Is there a word for serendipitous Wikipedia browsing? Yesterday I started out seeking information on punk music and I ended up discovering Bitcoin, an open source peer-to-peer digital currency. Bitcoin uses strong cryptography and decentralized computing to produce scarcity in the money supply, which grows at a predefined rate that is clearly visible in the source code. Tamper with that growth rate and your software becomes incompatible with the rest of the cloud, and your Bitcoin holdings become valueless. Double-spending is impossible unless at least half the computing power of the cloud is in on the attack against the currency. You can read all the technical details here.
The total supply of Bitcoins is scheduled to grow geometrically and will asymptotically approach 21 million. This means that if the currency becomes successful and its velocity does not accelerate proportionally to its use, we should expect long-run deflation in Bitcoin-denominated prices. Bitcoins are technically divisible to 8 decimal places to accommodate this. Notably, if I am reading the data correctly, Bitcoins have appreciated by a factor of 300 against the dollar in the last year. One Bitcoin is worth around 88 cents as of this writing.
I have a number of questions. Perhaps my readers know some of the answers, or perhaps some enterprising young monetary economist will address some of these in an academic paper (calling Will Luther).
- Currencies are based on trust, and trust in money is accomplished through scarcity. Bitcoin is cryptographically guaranteed to be scarce since its supply will never exceed 21 million. But there is reason to believe that a perfectly fixed supply is not optimal. If people suffer from money illusion, it is better if prices increase gradually over time. If money has real effects, then it is best if the money supply is countercyclical. These two facts are at least part of why Sumner advocates a fixed NGDP trajectory. Is it possible to create a cryptocurrency that targets NGDP instead of the money supply?
- If there are competing currencies would we still want any one currency to target NGDP? MV ≡ PT, but notably T only represents transactions denominated in a particular currency. In general, what is the optimal path of the various money supplies when there is more than one currency in use in a given economy? When there are competing currencies, is there less money illusion? Does money continue to have real effects?
- What are the monetary implications of the fact that governments will probably have difficulty regulating banking in cryptocurrency? Does cryptocurrency provide a test of the legal restrictions theory developed by Fischer Black, Neil Wallace, and others?
- What if prices come to be denominated in Bitcoin (with its fixed supply), but different media of exchange and settlement are used? How does that change any of the above?
- In a number of the above scenarios, there may not be much deflation in Bitcoin-denominated prices (since the money supply is not defined, say, under the absence of legal restrictions on financial intermediation). Putting these scenarios aside, if deflation were consistent, then Bitcoins would yield a positive return due to appreciation. Would we see more money hoarding during recessions? Would the world finally see a real liquidity trap? With monetary policy out of the picture, would fiscal policy become necessary? Is crypto-anarchy self-defeating because it requires big government interventions?
- Decentralization of the currency means that it cannot be debased, but it also means that it cannot be confiscated at an institutional level. What are the political effects of this change?
I suppose I should add that I am not exposed to Bitcoin and am long USD. And by the way, thinking about Bitcoin reminded me of David Friedman’s Future Imperfect, which you may want to read if you enjoyed this post.
Update 4/4/11 — Bitcoin is the subject of today’s EconTalk.
>Is crypto-anarchy self-defeating because it requires big government interventions?
A cryptocurrency doesn’t necessarily imply a fixed or bounded supply of currency. That is true in Bitcoin’s case, but not in my b-money proposal (http://weidai.com/bmoney.txt), which tried to take the macroeconomic problems caused by deflation into account.
If it turns out that having a fixed supply of bitcoins creates serious economic problems, it should be possible to change Bitcoin’s protocol by consensus. That is, release a new version of the Bitcoin software following a new protocol which allows more currency to be created as needed, then have everyone upgrade at the same time. Those who refuse to upgrade can continue to trade amongst themselves, but not with the ones who have upgraded. For those who do upgrade, their old Bitcoin balances can be carried over into the new protocol. I have not worked out the details of how to do this, but something like this seems possible to me.
It also seems possible to me to change the money supply by consensus. What I’d really like to see, however, is a money growth rate that varies inversely with the rate at which money is spent. That is, I’d like to see countercyclical monetary policy built into the protocol.
That’s an interesting idea, and it seems like it ought to be possible as well. Just have everyone upgrade to a new version that automatically adjusts the money growth rate based on the rate at which money is spent.
Or we can have manual monetary policy as well, if everyone uses a cryptocurrency software built to accept such policies cryptographically signed by a monetary authority.
But could it be done purely in software without requiring consensus or an external decision? Could the network aim for a given level of spending per period?
I don’t see why not. All transactions are publicly visible, so the software should be able to automatically adjust money growth based on those records. The only problem I can think of with this right now is that a malicious attacker could try to slow down or stop money creation by doing a lot of transactions between accounts they control.
As Wei said it should be possible to have an automatically adjusting countercyclical money supply. It should also be possible to distribute the new money with respect to income, historical propensity to spend or wealth. Do i understand bitcoin correctly in that previous owners of a coin can be seen or is this encrypted and not visible.
Victor, I think that’s right, but I am not 100% sure. Some remaining difficulties would be distinguishing between purchases of goods and services (which count in GDP) and pure transfers (which don’t), and figuring out what to do when the money supply needs to shrink.
Imagine Glenn Becks chalkboard!, if money would be fully traceable.
True what you said about transfers. Could be assumed to be constant or you subtract GDP ( measured in another way) from all bitcoin transfers.
Bitcoin is fully traceable, in the sense that you can see all transactions and for each transaction you can see the amount and the addresses of the sender and recipient. (An address is a public key, so you don’t necessarily know how they are linked to physical people.) Here’s a website that allows you to view these transactions: http://blockexplorer.com/
>what to do when the money supply needs to shrink
You can, by consensus, reduce everyone’s balance by a certain percentage. Or this can be done automatically based on transaction data. Or some altruist can trade a bunch of real goods for bitcoins and hold on to them.
A few comments:
-There could be a central monetary authority that conducts monetary policy, and signs its actions. That would kind of defeat the purpose of a decentralized currency though.
-Regarding the policy of making money creation inversely proportional to total spending rate (“NGDP”), Wei Dai said:
The only problem I can think of with this right now is that a malicious attacker could try to slow down or stop money creation by doing a lot of transactions between accounts they control.
This isn’t so much a problem of attacks on the currency, but one inherited from the problems of current monetary theory: economists like Scott Sumner think it would all be so much better if monetary policy aimed to stabilize total nominal spending. But such a measure is uninformative and Goodhart-prone for the very reason you give: the goal can be trivially met by simply doing a bunch of “toy” transactions between people until NGDP is at the desired people.
Incidentally, this is why I think the idea of NGDP targeting is fundamentally misguided, as are the people who conclude it’s a reasonable solution.
Also:
Bitcoin is fully traceable, in the sense that you can see all transactions and for each transaction you can see the amount and the addresses of the sender and recipient. (An address is a public key, so you don’t necessarily know how they are linked to physical people.)
But how do you tell people who to send the money to without telling someone the connection between your identity and your public key (from which they can trace all further targets of the money from that key)?
Hi, I am in no way smart enough to understand any of the things beings said about bitcoin, i dont understand economics at all, but i think that there are more people like me who might want to understand better, so can anyone explain bitcoin and why i should use it, in layman’s terms?
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Why would a malicious attacker try to slow down or stop money creation? I can imagine a few reasons but they seem far-fetched
1) To make the dollar appreciate against another currency. If someone had a large cache of these NGDP coins, they would be able to get more for them. But after they divested they wouldn’t have any incentive to continue manipulating the currency, so this might not be a long-term problem.
2) A producer in a different currency area might want to make their products more attractive to NGDP coin users.
This problem might be solved by making transaction fees mandatory, that way people wouldn’t just trade coins back and forth.
We need to think of a better name for these theoretical NGDP coins. Dorados? Hayeks? Sumners?
The transaction fees could be designed to increase if the velocity of money got too high.
If V is too low, increase M.
If V is too high, increase transaction fees.
Fortunately Bitcoin does not have such noble goals like saving rain forests built in!
Why can’t people just create money and stop trying to change the world?