The Bitcoin Crash – what it tells us about Crypto Currency

The travails of Bitcoin, the internet alternative currency, has gripped the internet but hardly touched legacy media.

It had been steadily growing since its inception in 2009, and this year had been getting some attention with calls for it to be banned as encouraging tax avoidance or even money laundering and drug deals.

Launch on May 15th called it

The most dangerous project we have ever seen

A month ago I heard folks talking online about a virtual currency called bitcoin that is untraceable and un-hackable. Folks were using it to buy and sell drugs online, support content they liked and worst of all — gasp! — play poker.

Bitcoin … could topple governments, destabilize economies and create uncontrollable global bazaars for contraband.

The exchange rate had risen from $4 a bitcoin a few months ago to $17.50 a bitcoin last week.

But in the last few days it has all come crashing down.

An online wallet was hacked into after a virus attach from an IP address in Hing Kong, following that the person stealing them tried to convert to half a million dollars worth of hard cash at exchange MtGox.

Within minutes the price had fallen  to $0.01 before Mt. Gox shut down their exchange.

The market has been reset to before the hack but this has been criticised by some users who had taken the opportunity to buy low.

Both Wikileaks and the Electronic Freedom Foundation have dropped taking donations in Bitcoin.

It remains to be seen if it can recover.  Convertability is still suspended.  For the time being the currency has failed and the vulnerability to an attack on a single computer is likely to dent confidence.

This kind of Cyrpto Currency is based on the idea that any sort of object, or any sort of record, accepted as payment for goods and services and repayment of debts in can serve as a currency.  This is quite correct, a symbol accepted as a store of value is a currency, and other features such as ability to be accepted in payment for taxes or be generated from credit are but contingent elements of money in certain contexts (and arguably features of any long-term successful currency).

Trust is important  as Jerry Brito explains

digital cash is different from physical cash in one very important way: If I hand you a 100 euro bill, I no longer have it. You can’t be as sure of that, however, when the cash is just 1’s and 0’s. So it’s been necessary to have a trusted intermediary deduct the amount from the payer’s account, and add it to the payee’s.

The attempted solution to this double payment problem is a distributed database spread across nodes of a peer-to-peer network tracks transaction, anonymity is assured through cryptography.  Currency is generated by mining, a deliberate allusion to mining for gold, only mining in this context is running an algorithm that only very very rarely creates a bitcoin.  It is a non-fiat curency, and a ‘hard’ currency in that it is not generated by fractional reserve lending but by this quasi-mining process.

The money supply of Bitcoins is programmed to reach 21 million over time.  So the more mining that occurs the less the chance of money generation.

But with the future supply fixed Bitcoin itself acknowledges that this could cause hoarding and crippling price deflation, why spend money in the Bitcoin economy today when the same currency will buy more tommorrow.  Bitcoin itself recognisances the model is flawed and could cause a deflationary spiral 

the supply of Bitcoins must grow in proportion to the total value of transactions undertaken using the system. This will lead to price stability and will eliminate the benefit that accrues to existing holders of the currency. This is fundamentally necessary to protect the existing value of Bitcoins. If this does not occur then an alternative system that does recognize the risk of deflation and price instability will present itself which will achieve a greater level of acceptance, destroying Bitcoin in the process.

In other words the supply of money must grow in proportion to the increase of value.  This is of course is the killer argument against the gold standard.  2-3% growth a year is not enough, especially when your pulling out if a recession.  Taking population growth and inflation into account you can very nearly get negative growth triggering a negative deflationary spiral and depression.  Whether or not Bitcoin is inherently delationary has sparked a lively debate, even reaching the pages of the economist.  Discussion though confuse inherent delationary tendencys with problems that occurr from Bitcoins (temporary) high exchange rate against the dollar.

Charles Schumer,  Democratic senator, claims it is just what drug dealers have been waiting for.  Specific sites for money laundering and drug dealing – slikroad –  have sprung up.

“Literally, it allows buyers and users to sell illegal drugs online, including heroin, cocaine, and meth, and users do sell by hiding their identities through a program that makes them virtually untraceable,”

With Gawker publishing a peice on anonymous purchase of pot on the 1st of June the number of people using Bitcoin exploded.

Whole Bitcoin farms sprung up, some using so much electricity they were mistaken as pot farms.  Rumors of huge botbnets gnerating bitcoins sprang up.

The best arguments against Bitcoins have been set down by Adam Cohen.  A key problem is bias to early adopers giving them free money with diminishing returns as people pile in like a ponzi scheme.   On the issue of crippling deflation Cohen says

Bitcoin is not designed to be a functioning currency, it’s designed to enrich early adopters. Again, that is why it is a scam. Period.

As a quick thought experiment, let’s say demand for bitcoins grew as more people found out about them. Well, you’d expect the price of Bitcoin in dollars to grow rapidly. Now assume I own one bitcoin. I also have a dollar bill. I would like to purchase a Pepsi. Which one of those will I spend? Obviously the devaluing dollar gets spent before the skyrocketing bitcoin.

Prophetically he predicted that when something goes wrong it will die – it did and it looks like it has, because there is no lender of last resort.  Its the same problem with so called free (in reality wildcat) banking, and Bitcoin is nothing more than internet wildcat bank where everybody is a wildcat bank.

Timothy B Lee in April speculated we were seeing a Bitcoin bubble.

the demand for Bitcoins seems to be driven by a combination of speculation and ideological enthusiasm. And we have a word for an asset whose value is driven by irrational exuberance: a bubble.

Because we think of a ‘bank’ as a big buiding with a vault, a physical thing, it is easy to think that there is no bank in bitcoin.  No there are many.

Each user is effectively a bank lending to themselves through endogenous money.

Think of it this way, if you wait a year of so it might generate a ‘block’ i.e. it expands the money supply, it issues credit to the owner. DIY QE.

This is a ‘credit system’ ‘which simulates specie.

People, briefly, trusted it as a store of value because the rate of credit expansion was low and predictable. Of course as it was never driven by demand for investment it would have proven deflationary in the long term, had it caught on.

Bitcoin is more interesting I think in showing up some of the proposed causes of interest as false as well as the Austrian (full reserve) view of abnking.

There was no ‘pure’ time preference here only an expectation of an increase in the service provided by the bitcoin wallet, i.e. it would increase.  Without this productivity it would have no value.

All that is needed to explain the interest it is rational to pay is rate of change of money value minus (existing debt payments +change of debt)+uncertainty premium.

Let me explain, if we know a field of rice will increase by 10% in one year (a famous case from Samuleson) then we might expect a 10% increase in the money value from that field of 10% (setting aside for one moment demand issues). If you had zero debt to begin with if you take on debt less than yield from the field times productivity (0.1) in this case we have made a rational decision.  If we have a debt overhang from the previous period we must also pay that before we turn in a profit.  If the burden of debt is not too great we have the opportunity for accumulation, further investment and growth.

If you anticipate productivity correctly and credit is cheap enough it presents an arbitrage opportunity between the imputed yield/rent of land today and the imputed yield/rent of land in the future  – hence profit.

It is not that the present is undervalued but that the opportunity cost of money as a source of investment is correctly valued when considered as net present value. Or as John Rae put it ‘The sagacious business man …he is constantly forecasting’

However if we grow 10% more rice we wont necessarily get 10% more.  If last year was a bad one and everyone plants we get a glut and losses.  Uncertainty and uncertainly alone is necessary to explain the difference between productivity and interest paid.  The difference being a premium, like insurance, on not realising value, such as from death and bad weather. Again there is no pure time preference here, time preference is explained by rational profit assessment issues.

Explaining the rate of interest it is rational to pay does not fully explain the amount of credit leant.  If the rate of change of savings (cash balances) is greater than the rate of change of investments we get a savings glut and vice versa.  Where savings funds are growing banks will seek to lower credit or credit worthiness to attract future interest income streams from lending, where it is shrinking banks will seek to restrict credit to increase income from interest and attract savers.

The circuit of credit is taken from profit and wages, so distributional issues and liquidity preference can lead to divergences between interest rates and profits, but they are intimately connected.

For bitcoin the left hand side of the equation (its self growing nature) attempts to compensate for the lack of a direct credit issuer (the right hand side).  You can of course get credit from other individuals but to do so they will have to have withdrawn money from exchange, which is deflationary.  Each individual lending will act as a full reserve bank, they cannot lend more bitcoins than they have.  This creates a problem of financial intermediation.  Few will have stores of wealth large enough to service large loans.  Someone could set up a bitcoin bank to serve as an intermediary but without being fractional they would need to charge  a premium to savers to attract funds.  This premium will come directly off profits and reduce growth.  A full reserve system will therefore restrict growth because of the extra change of intermediation.

Depsite the libertarian origins of many of bitcoins supporters few rushed to set up banks to fund investment, they were speculators, making mal-investment decisions  in search of a easy buck.  Exactly the Austrian critique of fiat banking.  The irony.

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