The economics of cryptocurrency
Mar 12, 2011
3 minute read

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).

  1. 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?
  2. 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?
  3. 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?
  4. 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?
  5. 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?
  6. 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.