words, every Canadian wakes up every morning, and waits for the price level announcement from the Bank of Canada, and then go off to work. This apparently is the consensus opinion.
  • The "money in the utility function" kludge. You stick the household's money balance into the utility function. This pins down the relative value between money and the composite good. That said, there is absolutely no microfoundational story to explain this kludge; it's just an arbitrary term introduced to make it possible to fit the model to data. We have no idea where this factor comes from, or how it could change.
  • A cash-in-advance constraint. You put an arbitrary limit on how many transactions can be supported by an amount of money. This is pretty much the same thing as assuming that velocity is fixed (or a stable function of something or another). The whole Monetarist nonsense peddled by various hucksters relied upon the apparent stability of velocity in the 1950s.
  • The fiscal theory of the price level. You impose a relatively arbitrary governmental budget constraint on your model, you do the mathematics, and you back out that the price level is the level that equates the real value of government debt to the discounted values of future primary surpluses. Although this is the correct mathematical answer, the profession slaps its hands over their ears and goes "la-la-la" when people bring it up. The reason being that the Fiscal Theory of the Price Level makes even stupider predictions than the belief that the central bank arbitrarily sets the price level. For example, the price level was supposed to jump a lot when the Republicans made it clear that they wanted to ram a tax cut through.
The reader would notice that these explanations are either obviously wrong or trivial (the price level is what it is).

Inching Towards the Real World

If we start to take into account the various things that are stripped out of DSGE models, we can start to get a better idea of what pins down the price level.

The first step to notice is that most people have debts denominated in the local currency. Let's say you woke up morning with a house and a car, and a $100,000 mortgage on your house. You have no other fixed ideas about prices. Then imagine that a free market fundamentalist tells you that fiat currency is inherently worthless, and offers you $100,000 for your car. You can think about: do I value the mortgage or the car more? This creates a way of determining the relative value.

However, the fact that we live in a capitalist society offers a better idea of how to pin down the value of a currency. The system is dominated by capitalists. What do capitalists do? For various reasons, people want to think that capitalists shuffle around paper claims on equity. That is the wrong answer. The correct answer is the scarily Marxist one: capitalists exploit employ workers. 

In other words, the value of currency is determined by how much labour a unit of currency commands.

(It should be noted that this leads to the Modern Monetary Theory arguments about price level determination: the Job Guarantee wage creates a nominal anchor for the currency.)

And as I repeatedly note, this breaks down if we start indexing wages to an external unit. A hyperinflation results when the value of the local currency versus the index unit goes to zero.

Back to Bitcoin

The techno-anarcho-crypto-Libertarians who brought us Bitcoin (and whatever other crypto-currencies you want to think of) have taken free market economics to its logical conclusion. They have created a currency unit that has no nominal anchors for value whatsoever.

At the time of writing, almost nobody has debts denominated in Bitcoin. A wage denominated in Bitcoin would probably run afoul of various labour regulations, and I doubt that most wage slaves workers would be willing to work for a fixed Bitcoin wage. (Since most people have fixed expenditures that are north of 90% of their after-tax wage, there is not a lot of room for currency volatility.)

Therefore, the price of Bitcoin is exactly as free as would be predicted by DSGE models. There is no central bank to magically set the price level. There is no government to do the Fiscal Theory of the Price Level thing. Since most non-speculative transactions are just a way to avoid bank intermediation, there is no "Bitcoin-in-advance" constraint. Even if 99.99% of Bitcoin are hoarded, the remaining 0.01% float would be enough to support transactions.

The only thing that will bring this wonderful natural experiment to an end is the inevitable march of energy constraints, or an outraged populace with pitchforks and torches forces the regulators to shut this puppy down.

But in the meantime, mainstream economists should pat themselves on the back for coming up with models that perfectly explain Bitcoin dynamics. Well done!

Addendum: What if We Treat Bitcoin Like a Commodity?

We could come up with a fair value estimate for Bitcoin if we treat it like a commodity (a parallel that the crypto-gold bugs played up in the marketing of this scheme). The fair value is related to the energy cost of mining Bitcoin -- just like mining gold!

If Bitcoin miners hedging programmes were large enough, they might be able to cap the dollar Bitcoin price at the cost of production. This could be aided by large holders who view that as the fair value. However, this will only work if they are willing to sell, and they do not believe their own press releases. (Think about how gold bugs hate the hedging programmes of gold miners.) However, the ability of these hedging programmes to hold a lid on prices when faced by a speculative wave is limited by the size of the programmes, which is probably much smaller than the supply of greater fools.

This cost of production is less useful on the way down. Unless miners want to double down on losing Bitcoin positions, all they can do is slow down mining. (Stopping mining would be putting a fork into this sucker.)

Another possible alternative is that some large actor steps in to create a nominal anchor. A real world commodity producer could offer commodities at a fixed Bitcoin price. Alternative a cartel of large holders could decide to fix a price, and then use their market power to keep trading near the target. However, such price fixing attempts would be susceptible to runs (and/or various anti-cartel regulations).

The problem with offering goods for sale at a fixed BTC price is that your expenses are probably not fixed in BTC terms. It might be possible in some cases, but it would be relatively rare.

I will offer an analysis from my own perspective. For example, if I sold my ebooks on my own sales platform, I could offer them at a fixed BTC price. I could do that relatively safely, since my marginal cost of production is near zero. However, I could not do that for paperback editions, since I do have a relatively large dollar (or GBP/EUR) fixed cost of production. Furthermore, putting the book up for a fixed BTC price would mean that I could not post a USD price, as otherwise I just end up arbing myself. Meanwhile, I would be sitting duck for Revenue Canada. They could use whatever random BTC quote they can get to make it look like I made a fortune selling the books, and I would end up owing a large CAD-denominated tax bill. (The fact that I probably would have translated the profit at different prices could be chalked up as capital losses -- and I would have no corresponding capital gains to offset them with!) Since I am not a complete idiot, I leave the sales to the online retailers. They can sell the books to customers using crypto-kitties if they wish; they just need to send me my fiat currency-denominated royalties.

In any event, if the price stabilises as a result of such forces, it can no longer be treated as a currency using mainstream analysis. The value of Bitcoin would be largely determined by a fairly arbitrary price relationship to an existing fiat currency. Unless energy production costs are expressed in Bitcoin, a linkage to energy costs is actually a linkage to the dollar cost of production and so is not derived from the Bitcoin economy itself. (Although not all energy is produced in the United States, most energy producers have a semi-dollarised economy, or are developed countries whose currencies are relatively stable versus the USD. Compared to the volatility of BTC, energy prices look pretty close to fixed in USD terms.) This is unlike the situation during the Gold Standard, where the cost of mining gold was set in currencies themselves linked to gold.

In any event, mainstream macro theory would revert to having no useful predictive powers.

(c) Brian Romanchuk 2017


  1. Hi!
    I am long silent reader of your blog and MMT.
    Usually I got the point and am impressed, but I do not quite understand this time. I see weak link between "how much labour a unit of currency commands" and the part of no debts in bitcoin meaning no nominal anchor. I think you too quickly turned to attacking bitcoin in the end. So, your point is that bitcoin has no nominal anchor. What nominal ancor has fiat? I guess yours (and MMT) response is government enforecement. But it can be just said that %anything% is not money because it is not legally enforced. Why say about debts in bitcoin and labor?

    Bitcoin price swings can be explained (now) by not wide acceptance and speculation. May be it is too early to celebrate failure of DSGE/mainstream economics and free market fundamentalists?

    By the way, about energy constraint. AFAIK much energy required to mining bitcoins, but after mining fixed supply no coins can be mined so energy is needed much like for a blockchain transacting server. I am not confident in this, though.

    In my opinion (I have phd in corporate finance - I am reading about macro things just for interest) MMT and austrian views on why something is used as money are compatible in core: in the end of day people use as a money the most wide-spread thing being it either metals in old days (by pure "free will") or government fiat enforced by law, tax authorities and police.

    My bet on bitcoin long-term future (up to 10 years) is that it will be partially incorporated into legal system (meaning no tax avoidance) and partially banned (those features that allow to escape the state). Yes, libertarians/austrians/anarchists/criminals will be pissed off. Chances of bitcoin 'crackdown' by government skyrocket after revealing that next big act of terrorism was financed by bitcoin.

    1. I am not a fan of Bitcoin on a variety of grounds, energy use being one. Yes, the mining is the major power draw, but I believe that is tied into transactions. Even if mining activity drops, the power consumption us still horrific. Furthermore, it has an obvious parallel with pyramid schemes, with early adopters making suckers of those late to the party. Finally, I am not exactly a techno-anarchist in political views. But beyond that, Bitcoin is great.

      For fiat, the nominal anchor is provided each day by the contractual agreements made earlier. Workers do not go into work each day and haggle over their wages, as is implied by mainstream models. This breaks down if we start indexing values, which provides a very testable empirical statement that shows up in the data.

      Are there *any* long-term contracts in the real economy denominated in bitcoin? I’ve never heard of any, but admittedly, I could care less about the stuff. Even if some contracts exist - probably among questionable businesses - the volume appears insignificant compared to speculative volume.

      If something does manage to stabilise bitcoin prices, that would be great for bitcoin - but a disaster for mainstream economic theory, which would no longer fit observed reality. It can explain the indeterminacy of the price level, but not a stable one.

      As for Austrian theories, I would stay clear of what they say about the history of money. (At least the internet Austrians, or the old Austrians. There are four or five living academic Austrians who might have something useful to say.) You can make up your mine about the applicability of Austrian theory in the present, but the historical analysis can only be described as hogwash. It was based on extrapolating very bad historical research done a century ago. Actual historians have moved on, Austrians just repeat the same old fairy stories based on disreputable sources.

    2. Sigh. Should read “make up your mind...”

  2. I completely agree that there is no fixed reference point for money or bitcoin.

    That said, the creators of bitcoin placed an arbitrary value on their creation and relinquished ownership into other hands. I read this morning that the top 100 owners of bitcoins have about 17% of the total number of coins. (This number is discoverable.)

    That said, each purchaser decides if the asking price is fair and makes/does-not-make a purchase. Once purchased, future SALE value is up to the owner.

    People hate to lose money. There is a cost of continued holding but there is also the potential for gain--eventually.

    If you only sell enough of your stash to meet needs, perhaps the stash will grow faster than sequentially occurring needs. Hmmm. Early investors in bitcoin may be in this position.

    A very interesting post; timely. Thanks

    1. Actually, you hit a point about behavioural economics that I was thinking about. If people are unwilling to sell at loss, that puts a floor under BTC price. You get a never-ending upward ratchet effect. Stick that into a pricing model, and see what happens...

      In practice, the upper limit is the point at which whales sell out to reap gains. If all the “smart money” is seen to be selling, what happens?

      This is what happens when you stop regulating financial activity.

  3. Your discussion about what sets the price level made me think of a discussion about the 1976 UK IMF crisis . Simon Wren Lewis wrote " It seemed as if the Treasury’s senior economists believed in the ‘cliff model’ of the exchange rate. The cliff theory suggests that if the rate moves significantly away from the target that the Bank was aiming at, it would collapse with no lower bound in sight. At the meeting I remember some more junior economists (but more senior than I) trying to explain ideas about fundamentals and Uncovered Interest Parity, but their seniors seemed unconvinced."

  4. If anything, BTC (Bitchcoin - as I believe it will come to be known)says everything about human behaviour and financial markets. Clearly, there is madness in the air and there are plentiful examples in history of how manias end - BTC will be no different. All this talk of "nominal anchors", cost of production and "fair value" is nonsense. This is pure unbridled madness. There is no way it can be otherwise rationalized.

    Henry Rech

  5. @Brian, I like your post and work but this one is pure gold :) Couldn't agree more and the DSGE link was most interesting. I have been thinking a lot about origin of value of money. This was complete list IMO and holds some ideas I haven't thought about.

    I *think* historically we had commodity money (gold and silver) and after the peg was dropped we had plenty of contractual texture (like wages) to ensure relative price stability.

    @stone, thanks for the interesting link, I missed that at the time.

    1. In “Abolish Money (From Economics)!”, I had a rant about the origins of money.

      If my reading of the anthropology is correct (this is only based on a couple of popular books I read), people used tokens across Europe as a form of debt marker. Since this was developed before writing, we can only guess how the system would work. The tokens were of different shapes and sizes, and presumably stood for various standard items.

      The argument I saw is that people started putting these tokens in sealed clay jars. They then put markers on the jars to indicate what tokens they contained, since the jars would only be broken open when the debt was settled. They then realised that all they needed was the record on the outside of the jar, and so they just stuck the markers on a clay tablet. Writing was born.

      In other words, trade was debt-based.

      People only relied on gold and silver for inter-group trade, and after a societal collapse. Eventually, society bounced back, and evolved back to debt-based money. The gold bugs blot out the fact that the gold use resulted from habits from the previous society.

      In any event, the fairy stories about the origins of money in some economics textbooks - and old histories - are largely nonsense. You would need to read historical and anthropological works published in the last couple of decades.

  6. There are a few noteworthy contrasts amongst Bitcoin and customary monetary standards (e.g. U.S. dollar): sell perfect money


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