One of the most valuable online sources of economic data comes from the St. Louis Federal Reserve bank. It is called FRED, which stands for Federal Reserve Economic Data. It’s the main and perhaps only reason I’ve ever visited the site.
Now there is another reason to visit. The St. Louis Fed has just published one of the clearest and most revealing papers on Bitcoin/Blockchain economics that I’ve ever seen. It is called “A Short Introduction to the World of Cryptocurrencies” and it is written by Aleksander Berentsen and Fabian Schär, two economists at Center for Innovative Finance at the Faculty of Business and Economics, University of Basel.
As I read, I was trying to discern the audience. My theory: the paper is written for bankers and policy makers of an older generation who have heretofore ignored or dismissed crypto-based innovations. They might know something about money and banking. But they know next to nothing about computer science, digital resources, and cryptography. As a result, the paper speaks in the plainest-possible English about these technical topics. It then turns to debunking the most common myths about crypto.
Why is it important that these people understand? The world of monetary policy necessarily intersects with cryptoeconomics. These authors are trying to shake this world out of its long state of denial about what is happening to a mighty sector of economic life that governments and central banks have monopolized until very recently. It is time for them to wake up and see what is going on, if only so that they stop treating Bitcoin is nothing but a tchotchke collected by the criminal class.
After going through all the basic of distributed networks, cryptography, proof-of-work protocols and so on, it deals with some common myths.
Myth: Bitcoin is unreliable because the code can be changed anytime. The authors point out that this is, in principle, correct but it is highly unlikely given the culture of the community. If anything, the potential runs the other direction: there is a tendency toward conservatism in this community. Moreover, the authors point out, any criticism of Bitcoin in this regard actually pertains to fiat:
Political interference in the fiat currency system can be interpreted as a change in the “fiat currency protocol.” Undesirable changes in fiat currency protocols are very common and many times have led to the complete destruction of the value of the fiat currency at hand. It could be argued that, in some ways, the Bitcoin protocol is more robust than many of the existing fiat currency protocols.
Myth: Bitcoin is doomed because it has no intrinsic value. This is the most common criticism I hear of crypto. It reflects an intuitive sense that you can’t just type on a keyboard and cause a money to come into existence and obtain value. It was for this reason that it took so many economists years before they even took Bitcoin seriously.
The answer I’ve provided for this criticism is as follows. The value of Bitcoin derives from the use value of the service of the underlying payment network. This network permits the uncensorable transfer of immutable information packets across any manner of geographically non-contiguous space. What this means is that ownership rights (or really any bundle of information) can now be held and ported peer-to-peer without relying on third-party intermediaries.
The Fed paper adds a delightful repose to this criticism:
Bitcoin is not the only currency that has no intrinsic value. State monopoly currencies, such as the U.S. dollar, the euro, and the Swiss franc, have no intrinsic value either. They are fiat currencies created by government decree. The history of state monopoly currencies is a history of wild price swings and failures. This is why decentralized cryptocurrencies are a welcome addition to the existing currency system.
Myth: Cryptocurrency is subject to inflation because digital units can always be copied and the network tricked. By way of background here, when I first looked into Bitcoin back in 2010, this criticism struck me as decisive. The whole structure of the digital world enables infinite copying, whereas a key feature of money is its scarcity. Therefore, purely digital money can’t exist. But as our authors point out, the most brilliant feature of the Bitcoin network is how it hacks the digital world to behave like the physical world. Among other features, this prevents what is called double spending:
The Bitcoin system solves this double spending problem in a clever way. The transaction that is first added to a valid block candidate, and therefore added to the Blockchain, is considered confirmed. The system ceases to process the other one—that is, miners will stop adding the conflicting transaction to their block candidates. Moreover, it is not possible for a miner to add conflicting transactions to the same block candidate. Such a block would be illegitimate and thus be rejected by all the other network participants.
Myth: Mining is pure waste. You read this criticism everywhere these days, constant kvetching about the electricity costs associated with confirming transactions and thereby earning ownership rights in new created monetary media, a process called (by metaphor) mining (as in gold mining). What this criticism forgets are the huge costs of the current fiat money system, among which we would have to include inflation, business cycles, government growth, debt financing of public policy, and even war.
Our authors don’t go that far but they too push back on this criticism:
From our perspective, however, the situation is not so clear-cut. Centralized payment systems are also expensive. Besides infrastructure and operating costs, one would have to calculate the explicit and implicit costs of a central bank. Salary costs should be counted among the explicit costs and the possibility of fraud in the currency monopoly among the implicit costs. Moreover, many cryptoassets use alternative consensus protocols, which do not (solely) rely on computational resources.
Myth: Bitcoin is too volatile to be a currency. Here is another bromide you hear tossed off on the news shows often. In this case, the authors seem to agree that there is merit to the criticism. As conventional monetary economists, they do not embrace the most controversial feature of Bitcoin: it has a fixed supply. Monetary economists are trained to believe that money must be constantly adaptive to accommodate changes in demand.
Our authors write:
If a constant supply of money meets a fluctuating aggregate demand, the result is fluctuating prices. In government-run fiat currency systems, the central bank aims to adjust the money supply in response to changes in aggregate demand for money in order to stabilize the price level. In particular, the Federal Reserve System has been explicitly founded “to provide an elastic currency” to mitigate the price fluctuations that arise from changes in the aggregate demand for the U.S. dollar.
Here we have a classic case of comparing an unrealized ideal (an all-knowing central bank that responds scientifically to changes in market demand for money) with an imperfect market-based reality. It is certainly true that Bitcoin is now and will always be subjected to the process of price discovery. So is every other good and service in a market economy. Stability is a chimera; what we should be seeking in a monetary system is soundness. The system of elastic currency is a proven mess. What’s more, in crypto economics, Bitcoin is not the only game in town. Traders are free to seek out any digital asset that best meets the needs of trade, whatever it is.
In general, I found this paper to be wonderfully enlightening and I hope it gets widely read in the central banking community. Obsolescence of nationalized money and central banking is not at hand, but it is time that everyone realizes that something dramatic is happening. The system of the 20th century is mutating into a competitive system of the 21st century, and it is happening not because monetary officials are encouraging it. They are only now beginning to understand it.