BackedCoin vs UnbackedCoin

Imagine there is competition between two currencies. The two currencies are identical in every respect, except one is backed by assets and the other isn't. Which one would win the competition to become the preferred medium of exchange?

I think the one that is backed by assets would win. For two reasons:

1. The issuer of the backed coin could use those assets to help stabilise the value of the coins in response to fluctuations in demand. If demand falls, the issuer could use the assets to buy back some of the coins in circulation. If demand rises, the issuer could sell more coins in exchange for more assets. The issuer can make the supply curve of the coins more elastic, so that fluctuations in demand cause smaller fluctuations in price. Other things equal, people prefer a safer asset to a less safe asset.

2. The issuer of the backed coin could use the returns on those assets to pay interest on the coins. Or to buy back coins so the owners of the coins would see capital gains. Other things equal, people prefer an asset that pays a higher rate of return to one that pays a lower rate of return.

Other things equal, we would therefore expect to see competition between currencies lead to issuers of those currencies having assets backing those currencies, and paying out all the returns from those assets (minus administrative costs) to those who own those currencies. Free entry and competition drives down the profits from issuing currency to zero. Only currencies with 100% backing would survive.

But are other things equal?

There could be network externalities and a first mover advantage. Like Microsoft, VHS vs BetaMax, and the English language. If UnbackedCoin got on the market first, and if everyone wants to use the same coins as everyone else, and translation costs are high enough, it could survive against competition from BackedCoin. Customers cannot coordinate their simultaneous switch from UnbackedCoin to BackedCoin.

One more post in response to Brad Delong's email query and arguments about competition for Bitcoin.

I recommend Tyler Cowen's post.

[Update: I think JP Koning got there first.]

(Mike Sproul deserves all the blame for making me think this way.)

Comments

[Robert]

Wouldn't the one NOT backed by assets win? Less likely to be used as a store of value and therefore more likely to be exchanged for other goods..... Is this not the lesson of bimetallism? The bad drives out the good.

[Nick Rowe]

Robert: Gresham's Law works if the two currencies have fixed exchange rates. Bimetallism was a fixed exchange rate between gold coins and silver coins. These two currencies would have flexible exchange rates.

[JP Koning]

Backed vs unbacked: this is exactly why I keep saying that Ripple (or something like it) is going to be the end of Bitcoin:

http://jpkoning.blogspot.ca/2013/03/selling-out-of-bitcoin-ledger.html

[Roger Sparks]

I would think the unbacked currency would win the circulation battle. The reasons are three:

1. If an owner has both backed and unbacked currency, he would trade the unbacked first. This reduces his risk of loss of value.

2. More of the unbacked currency will be produced. This happens because the issuer does not need to limit production to available real assets; production can follow political sale of desired, good, projects.

3. A long term holder-with-choices would place assets into the backed currency. That action would withdraw the backed currency, making it more a reserve currency, not a trading currency.

Only when a currency becomes unacceptably weak, does it receive reduced usage. Actual rejection must occur, not simply preferred unloading.

[Nick Rowe]

JP: I have updated the post, to link to yours.

[Majromax]

> Free entry and competition drives down the profits from issuing currency to zero. Only currencies with 100% backing would survive.

Isn't this what we see in traditional, "meat-space" alternative currencies such as gift cards or subway tokens?

The unbacked value of a currency comes from its transactional utility. That would come from both the chartalist notion of "you have to pay taxes" and the currency's use as a stable store of value (to allow for nominal-terms finances). The latter acts as the means by which currency failures (hyperinflation or unavailable supply) result in adoption of a foreign currency in practical circulation.

That source of "unbacked" value would allow a currency issuer to derive durable profits from seniorage: a cow is less valuable than a certificate that can be exchanged for a cow on demand, pays milk, and can be used to pay taxes.

Limiting the currency issuer's profits is the transactional value from the secondary market. A certificate that pays taxes might be less worthwhile than a certificate that pays for everything but taxes, so it's in the currency issuer's interest to have the currency adopted widely. (That is, under reasonable circumstances the transactional value of a currency slopes upward with velocity). In a coinage-dominated environment, currency is something close to a natural monopoly: people and businesses only have the time and resources to deal with a select few independent currencies.

Bitcoin is certainly a break from this. I think that the comment that Krugman makes is spot on: "I try to get them to explain to me why BitCoin is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange."

In that regard, Bitcoin is technically cool but I don't think it's a long-term medium of exchange. Its designer and community confuses certainty of quantity with certainty of value, so the reasoning on why Bitcoin in particular has value is circular. (It has value because it's limited, so its value can never go down (much!))

[Ralph Musgrave]

When some Bitcoin type operation manages to stabilise the value of its coins relative to the national currency, the operation becomes indistinguishable from a commercial bank.

That is, coins issued by bank X and with “bank X” imprinted on the coins are no different to notes issued by bank X, which in turn are no different to loans extended by bank X: they are all liabilities of the bank. And in all three cases the bank will nearly always want collateral in exchange for lending out any of the above three. So to that extent, all three are backed by real assets.

The existence of some other asset (e.g. lots of gold in the bank’s vault) doesn’t add much: i.e. the bank will still want collateral from those wanting coins / notes / loans. Indeed, as Robert above suggests, that gold backing would be a COST, which might make bank X uncompetitive. And if the bank has interest yielding assets (e.g. property instead of gold) that’s a separate business surely? It has nothing to do with, and isn't a necessary part of the coin / note / loan issuing business.

[NoniMausa]

You could argue that US currency is backed by their military. Ultimately, all other resources are vulnerable to theft, invasion, redefinition under law, obsolescence, and all the other hazards of the world, but a whompin' big military can offset many of those hazards, and can additionally assist in redefining other countries laws, tweaking their behaviour with mini-invasions, supporting their adversaries, and basically acting as the biggest thumb on the biggest scales in the world.

People wonder why the US wastes trillions on a military an order of magnitude bigger than anyone else's. That's why.

Noni

[Mike Sproul]

Nick:

Your first-mover advantage argument is plausible, but then we look around at modern-day dollars, pounds, euros, yen, etc, and find that they are listed as liabilities of the central banks that issued them, that those central banks hold assets against them, that no dollar is ever issued without getting a dollar's worth of assets in exchange, and so on. It sure looks like backed currencies win.

A couple of weeks ago I even heard some Federal Reserve officials publicly discouraging people from using bitcoin. They said it is safer to use a BACKED CURRENCY LIKE THE DOLLAR (!!)

[Nick Rowe]

MajroMax: "In that regard, Bitcoin is technically cool but I don't think it's a long-term medium of exchange."

I disagree. If there were no threat from competition, or from governments banning it, I think it could survive fine, despite its fluctuating value (and those fluctuations would diminish a bit over time as people learn more about the future demand to use Bitcoin). Because some people want to use a cryptocurrency. The danger is from competition from better backed competitors.

Ralph: "When some Bitcoin type operation manages to stabilise the value of its coins relative to the national currency, the operation becomes indistinguishable from a commercial bank."

Bingo!

A commercial bank is like a central bank that fixes its exchange rate against another central bank.

But you lost me on the rest. A commercial bank that pays less interest and/or has higher fees and/or worse service than competing banks will lose the competition for deposits. Unless they use the returns on their assets to do those things, they will lose out in competition, because their customers will switch.

Noni: I don't get that. Zimbabwe had a (relatively) strong military, but that didn't help the Zim dollar.

[Nick Rowe]

Mike: the backing of the Bank of Canada helps to make the supply curve elastic, to prevent the Lonnie fluctuating in value. But holders of Loonie currency don't see the interest on those assets.

[Ian Lippert]

JPK,

Your post that Rowe linked to states

"But that's not the sort of ledger space I'm talking about. What happens when we bring in bitcoin-quality ledger space that has an anchor? I'm talking stable-value crypto-currency, not the sort that dangles and has a null value. These new alternatives will copy the best aspects of bitcoin, specifically its fast, efficient and safe record-keeping abilities. But rather than just providing blank tokens, they'll twin the ledger with some intrinsically valuable item."

Why does a currency need to be backed by an object of value and why does that linking prevent fluctuation in demand for the currency?

Its like when people claim we should use gold over bitcoin because gold has "intrinsic" value due to its uses in certain production processes. This doesnt give gold intrinsic value, the value of gold is determined by the sum total of demand for the commodity regardless where that demand comes from.

Gold is currently about $1200/ounce, if there was no demand for Gold as a currency/speculative commodity what portion of the price would be due to the demand for "real" uses of gold? If 10% of gold is purchased for industrial use then what stops your fluctuation argument from applying to gold when it only a small portion is used for "real" projects.

You dismiss the ledger and claim it points to nothing, but when it is traded against real goods that ledger becomes a full account of the trade ratios between goods without any interference from non-trade demand or the wishes of those who provide a monopolized currency. That's the value of bitcoin, it removes the barriers that are created by those who are attempting to control the intertemporal trade in goods to fund their economic stimulation schemes.

[Ed]

I'm having trouble thinking through all of this.

The classic example is cigarettes in prison. Would you say that cigarettes are "backed" by the number of men that actually smoke them? And that would provide a floor on their value?

Now suppose cigarettes have a competitor in baseball cards. There's a few guys in prison that collect the cards for sentimental reasons - but fewer than the number of guys that smoke. The floor for baseball cards is lower. But there are advantages to cards as medium of exchange (just assume that's the case). For example, maybe they're easier to hide when there's a shakedown by the guards.

In any case, does the higher floor on cigarettes necessitate that it wins out as a medium of exchange? Is this example analogous to your note above?

[Mike Sproul]

Nick:

"holders of Loonie currency don't see the interest on those assets."

Maybe they do. It's just that the interest is burned up by costs. Assume costlessly-issued bonds pay 3% per year. Then along comes another bond, called the Loonie, that has printing/handling costs of 5% per year. The loonie earns a 3% yield just like other bonds, but the 3% yield is burned up by the 5% costs, leaving the loonie yielding -2% per year. The loonie has a high enough convenience yield (aka liquidity yield) that people are willing to hold it despite its low net yield.

Of course, a checkable loonie would have lower printing/handling costs, and would have a higher yield. Central banks are just now discovering this as they start paying interest on reserves.

[Nick Rowe]

Ed: in the case of cigarettes, there is a demand curve for cigarettes from smokers, and a demand curve for those who want to use them as currency. Smokers have a flow demand curve, and currency holders a stock demand curve. If the demand for cigs as currency drops, the price drops, smokers smoke more, so the stock supply falls over time, preventing the price falling as much.

So the cigarette case is very much like a backed currency with an elastic supply curve, but a bit more complicated because of stocks and flows.

[Nick Rowe]

Gold is like cigarets too, except the flow supply from new mining is very small, so fluctuations in monetary demand cause big fluctuations in price for a long time.

It's all in elasticity of demand and supply, and stocks vs flows. A currency that is 100% backed can have a perfectly elastic supply that adjusts the stock very quickly.

[Majromax]

@Mike Sproul:
> Your first-mover advantage argument is plausible, but then we look around at modern-day dollars, pounds, euros, yen, etc, and find that they are listed as liabilities of the central banks that issued them, that those central banks hold assets against them, that no dollar is ever issued without getting a dollar's worth of assets in exchange, and so on. It sure looks like backed currencies win.

That doesn't work, because "a dollar purchases a dollar's worth of assets" is meaninglessly true. Backing in this regard would involve some kind of fixed terms of exchange, such as the old gold standard. (You can derive an implied backing for currency by looking at the central bank's balance sheet, but that's descriptive rather than prescriptive.)

@Ian Lippert
> Why does a currency need to be backed by an object of value and why does that linking prevent fluctuation in demand for the currency?

Because that backing ensures scarcity, and it acts as a put option on value.

As proponents are quick to point out, Bitcoin proper does have scarcity in that its issuance is technically limited. However, the criticisms from the linked articles also apply; there's nothing preventing me from cloning Bitcoin into Bitcoin2, keeping everything technically the same but with a totally new blockchain. In *that* regard, cryptocurrencies are of unlimited issue.

That means that the only thing giving Bitcoin value over Bitcoin2 is the network effect -- there's no extrinsic reason I should choose Bitcoin over any particular alternative. But when the currency's value is governed solely by sentiment, that's not stable.

On the other hand, backing by a sufficiently credible entity does give a currency (potentially small, but nonzero) intrinsic value; that limits downside risk and makes a particular currency a much more attractive option. Imagine if the US government decided to accept payment of taxes in Dogecoin or one of the other joking alternatives -- that would instantly become a much more credible instrument than all of the other, nonprivileged currencies.

> Its like when people claim we should use gold over bitcoin because gold has "intrinsic" value due to its uses in certain production processes. This doesnt give gold intrinsic value, the value of gold is determined by the sum total of demand for the commodity regardless where that demand comes from.

You're confusing "value," which includes all forms of demand, with "intrinsic value," which excludes the presumed re-selling of gold. The intrinsic value of gold comes from all the things people want to do with it that don't involve giving it (in unmodified form) to other people -- industrial and ornamental uses.

Intrinsic value acts as a rough floor on total value, in that if the net value ever dropped below the intrinsic value then it would be profitable to buy the commodity solely to "do stuff" with it.

@Nick Rowe:
> I disagree. If there were no threat from competition, or from governments banning it, I think it could survive fine, despite its fluctuating value (and those fluctuations would diminish a bit over time as people learn more about the future demand to use Bitcoin). Because some people want to use a cryptocurrency. The danger is from competition from better backed competitors.

I think I was a bit unclear about what I meant. Bitcoin is totally fine as a medium of exchange for short-term holding periods, but even in the most optimistic of cases I don't see it as a stable medium of exchange for long-term holding periods. I can write and purchase nominally-denominated instruments in conventional currencies because there's widespread faith about the value of cash 6 months->30 years down the road (with increasing vagueness); there's no such faith about even the order of magnitude of Bitcoin's value 12 months hence.

That means that even if I expect to be able to complete a purchase->exchange for goods transaction in Bitcoin a year from now, I don't have a meaningful incentive to do the "purchase" portion of the exchange now. Even a presumed modest discount won't work for me, because there's no reasonably risk-free instrument to invest in. (Fiat, of course, gets by with well-managed inflation expectations, and for even more risk-averse holders there's government-backed inflation-protected securities.)

Bitcoin could potentially replace cash in my wallet, but without credible backing it can't replace the balance of my chequing account.

[Nick Rowe]

Mike: "Maybe they do. It's just that the interest is burned up by costs."

If that were the case, then, OK, it is equivalent to the owners of Loonies getting the interest, in kind.

But, as a matter of fact, it isn't. Costs are relatively small. Most of the interest gets paid to the government.

[Mike Sproul]

Majromax: If a dollar is pegged to 1 oz or 1 CPI basket, then that provides an anchor, and backing a dollar with a dollar is no longer meaningless.

Nick: Costs are pretty hard to judge. I think printing alone burns up 1% per year. Then there's vault storage at maybe another 1% per year, then the cost of all those armored cars, the cost of tellers counting out bills, the cost of chasing counterfeiters, etc. Nineteenth-century note-issuing bankers used to say that paper notes weren't profitable, but were just a good form of advertising.

[Min]

"Imagine there is competition between two currencies. The two currencies are identical in every respect, except one is backed by assets and the other isn't. Which one would win the competition to become the preferred medium of exchange?

"I think the one that is backed by assets would win."

Is there enough information to tell? The mandats of the French Revolution were backed by land, and quickly flopped. OTOH, the currency of the Pennsylvania colony was also backed by land, and was a success.

You did have Greenbacks vs. gold backed US Dollars during the Civil War. The Greenbacks dropped in value by about 1/3, but eventually recovered parity. {shrug}

As for Bitcoin, two analogies spring to mind: wampum and US Colonials. Wampum was a success, Colonials flopped.

[Min]

Correction: Colonials were not US currency. The US did not exist yet.

[Majromax]

> If a dollar is pegged to 1 oz or 1 CPI basket, then that provides an anchor, and backing a dollar with a dollar is no longer meaningless.

Those two things aren't the same; the definition of 1oz is fixed but the definition of $1-CPI-basket depends on the price level. Having a meaningful backing would require the central bank to credibly say that "tomorrow, I will exchange $1 for x% of a standard basket." That's not what happens now.

Think about it from the perspective of the goods-holder. Under the convertible gold standard, I could "always" exchange 1oz for 35 US$. However, under the current system, I can't make such an exchange -- excepting mortgage-backed securities the central bank doesn't deal in real goods. I can have faith that through appropriate actions the central bank will keep the price level controlled within certain rough limits, but that's qualitatively different than a precise (and known in advance) peg. That faith can break down in exceptional circumstances, of course.

Bitcoin, as it currently stands, lacks neither fixed nor "faithful" backing. The quantity of the bitcoin supply is known in advance, but that does not necessarily reflect upon the exchange of bitcoins for real goods and services. There's no large, credible entity willing to stand behind a value-peg, nor is there a central bank policy regime willing and capable of controlling supply to target (fixed or relative) price levels.

[Ian Lippert]

Majormax,

"That means that the only thing giving Bitcoin value over Bitcoin2 is the network effect -- there's no extrinsic reason I should choose Bitcoin over any particular alternative. But when the currency's value is governed solely by sentiment, that's not stable.

On the other hand, backing by a sufficiently credible entity does give a currency (potentially small, but nonzero) intrinsic value"

Where do governments get their credibility from? The network effects that have developed over hundreds of years from the vast financial infrastructure that has been built up around the state. If bitcoin gains this level of credibility then there is no reason to believe bitcoin can't be a sufficiently credible monetary institution, its just a matter of time for the bitcoin infrastructure to be put into place.

Intrinsic value (thanks for clearing up the definitions) might provide a lower floor but if that floor is really low (as in the case of gold) then the same criticisms apply to currency with intrinsic value. Fiat currency has intrinsic value only in so far as the monetary authority correctly manages it. The whole point of moving to bitcoin is that savers dont want to ride the QE inflation train and now potentially have an easily accessible currency to hold their savings.

I know the NGDPers like Nick dont want that to happen because they believe that certain points in history require the sacrifice of savers for the greater good of the economy but the fact is that in the face of massive US QE programs savers are going to perform that experiment regardless of what the monetarist economists want.

If the NGDPers are wrong then a massive shift to bitcoin can easily shift to bitcoin the credibility that the central monetary authorities have lost.

[Ian Lippert]

Edit: "no reason to believe bitcoin CAN'T be a sufficiently credible monetary institution"

(is there an edit function I dont know about?)

[I edited it for you NR.]

[Frank Restly]

Ian,

"Where do governments get their credibility from?"

The system of laws that they create and govern by. A market system without a legal system will not get you very far and lawyers don't work for free.

[Mike Sproul]

Min:

"The mandats of the French Revolution were backed by land, and quickly flopped. OTOH, the currency of the Pennsylvania colony was also backed by land, and was a success."

A dollar backed by 1 oz worth of land will be worth 1 oz, and a dollar backed by 0.2 oz will be worth 0.2 oz. The assignats, and later the mandats, were initially well-backed by land, but as the land was sold off, and paper money was printed and spent like crazy, there was less land per unit of currency, so the currency lost value. Pennsylvania, on the other hand, held enough assets to adequately cover the money it issued, so the money held its value.

"Colonials flopped" You probably mean Continentals, which flopped because their quantity outran the assets (i.e., taxes receivable) backing them.

Majromax:

The CPI basket is defined by physical amounts of key commodities, so pegging to it is tantamount to pegging to 1 oz.

[Squarely Rooted]

I'm going to by my usual navel-gazing self and dig into the two key words here:

"backed" by "assets"

second one first:

"Asset:" So what is an asset? Traditionally, its been rare metals, because that's what technologically made sense for pre-industrial societies. But couldn't assets be lots of thing? The United States owns 635 million acres of land; could you have a land-backed currency where every dollar is worth 100 square feet of land? What if the currency was backed by shares in a holding company that owned corporations that issue mortgages or make cars (to pick two totally random examples)? Or what if all patents and copyrights, instead of reverting to the public, reverted to the government, which licensed them for free but retained the right to alienate them and then used them to back the currency? What if a bunch of folks with guns and tanks and maybe even thermonuclear weapons, as well as large, unpleasant, remote buildings in which many people were forced to stay for a very long time, told everyone that unless they used the currency those folks liked that those folks would use those guns or put them into those large, unpleasant, remote buildings? Is "avoidance of violence or loss of freedom" an "asset?"

"Backed:" this is all about credibility, no? If you said that every currency unit could be theoretically redeemed for a gram-and-a-half of gold, but you issued lots and lots of currency and didn't really have very much gold, is your currency "backed?" What if you really did have all the gold, but nobody believed that if push came to shove you'd actually redeem all that paper for delicious, delicious gold? Is your currency "backed?" What if you had all the gold and people believed you'd redeem all the paper for all the gold but somebody else in the country next door was trying the same scheme but nobody believe HE'D redeem the paper for gold so suddenly all the gold starts getting sucked out? What if that could happen at any moment?

I guess where I'm going is, if the government has a whole lot of guns, and they can credibly threaten to use them on people if they don't use the government's currency, then that currency is just as "backed" by an "asset" as any other.

[Majromax]

> Where do governments get their credibility from?

At a basic level, the power to enact laws and collect taxes. Beyond that, they develop and justify reputations as competent managers, so that their claims about future outcomes are respected.

Bitcoin has none of those effects going for it. Bitcoins are not backed by tangible (convertible) assets beyond the ability to say "I provably own some bitcoin," and that "coolness factor" will go down as novelty wears off. Likewise, Bitcoins have no governing authority backing their use as a matter of law (nor has a large, credible company stepped in to use it to denominate its own offerings). The *supply* of bitcoins are credibly controlled, but that has no independent link to the *value* of bitcoins.

In the meantime, all of that "bitcoin infrastructure" -- while potentially extremely useful for bitcoin transactions -- can be easily switched to any other similar currency, including a clone of bitcoin. The technical adoption of bitcoin transactions reduces, rather than increases, barriers to entry for other digital currencies. (This is distinct from cash: if I invest in machines and training to spot legitimate $100 bills, for example, it doesn't help me to accept €100 bills.)

> Fiat currency has intrinsic value only in so far as the monetary authority correctly manages it. The whole point of moving to bitcoin is that savers dont want to ride the QE inflation train and now potentially have an easily accessible currency to hold their savings.

I'd be more inclined to believe your point here if bitcoin was actually effective as an instrument of savings. It isn't; over the past year alone the currency has suffered from several 50% peak to trough drops. Regardless of your opinions on the long-term value of bitcoins, this makes it a lousy instrument for currency-type savings: I wouldn't want to put the cash for next week's groceries in bitcoin.

> I know the NGDPers like Nick dont want that to happen because they believe that certain points in history require the sacrifice of savers for the greater good of the economy but the fact is that in the face of massive US QE programs savers are going to perform that experiment regardless of what the monetarist economists want.

Without putting words into Nick's mouth, "savers" are indistinguishable from "creditors." Without putting words into your mouth, it seems an inherent contradiction of the entire bitcoin community is that it is highly skeptical of the creditors of the modern economy (namely financial institutions) while being highly protective of their own financial assets.

> If the NGDPers are wrong then a massive shift to bitcoin can easily shift to bitcoin the credibility that the central monetary authorities have lost.

That will work if and only if monetary policy can be reduced to a simple formula regarding the quantity of base money, in the absence of trading costs. The lessons of the last eighty or so years of economics suggest that it really isn't that simple.

[Majromax]

I had a response to Ian posted, but I think it got spam-trapped, possibly due to a link to an externally-hosted bitcoin value chart. I'd much appreciate it if that spam-trapping could be looked into.

[Summary in lieu: bitcoin has no natural monopoly because the infrastructure can be redirected to other cryptocurrencies, it doesn't work -now- as a means of savings because it's suffered several large drops in value in the past year, and bitcoin can only be monetarily credible if and only if monetary policy can be reduced to a simple equation on quantity of money.]

@Mike:
> The CPI basket is defined by physical amounts of key commodities, so pegging to it is tantamount to pegging to 1 oz.

I think we might be starting to talk past each other. The central bank could peg to a CPI basket in just that manner, but it doesn't; it only acts through transactions on largely nominal-terms financial instruments. The "CPI backing" is an outcome, not a constraint of that system, and it only holds insofar as the central bank's actions can actually affect the CPI.

This is also in large part why the central bank doesn't pay much attention to "true" CPI in favour of "core" CPI; monetary policy has even less impact on volatile food and energy prices, even though people very much care about those.

The indirect transmission is also the mechanism by which money can fail, either through a zero lower bound (arguably in play now) or through hyperinflation.

@Squarely:
> I guess where I'm going is, if the government has a whole lot of guns, and they can credibly threaten to use them on people if they don't use the government's currency, then that currency is just as "backed" by an "asset" as any other.

But that's not usually what happens; the private use of alternate currencies is mostly legal. The government only uses its powers to enforce the use of the national currency in dealings with itself, mostly via taxes. In fact, that increased freedom is a product of a more-unbacked currency, as capital controls are often necessary to defend fixed exchange rates (and equivalently real-goods convertibility).

[Ian Lippert]

Majromax,

"[Summary in lieu: bitcoin has no natural monopoly because the infrastructure can be redirected to other cryptocurrencies, it doesn't work -now- as a means of savings because it's suffered several large drops in value in the past year, and bitcoin can only be monetarily credible if and only if monetary policy can be reduced to a simple equation on quantity of money.]"

Several large drops...that occurred after several large increases. No one is saying the bitcoin of today is the optimal cryptocurrency. Its highly volatile, there are many other competitors, etc. But where was the internet 15 years ago? Completely indistinguishable from what we have today. Once it becomes less volatile it could easily become a vehicle for savings.

Frank,

"The system of laws that they create and govern by. A market system without a legal system will not get you very far and lawyers don't work for free."

Where do those laws gain credibility? From the credibility of the government that enforces them, which comes from the credibility that citizens have in their governing institutions. Have you guys never heard of civil war? Citizens can lose faith in their governments, governments are backed by nothing other than faith in the governing body. If faith based institutions can gain credibility after developing for hundreds of years there is no reason why bitcoin cant either, especially considering its non-physical form which allows for people from all over the world to support it essentially cost free.

[Nick Rowe]

Majromax and Roger Sparks: I found your comments in spam.

[Nick Rowe]

Ian Lippert: "Where do governments get their credibility from? The network effects that have developed over hundreds of years from the vast financial infrastructure that has been built up around the state."

Gotta say I loved that bit.

[Majromax]

> Several large drops...that occurred after several large increases. No one is saying the bitcoin of today is the optimal cryptocurrency. Its highly volatile, there are many other competitors, etc. But where was the internet 15 years ago? Completely indistinguishable from what we have today. Once it becomes less volatile it could easily become a vehicle for savings.

The large increases are just as bad from a currency point of view. What incentive would I have to take out a bitcoin-denominated overnight loan if I might need substantially and unpredictably more stuff to pay it off in a day?

If bitcoin is totally unsuitable for cash-type savings today but might be in the future, then how does it get there from here? An increasing profile has not yet given the currency price-stability, nor would I expect it to without the entry of a suitably large and credible market-maker willing to enforce a guarantee -- a situation analogous to the "BackedCoin" proposed in this post.

I think you're also wrong about "no one is saying the bitcoin of today is the optimal cryptocurrency" -- that's implicitly stated by anybody holding a long position. If bitcoin isn't the optimal cryptocurrency, then its long term value is $0 (plus a curiosity premium, I suppose) as everybody trades in OptimalCoin instead.

The network effects of bitcoin help, but they're mostly ephemeral. Technical success can be replicated at a keypress, and for the most part bitcoin's transactional utility is contingent on its convertibility to other currencies. (To put it another way, I don't think that bitcoin-denominated prices have ever deviated much from purchasing power parity.)

> If faith based institutions can gain credibility after developing for hundreds of years there is no reason why bitcoin cant either, especially considering its non-physical form which allows for people from all over the world to support it essentially cost free.

Provided, of course, the conveniences of industrial life are entirely maintained without interruption in this scenario when existing governmental institutions lose all currency-issuing credibility. If the revolution will not be webcast (so to speak), then there's no ability to spend or verify those bitcoins.

[Nick Rowe]

Majromax: " Its designer and community confuses certainty of quantity with certainty of value, so the reasoning on why Bitcoin in particular has value is circular. (It has value because it's limited, so its value can never go down (much!))"

With any intrinsically worthless medium of exchange there are always two equilibria:

1. if its price is positive, it *may* be demanded as a medium of exchange, and at some price demand = supply (as long as supply is limited).

2. if its price is zero, it can't be used as a medium of exchange, so demand is zero, so it's a free good.

[Mike Sproul]

Squarely rooted:

I find it best to think of backing this way: The tax man will demand 5 oz of silver from you every year. If you don't pay you'll go to jail. But the government just built a road, and it paid the contractors with 1 oz certificates that the tax man will accept in lieu of actual ounces. If the present value of all the government's tax collections is 1000 oz, then the government can issue up to 1000 certificates without causing inflation. But if it issued 2000 of those certificates, against only 1000 oz of taxes receivable, then 1 certificate=0.5 oz.

Majromax:

If the central bank pegs a 2% inflation target, (pegged against a basket with specified amounts of various goods), then the money is tied to goods.

[Majromax]

> With any intrinsically worthless medium of exchange there are always two equilibria:

I can count three; your first example has the potential for two equilibria.

> 1. if its price is positive, it *may* be demanded as a medium of exchange, and at some price demand = supply (as long as supply is limited).

That's assuming that the curves have only one intersection. I'm not sure that this is true with a currency like bitcoin. Since part of a currency's value comes from transactional utility, simply having more effective transactions denominated in that currency has a positive feedback effect on value.

That can only have a positive effect on price, however, if the currency has a positive marginal transaction utility over alternatives.

At this low-price equilibrium, the currency still has a fundamental value: the low possibility it will come into fashion again. It will trade like the stock of a bankrupt company, and everyone holding it will be making the same fundamental assumption. (The first documented bitcoin transaction was an early-adopter in 2010 purchasing a pizza for 10,000BTC.)

At some point, the currency's transactional value will -- for some people -- exceed the transactional value of other currencies. This has so far been true amongst the more politically active users of bitcoin and those who are using the currency to evade capital controls. Under those circumstances, the currency in motion has additional value in trade, and then the traditional network effect starts to take over.

I think that most fiat currencies don't have to worry about the first equilibrium, because a credibly-acting government gives the currency a nontrivial intrinsic value, even if it's in the form of "don't get sent to jail for nonpayment of taxes." Bitcoin doesn't have that governmental backing, and so it runs the risk of switching between regimes.

[Patrick]

I haven't had a chance to read all the comments, so I apologize if this is a repeat ...

It seems to me that the major problem with bitcoin is the built in deflation. In my amateur opinion, that's what makes it unworkable. Especially if people start to consider it a store of value as well as a medium of exchange. The supply constraint and hoarding will cause a recession/depression and Nick will be screaming "I told you so!"

Now if some clever person figures out a way to automatically make sure that the supply of some future electronic crytocash system is perfectly balanced to achieve e.g. 4% NGDP growth, then we might be on to something. Until then, meh. It's vaguely interesting from a technical point of view but that's about it.

[Vaidas]

Nick:

" The two currencies are identical in every respect, except one is backed by assets and the other isn't."
Is the second currency a pure bubble asset, or is it fairly valued and backed by the present value of future payment services provided? My guess is that bitcoin today is a mix of the two. I guess that sometime ago bitcoin was fairly valued and it was completely backed by the discounted value of future payment services.

"2. The issuer of the backed coin could use the returns on those assets to pay interest on the coins. Or to buy back coins so the owners of the coins would see capital gains. Other things equal, people prefer an asset that pays a higher rate of return to one that pays a lower rate of return."

Other things equal is the tricky part here. Other things equal should not include the price of the coin. Is expensive backedcoin better than a cheap unbackedcoin? We have no idea. Historically, when people wanted exposure to bubble assets, they bought them pure without any stabilizing add-ons.

If you have an unbackedcoin, you can create a substitute backedcoin yourself at home by putting an unbackedcoin and a treasury bill into an envelope - you can pay yourself interest. Is there any benefit of doing this combination on the level of the coin? We have no idea.

[Vaidas]

Nick:
"The issuer of the backed coin could use those assets to help stabilise the value of the coins in response to fluctuations in demand. If demand falls, the issuer could use the assets to buy back some of the coins in circulation. If demand rises, the issuer could sell more coins in exchange for more assets."

There are two types of stabilization, and it is unclear which you have in mind.

1. The first type is concerned with the arbitrage between the markets for the coin and the underlying assets. The benefits of this type of stabilization are limited. Closed end funds work reasonably well. Bitcoin is like a closed end fund.

2. The second type uses two tranches of liabilities, one is safer and more liquid, the second is riskier and less liquid. Central banks and commercial banks are good examples. But this type of stabilization has got nothing to do with backing. We could imagine TrancheCoin with two classes of coins, one tranche safer and more liquid, the other tranche riskier and less liquid. TrancheCoin would enjoy the benefits of this type of stabilization.

[jt]

Isn't liquidity, moneyness premium/"temporary store of value"/stability the prime concerns? It's probably true that BackedCoin will win on these features (for the reasons you mention), especially, the competition/replication/counterfeiting issue. Even for *cash* counterfeiting is an issue (for example in some small stores they won't accept cash denominations more than $20; they prefer credit cards or debit).

[Min]

Suppose that we had money backed by land, called Thalers (pronounced TAHLERS). Since "Thal" means "valley" in German, that's not a bad name. :)

Perhaps one problem with it as a medium of exchange is that if thalers are used to buy land from the issuer of currency, then those thalers should be retired. That's pretty crappy monetary policy, isn't it?

[Lord]

Preferred medium of speculation, followed by preferred medium of collectors? I hear Confederate money is quite collectible.

[JP Koning]

Thanks Nick.

"Why does a currency need to be backed by an object of value and why does that linking prevent fluctuation in demand for the currency?"

Ian, I don't have much time, but the comment below covers my thoughts on the gold vs bitcoin comparison:

http://jpkoning.blogspot.ca/2013/12/tales-from-litecoin-universe.html?showComment=1388165024432#c4580164208435040691

[Peter T]

Comments above have it right I think. What's an "asset" in this context? A government's main "asset" is the power to tax (or redistribute property, or acquire property). While all these have limits, they are essentially political rather than related to any notion of what the government "owns". But do we need to theorise when there is ample history to look at? For the first 2000 years of money there was no coin, just a unit of account. And any token, public or private, was backed by the ability of the issuer to exchange it for some tangible good. What was the proof of that ability? Continued exchange. Likewise, metallic coins are not goods in themselves, just tokens. They were used on a par with other tokens, and their value derived from their use in exchange, not from the ability to use them to pay taxes (which until early modern times in Europe were mostly collected in kind). It might help to think of two companies issuing commercial paper. One has a small asset base, but a high cash flow, and regularly redeems its paper and re-issues it without difficulty. The other has a low or irregular cash flow, but a large asset base. It sometimes misses a payment or delays redemption. Which one would command a premium? Which would be most acceptable as collateral?

[Ralph Musgrave]

Nick,

Thanks for saying “bingo”, but I’m not 100% sure I’m right: I’m just thinking aloud.

You claim that a bank must “use the returns on their assets to do those things..” else it loses out to the competition. As I understand you, you’re saying that where a bank has a big pile of income yielding assets, and uses that income to subsidise its customers, the bank will beat the competition. My answer is: “sure, but that’s cross subsidisation”. A garage or restaurant owner could do the same: i.e. subsidise their business out of income from assets that are not relevant to or necessary for running the garage or restaurant.

[Ian Lippert]

Majromax,

>At a basic level, the power to enact laws and collect taxes. Beyond that, they develop and justify reputations as competent managers, so that their claims about future outcomes are respected.

This is just question begging. The credibility of laws and the government that enforces them are one and the same. If people lose faith in their government then they lose faith in the laws (including laws of taxation) and those laws cannot be enforced anymore. The government has no "intrinsic value" (by your definition) because it's not backed by anything other than faith in its value and therefore the currency it backs has no intrinsic value either.

Institutions not having intrinsic value is not really a problem for their long term use and viability. I think the term intrinsic value leads to a lot of confusion because the word intrinsic means "in and of itself" but your use it in terms of "in and of something else" and people often move between the two definitions of the word without realizing it.

>In the meantime, all of that "bitcoin infrastructure" -- while potentially extremely useful for bitcoin transactions -- can be easily switched to any other similar currency, including a clone of bitcoin.

When I speak of bitcoin I am just broadly speaking of crypto currencies in general. I do not really care if it's bitcoin or lite coin or dodge coins that eventually win this early race to adoption. At some point an equilibrium will be found and we will have the Facebook of bit coins. It's fiat versus crypto currency not bitcoin specifically. Sorry for the confusion.

>I'd be more inclined to believe your point here if bitcoin was actually effective as an instrument of savings. It isn't; over the past year alone the currency has suffered from several 50% peak to trough drops. Regardless of your opinions on the long-term value of bitcoins, this makes it a lousy instrument for currency-type savings: I wouldn't want to put the cash for next week's groceries in bitcoin.

You previous comment was retrieved from the spam filter and your summary only referred to bitcoins drop which I found a little confusing.

Yes, for bitcoin to be accepted its volatility will have to come down drastically. But it's current volatility is due entirely to its rapid adoption. Rapid adoption leads to fast run ups, fast run ups lead to excessive speculation, excessive speculation lead to crashes. At some point if bitcoin is widely accepted we won't see large price increases and speculation will mostly be curbed.

The point is that even after china banned bitcoins the price did not crash to below its previous high of the last crash suggesting that it's not all speculative value. It is still on an upward trajectory. If you are saving in bitcoins for the long term eventually the increase in the value of your bitcoins is greater than the volatility and therefore cashing out at any point (peak to trough) is more valuable than cashing out in fear of volatility.

>Without putting words into Nick's mouth, "savers" are indistinguishable from "creditors." Without putting words into your mouth, it seems an inherent contradiction of the entire bitcoin community is that it is highly skeptical of the creditors of the modern economy (namely financial institutions) while being highly protective of their own financial assets.

Why is this a contradiction? They are skeptical of modern creditors so they have found a competitor. Is that competitor actually more trust worthy than the modern financial industry? Thats what we are going to find out, we are performing the largest monetary experiment in history. Bit coiners could be completely wrong but that does not mean their actions before the experiment has run its course are contradictory

>That will work if and only if monetary policy can be reduced to a simple formula regarding the quantity of base money, in the absence of trading costs. The lessons of the last eighty or so years of economics suggest that it really isn't that simple.

I don't really understand. If governments and bitcoin are both based on the same kind of faith the people's faith in government currency could easily shift to bitcoin.

>I think you're also wrong about "no one is saying the bitcoin of today is the optimal cryptocurrency" -- that's implicitly stated by anybody holding a long position. If bitcoin isn't the optimal cryptocurrency, then its long term value is $0 (plus a curiosity premium, I suppose) as everybody trades in OptimalCoin instead.

Not optimal in the present but optimal in the long run. Bitcoin has been around for a ridiculously short amount of time, especially if you consider that it only really caught on in the mainstream in 2012. Does anyone think that the bitcoin of today (price, infrastructure, acceptance) is at an equilibrium? The answer is no. Bitcoin supporters think that acceptance will only increase.

While bitcoins long term value might be zero, I do not believe that the long term value of all crypto currencies to be zero. Like I said, I don't really care if it's still bitcoin or not in 10 years.

[Ian Lippert]

JPK

>Ian, I don't have much time, but the comment below covers my thoughts on the gold vs bitcoin comparison:

The fact that gold could lose 90% of its value instead of 100% doesn't really change the nature of the criticism. And that criticism of bitcoins applies to fiat currencies as much as it does to crypto currencies. If people lose faith in the European Union, the value of the Euro will drop to zero. Should people trade in Euros and not bitcoins? Well I'd be more scared of saving in Euros than in bitcoins for the long run but that does not mean Euros are not viable in the short run for small transactions.

[Nick Rowe]

Vaidas: "There are two types of stabilization, and it is unclear which you have in mind."

Neither of those two types.

I am talking about simple Open Market Operations. The issuer of BackedCoin is just like a regular central bank, that has some monetary policy target, like a price level or inflation target. If it sees the value of BackedCoin dropping below the target, it does an open market sale of assets, buying its own coins, to reduce the stock in circulation. If it sees the value of BackedCoin rising above target, it does an open market purchase of assets, selling its own coins, to increase the stock in circulation.

[Vaidas]

Nick, that is a second type - central banks have two classes of liabilities - monetary base and equity which usually is owned by Treasury. The profits or losses of OMOs go to the owners of equity. It is possible to replicate this with UnbackedCoins by changing the distribution of the bubble asset plus intangibles between two classes of coins.

[Vaidas]

Nick, consider UnbackedCoin with two classes of coins - EquityCoins (EC) and LiquidCoins (LC). ECs pays dividends in LCs. LCs pay interest on reserves in LCs. By changing IOR and dividend rates, UnbackedCoin can replicate OMOs.

[Nick Rowe]

Ralph: it isn't cross-subsidisation.

Suppose I start a currency. Suppose people are willing to give me valuable goods in exchange for little bits of paper, with my signature, but that don't promise them anything. I can make profits from doing that, and buy a lot of assets by issuing a new currency. The returns on those assets I buy are my profits from issuing currency. If there were free entry and competition, and if other currencies were otherwise equal to mine, I would need to return those profits to my customers in order to compete with those other currencies, or else watch the price of my currency collapse to zero.

The Bank of Canada doesn't worry about this competition, because it has a legal monopoly on issuing paper currency denominated in Canadian dollars, plus it has a big first-mover advantage, and it would be hard for all Canadians to switch to using Swiss Francs instead.

The seigniorage profits of a central bank are monopoly profits. The whole of MMT is based on spending those monopoly profits ;-)

[Nick Rowe]

Vaidas: why would anyone hold LC if they could hold EC instead? And if your answer is "because EC isn't convenient to use as a medium of exchange", then a competing firm could issue something as liquid as LC but paying interest like EC, to get the best of both worlds. Price discrimination can't survive in perfect competition.

[Vaidas]

Nick, I wrote that LC is paying interest in LCs. This is not a price discrimination, but financial engineering. Owners of Bitcoin are owners of bubble asset. LC and EC splits the bubble in two parts - safer and riskier. By picking the right relative size of the tranches, we can design LC to be very safe and with a yield that is competitive with other safe assets.
The question is - why would anyone want tho hold ECs? Well, lotteries are popular, and with the right marketing ECs can work.

[Roger Sparks]

Vaidas writes "Nick, consider UnbackedCoin with two classes of coins - EquityCoins (EC) and LiquidCoins (LC). ECs pays dividends in LCs. LCs pay interest on reserves in LCs............."

I see the United States doing exactly that, doing it for years! EquityCoins are Treasury Bonds and LiquidCoins are Federal Reserve Notes.

[Ian Lippert]

Nick,

"Suppose I start a currency. Suppose people are willing to give me valuable goods in exchange for little bits of paper, with my signature, but that don't promise them anything."

This is an important first step, its hard to see why people would give random people goods for their currency when there is no safe guards preventing that individual from printing more currency

"I can make profits from doing that, and buy a lot of assets by issuing a new currency."

What do you mean by profits? You have gained value through trade presumably because your currency provides value (assuming you have overcome the first step above) as a currency. Is this what you refer to as profits? The gains from trade? Is your profit the whole value of the goods you receive or just the difference between what you value the currency at and the value of the goods.

"The returns on those assets I buy are my profits from issuing currency."

You started talking about valuable goods (consumer goods?) and are now talking about assets (financial assets?). If you are using profits now in the financial sense do you mean the returns to your assets in the form of dividends or like payments?

"If there were free entry and competition, and if other currencies were otherwise equal to mine, I would need to return those profits to my customers in order to compete with those other currencies, or else watch the price of my currency collapse to zero."

People are only going to accept your currency if it has value. If they have taken the currency for goods then they already presume it has value. I do not see why you owe them future profits if they have already accepted the initial trade as fair.

You have packed a lot in here and its not entirely clear to me what you are talking about. I just want to figure it out before I respond.

[Nick Rowe]

Ian: If I can persuade you to give me financial assets in exchange for my paintings, and it costs me nothing to produce paintings (ignore the costs of paper and ink) then I have made a profit. When the Bank of Canada does it, we call those paintings "money".

[Nick Rowe]

And Bitcoin has already passed that first step.

[Squarely Rooted]

Majormax:

"But that's not usually what happens; the private use of alternate currencies is mostly legal. The government only uses its powers to enforce the use of the national currency in dealings with itself, mostly via taxes. In fact, that increased freedom is a product of a more-unbacked currency, as capital controls are often necessary to defend fixed exchange rates (and equivalently real-goods convertibility)."

At least in the US, that's not true:

http://en.wikipedia.org/wiki/Liberty_Dollar#Conviction

Prosecuted under, among other offenses:

http://www.law.cornell.edu/uscode/text/18/486

"Whoever, except as authorized by law, makes or utters or passes, or attempts to utter or pass, any coins of gold or silver or other metal, or alloys of metals, intended for use as current money, whether in the resemblance of coins of the United States or of foreign countries, or of original design, shall be fined under this title [1] or imprisoned not more than five years, or both."

So you can be prosecuted in the US for using alt currencies. Here's a statement from the mint about it:

http://www.usmint.gov/pressroom/index.cfm?flash=yes&action=press_release&id=710

@Mike Sproul:

"I find it best to think of backing this way: The tax man will demand 5 oz of silver from you every year. If you don't pay you'll go to jail. But the government just built a road, and it paid the contractors with 1 oz certificates that the tax man will accept in lieu of actual ounces. If the present value of all the government's tax collections is 1000 oz, then the government can issue up to 1000 certificates without causing inflation. But if it issued 2000 of those certificates, against only 1000 oz of taxes receivable, then 1 certificate=0.5 oz."

Right, that I get, but the point I was trying to get at is: isn't there an implicit credibility issue? In theory, assuming the gov't in this case only issues 1000 certs, each cert should trade at par with an oz of Ag. But even if everyone is certain the gov't has Ag equal to or in excess of all certs, if they don't believe the gov't will actually redeem the certs, wouldn't they still trade at discount relative to Ag?

@JP Koning: You are of course absolutely right about the non-monetary use value of gold putting a floor on the value of gold as an exchange media, but curiously that also has an inverse effect. Say, for example, you could use gold to cure cancer:

http://scitechdaily.com/gold-plated-nanoparticles-seek-destroy-cancer-cells/

Say such cancer-curing methods become highly demanded. Suddenly the price of gold, driven by its use value, skyrockets. So take a $100,000 mortgage; if a dollar is worth a gram-and-a-half of gold, and the price of gold increases by an order of magnitude, so does your mortgage, to the glee of the bank and the woe of the homeowner. The same use value that prevents a gold-backed currency from zeroing the way BTC could at any minute also could cause the currency to anti-zero, and boom you have a depression.

The thing about BTC is that it is a backed currency, it's just backed by an algorithm. And the current price suggests that, at the very least, some minority of folks are extremely confident in the credibility of that algorithm. The issue is that the algorithm is targeting the money supply irrespective of money demand, meaning that as BTC becomes more popular, its price should rise, causing it to become more popular to investors, causing its price to rise, potentially ad infinitum.

The thing about fiat currency is that it's also an algorithm-backed currency, but the algorithm in the case of the US dollar is "this currency unit will always be worth, one year from today, between 98% and 100% of what it is worth today, regardless of what happens with money demand." Market monetarists are advocating for a change of that algorithm to "this currency unit will always be worth whatever value is necessary, commensurate with annualized 5% NGDP growth, regardless of what happens with money demand."

[Roger Sparks]

Ian Lippert writes
"Nick,

"Suppose I start a currency. Suppose people are willing to give me valuable goods in exchange for little bits of paper, with my signature, but that don't promise them anything." ......................."

It sounds improbable that physical assets would be traded for paper, but what about labor? If an individual is looking to make his time valuable, he must sell time (his labor) to someone. If the individual has no market, even a speculative sale for paper may be better than no market.

Ultimately, even physical assets (excluding land) are the product of labor so the sale of assets for paper is simply an indirect sale of labor.

Thus, it is easier to sell value for paper than may first appear.

[Nick Rowe]

SquarelyRooted: "The thing about fiat currency is that it's also an algorithm-backed currency, but the algorithm in the case of the US dollar is "this currency unit will always be worth, one year from today, between 98% and 100% of what it is worth today, regardless of what happens with money demand." "

Yes. Nicely put.

And I am arguing that, other things equal, a cryptocurrency with an algorithm (something) like that would beat one without that algorithm in competition. Because people like safety. But the issuer would need to have marketable assets to buy and sell for coin in order to implement that algorithm. And the issuers of Bitcoin don't.

[Ian Lippert]

Nick: "Ian: If I can persuade you to give me financial assets in exchange for my paintings, and it costs me nothing to produce paintings (ignore the costs of paper and ink) then I have made a profit. When the Bank of Canada does it, we call those paintings "money"."

Ok I understand now what you are saying, but I dont understand how the BoC is going to return those profits to holders of currencies. If the Bank of Canada is buying and selling financial assets to stabilize the price of the dollar I dont see how it can buy enough assets to make enough profits to pay Canadian dollar holders a significant amount of the BoC profits without printing a lot of money. Sure if it prints lots of money it could buy up all the financial assets and make more profits in terms of dollars but those would be highly inflated dollars and would be worth much less in terms of purchasing power.

I've never received payment for holding Canadian dollars, please tell me how I can get in on that :)

"If there were free entry and competition, and if other currencies were otherwise equal to mine, I would need to return those profits to my customers in order to compete with those other currencies, or else watch the price of my currency collapse to zero."

This is potentially why bitcoin will beat out fiat currencies, deflationary currencies would pay the holders back as long as the deflationary currency is deflating in a stable manner. I dont understand how fiat currencies payback their customers, 1-2% inflation is a cost.

[Nick Rowe]

Ian: there are two ways the BoC can make payments to holders of its currency:

1. pay interest. Yes, it's totally impractical with paper currency. (Unless you hold a lottery with a big prize for the winning serial number once a month, which is what the UK government does with "Premium Bonds"). But the BoC does pay interest on electronic currency, that is held by banks in their chequing accounts at the BoC (we call them 'reserves"). And if the currency is electronic, there's no practical problem.

2. Buy back currency (which is like a share buyback) so it's worth more (deflation). You get capital gains instead of interest, but it's the same thing.

But the Bank of Canada has a monopoly. So it pays negative 2% interest on its currency.

[Ian Lippert]

Nick: "2. Buy back currency (which is like a share buyback) so it's worth more (deflation). You get capital gains instead of interest, but it's the same thing.

But the Bank of Canada has a monopoly. So it pays negative 2% interest on its currency."

If the 2% inflation is seinorage (profits) on the Canadian currency then wouldnt your argument imply that bitcoin introduces competition and will reduce the BoC profits to zero? Bitcoin will become the defacto currency because it will (at some theoretical point in the future) provide a positive 2% interest from its deflationary nature?

I dont see how it follows from this that only currencies with 100% backing will survive. A monopolistic currency provider could impose deflation to return its profits to the holders of its currency but no central bank is doing this now and that is why people want to shift over to bitcoins.

Tyler and JPK were arguing that bitcoins value will drop to zero because it has no intrinsic value. It seems to me like you are making a different point entirely. You are assuming that bitcoins value will fall to zero because it will be out competed, but your axis of competition is one where bitcoin is currently defeating monopolized fiat currencies so I do not see how your conclusions follow from your premises.

[Vaidas]

Nick:"And I am arguing that, other things equal, a cryptocurrency with an algorithm (something) like that would beat one without that algorithm in competition. Because people like safety. But the issuer would need to have marketable assets to buy and sell for coin in order to implement that algorithm. And the issuers of Bitcoin don't."

It is interesting that such marketable asset can be a cryptocoin itself. Suppoose there is a bank of BitSquared, that buys and sells bitcoins to stabilize the value of BitSquared liabilities.

[Jeff Y.]

@vaidas, Aren't you just describing derivatives?

[Squarely Rooted]

@Ian Lippert:

I think the key is that the point of money is not to gain a positive real return. Money is a very efficient solution for a network of collective action problems, transaction costs problems, record-keeping problems, information asymmetry problems, etc. If you want a positive real return you have to invest. In theory you could invest in money, and certainly speculation on money is an important vector for exchange rate adjustment, but in general the point of currency is not itself to be a long-term savings or investment mechanism. It is possible, too, to make investments that implicitly depend on the future value of the currency, but it is also possible to make investments that do not depend on the future value of the currency, or depend inversely on the future value of the currency.

@Nick Rowe:

"And I am arguing that, other things equal, a cryptocurrency with an algorithm (something) like that would beat one without that algorithm in competition. Because people like safety. But the issuer would need to have marketable assets to buy and sell for coin in order to implement that algorithm. And the issuers of Bitcoin don't."

I would take some issue with that; Bitcoin does have an algorithm in place that market participants find credible; that is, "Bitcoins in circulation will never, ever exceed 21mm BTC, no matter what, ever." I suppose what you're referring to is something like an additional clause in the algorithm that would read something like "The BTC Nexus stands ready to exchange BTC at a fixed rate for [ten gallons of distilled water/a bottle of delicious whiskey/stock in Twitter/a chunk of pure osmium]." But you shouldn't actually need that second clause as long as people believe the first clause, unless the currency is difficult to use in exchange for some reason; in that case, the second clause will result in the BTC Nexus possessing 100% of all BTC and everyone else walking away with all the water/whiskey/stock/osmium.

An unbacked currency, I think I'm thinking, would be one whose algorithm is either a) not found credible by market participants or b) is sufficiently ambiguous about the future supply or price of the currency as to drive the value down very rapidly. Regarding national currencies, the latter is called hyperinflation, and is usually a symptom of total political/economic breakdown; regarding cryptocurrencies, its the result of bad design. But it's decidedly not the case with Bitcoin. I'm skeptical/pessimistic about Bitcoin because I disagree with the political and economic assumptions of its creators/vanguard and therefore think the problem it is attempting to solve will not materialize, thus rendering the currency superfluous for non-black-market transactions. But that's not the same as saying that Bitcoin is unbacked, I think, or that its unbacked relative to a currency backed by a material asset.

Let's look the idea of cryptocurrencies more broadly. Amazon.com offers a cryptocurrency called "store credit" - which from here on out I'm called "BezosBux" or BB - that exists solely in digital form, is stored in a secure wallet by Amazon, and each unit can be exchanged for one dollar of goods and services offered by Amazon.com. Currently the exchange rate for USD:BB is 1:1 as offered by Amazon.com, but how does it exchange on the market? Well, I collect all my USD change in a jar. When I have a full jar, roughly ~$50, I take it to a Coinstar machine. The Coinstar machine will give me more exchangeable denominations of USD at 1:1 but will charge me 10.9% to do so; Amazon.com, however, will offer me BB at 1:1 with no fee at all. I always, always take the BB. Which means that, outside the gift economy, the promise of redeemability into "stuff Amazon sells" means that I consider the BB:USD ratio to be at least 1:0.9. But that's because I find Amazon's promise credible and valuable! I would never take store credit at Barnes and Noble or Best Buy or any place I either don't like to shop or think would go out of business. The market, unfortunately, for BB is illiquid but I am certain that if it were liquid it would look a lot like the market for USD, conditional on stability or growth in AMZN. Which is basically the promise made by national currency issuers - as long as you think this government is going to be stable over the future, you should take this paper because you can exchange it for a wide network of goods and services.

[Nick Rowe]

Ian: Bitcoin and Bank of Canada paper currency are very imperfect substitutes. It is quite possible that two imperfect substitutes could share the market. But if there's a competitor to Bitcoin that is backed, but is otherwise a perfect substitute, things could be different.

[Majromax]

@Squarely:
> http://en.wikipedia.org/wiki/Liberty_Dollar#Conviction

Interesting case, thank you. It appears that the main arguments at trial were that the "Liberty Dollars" were confusingly similar to US coinage and designed to circulate in their stead (at par). That's sensible and roughly equivalent to a trademark issue. I wonder how a similar case with a totally distinct currency would pan out, as it would touch much more strongly upon free speech issues.

> The thing about BTC is that it is a backed currency, it's just backed by an algorithm. And the current price suggests that, at the very least, some minority of folks are extremely confident in the credibility of that algorithm. The issue is that the algorithm is targeting the money supply irrespective of money demand, meaning that as BTC becomes more popular, its price should rise, causing it to become more popular to investors, causing its price to rise, potentially ad infinitum.

It's not "backed" in a traditional sense here; I can't take bitcoins and redeem them for bits of an algorithm. (In that sense, they're "backed" by an algorithm in the same way that coins are "backed" by the person at the mint who runs the presses.)

The algorithm is extremely important for their anti-counterfeit measures, however, and so it what acts as a guarantee that bitcoins are both limited and genuine.

@Ian:
> This is just question begging. The credibility of laws and the government that enforces them are one and the same.

But the difference is that the government has credibility. The Bank of Canada can say "next year, we will ensure that inflation is between 1% and 3%;" such a statement will be widely believed. There and both plausible actions that the Bank of Canada can take to enforce that statement and historical precedent that they will indeed take those actions if necessary.

Bitcoin, at the moment, does not have that credibility. Nobody currently involved can believably make a claim on bitcoin's value 12 months from now, much less enforce that value with plausible actions.

> When I speak of bitcoin I am just broadly speaking of crypto currencies in general. I do not really care if it's bitcoin or lite coin or dodge coins that eventually win this early race to adoption. At some point an equilibrium will be found and we will have the Facebook of bit coins. It's fiat versus crypto currency not bitcoin specifically. Sorry for the confusion.

It's not that bitcoin in specific is vulnerable to clones, it's that any cryptocurrency without organizational backing is vulnerable in the same way. The technological advantages of bitcoin-et-al are easily copied, so the sole unique advantage of an existing digital currency is the network effect of possible transactions. However, that's less durable.

> Yes, for bitcoin to be accepted its volatility will have to come down drastically. But it's current volatility is due entirely to its rapid adoption. Rapid adoption leads to fast run ups, fast run ups lead to excessive speculation, excessive speculation lead to crashes. At some point if bitcoin is widely accepted we won't see large price increases and speculation will mostly be curbed.

That's contradictory; as bitcoin is more rapidly adopted its price is more volatile which makes it worse currency. According to this story, it's inevitably going to be a victim of its own success. (From a mathie point of view: even if we assume that universal adoption will give some sort of predictable price, if the process of adoption is instead giving us an unpredictable price then it's a singular perturbation and the predictable-in-universality equilibrium may be unstable.)

> I don't really understand. If governments and bitcoin are both based on the same kind of faith the people's faith in government currency could easily shift to bitcoin.

Governments have a wide range of actions that they can take to enforce a particular exchange value for their own currency. Bitcoin does not have any capability of enforcing a stable value; algorithmically its quantity is fixed and predictable, irrespective of valuation.

@Nick:
> Suppose I start a currency. Suppose people are willing to give me valuable goods in exchange for little bits of paper, with my signature, but that don't promise them anything.

Honest question here: has anything like this happened historically -- the introduction or evolution of a wholly unbacked currency, ab nihilo? The common currencies that come to mind have always had an introductory history of *some* kind of backing in real goods or foreign currency, even if that initial backing was a promise to pay the bearer at a later date.

Perhaps the Rai Stones? What makes a bitcoin different than a large stone disc?

[Ian Lippert]

Nick:"Ian: Bitcoin and Bank of Canada paper currency are very imperfect substitutes. It is quite possible that two imperfect substitutes could share the market. But if there's a competitor to Bitcoin that is backed, but is otherwise a perfect substitute, things could be different."

But the currencies arent competing on whether or not they are backed, they are competing on how much value they return to those holding the currencies. You are just saying that backed currencies would return more value to their holders which I say you still havent shown since no fiat currency gives value back to its holders (excluding banks with reserves for the moment).

The only advantage that fiat currencies have over bitcoins is that their price stability can be maintained. Price stability could be a feature where fiat out competes bitcoin if people do indeed value price stability over value. The negative interest on currency would be like an insurance policy.

The problem is that fiat currencies aren't stable. QE has shown that when the economy is in the dumps the Fed is more than willing to throw price stability out the window, which throws out the one feature where fiat has an edge against bitcoin and is why people are starting to make the shift to bitcoin.

This brings us back to the definition of backed. You claim backed means to be backed by the full faith of the government, Tyler and JPK used backed in terms of intrinsic value (a lower bound due to other demands for the commodity currency).

But intrinsic value is just an assumption that demand that comes from physical uses is somehow more important than demand that comes from digital informational uses. To be frank, thats a very 20th century way to look at the world. Demand is demand regardless of whether or not it comes from physical use or informational use and bitcoin (and all currencies) is providing an informational services as a unit of account.

Currencies do not need to be backed by anything other than the confidence that others will continue to support them, similarly to how goverments (that back their dollars) are not backed by anything other than the confidence that others will continue to support them. If that confidence disappears then yes bitcoin's value drops to zero in the same way that the value of a state can collapse to zero when people lose confidence in its ability to govern.

[Jeff Y.]

@Maj, http://en.wikipedia.org/wiki/Ithaca_Hours

[Nick Rowe]

Majromax: "Honest question here: has anything like this happened historically -- the introduction or evolution of a wholly unbacked currency, ab nihilo?"

And a very good question. I did not know of any clear historical example, before Bitcoin. I always wondered whether it would be possible. Theory always says there are two (OK, or more) equilibria: one in which the fiat money has zero value. How could you make sure you start out in the positive value equilibrium?

In historical practice, something like von Mises regression theory of money seemed to be correct. You start out with money convertible into some real good, get people used to using it, then you temporarily suspend convertibility, but it's still valued because people think convertibility might be restored some time in the future, then the expectation of future convertibility slowly fades away, but people get used to using it as money, so it stays in the positive value equilibrium. You need a convertible catapult to launch Tinkerbell the confidence fairy into the air, but once she's flying she can stay up under her own power because everybody believes she can fly.

So Bitcoin has been fascinating to me, as a natural experiment. It also demolishes the theory that fiat money is only valued because you have to pay it in taxes. (I never accepted that theory.)

JP Koning had a good post on the Yap stones. I think they did have some intrinsic value, aside from their use as medium of exchange. But my memory has failed again.

[Majromax]

> But the currencies arent competing on whether or not they are backed, they are competing on how much value they return to those holding the currencies. You are just saying that backed currencies would return more value to their holders which I say you still havent shown since no fiat currency gives value back to its holders (excluding banks with reserves for the moment).

Doesn't that defeat the purpose of a currency? If I choose to hold nominal currency over some real good (or equity), then I am presumably doing so because I value the liquidity premium of the currency over the real thing. I can choose to forego that liquidity premium through a loan, time deposit, or other nominal-terms debt instrument, and then I am paid compensation in the form of interest.

So in converse, if I do not value liquidity at the moment then I should universally seek to *not* hold base currency -- otherwise I am "paying for" liquidity that I won't be using. However, that is incompatible with base currencies having a positive return that they offer their holders.

The real return on real goods has a floor just slightly below 0% -- I can buy twinkies, store them at relatively low cost, and then sell them later.

That's also a self-reinforcing cycle, monetarily speaking. If I do not value liquidity, I sell my currency for goods to someone who does, meaning the currency enters circulation and increases its liquidity (and thus drives down liquidity prices).

That's incompatible with a positive real return on holding currency. In such a situation, the twinkie investment is a rotten deal. If I do not value liquidity, selling it in the form of a twinkie purchase also loses me the prospective real return, so it's beneficial for me to sit on the prospective liquidity. This is weakly unstable, in that it's a positive feedback: if I do not value liquidity, it's not in my interests to provide it to other people, so the price of liquidity remains the same or increases.

(Or to nutshell: the value of a currency is in its circulation, not its hoarding.)

> The problem is that fiat currencies aren't stable. QE has shown that when the economy is in the dumps the Fed is more than willing to throw price stability out the window, which throws out the one feature where fiat has an edge against bitcoin and is why people are starting to make the shift to bitcoin.

What economic data are you using? QE has shown that the real-terms value of a currency is only weakly related to the quantity of its issue, at least under some economic and QE regimes. You'd have a stronger point here if there *was* hyperinflation going on, but there isn't.

[Nick Rowe]

Ian: "The problem is that fiat currencies aren't stable. QE has shown that when the economy is in the dumps the Fed is more than willing to throw price stability out the window, which throws out the one feature where fiat has an edge against bitcoin and is why people are starting to make the shift to bitcoin."

A massive exaggeration. Inflation has changed very little (it was actually a little below normal). Much less price volatility than in the 1970's. Massively less than Bitcoin.

But you can do things with Bitcoin you can't do with US or Canadian dollars. And vice versa.

"This brings us back to the definition of backed. You claim backed means to be backed by the full faith of the government..."

No I don't. But if the issuer has no assets with which to buy back the coin if demand ever drops, they cannot have an elastic supply curve for the stock of the coin, and so cannot stabilise its value in the face of fluctuations in demand. Somokers stabilise the value of cigarettes in the face of fluctuations in monetary demand (unless the smokers themselves have perfectly inelastic demand curves). Same with the non-monetary demand for gold as with cigarettes.

[Mike Sproul]

Nick:
"If it sees the value of BackedCoin dropping below the target, it does an open market sale of assets, buying its own coins, to reduce the stock in circulation. If it sees the value of BackedCoin rising above target, it does an open market purchase of assets, selling its own coins, to increase the stock in circulation."

There's a complication to this. If 100 coins are backed by 100 oz of assets, then 1 coin=1 oz. If they sell 1 oz and buy back 1 coin, then 99 coins are backed by 99 oz, and still, 1 coin=1 oz, even though the stock of coins has fallen. So it's not really the rise and fall of the stock of coins that maintains the value of the coins. It's the constancy of the ratio of assets to coins that matters.

But of course if the public desired 1 less coin, and the central bank failed to buy back that 1 unwanted coin, then the public might see this as a loss of backing, and the value of the coin might fall (by a negligible amount, I think). On the other hand, if the public wanted 1 more coin, and the bank failed to issue that new coin (in exchange for 1 oz), then the main result would be a shortage of coins and a hindrance to trade. Coins might start to sell for a slight premium, but there's still the fact that 100 coins are backed by 100 oz, so the math says 1 coin=1 oz, in spite of the coin shortage.

Squarely rooted:

"if they don't believe the gov't will actually redeem the certs, wouldn't they still trade at discount relative to Ag?"

Right. In this sense the cert's price and yield includes a risk premium, just like stocks, bonds, or any other financial security.

[Nick Rowe]

Ian: "Currencies do not need to be backed by anything other than the confidence that others will continue to support them,.."

I would say: "Currencies do not need to be backed by anything other than the confidence that others will continue to use them as currencies,"

True. I've been teaching that for decades, well before Bitcoin came along.

But if some other better currency comes along, people may stop using the worse currency, and people will lose confidence that others will continue to use it.

[JRHulls]

In what sense could the Bitcoin be considered as being minted? This post is an interesting economic debate on Bitcoins, but it doesn't discuss the huge sociological aspect to the question as to people's decisions to purchase and hold minted items. There's lots of precedent in the activities of private mints. Most are outright rip-offs, yet they still persist. Even the U.S. Mint has warned against Obama coins. http://coins.about.com/od/coinbuyingadvice/a/obama_coins.htm
There is even a lively market for Franklin Mint collectibles on EBay, http://www.ebay.com/gds/Franklin-Mint-Collectibles-Buying-Guide-/10000000177627334/g.htmland and it was only a few years ago that people were amassing portfolios of Beanie Babies to pay for their children's college education. Was Shakespeare being cynical when he asked, in "Troilus and Cressida," "What is aught, but as 'tis valued?"

[Majromax]

@Jeff:
> http://en.wikipedia.org/wiki/Ithaca_Hours

I saw that reference under the Liberty Dollar article, and that's really neat. It appears to still be operating, so I can presume that means that the US government hasn't cracked down on it.

@Nick:
> You need a convertible catapult to launch Tinkerbell the confidence fairy into the air, but once she's flying she can stay up under her own power because everybody believes she can fly.

No comment, but I love the imagery.

> So Bitcoin has been fascinating to me, as a natural experiment. It also demolishes the theory that fiat money is only valued because you have to pay it in taxes. (I never accepted that theory.)

I'm quite willing to entertain the notion that the initial backing for Bitcoin came from the technical evangelists and politically-skeptical types. Certainly I can't argue that bitcoins are currently worthless. I suspect the longer-term natural experiment will be in the decidedly heterodox "monetary policy" hard-wired into the algorithm, since I really can't see how such a currency won't drive itself to a deflationary, illiquid equilibrium. At the same time, any competing currency with more traditional monetary policy requires some kind of control, which is anathema to the libertarian-currency crowd.

> JP Koning had a good post on the Yap stones. I think they did have some intrinsic value, aside from their use as medium of exchange. But my memory has failed again.

I think that this (http://jpkoning.blogspot.ca/2013/01/yap-stones-and-myth-of-fiat-money.html) is the post you're referring to, which links to the others? I'll have to give them a read.

[Nick Rowe]

Majro: yes, that was the JP post I had in mind. He says they did have intrinsic religious/ornamental value.

[Ian Lippert]

Nick,

"Doesn't that defeat the purpose of a currency? If I choose to hold nominal currency over some real good (or equity), then I am presumably doing so because I value the liquidity premium of the currency over the real thing. I can choose to forego that liquidity premium through a loan, time deposit, or other nominal-terms debt instrument, and then I am paid compensation in the form of interest.

That's incompatible with a positive real return on holding currency. In such a situation, the twinkie investment is a rotten deal. If I do not value liquidity, selling it in the form of a twinkie purchase also loses me the prospective real return, so it's beneficial for me to sit on the prospective liquidity. This is weakly unstable, in that it's a positive feedback: if I do not value liquidity, it's not in my interests to provide it to other people, so the price of liquidity remains the same or increases."

This I don't understand because you were stating in your OP that

"2. The issuer of the backed coin could use the returns on those assets to pay interest on the coins. Or to buy back coins so the owners of the coins would see capital gains. Other things equal, people prefer an asset that pays a higher rate of return to one that pays a lower rate of return."

Your OP is arguing that backed coins would produce more value for their holders and outcompete the backed coins. How does this coin from your OP not also suffer from the same problem? If the backed currency was paying interest to the holders of the currency wouldn't the backed coins also face problems of liquidity?

You say coins that pay out to holders would outcompete bitcoin because they are backed by assets, I say bitcoin also pays out to its holders as a deflationary currency, and then you say that currencies that incentivize people to hoard have liquidity problems which defeat the purpose of using them as a currency in the first place. I am not really ready to discuss the liquidity problems of deflationary currencies until we have resolved why you think backed currencies are more competitive than unbacked ones.

"What economic data are you using? QE has shown that the real-terms value of a currency is only weakly related to the quantity of its issue, at least under some economic and QE regimes. You'd have a stronger point here if there *was* hyperinflation going on, but there isn't."

I am not talking about what inflation is now but what those that support NGDP targeting (I think this includes you) have called for a move from the fed targeting 2% inflation to something closer to 5%. QE is of this type of stimulus, maybe I misspoke because it's not technically as aggressive as upping the inflation target but the point is that inflationary monetary policy incentivizes people to move to bitcoin.

In addition we cannot forget that bitcoin is a global currency so it's demand will be driven by inflationary policies of all central banks. In canada we might have little incentive to risk moving our net worth into bitcoins, but plenty of people live under terrible monetary regimes and their demand will drive the acceptance of bitcoins.

[Ian Lippert]

Nick,

"No I don't. But if the issuer has no assets with which to buy back the coin if demand ever drops, they cannot have an elastic supply curve for the stock of the coin, and so cannot stabilise its value in the face of fluctuations in demand. Somokers stabilise the value of cigarettes in the face of fluctuations in monetary demand (unless the smokers themselves have perfectly inelastic demand curves). Same with the non-monetary demand for gold as with cigarettes."

What is your theoretical backed coin backed by then? What it's backed by will effect how volatile it is. If it's backed by the government then we know the price won't fluctuate greater than 1% either way under current policy. If it's backed by gold then it will fluctuate within the range of its price that is accounted for by its value as a currency. Like I said to JPK earlier if non-monetary uses account for only 10% of the price then golds use for non-monetary uses isn't really that much of a stabilizing force. Gold suffers from the same fluctuations as bitcoin, as we have seen happen in recent fluctuations in the price of gold.

"True. I've been teaching that for decades, well before Bitcoin came along.

But if some other better currency comes along, people may stop using the worse currency, and people will lose confidence that others will continue to use it."

If you are saying this in the OP then it's kind of confusing why you would link to Cowen and JPK who are essentially disagreeing with your point here. I think that you are saying something fundamentally different from what they are.

[Ian Lippert]

I clipped the last copy and paste, my last post is responding to this

I would say: "Currencies do not need to be backed by anything other than the confidence that others will continue to use them as currencies,"

[Nick Rowe]

Ian: "What is your theoretical backed coin backed by then?"

Presumably a basket of assets. It would depend on what they wanted to stabilise its price against. And they don't have to stabilise it precisely against that basket. Having *any* assets will be better than having *no* assets, because when you have no assets you can't buy back *any* coins if demand for the coins drops.

[Majromax]

> This I don't understand because you were stating in your OP that

That was my point you're responding to, not Nick's.

In the case of a backed coin, the backing may have some sort of return. LandCoin, for example, sees return from the rent of its land. Since the land is possessed by the central bank, it initially sees the land rents; it can then distribute them as it sees fit according to policy. (Keeping the rents would act as seniorage profits.)

Unbacked coinage (or alternately coins backed by static assets that have no yield, such as gold) cannot have this sort of return. Ownership of a bitcoin is an entitlement to pretty much nothing; likewise the "central bank of bitcoin" does not see any real gain commensurate with the quantity of bitcoin in circulation.

> I am not really ready to discuss the liquidity problems of deflationary currencies until we have resolved why you think backed currencies are more competitive than unbacked ones.

I'm not Nick, but the answer is that all other things equal backed currencies have strictly greater utility than unbacked currency. The traditional lament of money is that you can't eat it, but with CowCoin you could exchange your money for steak at the central bank (and/or receive a milk dividend).

The flipside, of course, is that all other things aren't equal. History has shown that backing currency with appreciable values of anything can cause outright currency shortages, which then cause illiquidity.

The historical jump has often been (as Nick points out above) to have an initial period of convertibility to set expectations of value, but then to leave that behind and suspend effective convertibility after reaching stability. The problem comes in that the values still have to be managed, independently of convertibility; doing so is a problem addressed by every central bank.

A deflationary currency has the problem of free lunches. If I give you a haircut today for one DeflateCoin, then absent any economic or productivity growth, I could come back to you in a year and demand two haircuts. This is very much the definition of a Ponzi scheme, where early adopters (hoarders) of the currency are promised an excess of real goods in the future without productive investment to produce those goods.

> the point is that inflationary monetary policy incentivizes people to move to bitcoin.

I still don't see it. Most currencies in circulation today do not have the problem of wildly-fluctuating price levels. Adopting NGDP targeting or inflation-rate targeting does not make a difference here, as the difference between 2% and 5%/yr is trivial in comparison to the wild fluctuations that bitcoin has seen in recent history.

[Frank Restly]

Majormax,

"I'm not Nick, but the answer is that all other things equal backed currencies have strictly greater utility than unbacked currency."

"The flipside, of course, is that all other things aren't equal. History has shown that backing currency with appreciable values of anything can cause outright currency shortages, which then cause illiquidity."

Suppose you wanted the best of all worlds - real good backing, demand / supply are both market determined, utilitarian value of backing is high, and yet supply of backing is inexhaustible (no shortages). What could possibly fill the bill?

[Ian Lippert]

My apologies, I was responding from my iPhone on my bus ride home and I must have confused who was saying what, which is why I was so confused. I'll just start over and try to salvage my argument

Nick,

>I would say: "Currencies do not need to be backed by anything other than the confidence that others will continue to use them as currencies,"

>Presumably a basket of assets. It would depend on what they wanted to stabilise its price against. And they don't have to stabilise it precisely against that basket. Having *any* assets will be better than having *no* assets, because when you have no assets you can't buy back *any* coins if demand for the coins drops.

So you do agree that currencies can exist based solely on the confidence of those that use them?

How can a currency like gold buy back the coins when the market for non monetary uses is so much smaller than monetary uses. If the faith in gold collapses and it is no longer used as currency then people are going to dump their currency onto the market quickly as they supply those with non-monetary needs. Those needs will fill up pretty quickly and the price will need to collapse to near zero for the remaining holders of coins to sell them off.

There Isn't much difference between not being able to sell any of your coins and not being able to sell any of your coins at a reasonable price. And since you already stated that currencies can be backed by the confidence that others will use them as currency I don't see what is so crucial about having the currency backed by a basket of goods that is only going to cover a small portion of the demand for the currency.

Majromax,

>In the case of a backed coin, the backing may have some sort of return. LandCoin, for example, sees return from the rent of its land. Since the land is possessed by the central bank, it initially sees the land rents; it can then distribute them as it sees fit according to policy. (Keeping the rents would act as seniorage profits.)

>Unbacked coinage (or alternately coins backed by static assets that have no yield, such as gold) cannot have this sort of return. Ownership of a bitcoin is an entitlement to pretty much nothing; likewise the "central bank of bitcoin" does not see any real gain commensurate with the quantity of bitcoin in circulation.

If you are going to have it backed by something that provides significant coverage (unlike my gold example above) the adoption of your currency is going to be severely limited as you will have to buy up assets every time you want to let someone else in on the currency. This means you will be charging early adopters more than late adopters as the value of the land that you purchase decreases in terms of your currency as you print more to buy more assets. Additionally, you can only let people into the currency who have land to sell you which hinders adoption.

Bitcoin solves this problem by rewarding early adopters the enormous amounts required to overcome everyones rational view that using a new currency is a pretty absurd idea.

>The flipside, of course, is that all other things aren't equal. History has shown that backing currency with appreciable values of anything can cause outright currency shortages, which then cause illiquidity.

>The historical jump has often been (as Nick points out above) to have an initial period of convertibility to set expectations of value, but then to leave that behind and suspend effective convertibility after reaching stability. The problem comes in that the values still have to be managed, independently of convertibility; doing so is a problem addressed by every central bank.

So backed currencies have problems when linked to real goods, suggesting that currencies are most valuable when they aren't backed by anything. Isn't this why we use fiat currencies now? So that the government can declare price by fiat? Why would you want to back a currency by anything and how would a backed crypto currency outcompete bitcoin without running into these problems?

>A deflationary currency has the problem of free lunches. If I give you a haircut today for one DeflateCoin, then absent any economic or productivity growth, I could come back to you in a year and demand two haircuts. This is very much the definition of a Ponzi scheme, where early adopters (hoarders) of the currency are promised an excess of real goods in the future without productive investment to produce those goods.

This is only true because bitcoin is in a stage of rapid acceptance, pushing up its value drastically. Once this stage is over the deflation will only occur because growth in the economy allows for a bitcoin to purchase more goods over time. At this point a deflation of 2-3% isn't going prevent anyone from spending their money year over year in the same way that I don't push off computer purchases even though I know in a year I can get the same product at a much cheaper price.

A Ponzi scheme occurs when the people putting the money in are paying the people taking the money out. The person running the Ponzi scheme hopes that the people pulling money out are only pulling out the interest and don't realize that all their money is being siphoned away. Once the Ponzi runner can't get any new entrants he runs out of money to pay interest, people get suspicious and pull everything and the whole scheme collapses.

Bitcoin is a completely different animal. No one is promised anything. Those that adopt early are taking on the risk that the currency will not be adopted and that their bitcoins will be worthless at some point in the future. Why shouldn't those that take on the greatest risks receive the greatest rewards?

>I still don't see it. Most currencies in circulation today do not have the problem of wildly-fluctuating price levels. Adopting NGDP targeting or inflation-rate targeting does not make a difference here, as the difference between 2% and 5%/yr is trivial in comparison to the wild fluctuations that bitcoin has seen in recent history.

It not about centrally controlled currencies fluctuating, it's about the 2-5% a year savers have to pay to hold assets denominated in the inflationary currency. Assuming bitcoin doesn't get its volatility problem under control then you would have a trade off of volatility versus paying the monopolists insurance costs. If bitcoin gains a semblance of stable prices then the monopolistic currencies lose all their marginal value and there is no reason why everyone shouldn't move into the crypto currencies.

[Kaleberg]

I'm wondering about the difference between a "backed" currency and one that you can pay your taxes with. The former can always be exchanged for some particular commodity at a fixed price, but most commodities go up and down in value, so there is a lot of instability. On the other hand, a commodity that is absolutely vital e.g. oxygen in a space station economy, is something different. Since need oxygen in outer space and you need to pay your taxes on earth for similar reasons, some backed currencies are quite different from others. A backed currency that lets you pay your required taxes or buy oxygen for your space suit tank is always going to drive out a backed currency redeemable in Beanie Babies or baseball cards. The fiat currencies that I know of can be used to pay taxes which suggests that they are basically backed currencies with a more valuable backing than most.

P.S. Isn't bit coin just based on artificial scarcity? It's like a limited edition print, except they've tied in computing power. What happens when the typical smart watch can run all the world's bit coin computing? What happens if Moore's Law speeds up or slows down? What if there is an algorithmic breakthrough with quantum computing or P=NP is proven? Bit coin just seems horribly speculative to me.

[Lord]

It is purely speculative. It won't be adopted unless stable and won't be stable unless adopted. Speculation is a reason to acquire but not to hold and not as currency. Speculation can be profitable but profit and loss are contrary to stability.

[Vaidas]

I was always amazed how Bitcoin - a financial asset that is not money-like has gained popularity as a money. It is almost like using shares of Bank of Montreal to buy a cup of coffee. Except that the balance sheet structure of Bitcoin is not similar to Bank of Montreal, but it is very similar to the balance sheet of Twitter. To a first approximation, Twitter and Bitcoin have nothing but popularity on the asset side of the balance sheet, and nothing but equity on the other side of the balance sheet. So make that using shares of Twitter to buy a cup of coffee.

If Twitter started a commercial paper program, and this commercial paper would be used as money in the Silicon Valley, this would not be very strange. Bitcoin could start such a program too, and we could get bitcoin based money that has risk and return characteristics of commercial paper. But this has not happened (yet).

But now I wonder how people are actually using bitcoin. My impression that bitcoin is used in two most important ways, first, as a vehicle to speculate on the future of bitcoin, and second, as a way to participate in illegal transactions. In the old movies we saw how bearer bonds and bearer shares were used in large illegal transactions, so nothing has much really changed, except the risk appetite, people in the old movies preferred to allocate their portfolio to safer anonymous instruments, and now we have a dotcom mania 2.0.

[Nick Rowe]

Happy New Year everyone!

I found a couple of comments in spam: Mike and Ian's, IIRC.

Vaidas: Bank of Canada notes can be thought of as zero-coupon perpetuities bearer bonds/shares in the Bank of Canada.

Mike: on the backing. The fact that money has backing assets doesn't necessarily mean the issuer will peg its exchange rate against those assets. If a central bank has lots of gold, it could have a fixed peg against gold if it wanted to, but it doesn't have to. It could use the gold to maintain indirect convertibility with the CPI, and target the CPI, by varying the price of dollars against gold.

[Vaidas]

Nick,
Bank of Canada notes are bearer bonds, not bearer shares. Bonds and shares are in the opposite ends of the Bank of Canada capital structure spectrum. So for people doing large scale illegal transactions, there are two choices - BoC paper bearer bonds and electronic bitcoin bearer shares.

"The fact that money has backing assets doesn't necessarily mean the issuer will peg its exchange rate against those assets."
If there is no peg, this means that the issuer will have at least two classes of different liabilities, one which is safer than the underlying assets, and the second riskier one.

[Vaidas]

Jeff Y: "Aren't you just describing derivatives?"

I am describing equity and debt, which in a sense are derivatives of the underlying business. Random quote from the internet:
"debtholders can be regarded as having sold a put option on the market value of the firm; and equityholders’ claim on the firm’s value, net of its debt obligations, resembles a call option"

[Majromax]

@Kaleberg:
> P.S. Isn't bit coin just based on artificial scarcity? It's like a limited edition print, except they've tied in computing power. What happens when the typical smart watch can run all the world's bit coin computing? What happens if Moore's Law speeds up or slows down? What if there is an algorithmic breakthrough with quantum computing or P=NP is proven? Bit coin just seems horribly speculative to me.

The bitcoin protocol adjusts in difficulty, such that new coins are "mined" at an average of once per ten minutes. The mining reward was initially 50 bitcoins/block, but has since halved and will do so at roughly 4-year increments.

The overall amount of computing power devoted to bitcoin has increased exponentially already from its earliest adoption; now specialized "miners" are using partially custom-designed hardware to accelerate the computation. A malicious person would have to control something approaching 50% of the computing power in the network to execute the known attack methods (which would, most critically, allow for multiply-spending their coins by "rewinding" the blockchain and supplying new history.)

P=NP doesn't seem likely, but even if it is it would still require a fairly tight relationship: NP=much-bigger-P may still be useful for cryptography. Regardless, a full break here has much bigger implications than bitcoin.

A viable computer would be the same kind of break as P=NP. The proof-of-work would probably still survive (the difficulty would just be roughly the square root of what it is now, with Grover's Algorithm), but more critically the entire public/private keypair securing "ownership" of coins might be compromised (via Shor's algorithm and variants thereof). There's some theoretical work in developing quantum-resistant encryption, but at the moment it's impractically large.

@Vaidas:
> To a first approximation, Twitter and Bitcoin have nothing but popularity on the asset side of the balance sheet, and nothing but equity on the other side of the balance sheet. So make that using shares of Twitter to buy a cup of coffee.

Not really, as Twitter has more-or-less credible means by which it can/will give shareholders a return, even if no more shares of Twitter change private hands. Bitcoin cannot offer existing holders a real return except in the exchange.

> "debtholders can be regarded as having sold a put option on the market value of the firm; and equityholders’ claim on the firm’s value, net of its debt obligations, resembles a call option"

Which is why shares of a bankrupt but not yet wound-up firm still trade, but are priced like out-of-the-money options.

@Nick:
> If a central bank has lots of gold, it could have a fixed peg against gold if it wanted to, but it doesn't have to. It could use the gold to maintain indirect convertibility with the CPI, and target the CPI, by varying the price of dollars against gold.

That's also what central banks have done when trying to maintain exchange rate pegs. I think it may also be where a BackedCoin might be doomed to fail. The political advantage of BitCoin is that its central bank is purely and verifiably algorithmic, but this kind of control -- seemingly necessary for an effective monetrary policy -- requires human decisionmaking and/or arbitrary sources of data.

On the other hand, that only affects the minting of bitcoins. The exchange of bitcoins requires no such central bank action. With a suitable "installed base", something could possibly take off. Perhaps a distributed stock exchange?

[Squarely Rooted]

@Mike Sproul:

"In this sense the cert's price and yield includes a risk premium, just like stocks, bonds, or any other financial security."

I agree; and to my mind its that factor that makes the line between "backed" and "unbacked" currencies either very fuzzy or mostly arbitrary. If you have a fiat money, there is some risk the central bank will for whatever reason fail or be unable to meet its promises re: inflation, money supply, or NGDP; similarly, if you have a currency redeemable in metal, there is some risk the central bank or treasury will for whatever reason fail or be unable to meet its promises re: exchanging paper for metal. In both circumstances, the value of the currency is dependent on the nature and credibility of the promises made by the issuer, and the risk is dependent on the same. in that sense all money is about promises and credibility, and metal-redeemable currencies are just one subset of promises. They have their own specific features, certainly, but the only difference I see is that the currency issuer guarantees that they themselves are willing to sell you some asset, other than "services paid for by taxes" and "avoiding legal sanctions," at a fixed price relative to the currency, as opposed to guaranteeing that third parties will be willing to do so. I guess to me though the terminology of "backing" doesn't really get at the distinction; I guess I'd call those kinds of currencies "direct-redeemable currencies" and not use the kind of language that implies metal-redeemable currencies are somehow sturdier, worthier, or steadier than those not redeemable in metal.

[Ian Lippert]

I agree with this entirely

[Nick Rowe]

Assume a currency that is redeemable on demand into (say) gold, at a fixed price of gold that never changes, and has 100% gold reserves. I see that as a limiting extreme case of that currency having backing. We can imagine less extreme cases, where the price fluctuates, where the target price is not the same as the price of the asset held, where there are less than 100% assets.