There’s a reason we don’t make coins out of precious metals. Mining them is a waste of resources. Mining bitcoins has the same problem. If they’re worried about people not liking them because of the profit they’d get, can’t they just donate the money to charity or something?
There are several reasons why we don’t make coins out of precious metals, and also a few why we should. The wastefulness of resources is relatively low down the list.
The point of a commodity-backed currency is to provide stability in the money supply. Provided the commodity is widely regarded as valuable, but isn’t likely to change in raw value in the long term, having x amount of money represent y amount of that commodity means that your money is a safe store of wealth. If you want to earn lots of money now and spend it in the future, you can be confident that inflation isn’t going to devalue your savings in the interim.
This is one of the reasons the price of gold is negatively correlated with equity performance. In Bear markets, people buy gold because they believe it’s less likely to lose value than holding your wealth in stock or currency, and generally they’re correct to hold this belief. In part, this then becomes a self-fulfilling trend, as gold itself becomes a good investment at the start of market decline. Partly because of this, you’ll find armchair investors are especially keen on the Gold Standard, because that’s what they think money is for.
There are problems with this, though, namely that inflation isn’t just a monetary phenomenon, and currency isn’t just a store of wealth. Money is also a medium of transaction. There has has to be enough money, in sensible units, to represent the value of all the goods and services that are traded with it, so as the economy grows, there has to be a proportional increase in the money supply, otherwise your currency will appreciate to unwieldy levels and you’ll suffer from effective deflation.
Gold is a bad candidate for fulfilling this function of money. There’s a finite amount of it. We’ve already mined most of what’s easily obtainable, and eventually any given good or service will be represented by an increasingly small quantity of gold. Any changes to the gold supply are going to be sudden shocks to the economy (say I irradiate a whole bunch of it like in Goldfinger, we discover a massive new supply of it, or a huge gold asteroid drifts into Earth’s orbit). Also, part of the usefulness of gold as a basis for currency was that it wasn’t used for a whole lot else. As various industrual uses were found for it, that impacted both those industries and the currency. If we found out tomorrow that eating gold cured cancer, increased penis/breast size, and gave people superpowers, that would be bad news for a gold-backed currency.
The purpose of the bitcoin mining process is to provide a stable supply of bitcoin. Since each block adjusts the difficulty of producing the next based on the efficacy of mining currently taking place, the production of bitcoin should be continual but stable, (at least until we mine them all).
I am still thinking about the ramifications of bitcoin, and what properties it has as a currency, but the method of bitcoin production is one of the things that makes it novel and special as far as currencies go. It can function as both a store of wealth and a medium of transaction without those functions necessarily working against each other as they do with traditional commodity-backed currencies.
There has has to be enough money, in sensible units, to represent the value of all the goods and services that are traded with it, so as the economy grows, there has to be a proportional increase in the money supply, otherwise your currency will appreciate to unwieldy levels and you’ll suffer from effective deflation.
The key idea here is not that you need enough currency to complete all transactions (since money gets reused many many times), but that people’s desire to hold a currency is a key determinant of its value. If people’s desire to hold a currency increases in real terms (such as during , but the nominal amount of money does not increase then the currency has to appreciate. This can lead to unwieldy currency units as you mention, but it also has bad dynamics. An overall shortage of money will lead to a reduction of economic activity as people try to get more currency (this logic also works in the reverse direction).
Fiat (public or private) currencies have the advantage that they can increase or decrease the amount of their currency in circulation at will using open market operations to match people’s overall desire to hold their currency. Whether this advantage is actually an advantage depends on how good of a job you think central banks do of actually doing this.
Inflation talk like this always makes me antsy. I pretty much agree with what you say above, but a monetary interpretation of inflation, specifically as regards the money supply relative to total economic activity, strikes me as the most sensible way to talk about why we’d experience de facto deflation with an exhausted commodity-backed currency in a growing economy, which was the salient point as far as bitcoin and the Gold Standard are concerned.
I don’t think the desire-to-hold interpretation of currency value is incorrect (in a sense it’s almost tautologically true), but in this case I think it makes sense to view that as a repercussion (an increase in demand for finance with no corresponding increase in real loanable funds, for example), rather than as a driving factor. The money supply is opaque to most agents in an economy, and their desire to hold onto it is based on how much they can get away with sitting on at any given time. If the money supply is small in relation to the number of transactions they have to make, that number must, by necessity, decrease.
Edit: Wait a minute. That last bit doesn’t make any sense at all. If I’m an agent in an economy, my only evidence for the true value of the money supply is how much I can buy with it relative to what I could buy with it in the past. After a period of growth I should be able to purchase a relatively larger amount with the same quantity of currency, so in that sense I guess my desire to retain currency is a direct effect of growth with a fixed money supply without even having to think about the size of the money supply in relation to transactions. They are implicit in whatever background activity is responsible for the growth, however.
Hm. OK. I could be convinced that either angle is useful for addressing the issue. I guess it depends on where you think the action is. The example of number of borrowers in relation to loanable funds is definitely one for the money-supply-to-economic-activity ratio. It’s also possibly best dealt with in terms of interest rates, but it suggests a category of coarse, high-capital exchanges which are susceptible to policy intervention. On the level of individual economic agents, currency-retention is probably the easier idea to work with, but it’s dealing with very fine-grained aggregate processes that are less tractable in terms of interventionist policy.
I don’t understand what you mean. Are you just saying “the way I explained it is a quick way to communicate the sort of problem I have in mind”? Your mention of inflation confuses me because neither of us had mentioned it before.
I didn’t mean to say “the value of money = desire to hold it”, which I think would probably be wrong or ill specified. A price is the rate at which you can trade one good for another good. Money has lots of different prices (2$ per lb apples, $300 per oz gold etc., $50 per hour of massage etc.) since it participates in lots of different markets, whereas most goods only participate in one market (where they can be traded for money). You can talk about a “price level”, but coming up with a precise and useful definition is a little tricky.
I just meant that if for each agent, the marginal utility of money rises (or you add more agents) and the quantity of money does not rise then at equilibrium the price of money will have to rise across the board (deflation). I was saying that your example of economic growth leading to more transactions is a special case and trying to explain that broader framework.
There are many reasons why people’s general desire to hold money might rise or fall, for example if a checking mechanism is introduced then people will need to hold less money to conduct their transactions (reduced desire to hold money) or if there’s a global financial crisis, people might say “holy shit, I can’t trust any of these assets, I’d best just hold money” then people’s general desire to hold money would rise.
Sorry...you might want to see my edit, which I started before reading this response, and which basically (although less concisely) repeats your explanation about marginal utility of money rising for each agent.
I have totally confused the issue, and you are quite right.
That makes more sense to me. Have you heard of Monetary Disequilibrium theory? It’s the most reductionist approach to monetary economics, and what I was describing more or less.
Not by name, but it seems highly compatible with many other accounts of macroeconomic fluctuation.
As you may have gathered, macro is not my strongest suit. I mostly hopped on board an econ syllabus for other reasons, and now find myself with a whole bunch of useful and explanatory macroeconomic concepts that most other people have never heard of.
The mining system provides the block chain that verifies transactions; yes. And eventually the payoff to miners becomes dominated by transaction fees rather than by payouts for finding blocks.
One of my concerns with Bitcoin is that today, on the margin, choosing to accept BTC in exchange for goods means agreeing to give lots of goods, on demand, to the people who currently are sitting on a lot of BTC — who have not (on the whole) done anything particularly useful to earn that wealth. Even a merchant who thinks a Bitcoin-like system is a good idea may be reluctant to agree to participate in making a bunch of nerds with video cards very, very rich.
Even a merchant who thinks a Bitcoin-like system is a good idea may be reluctant to agree to participate in making a bunch of nerds with video cards very, very rich.
I don’t think the merchants really care about that. They care about make themselves rich. If making nerds with video cards also rich is a side effect, so be it. But if nerds with video cards can dilute the value of their currency, they may have a problem. If this dilution occurs on a known schedule and will slow down over time and eventually stop altogether, and competing currencies can be diluted at any time by central bankers, it may not be much of a problem.
A bit of a tangent, but the increase in supply of bitcoin is not the only thing that affects the value of bitcoin. A key determinant is how much people want to hold bitcoin. How much people want to hold a currency is not a very stable thing, meaning that the even with a fixed quantity of bitcoin in circulation, the future value of bitcoin will be highly uncertain. This will also tend to produce gluts and shortages of bitcoin, which have their own negative effects.
Well the problem is arguably worse with regular money since the number of bitcoins that will ever exist is limited, whereas with regular money governments can, and sometimes do, print arbitrarily large quantities.
Have you heard the criticism that bitcoin is significantly suboptimal because the quantity of bitcoin can’t adjust the quantity to fluctuating demand to hold bitcoin? Do you take it seriously?
I’ve heard it, and I don’t take it too seriously: adjustments are as adjustments do. A fiat currency like the US dollar seems to be getting the worst of both worlds—vulnerability to pathologies like hyperinflation, and yet, the Fed won’t loosen money despite inflation expectations that verge on zero or negative. What’s the point, then?
Gotcha, I guess it depends on what you’re comparing bitcoin to.
Though bitcoin will generally be in constant deflation at a bit less than the rate of economic growth. Some people think that would be bad, though I personally don’t have a strong opinion about that.
I’ve heard it argued that the predictability of the amount of inflation/deflation could be more important for stability than the actual amount. If so, that would be an advantage for bitcoin over other currencies.
Do you have any thoughts on that?
EDIT: just saw your other comment where you said, “A bit of a tangent, but the increase in supply of bitcoin is not the only thing that affects the value of bitcoin. A key determinant is how much people want to hold bitcoin. How much people want to hold a currency is not a very stable thing, meaning that the even with a fixed quantity of bitcoin in circulation, the future value of bitcoin will be highly uncertain. This will also tend to produce gluts and shortages of bitcoin, which have their own negative effects.”
Yup, predictable inflation/deflation is going to be better than unpredictable inflation/deflation because people can plan for it. Bitcoin will have uncertainty about its future value. I don’t know whether this would be more or less than for USD.
As a side note: because money is an asset, expectations about its future value are very important for its present value so most of the time “predictable inflation/deflation” will mean “constant inflation/deflation”.
The following is just cause I misunderstood your post at first:
Another way: if central banks don’t pay interest on cash, then people will have inappropriate incentives about how much money they should hold. If you have strong inflation and pay 0 interest on cash then it has a large negative real return and you punish people for holding it even if that doesn’t reflect real costs. If you have strong deflation and pay 0 interest then cash has large positive real return and you reward people for holding it even if this doesn’t reflect actual benefits. The interest rate on cash should probably be lower than short term real interest rates since otherwise people will choose to hold cash rather than other short term securities leading to an explosion in the demand for cash (and if it were higher, the currency issuer would probably be losing money). The Fed recently (2008) started paying interest on reserves (which is cash banks hold at the Fed), but they set that interest rate in a stupid way (it should probably be negative right now).
Bitcoin’s mining system seems odd.
There’s a reason we don’t make coins out of precious metals. Mining them is a waste of resources. Mining bitcoins has the same problem. If they’re worried about people not liking them because of the profit they’d get, can’t they just donate the money to charity or something?
There are several reasons why we don’t make coins out of precious metals, and also a few why we should. The wastefulness of resources is relatively low down the list.
The point of a commodity-backed currency is to provide stability in the money supply. Provided the commodity is widely regarded as valuable, but isn’t likely to change in raw value in the long term, having x amount of money represent y amount of that commodity means that your money is a safe store of wealth. If you want to earn lots of money now and spend it in the future, you can be confident that inflation isn’t going to devalue your savings in the interim.
This is one of the reasons the price of gold is negatively correlated with equity performance. In Bear markets, people buy gold because they believe it’s less likely to lose value than holding your wealth in stock or currency, and generally they’re correct to hold this belief. In part, this then becomes a self-fulfilling trend, as gold itself becomes a good investment at the start of market decline. Partly because of this, you’ll find armchair investors are especially keen on the Gold Standard, because that’s what they think money is for.
There are problems with this, though, namely that inflation isn’t just a monetary phenomenon, and currency isn’t just a store of wealth. Money is also a medium of transaction. There has has to be enough money, in sensible units, to represent the value of all the goods and services that are traded with it, so as the economy grows, there has to be a proportional increase in the money supply, otherwise your currency will appreciate to unwieldy levels and you’ll suffer from effective deflation.
Gold is a bad candidate for fulfilling this function of money. There’s a finite amount of it. We’ve already mined most of what’s easily obtainable, and eventually any given good or service will be represented by an increasingly small quantity of gold. Any changes to the gold supply are going to be sudden shocks to the economy (say I irradiate a whole bunch of it like in Goldfinger, we discover a massive new supply of it, or a huge gold asteroid drifts into Earth’s orbit). Also, part of the usefulness of gold as a basis for currency was that it wasn’t used for a whole lot else. As various industrual uses were found for it, that impacted both those industries and the currency. If we found out tomorrow that eating gold cured cancer, increased penis/breast size, and gave people superpowers, that would be bad news for a gold-backed currency.
The purpose of the bitcoin mining process is to provide a stable supply of bitcoin. Since each block adjusts the difficulty of producing the next based on the efficacy of mining currently taking place, the production of bitcoin should be continual but stable, (at least until we mine them all).
I am still thinking about the ramifications of bitcoin, and what properties it has as a currency, but the method of bitcoin production is one of the things that makes it novel and special as far as currencies go. It can function as both a store of wealth and a medium of transaction without those functions necessarily working against each other as they do with traditional commodity-backed currencies.
A nit pick:
The key idea here is not that you need enough currency to complete all transactions (since money gets reused many many times), but that people’s desire to hold a currency is a key determinant of its value. If people’s desire to hold a currency increases in real terms (such as during , but the nominal amount of money does not increase then the currency has to appreciate. This can lead to unwieldy currency units as you mention, but it also has bad dynamics. An overall shortage of money will lead to a reduction of economic activity as people try to get more currency (this logic also works in the reverse direction).
Fiat (public or private) currencies have the advantage that they can increase or decrease the amount of their currency in circulation at will using open market operations to match people’s overall desire to hold their currency. Whether this advantage is actually an advantage depends on how good of a job you think central banks do of actually doing this.
Inflation talk like this always makes me antsy. I pretty much agree with what you say above, but a monetary interpretation of inflation, specifically as regards the money supply relative to total economic activity, strikes me as the most sensible way to talk about why we’d experience de facto deflation with an exhausted commodity-backed currency in a growing economy, which was the salient point as far as bitcoin and the Gold Standard are concerned.
I don’t think the desire-to-hold interpretation of currency value is incorrect (in a sense it’s almost tautologically true), but in this case I think it makes sense to view that as a repercussion (an increase in demand for finance with no corresponding increase in real loanable funds, for example), rather than as a driving factor. The money supply is opaque to most agents in an economy, and their desire to hold onto it is based on how much they can get away with sitting on at any given time. If the money supply is small in relation to the number of transactions they have to make, that number must, by necessity, decrease.
Edit: Wait a minute. That last bit doesn’t make any sense at all. If I’m an agent in an economy, my only evidence for the true value of the money supply is how much I can buy with it relative to what I could buy with it in the past. After a period of growth I should be able to purchase a relatively larger amount with the same quantity of currency, so in that sense I guess my desire to retain currency is a direct effect of growth with a fixed money supply without even having to think about the size of the money supply in relation to transactions. They are implicit in whatever background activity is responsible for the growth, however.
Hm. OK. I could be convinced that either angle is useful for addressing the issue. I guess it depends on where you think the action is. The example of number of borrowers in relation to loanable funds is definitely one for the money-supply-to-economic-activity ratio. It’s also possibly best dealt with in terms of interest rates, but it suggests a category of coarse, high-capital exchanges which are susceptible to policy intervention. On the level of individual economic agents, currency-retention is probably the easier idea to work with, but it’s dealing with very fine-grained aggregate processes that are less tractable in terms of interventionist policy.
I don’t understand what you mean. Are you just saying “the way I explained it is a quick way to communicate the sort of problem I have in mind”? Your mention of inflation confuses me because neither of us had mentioned it before.
I didn’t mean to say “the value of money = desire to hold it”, which I think would probably be wrong or ill specified. A price is the rate at which you can trade one good for another good. Money has lots of different prices (2$ per lb apples, $300 per oz gold etc., $50 per hour of massage etc.) since it participates in lots of different markets, whereas most goods only participate in one market (where they can be traded for money). You can talk about a “price level”, but coming up with a precise and useful definition is a little tricky.
I just meant that if for each agent, the marginal utility of money rises (or you add more agents) and the quantity of money does not rise then at equilibrium the price of money will have to rise across the board (deflation). I was saying that your example of economic growth leading to more transactions is a special case and trying to explain that broader framework.
There are many reasons why people’s general desire to hold money might rise or fall, for example if a checking mechanism is introduced then people will need to hold less money to conduct their transactions (reduced desire to hold money) or if there’s a global financial crisis, people might say “holy shit, I can’t trust any of these assets, I’d best just hold money” then people’s general desire to hold money would rise.
Are we communicating better?
Also I categorised this as “inflation talk”, because it was wheeling out a few of the concepts behind the question “what are the causes of inflation?”
I think there’s something about macro that makes me communicate badly.
Sorry...you might want to see my edit, which I started before reading this response, and which basically (although less concisely) repeats your explanation about marginal utility of money rising for each agent.
I have totally confused the issue, and you are quite right.
That makes more sense to me. Have you heard of Monetary Disequilibrium theory? It’s the most reductionist approach to monetary economics, and what I was describing more or less.
Not by name, but it seems highly compatible with many other accounts of macroeconomic fluctuation.
As you may have gathered, macro is not my strongest suit. I mostly hopped on board an econ syllabus for other reasons, and now find myself with a whole bunch of useful and explanatory macroeconomic concepts that most other people have never heard of.
You do understand why Bitcoin is analogous to making coins out of precious metal rather than fiat, and what purpose the mining system serves, right?
The mining system provides the block chain that verifies transactions; yes. And eventually the payoff to miners becomes dominated by transaction fees rather than by payouts for finding blocks.
One of my concerns with Bitcoin is that today, on the margin, choosing to accept BTC in exchange for goods means agreeing to give lots of goods, on demand, to the people who currently are sitting on a lot of BTC — who have not (on the whole) done anything particularly useful to earn that wealth. Even a merchant who thinks a Bitcoin-like system is a good idea may be reluctant to agree to participate in making a bunch of nerds with video cards very, very rich.
I don’t think the merchants really care about that. They care about make themselves rich. If making nerds with video cards also rich is a side effect, so be it. But if nerds with video cards can dilute the value of their currency, they may have a problem. If this dilution occurs on a known schedule and will slow down over time and eventually stop altogether, and competing currencies can be diluted at any time by central bankers, it may not be much of a problem.
A bit of a tangent, but the increase in supply of bitcoin is not the only thing that affects the value of bitcoin. A key determinant is how much people want to hold bitcoin. How much people want to hold a currency is not a very stable thing, meaning that the even with a fixed quantity of bitcoin in circulation, the future value of bitcoin will be highly uncertain. This will also tend to produce gluts and shortages of bitcoin, which have their own negative effects.
Doesn’t regular money have this same problem?
Sure, in a sense; but merchants don’t really have a meaningful choice of whether to accept it. BTC is new.
Well the problem is arguably worse with regular money since the number of bitcoins that will ever exist is limited, whereas with regular money governments can, and sometimes do, print arbitrarily large quantities.
Tangent:
Have you heard the criticism that bitcoin is significantly suboptimal because the quantity of bitcoin can’t adjust the quantity to fluctuating demand to hold bitcoin? Do you take it seriously?
I’ve heard it, and I don’t take it too seriously: adjustments are as adjustments do. A fiat currency like the US dollar seems to be getting the worst of both worlds—vulnerability to pathologies like hyperinflation, and yet, the Fed won’t loosen money despite inflation expectations that verge on zero or negative. What’s the point, then?
Gotcha, I guess it depends on what you’re comparing bitcoin to.
Though bitcoin will generally be in constant deflation at a bit less than the rate of economic growth. Some people think that would be bad, though I personally don’t have a strong opinion about that.
I’ve heard it argued that the predictability of the amount of inflation/deflation could be more important for stability than the actual amount. If so, that would be an advantage for bitcoin over other currencies.
Do you have any thoughts on that?
EDIT: just saw your other comment where you said, “A bit of a tangent, but the increase in supply of bitcoin is not the only thing that affects the value of bitcoin. A key determinant is how much people want to hold bitcoin. How much people want to hold a currency is not a very stable thing, meaning that the even with a fixed quantity of bitcoin in circulation, the future value of bitcoin will be highly uncertain. This will also tend to produce gluts and shortages of bitcoin, which have their own negative effects.”
I suppose that answers my question.
Yup, predictable inflation/deflation is going to be better than unpredictable inflation/deflation because people can plan for it. Bitcoin will have uncertainty about its future value. I don’t know whether this would be more or less than for USD.
As a side note: because money is an asset, expectations about its future value are very important for its present value so most of the time “predictable inflation/deflation” will mean “constant inflation/deflation”.
The following is just cause I misunderstood your post at first:
Predictable inflation/deflation can have real effects if it’s expensive for plan for it. For example if it’s not very practical to index things to inflation or costly to change prices (supermarket prices have frequent sales, but their reference prices only change about once a year).
Another way: if central banks don’t pay interest on cash, then people will have inappropriate incentives about how much money they should hold. If you have strong inflation and pay 0 interest on cash then it has a large negative real return and you punish people for holding it even if that doesn’t reflect real costs. If you have strong deflation and pay 0 interest then cash has large positive real return and you reward people for holding it even if this doesn’t reflect actual benefits. The interest rate on cash should probably be lower than short term real interest rates since otherwise people will choose to hold cash rather than other short term securities leading to an explosion in the demand for cash (and if it were higher, the currency issuer would probably be losing money). The Fed recently (2008) started paying interest on reserves (which is cash banks hold at the Fed), but they set that interest rate in a stupid way (it should probably be negative right now).