Here’s How Cryptocurrencies Could Replace the US Dollar

Ever since Bitcoin started to capture the public imagination, I have downplayed the idea that it could ever represent a serious challenge to the US dollar. I disagree with the goldbugs who believe that simply fixing the supply of money is the best monetary policy, that inflation is theft, etc. Rather, I have argued that Bitcoin is a good medium of exchange despite being a bad unit of account and a risky store of value. These three functions of money tend to go together for reasons that Ludwig von Mises outlined over a century ago in The Theory of Money and Credit. But more recent research from the 1980s and 90s has explored the possibility of the separation of these three functions. A contemporary example of separation is that Treasurys are used to settle transactions in the shadow banking system, even though the transactions are denominated in dollars—the medium of exchange is different than the unit of account. Bitcoin could be just another example of the continuing separation of the functions of money as technology progresses.

I still think that this is correct—we are observing modest separation of the functions of money. Bitcoin doesn’t need to be a unit of account in order to be useful. On it’s own, Bitcoin makes a terrible unit of account.


This is speculative, but there is a scenario in which Bitcoin could create a real challenge for state-backed currencies. This scenario is not impossible.

As I wrote last week at The Umlaut, Bitcoin is not just money, it is a decentralized platform for generalized, programmable contracting, a transport layer for finance. It can be used to create all kinds of financial contracts, including, with the help of a trusted computer called an oracle, contracts contingent upon events in the real world. Suppose that an oracle existed that reliably provided information about the USD/BTC exchange rate. It would become possible to create a long-term contract, executed through Bitcoin, denominated in dollars. If the cost of querying the oracle were negligible (as we might expect it to be), then the cost of this trade would be the forgone interest on the funds used to meet the “margin requirements” built into the contract.

Now assume a second oracle that reports nominal GDP. By combining the two oracles, it becomes possible to write a contract, executed over Bitcoin, that is denominated in shares of NGDP. In fact, we could simply standardize this transaction and create a new currency unit, built on top of Bitcoin, that is equal to a trillionth of NGDP. We could call it a Sumner. Instead of getting a mortgage for $300,000 for a house, you could promise to pay 19,000 Sumners. That way, if the economy went south, you would owe less in real terms, and repayment would not become harder. If the economy boomed, you would owe more in real terms, and repayment would not become easier. Similarly, workers who had wage contracts denominated in Sumners would experience a real pay cut when the economy shrank, decreasing their employers’ incentive to fire them, and an automatic raise as the economy grew again. Sumners would have built-in monetary policy.

So by combining information from two oracles into a simple, standardized, tradable futures contract executed over Bitcoin, we create a cryptocurrency overlay that is superior to dollars, at least according to the market monetarists (see Scott Sumner’s 1989 paper and his recent Mercatus paper). As I said above, this is speculative; as far as I can tell, there are no oracles or Bitcoin-executed futures contracts yet. And there are at least two further (possibly surmountable) problems.

First, it remains to be seen what the long-term cost of hedging will be. The margin requirements built into a Sumner depend on how volatile Bitcoin is with respect to NGDP. It’s possible that over the long run, the volatility of Bitcoin will settle down a fair bit, even if it is never as stable as the dollar. If Bitcoin is some day only 3-5 times more volatile than the dollar, that should be enough to support the creation of Sumners. For now, Bitcoin’s price swings are still incredibly wide.

Second, there remains the puzzle of why we don’t see NGDP futures in the dollar economy. As far as I can tell, there are no regulatory barriers to creating them and using them to denominate transactions. Yet in spite of their supposed superiority to dollars, no one uses NGDP futures to trade, and indeed, there aren’t even NGDP futures markets. If it’s a question of there not being enough permissionless innovation in the financial system, then maybe market monetarists should embrace cryptocurrencies as a way to try out their ideas.

Tyler vs. Tyler on Cryptocurrency Network Externalities

Tyler Cowen thinks Bitcoin is going to “plummet in price.” While I agree with my colleagues Jerry Brito and Andrea Castillo that the price is not really what’s interesting about Bitcoin, it is always worth grappling with Tyler’s arguments.

Tyler first argues that entry into the cryptocurrency market is limited primarily by the cost of marketing the new currency. Tyler notes that these marketing costs are isomorphic to the network externalities enjoyed by incumbent cryptocurrencies. “Alternatively you can think of that sum as representing the natural monopoly reserve currency advantage of Bitcoin.” OK, I prefer the latter terms, so let’s push marketing to one side.

From there, Tyler is able to derive the following theorem: “the value of WitCoin should, in equilibrium, be equal to the marketing costs of its potential competitors.” To put this in simpler terms, Bitcoin’s network externalities should drive the value of Bitcoin. Tyler says in theory you could argue that Bitcoin’s price reflects these fundamentals, but he doesn’t buy it. Therefore, Bitcoin is due for a crash.

I agree with Tyler’s theorem, or at least my simpler paraphrase. Nevertheless, I am not so convinced by Tyler’s conclusion. As a wise man once said (in an addendum to the same post), “expected price changes usually get compressed into the present and [] an overall expected rate of return equality must hold.” So the network externalities that matter in determining Bitcoin’s equilibrium price are mostly expected future ones, not present ones. Is it so unreasonable to expect that future Bitcoin network externalities would equal $20 billion or more?

Well, that depends on whether network externalities in currencies in general tend to be strong or weak. To answer that question we might turn to an expert such as Tyler Cowen, who in 2011 argued (1, 2) that currency network externalities are so strong that Bitcoin couldn’t possibly succeed. Now Tyler is arguing that currency network externalities are so weak that Bitcoin can’t possibly succeed. Who are we to believe?

I think a reasonable view is that in general, currency network effects are quite strong, but they can be overcome through technical superiority and perhaps an assist from the War on Drugs (although note that the latter is mostly a one-shot deal; additional cryptocurrencies without a pre-existing network won’t really benefit to the extent that Bitcoin de facto legalizes drugs). There’s probably a market for 2 or 3 major cryptocurrencies competing on different points on the technical possibilities frontier. Note also that Bitcoin is not a static project; technical improvements discovered in experimental currencies can be added to Bitcoin.

However strong you think network externalities are for currencies, they are higher for cryptocurrencies, because optimal currency area considerations are moot: no one is using them as media of account. Several of us repeatedly belabor the point that Bitcoin is really more of a payment system like Visa than a currency like the dollar. I take the fact that there are only three major credit card companies in the world as a sign that cryptocurrency network externalities are likely to be high.

Tyler is certainly right about one thing: there is a lot of mood affiliation going around in Bitcoin discussions. While I am happy to plead guilty to a bit of it myself, I’m not convinced that the majority of it is on the Bitcoin-optimist side. I think the technical aspects of Bitcoin are more impressive than has yet been widely recognized by the pessimists, but alas that discussion will have to wait for another post.

How Much Carbon Does It Take to Keep Ben Bernanke Alive?

Everyone seems to be worried about Bitcoin’s carbon footprint lately. Last week, an article on Quartz claimed that Bitcoin miners are spending $17 million per day on electricity in order to reap $4.4 million worth of bitcoins. And Yesterday, Pando Daily ran a piece that ominously warned about Bitcoin’s carbon footprint.

One problem with both of these pieces is that they seem to rely on electricity consumption estimates from While this site is great for getting stats about the Bitcoin network, it’s not such a great site for estimating electricity consumption. clearly states that it is using an estimate of 650 Watts per gigahash [per second, I assume] in its electricity calculations. While this may have been a good estimate of the efficiency of the Bitcoin network when the page was first created, the network has become much more efficient since then. shows that the 650W/GH/s figure was used on the earliest cached copy of the page, from December 2, 2011; yes, that is over two years ago.

Furthermore, we can use data from current-generation mining hardware to see how absurd the 650W/GH/s number is. In recent months, the Bitcoin network has mostly switched to application-specific integrated circuits, or ASICs. These devices are much more efficient at mining than previous generations of hardware. A look at this table of mining hardware shows that ASICs all seem to mine at less than 10W/GH/s. Some discontinued models seem to mine as efficiently as 2W/GH/s, and some models that are shipping next year will use less than 0.5W/GH/s. Not everyone in the Bitcoin network is using the latest-generation models of ASICs, and of course botnet mining is based on stealing electricity, so it’s not likely that the network averages 2W/GH/s or less. Nevertheless, it seems that the electricity estimates that these articles are based on may be off by a factor of close to 100.

Furthermore, we should always ask “compared to what?” Yes, the Bitcoin network uses a lot of electricity, but the computations that use this electricity are used to clear transactions, move money around the blockchain, increment the money supply, etc. In order to make a fair comparison to non-cryptocurrency payment systems, we need to ask how many resources (and how much carbon) is used to keep those systems going. And I think the answer is quite a lot. Banks, too, use computers, sometimes ancient ones, to process transactions. Furthermore, humans use a lot of carbon. Since our financial system uses a lot more human intervention than Bitcoin, much of those humans’ carbon use is due to the financial system. (Another way to put this is that if we all switched to cryptocurrency, those humans would get other jobs and produce other social benefits in exchange for the carbon used to keep them alive.) And there are of course costs of physically moving cash around, for example on armored trucks.

The relevant calculations are admittedly difficult, but it seems quite possible to me, when all is accounted for, that Bitcoin is the green alternative to Federal Reserve Notes. Cryptoanarchy and the environment don’t have to be enemies.

Using Bayes’s Rule to Think About a Bitcoin Bubble

Is there a Bitcoin bubble? Jason Kuznicki thinks so and believes that he has conclusive proof. He blogs three graphs that show more or less that there is a lot of speculation in Bitcoin. But does speculation prove that there’s a bubble? Let’s use Bayes’s rule to think about this carefully.

Bayes’s rule is a mathematical tool for thinking about the incorporation of new evidence into subjective probabilities. Let’s suppose that there is some proposition A for which you have a prior belief. Somebody offers evidence B for or against A. How much should you change your belief in A based on evidence B?

Bayes’s rule boils the answer down to a simple mathematical form:

P(A|B) = P(B|A)\dfrac{P(A)}{P(B)}

In English, the probability of A given B equals the probability of B given A, times the probability of A and divided by the probability of B.

So to evaluate Jason’s argument and see how much we should change our estimate of a Bitcoin bubble based on the evidence that there’s speculation, we can simply assign the proposition and the evidence to A and B. In this case, A is the proposition that there’s a bubble, and B is the evidence that there’s speculation in Bitcoin. If we figure out our subjective probabilities for B|A and B, we can use those to determine how different P(A|B) should be from P(A).

So what is B|A? Since B is the evidence that there is speculation in Bitcoin and A is the proposition that there is a bubble, B|A simply states the proposition that given that there is a bubble, there is speculation. It seems pretty much impossible to have a bubble without speculation, so I’ll go with a subjective probability of 1. Picking a different value here will only work against Jason’s argument.

So what is the probability of B, the fact that there is speculation in Bitcoin? The Bitcoin ecosystem isn’t built out yet. Most of the protocol’s most exciting uses haven’t even seen the light of day yet. As I blogged last week, multisignature transactions are barely in use yet, but they form the foundation for a decentralized architecture of arbitration. Ed Felten at Princeton is working on decentralized prediction markets. Jerry Brito points to microtransactions, or even nearly-continuous transactions, as another exciting future use scenario.

Given that we don’t know whether this ecosystem will ever materialize, holders of bitcoin are necessarily speculating. If the ecosystem matures and is useful, bitcoins will be worth something. If none of these innovations come about, or if we decide they’re not that useful after all, then bitcoins will probably be worth nothing. There’s no way out of speculating, because we simply don’t know for sure if the ecosystem will come along. Almost the entire “fundamental value” of Bitcoin rests on future events.

So the probability of B, I think, is 1. When P(B|A) is 1, and P(B) is 1, what does Bayes’s rule reduce to?

P(A|B) = P(A)

B simply offers no information as to whether A is true.

A similar argument can be made when Bitcoin’s volatility is offered as evidence of a bubble. Bitcoin is a thinly-traded asset where supply does not adjust to accommodate demand. It is going to be volatile. So the fact that Bitcoin is volatile adds no new information to the question of whether it’s a bubble.

What does provide information? I think the most reliable evidence is on the maturation (or not) of the Bitcoin ecosystem. If Bitcoin seemed static right now, I would interpret that as evidence of a bubble. But it doesn’t. Every day, people are working to build businesses that leverage some of the unique features of Bitcoin’s protocol. As long as that continues, I think it’s most reasonable to be highly agnostic about the correct price of Bitcoin.

Stop Saying Bitcoin Transactions Aren’t Reversible

One of the criticisms leveled at Bitcoin by those people determined to hate it is that Bitcoin transactions are irreversible. If I buy goods from an anonymous counterparty online, what’s to stop them from taking my bitcoins and simply not sending me the goods? When I buy goods online using Visa or American Express, if the goods never arrive, or if they aren’t what was advertised, I can complain to the credit card company. The company will do a cursory investigation, and if they find that I was indeed likely ripped off, they will refund me my money. Credit card transactions are reversible, Bitcoin transactions are not. For this service (among others), credit card companies charge merchants a few percentage points on the transaction.

The problem with this account is that it’s not true: Baked into the Bitcoin protocol, there is support for what are known as “m-of-n” or “multisignature” transactions, transactions that require some number m out of some higher number n parties to sign off.

The simplest variant is a 2-of-3 transaction. Let’s say that I want to buy goods online from an anonymous counterparty. I transfer money to an address jointly controlled by me, the counterparty, and a third-party arbitrator (maybe even Amex). If I get the goods, they are acceptable, and I am honest, I sign the money away to the seller. The seller also signs, and since 2 out of 3 of us have signed, he receives his money. If there is a problem with the goods or if I am dishonest, I sign the bitcoins back to myself and appeal to the arbitrator. The arbitrator, like a credit card company, will do an investigation, make a ruling, and either agree to transfer the funds back to me or to the merchant; again, 2 of 3 parties must agree to transfer the funds.

This is not an escrow service; at no point can the arbitrator abscond with the funds. The arbitrator is paid a market rate in advance for his services, which are offered according to terms agreed upon by all three parties. This is better than the equivalent service using credit cards, because credit cards rely on huge network effects and consequently there are only a handful of suppliers of such transaction arbitration. Using Bitcoin, anyone can be an abitrator, including the traditional credit card companies (although they might have to lower their fees). Competition in both terms and fees is likely to result in better discovery of efficient rules for dispute resolution.

While multisignature transactions are not well understood, they are right there in the Bitcoin protocol, as much a valid Bitcoin transaction as any other. So some Bitcoin transactions are irreversible; others are reversible, exactly as reversible as credit card transactions are. is a new site (announced yesterday on Hacker News) that facilitates setting up multisignature transactions. Bitcoin client support for multisignature transactions is limited, so the site helps create addresses that conform to the m-of-n specifications. At no point does the site have access to the funds in the multisignature address.

In addition, Bitrated provides a marketplace where people can advertise their arbitration services. Users are able to set up transactions using arbitrators both from the site or from anywhere else. The entire project is open source, so if you want to set up a competing directory, go for it.

What excites me most about the decentralized arbitration afforded by multisignature transactions is that it could be the beginnings of a Common Law for the Internet. The plain, ordinary Common Law developed as the result of competing courts that issued opinions basically as advertisements of how fair and impartial they were. We could see something similar with Bitcoin arbitration. If arbitrators sign their transactions with links to and a cryptographic hash of a PDF that explains why they ruled as they did, we could see real competition in the articulation of rules. Over time, some of these articulations could come to be widely accepted and form a body of Bitcoin precedent. I look forward to reading the subsequent Restatements.

Multisignature transactions are just one of the many innovations buried deep in the Bitcoin protocol that have yet to be widely utilized. As the community matures and makes full use of the protocol, it will become more clear that Bitcoin is not just a currency but a platform for financial innovation.

The Great Disintermediation

Yesterday at Forbes, William Pentland had an interesting piece on possible disintermediation in the electricity market.

In New York and New England, the price of electricity is a function of the cost of natural gas plus the cost of the poles and wires that carry electrons from remotely-sited power plants to end users. It is not unusual for customers to spend two dollars on poles and wires for every dollar they spend on electrons.

The poles and wires that once reduced the price of electricity for end users are now doing the opposite. To make matters worse, electricity supplied through the power grid is frequently less reliable than electricity generated onsite. In other words, rather than adding value in the form of enhanced reliability, the poles and wires diminish the reliability of electricity.

If two thirds of the cost of electricity is the distribution mechanism, then, as Pentland notes, there is a palpable opportunity to switch to at-home electricity generation. Some combination of solar power, batteries, and natural gas-fired backup generators could displace the grid entirely for some customers. And if I understand my electricity economics correctly, if a significant fraction of customers go off-grid, the fixed cost of maintaining the grid will be split over fewer remaining customers, making centrally-generated electricity even more expensive. The market for such electricity could quickly unravel.

While it remains to be seen whether electricity generation will indeed become decentralized, such disintermediation would be the continuation of a decades-long social trend. It all began (plausibly) in 1984. The Macintosh was released, and desktop computing became a thing. Desktop printers disintermediated printing departments, Kinkos, and the steno pool. The Internet has disintermediated telephone companies, music labels, television networks, newspapers, and much more. Online education is unbundling university courses.

What’s even more exciting is the next generation of disintermediating technologies. Bitcoin could displace some financial institutions—to varying degrees, banks, the Federal Reserve, Western Union, and credit card companies. Mesh networks could solve the last-mile problem of Internet service delivery, which tends to be monopolized or at least concentrated. 3D printers could disintermediate supply chains. 3D chemical printers could disintermediate drug companies and the FDA.

Delivery drones like Amazon Prime Air‘s arguably disrupt package delivery services, though not entirely because FedEx and UPS will still run drone-utilizing distribution networks. More importantly, delivery drones disintermediate the real estate market for small businesses. It will no longer be important, if you run a local business, to have a storefront in a prime location. Your customers can order online and items can be delivered to them in half an hour straight from the factory or artisanal workshop. It could be the Etsyfication of the economy.

If information, electricity, money, and production all get disintermediated, what is left? If these trends continue, the future will be one in which human interaction is unmediated, and to a surprising degree, unregulable. It will be difficult to stop a willing buyer and seller from transacting. Information about the proposed transaction might not be censorable. Payment via Bitcoin or other cryptocurrencies can’t be stopped. Production and delivery of the item may be difficult or impossible to detect and intercept.

Intermediaries are often used by governments as points of control. As we shed intermediaries, it may become possible to live one’s entire life without any particular authority even knowing that one exists. I doubt that we’ll ever get that far in the process, because using non-abusive intermediaries often makes economic sense. But for the next few decades, at least, I expect the trend to continue and the world to get a lot more interesting.

New Dourado and Tabarrok Paper on Intellectual Property

I’m pleased to announce that Alex Tabarrok and I have a new working paper out from the Mercatus Center today, “Public Choice and Bloomington School Perspectives on Intellectual Property.” The paper will appear in Public Choice in 2014.

Here’s the abstract:

We mine two underexplored traditions for insights into intellectual property: the public choice or Virginia school, centered on James Buchanan and Gordon Tullock, and the Bloomington or Institutional Analysis and Development school, centered on Elinor Ostrom and Vincent Ostrom. We apply the perspectives of each school to issues of intellectual property and develop new insights, questions, and focuses of attention. We also explore tensions and synergies between the two schools on issues of intellectual property.

The gist of the paper is that the standard case for intellectual property—that a temporary monopoly is needed in order to recoup the sunk costs of innovation or creation—ignores issues raised by the two schools we investigate.

From a public choice perspective, a temporary monopoly provides enormous opportunities for rent seeking. Copyright and patent owners are constantly manipulating the political environment to expand either the duration of the monopoly or the scope of what can be monopolized. We document the evolution of intellectual property in the United States from its modest origins to its current strong and expansive state.

From a Bloomington perspective, the standard case for IP wrongly treats the commons as a kind of wasteland. In fact, numerous innovations and sprawling creative works occur without monopolization—just look at Wikipedia. Innovation occurs when the right institutional structures are in place, and intellectual property that is too severe can hamper the smooth operation of these institutions. Too much IP can harm as much as too little.

Read the whole thing, cite it copiously, etc.