April 16, 2018 Reading Time: 4 minutes

Bitcoin has become a test for the validity of many theories about money. Monetary theories that have proven capable of explaining Bitcoin have become more credible; those that haven’t have become less credible. Nicolás Cachanosky and Casey Pender, for instance, recently pointed out that Bitcoin and other cryptocurrencies can be explained as corresponding to Friedrich Hayek’s vision of a system of private currencies, originally outlined in The Denationalisation of Money.

If Bitcoin is a test, it’s tempting to apply it to a fascinating early 20th-century monetary debate between Joseph Shield Nicholson and Benjamin Anderson concerning what sorts of things can become money. Neither economist ranks in the pantheon of great economists, but the set of ideas they were debating is important and timeless. Nicholson hypothesized that the most useless thing he could imagine — the bones of the dodo bird — could be introduced into circulation. The initial purchasing power of these dodo bones would be determined mechanically by reference to the quantity of bones and their “rapidity of circulation,” or what we know today as velocity.

Anderson didn’t buy the idea that a useless thing could become money, and in The Value of Money he devoted a full chapter to criticizing Nicholson’s thought experiment. Nicholson had imagined 10 merchants each of whom owned one unit of an identical good, and 1 trader who desired to buy everything up with a purse full of money consisting of 100 dodo bones. When the market opened for business, the trader with the dodo bones would offer to purchase the 10 merchants’ goods at a price of 10 bones per good.

Anderson leveled the charge of circularity against Nicholson. Why would anyone give up their valuable commodity for worthless dodo bones? Perhaps the trader might know other merchants that might take the bones off of him. But why would these other merchants do that? “It is, in effect, saying that the dodo-bones will circulate because they will circulate,” wrote Anderson, hardly a satisfying answer to the mystery of how a new money gets value.

To solve Anderson’s circularity problem, all that was needed was an instrument that was already valued for some other use not related to its monetary purposes. Perhaps this instrument was also used as a commodity, or convertible into something else, or the government required it to settle taxes. Whatever the case, person A needn’t accept a token as payment because he expected he could fob it off on person B, who in turn expected person C to accept it, and so on. Instead, A might accept that token because it was already valuable for some other reason.

History shows that Anderson’s theory is generally borne out. New coins have always been minted out of precious metals rather than an intrinsically worthless medium such as paper. According to George Selgin’s 1994 paper “On Ensuring the Acceptability of a New Fiat Money,” most new paper monies have been linked to established media of exchange at a fixed rate of exchange. When the euro was introduced, for instance, it was pegged to the 12 original national currencies. Even the world’s most notorious paper-money experiment, John Law’s Banque General, began with notes redeemable in gold coin.

Selgin’s paper was written in 1994, long before the emergence of cryptocurrencies. The post-2008 blooming of thousands of cryptocurrencies — from Bitcoin to Dentacoin to Sexcoin — seems to finally favor Nicholson. Like Nicholson’s dodo bones, these digital tokens do not have any value apart from their ability to be exchanged, and they do not come into existence with a fixed exchange rate to a pre-existing commodity or currency. Cryptocurrencies are thus fatally handicapped by Anderson’s circularity problem, and this should —in theory at least — rule out their existence. Yet there they are, trading at a positive price. Crypto analysts like Chris Burniske are even using Nicholson-style logic, the equation of exchange, in an effort to arrive at a fair value for Bitcoin.

Bitcoin didn’t magically start to trade at a positive value. If a group of insiders worked together to generate a set of Bitcoin trades, outsiders would have been able to observe a history of positive prices, and this might have tricked them into adopting what were essentially intrinsically useless tokens. In his paper Getting off the Ground: The Case of Bitcoin, William Luther analyzes messages left on early Bitcoin discussion lists that illustrate how early adopters might have understood the importance of coordinating to bootstrap the price of Bitcoin.

The fact that Anderson’s theory of money seems to fail the Bitcoin test forces us to question our long tradition of issuing new coins that contain precious metals, or banknotes redeemable for some other, already valuable instrument. Going forward, why don’t nations simply create new fiat currencies out of nothing, sort of like how Bitcoin pulled itself up by its own bootstraps?

I’m wary of using Bitcoin as a test for monetary theory, whether this be Hayek’s theory, Anderson’s, or anyone else’s. Not only has Bitcoin been lifted off the ground, so have hundreds, perhaps thousands, of other cryptocurrencies over the last decade. The launching of these new monies seems suspiciously easy. While there is no precedent in monetary history for dodo-bones money, within the broader stream of financial history there is certainly precedent for a dodo-bones asset. Intrinsically useless IOUs such as chain letters and promises issued by Ponzi and pyramid schemers have been popping up for centuries. Cryptocurrencies may have more in common with these phenomena and less with monetary phenomena like dollars, banknotes, and coins.

This is somewhat confirmed by the observation that cryptocurrencies do not show the same transaction patterns of traditional media of exchange. The most important of them, Bitcoin, is only accepted by a handful of large retailers. When cryptocurrencies do trade hands, participants seem to be motivated by speculation, not payments for goods and services. That they aren’t used much to buy stuff leads me to believe that Bitcoin and other cryptocurrencies have not yet qualified as a monetary phenomenon, and thus monetary economists are under no obligation to explain it. Anderson’s critique of Nicholson’s dodo-bones theory is probably safe, for now.

J.P. Koning


J.P. Koning is a financial writer and blogger with interests in monetary economics, economic history, finance, and fintech. He has worked as an equity researcher at a Canadian brokerage firm and a financial writer and publisher at a large Canadian bank. More recently, he has written several papers for R3, a distributed ledger company, on the topics of central bank cryptocurrency and cross border payments. He founded the popular blog Moneyness in 2012. He designs economics and financial wallcharts at Financial Graph & Art.

Koning earned his B.A. in Economics from McGill University.

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