Bitcoin’s monetary bluff

Beat Weber
May 15, 2015

Most Bitcoin supporters may no longer beat the drum to threaten  government-back money. But, this challenge is certainly the most  interesting aspect for economists.

Economists may have their own internal disagreements about money, but  in general they agree on a definition based on three functions: Unit of  account, means of payment, store of value. Bitcoin’s concept, on the  other hand, assumes that current money would be rejected if there only  was an alternative like Bitcoin. This assumption is covered over by lots  of technical discussion, but does not delve into the economics and  definition and function of money itself.

In economics, the unit of account is usually perceived as a public  monopoly. All prices in the Euro area are denominated  in Euro, in  Pounds in the UK, in Dollar in the US etc. Thereby, consumers can  compare prices easily within currency areas. A currency works like a  language for the economy. Once a language is established among a  community, a new language will find it very hard to displace it, because  people shy the cost of switching as long as the current language  “works“. In general, people do not have to be forced to stick with their  first language (indeed forcing them could prove quite useless if it  were necessary). Apart from exceptions due to severe monetary crisis  (e.g. hyperinflation), the same goes for the prevailing unit of account.

While there is usually only one unit of account in a currency area,  there are many issuers of means of payment, but all are denominated in  the prevailing currency unit. Money, the ultimate means of payment, is  issued by public authorities (notes and coins), but most retail payments  are made by transfer of bank account balances among individuals and  firms, not cash. These balances come into existence as a by-product of  private banks’ credit creation, and certify a claim on notes and coins  that can be used instead of cash in payments on the retail level. Beyond  that, IOUs of other private debtors could also be used as means of  payment as long as their promises to pay are considered credible by  users. Bitcoin is one among many other private means of payment,  although it entails some peculiarities.

The third function of money is to serve as store of value. Holding  cash is a way for individuals to transfer purchasing power over time  while retaining maximum liquidity. In economic history, coin  manipulation in the interest of creating income for the state could  shatter this quality. Such manipulation was prevalent before the  capitalist state discovered the benefits of promoting economic  development and regular taxation. In the modern economy, central banks  as issuers of money are guided by a public mandate to stabilize money’s  purchasing power and contribute to overall economic stability in their  issuing behaviour.

Libertarian proclaimers  of Bitcoin as an alternative monetary system tend to underappreciate  this transformation. From such a stance against the perceived dangers of  manipulation, three peculiar features of Bitcoin’s “monetary system“  result: “Money“ in Bitcoin is not issued as liability by an issuer  rather,  it is a pure asset to be “discovered“ by miners. It is  denominated in its own unit of account. And it has a fixed supply.

These features represent a divergence from common practice in current monetary systems.

The unit of account tends to be a monopoly in any currency area  because it is more convenient for users to compare prices in the same  unit. By offering a competing unit of account of unstable value in  relation to existing units, Bitcoin enhances choice for users in a way  comparable to the invention of a private language. More precisely: a  private language that consists of a strictly limited number of words of  unstable meaning: Not very attractive to learn unless it gets you access  to an attractive community or enables you to express things which  cannot be expressed in the prevailing language. As a result, there are  no commodities on offer worth mentioning that are priced in Bitcoin. In  general, merchants that accept Bitcoin denominate their prices in  official currency and vary the Bitcoin price according to the current  exchange rate.

Use of Bitcoin for the second function of money, as a means of  payment, is made unattractive by its own design. When supply is fixed,  and the community of Bitcoin users is expected to grow, Bitcoin’s value  in terms of official currency can be expected to rise over time.  Therefore, holders of Bitcoin have an incentive to hoard the currency,  and use official currency for transactions instead. Exceptions are  transactions where use of official currency might be unwarranted due to  costs or traceability, e.g. small denomination online payments and  illicit transactions.

Concerning the store of value function of money, its supply can be  adjusted to variations in economic activity in the current system:  Central bank interest rate policy influences the terms of credit  creation, whose by-product is creation of means of payments. Issuers of  means of payment guarantee relative stability of value. In Bitcoin,  fluctuation in economic activity concerning Bitcoin results in  fluctuation of Bitcoin’s value. There is no issuer able or interested in  guaranteeing any stability. As a result, Bitcoin does not provide for a  stable store of value.

As a result, institutions such as the ECB  governing the current monetary system do not perceive Bitcoin as an  economic threat. Bitcoin may be a compelling solution for the problem of  finding agreement among mutually distrustful parties, but it does not  enable them to govern a substitute for money in a way that provides the  qualities most users of money expect. While the system seems able to  generate economic activity (mining, exchange rate transactions, various  business models for related services etc.), Bitcoin must be expected to  serve more as speculative asset than as a substitute for money.

Statements of authorities on Bitcoin therefore usually stress risks  to consumers from using Bitcoin as payment system and its possible use  for illicit transactions. But that‘s it. Bitcoin does not break new monetary ground, despite its claimed “challenge to a monopoly“ rhetoric or claims of a general “tendency towards diversification“  of money. Nobody uses it as unit of account. It is one among many other  private means of payment in the economy. Due to its inherent  instability, there are few incentives to use it instead of official  currency outside of special niches, and it is a poor store of value.

Some voices from within central banks located in world financial  centres have speculated on whether some features of Bitcoin technology  could be adopted by monetary authorities (see commentary by the BoE and David Andolfatto).  But it is clear that any such solution would require a break with some  of the cornerstones of the existing Bitcoin project’s monetary design.  Whether a selective cooptation could result in something useful remains  unclear at this stage. So far, Bitcoin’s challenge to current money is  more or less a bluff.


All by
Beat Weber