Imagine there is competition between two currencies. The two currencies are identical in every respect, except one is backed by assets and the other isn't. Which one would win the competition to become the preferred medium of exchange?
I think the one that is backed by assets would win. For two reasons:
1. The issuer of the backed coin could use those assets to help stabilise the value of the coins in response to fluctuations in demand. If demand falls, the issuer could use the assets to buy back some of the coins in circulation. If demand rises, the issuer could sell more coins in exchange for more assets. The issuer can make the supply curve of the coins more elastic, so that fluctuations in demand cause smaller fluctuations in price. Other things equal, people prefer a safer asset to a less safe asset.
2. The issuer of the backed coin could use the returns on those assets to pay interest on the coins. Or to buy back coins so the owners of the coins would see capital gains. Other things equal, people prefer an asset that pays a higher rate of return to one that pays a lower rate of return.
Other things equal, we would therefore expect to see competition between currencies lead to issuers of those currencies having assets backing those currencies, and paying out all the returns from those assets (minus administrative costs) to those who own those currencies. Free entry and competition drives down the profits from issuing currency to zero. Only currencies with 100% backing would survive.
But are other things equal?
There could be network externalities and a first mover advantage. Like Microsoft, VHS vs BetaMax, and the English language. If UnbackedCoin got on the market first, and if everyone wants to use the same coins as everyone else, and translation costs are high enough, it could survive against competition from BackedCoin. Customers cannot coordinate their simultaneous switch from UnbackedCoin to BackedCoin.
One more post in response to Brad Delong's email query and arguments about competition for Bitcoin.
I recommend Tyler Cowen's post.
[Update: I think JP Koning got there first.]
(Mike Sproul deserves all the blame for making me think this way.)
Worthwhile Canadian Initiative 
Ralph: it isn’t cross-subsidisation.
Suppose I start a currency. Suppose people are willing to give me valuable goods in exchange for little bits of paper, with my signature, but that don’t promise them anything. I can make profits from doing that, and buy a lot of assets by issuing a new currency. The returns on those assets I buy are my profits from issuing currency. If there were free entry and competition, and if other currencies were otherwise equal to mine, I would need to return those profits to my customers in order to compete with those other currencies, or else watch the price of my currency collapse to zero.
The Bank of Canada doesn’t worry about this competition, because it has a legal monopoly on issuing paper currency denominated in Canadian dollars, plus it has a big first-mover advantage, and it would be hard for all Canadians to switch to using Swiss Francs instead.
The seigniorage profits of a central bank are monopoly profits. The whole of MMT is based on spending those monopoly profits 😉
Vaidas: why would anyone hold LC if they could hold EC instead? And if your answer is “because EC isn’t convenient to use as a medium of exchange”, then a competing firm could issue something as liquid as LC but paying interest like EC, to get the best of both worlds. Price discrimination can’t survive in perfect competition.
Nick, I wrote that LC is paying interest in LCs. This is not a price discrimination, but financial engineering. Owners of Bitcoin are owners of bubble asset. LC and EC splits the bubble in two parts – safer and riskier. By picking the right relative size of the tranches, we can design LC to be very safe and with a yield that is competitive with other safe assets.
The question is – why would anyone want tho hold ECs? Well, lotteries are popular, and with the right marketing ECs can work.
Vaidas writes “Nick, consider UnbackedCoin with two classes of coins – EquityCoins (EC) and LiquidCoins (LC). ECs pays dividends in LCs. LCs pay interest on reserves in LCs………….”
I see the United States doing exactly that, doing it for years! EquityCoins are Treasury Bonds and LiquidCoins are Federal Reserve Notes.
Nick,
“Suppose I start a currency. Suppose people are willing to give me valuable goods in exchange for little bits of paper, with my signature, but that don’t promise them anything.”
This is an important first step, its hard to see why people would give random people goods for their currency when there is no safe guards preventing that individual from printing more currency
“I can make profits from doing that, and buy a lot of assets by issuing a new currency.”
What do you mean by profits? You have gained value through trade presumably because your currency provides value (assuming you have overcome the first step above) as a currency. Is this what you refer to as profits? The gains from trade? Is your profit the whole value of the goods you receive or just the difference between what you value the currency at and the value of the goods.
“The returns on those assets I buy are my profits from issuing currency.”
You started talking about valuable goods (consumer goods?) and are now talking about assets (financial assets?). If you are using profits now in the financial sense do you mean the returns to your assets in the form of dividends or like payments?
“If there were free entry and competition, and if other currencies were otherwise equal to mine, I would need to return those profits to my customers in order to compete with those other currencies, or else watch the price of my currency collapse to zero.”
People are only going to accept your currency if it has value. If they have taken the currency for goods then they already presume it has value. I do not see why you owe them future profits if they have already accepted the initial trade as fair.
You have packed a lot in here and its not entirely clear to me what you are talking about. I just want to figure it out before I respond.
Ian: If I can persuade you to give me financial assets in exchange for my paintings, and it costs me nothing to produce paintings (ignore the costs of paper and ink) then I have made a profit. When the Bank of Canada does it, we call those paintings “money”.
And Bitcoin has already passed that first step.
Majormax:
“But that’s not usually what happens; the private use of alternate currencies is mostly legal. The government only uses its powers to enforce the use of the national currency in dealings with itself, mostly via taxes. In fact, that increased freedom is a product of a more-unbacked currency, as capital controls are often necessary to defend fixed exchange rates (and equivalently real-goods convertibility).”
At least in the US, that’s not true:
http://en.wikipedia.org/wiki/Liberty_Dollar#Conviction
Prosecuted under, among other offenses:
http://www.law.cornell.edu/uscode/text/18/486
“Whoever, except as authorized by law, makes or utters or passes, or attempts to utter or pass, any coins of gold or silver or other metal, or alloys of metals, intended for use as current money, whether in the resemblance of coins of the United States or of foreign countries, or of original design, shall be fined under this title [1] or imprisoned not more than five years, or both.”
So you can be prosecuted in the US for using alt currencies. Here’s a statement from the mint about it:
http://www.usmint.gov/pressroom/index.cfm?flash=yes&action=press_release&id=710
@Mike Sproul:
“I find it best to think of backing this way: The tax man will demand 5 oz of silver from you every year. If you don’t pay you’ll go to jail. But the government just built a road, and it paid the contractors with 1 oz certificates that the tax man will accept in lieu of actual ounces. If the present value of all the government’s tax collections is 1000 oz, then the government can issue up to 1000 certificates without causing inflation. But if it issued 2000 of those certificates, against only 1000 oz of taxes receivable, then 1 certificate=0.5 oz.”
Right, that I get, but the point I was trying to get at is: isn’t there an implicit credibility issue? In theory, assuming the gov’t in this case only issues 1000 certs, each cert should trade at par with an oz of Ag. But even if everyone is certain the gov’t has Ag equal to or in excess of all certs, if they don’t believe the gov’t will actually redeem the certs, wouldn’t they still trade at discount relative to Ag?
@JP Koning: You are of course absolutely right about the non-monetary use value of gold putting a floor on the value of gold as an exchange media, but curiously that also has an inverse effect. Say, for example, you could use gold to cure cancer:
http://scitechdaily.com/gold-plated-nanoparticles-seek-destroy-cancer-cells/
Say such cancer-curing methods become highly demanded. Suddenly the price of gold, driven by its use value, skyrockets. So take a $100,000 mortgage; if a dollar is worth a gram-and-a-half of gold, and the price of gold increases by an order of magnitude, so does your mortgage, to the glee of the bank and the woe of the homeowner. The same use value that prevents a gold-backed currency from zeroing the way BTC could at any minute also could cause the currency to anti-zero, and boom you have a depression.
The thing about BTC is that it is a backed currency, it’s just backed by an algorithm. And the current price suggests that, at the very least, some minority of folks are extremely confident in the credibility of that algorithm. The issue is that the algorithm is targeting the money supply irrespective of money demand, meaning that as BTC becomes more popular, its price should rise, causing it to become more popular to investors, causing its price to rise, potentially ad infinitum.
The thing about fiat currency is that it’s also an algorithm-backed currency, but the algorithm in the case of the US dollar is “this currency unit will always be worth, one year from today, between 98% and 100% of what it is worth today, regardless of what happens with money demand.” Market monetarists are advocating for a change of that algorithm to “this currency unit will always be worth whatever value is necessary, commensurate with annualized 5% NGDP growth, regardless of what happens with money demand.”
Ian Lippert writes
“Nick,
“Suppose I start a currency. Suppose people are willing to give me valuable goods in exchange for little bits of paper, with my signature, but that don’t promise them anything.” …………………..”
It sounds improbable that physical assets would be traded for paper, but what about labor? If an individual is looking to make his time valuable, he must sell time (his labor) to someone. If the individual has no market, even a speculative sale for paper may be better than no market.
Ultimately, even physical assets (excluding land) are the product of labor so the sale of assets for paper is simply an indirect sale of labor.
Thus, it is easier to sell value for paper than may first appear.
SquarelyRooted: “The thing about fiat currency is that it’s also an algorithm-backed currency, but the algorithm in the case of the US dollar is “this currency unit will always be worth, one year from today, between 98% and 100% of what it is worth today, regardless of what happens with money demand.” ”
Yes. Nicely put.
And I am arguing that, other things equal, a cryptocurrency with an algorithm (something) like that would beat one without that algorithm in competition. Because people like safety. But the issuer would need to have marketable assets to buy and sell for coin in order to implement that algorithm. And the issuers of Bitcoin don’t.
Nick: “Ian: If I can persuade you to give me financial assets in exchange for my paintings, and it costs me nothing to produce paintings (ignore the costs of paper and ink) then I have made a profit. When the Bank of Canada does it, we call those paintings “money”.”
Ok I understand now what you are saying, but I dont understand how the BoC is going to return those profits to holders of currencies. If the Bank of Canada is buying and selling financial assets to stabilize the price of the dollar I dont see how it can buy enough assets to make enough profits to pay Canadian dollar holders a significant amount of the BoC profits without printing a lot of money. Sure if it prints lots of money it could buy up all the financial assets and make more profits in terms of dollars but those would be highly inflated dollars and would be worth much less in terms of purchasing power.
I’ve never received payment for holding Canadian dollars, please tell me how I can get in on that 🙂
“If there were free entry and competition, and if other currencies were otherwise equal to mine, I would need to return those profits to my customers in order to compete with those other currencies, or else watch the price of my currency collapse to zero.”
This is potentially why bitcoin will beat out fiat currencies, deflationary currencies would pay the holders back as long as the deflationary currency is deflating in a stable manner. I dont understand how fiat currencies payback their customers, 1-2% inflation is a cost.
Ian: there are two ways the BoC can make payments to holders of its currency:
1. pay interest. Yes, it’s totally impractical with paper currency. (Unless you hold a lottery with a big prize for the winning serial number once a month, which is what the UK government does with “Premium Bonds”). But the BoC does pay interest on electronic currency, that is held by banks in their chequing accounts at the BoC (we call them ‘reserves”). And if the currency is electronic, there’s no practical problem.
2. Buy back currency (which is like a share buyback) so it’s worth more (deflation). You get capital gains instead of interest, but it’s the same thing.
But the Bank of Canada has a monopoly. So it pays negative 2% interest on its currency.
Nick: “2. Buy back currency (which is like a share buyback) so it’s worth more (deflation). You get capital gains instead of interest, but it’s the same thing.
But the Bank of Canada has a monopoly. So it pays negative 2% interest on its currency.”
If the 2% inflation is seinorage (profits) on the Canadian currency then wouldnt your argument imply that bitcoin introduces competition and will reduce the BoC profits to zero? Bitcoin will become the defacto currency because it will (at some theoretical point in the future) provide a positive 2% interest from its deflationary nature?
I dont see how it follows from this that only currencies with 100% backing will survive. A monopolistic currency provider could impose deflation to return its profits to the holders of its currency but no central bank is doing this now and that is why people want to shift over to bitcoins.
Tyler and JPK were arguing that bitcoins value will drop to zero because it has no intrinsic value. It seems to me like you are making a different point entirely. You are assuming that bitcoins value will fall to zero because it will be out competed, but your axis of competition is one where bitcoin is currently defeating monopolized fiat currencies so I do not see how your conclusions follow from your premises.
Nick:”And I am arguing that, other things equal, a cryptocurrency with an algorithm (something) like that would beat one without that algorithm in competition. Because people like safety. But the issuer would need to have marketable assets to buy and sell for coin in order to implement that algorithm. And the issuers of Bitcoin don’t.”
It is interesting that such marketable asset can be a cryptocoin itself. Suppoose there is a bank of BitSquared, that buys and sells bitcoins to stabilize the value of BitSquared liabilities.
@vaidas, Aren’t you just describing derivatives?
@Ian Lippert:
I think the key is that the point of money is not to gain a positive real return. Money is a very efficient solution for a network of collective action problems, transaction costs problems, record-keeping problems, information asymmetry problems, etc. If you want a positive real return you have to invest. In theory you could invest in money, and certainly speculation on money is an important vector for exchange rate adjustment, but in general the point of currency is not itself to be a long-term savings or investment mechanism. It is possible, too, to make investments that implicitly depend on the future value of the currency, but it is also possible to make investments that do not depend on the future value of the currency, or depend inversely on the future value of the currency.
@Nick Rowe:
“And I am arguing that, other things equal, a cryptocurrency with an algorithm (something) like that would beat one without that algorithm in competition. Because people like safety. But the issuer would need to have marketable assets to buy and sell for coin in order to implement that algorithm. And the issuers of Bitcoin don’t.”
I would take some issue with that; Bitcoin does have an algorithm in place that market participants find credible; that is, “Bitcoins in circulation will never, ever exceed 21mm BTC, no matter what, ever.” I suppose what you’re referring to is something like an additional clause in the algorithm that would read something like “The BTC Nexus stands ready to exchange BTC at a fixed rate for [ten gallons of distilled water/a bottle of delicious whiskey/stock in Twitter/a chunk of pure osmium].” But you shouldn’t actually need that second clause as long as people believe the first clause, unless the currency is difficult to use in exchange for some reason; in that case, the second clause will result in the BTC Nexus possessing 100% of all BTC and everyone else walking away with all the water/whiskey/stock/osmium.
An unbacked currency, I think I’m thinking, would be one whose algorithm is either a) not found credible by market participants or b) is sufficiently ambiguous about the future supply or price of the currency as to drive the value down very rapidly. Regarding national currencies, the latter is called hyperinflation, and is usually a symptom of total political/economic breakdown; regarding cryptocurrencies, its the result of bad design. But it’s decidedly not the case with Bitcoin. I’m skeptical/pessimistic about Bitcoin because I disagree with the political and economic assumptions of its creators/vanguard and therefore think the problem it is attempting to solve will not materialize, thus rendering the currency superfluous for non-black-market transactions. But that’s not the same as saying that Bitcoin is unbacked, I think, or that its unbacked relative to a currency backed by a material asset.
Let’s look the idea of cryptocurrencies more broadly. Amazon.com offers a cryptocurrency called “store credit” – which from here on out I’m called “BezosBux” or BB – that exists solely in digital form, is stored in a secure wallet by Amazon, and each unit can be exchanged for one dollar of goods and services offered by Amazon.com. Currently the exchange rate for USD:BB is 1:1 as offered by Amazon.com, but how does it exchange on the market? Well, I collect all my USD change in a jar. When I have a full jar, roughly ~$50, I take it to a Coinstar machine. The Coinstar machine will give me more exchangeable denominations of USD at 1:1 but will charge me 10.9% to do so; Amazon.com, however, will offer me BB at 1:1 with no fee at all. I always, always take the BB. Which means that, outside the gift economy, the promise of redeemability into “stuff Amazon sells” means that I consider the BB:USD ratio to be at least 1:0.9. But that’s because I find Amazon’s promise credible and valuable! I would never take store credit at Barnes and Noble or Best Buy or any place I either don’t like to shop or think would go out of business. The market, unfortunately, for BB is illiquid but I am certain that if it were liquid it would look a lot like the market for USD, conditional on stability or growth in AMZN. Which is basically the promise made by national currency issuers – as long as you think this government is going to be stable over the future, you should take this paper because you can exchange it for a wide network of goods and services.
Ian: Bitcoin and Bank of Canada paper currency are very imperfect substitutes. It is quite possible that two imperfect substitutes could share the market. But if there’s a competitor to Bitcoin that is backed, but is otherwise a perfect substitute, things could be different.
@Squarely:
Nick:”Ian: Bitcoin and Bank of Canada paper currency are very imperfect substitutes. It is quite possible that two imperfect substitutes could share the market. But if there’s a competitor to Bitcoin that is backed, but is otherwise a perfect substitute, things could be different.”
But the currencies arent competing on whether or not they are backed, they are competing on how much value they return to those holding the currencies. You are just saying that backed currencies would return more value to their holders which I say you still havent shown since no fiat currency gives value back to its holders (excluding banks with reserves for the moment).
The only advantage that fiat currencies have over bitcoins is that their price stability can be maintained. Price stability could be a feature where fiat out competes bitcoin if people do indeed value price stability over value. The negative interest on currency would be like an insurance policy.
The problem is that fiat currencies aren’t stable. QE has shown that when the economy is in the dumps the Fed is more than willing to throw price stability out the window, which throws out the one feature where fiat has an edge against bitcoin and is why people are starting to make the shift to bitcoin.
This brings us back to the definition of backed. You claim backed means to be backed by the full faith of the government, Tyler and JPK used backed in terms of intrinsic value (a lower bound due to other demands for the commodity currency).
But intrinsic value is just an assumption that demand that comes from physical uses is somehow more important than demand that comes from digital informational uses. To be frank, thats a very 20th century way to look at the world. Demand is demand regardless of whether or not it comes from physical use or informational use and bitcoin (and all currencies) is providing an informational services as a unit of account.
Currencies do not need to be backed by anything other than the confidence that others will continue to support them, similarly to how goverments (that back their dollars) are not backed by anything other than the confidence that others will continue to support them. If that confidence disappears then yes bitcoin’s value drops to zero in the same way that the value of a state can collapse to zero when people lose confidence in its ability to govern.
@Maj, http://en.wikipedia.org/wiki/Ithaca_Hours
Majromax: “Honest question here: has anything like this happened historically — the introduction or evolution of a wholly unbacked currency, ab nihilo?”
And a very good question. I did not know of any clear historical example, before Bitcoin. I always wondered whether it would be possible. Theory always says there are two (OK, or more) equilibria: one in which the fiat money has zero value. How could you make sure you start out in the positive value equilibrium?
In historical practice, something like von Mises regression theory of money seemed to be correct. You start out with money convertible into some real good, get people used to using it, then you temporarily suspend convertibility, but it’s still valued because people think convertibility might be restored some time in the future, then the expectation of future convertibility slowly fades away, but people get used to using it as money, so it stays in the positive value equilibrium. You need a convertible catapult to launch Tinkerbell the confidence fairy into the air, but once she’s flying she can stay up under her own power because everybody believes she can fly.
So Bitcoin has been fascinating to me, as a natural experiment. It also demolishes the theory that fiat money is only valued because you have to pay it in taxes. (I never accepted that theory.)
JP Koning had a good post on the Yap stones. I think they did have some intrinsic value, aside from their use as medium of exchange. But my memory has failed again.
Ian: “The problem is that fiat currencies aren’t stable. QE has shown that when the economy is in the dumps the Fed is more than willing to throw price stability out the window, which throws out the one feature where fiat has an edge against bitcoin and is why people are starting to make the shift to bitcoin.”
A massive exaggeration. Inflation has changed very little (it was actually a little below normal). Much less price volatility than in the 1970’s. Massively less than Bitcoin.
But you can do things with Bitcoin you can’t do with US or Canadian dollars. And vice versa.
“This brings us back to the definition of backed. You claim backed means to be backed by the full faith of the government…”
No I don’t. But if the issuer has no assets with which to buy back the coin if demand ever drops, they cannot have an elastic supply curve for the stock of the coin, and so cannot stabilise its value in the face of fluctuations in demand. Somokers stabilise the value of cigarettes in the face of fluctuations in monetary demand (unless the smokers themselves have perfectly inelastic demand curves). Same with the non-monetary demand for gold as with cigarettes.
Nick:
“If it sees the value of BackedCoin dropping below the target, it does an open market sale of assets, buying its own coins, to reduce the stock in circulation. If it sees the value of BackedCoin rising above target, it does an open market purchase of assets, selling its own coins, to increase the stock in circulation.”
There’s a complication to this. If 100 coins are backed by 100 oz of assets, then 1 coin=1 oz. If they sell 1 oz and buy back 1 coin, then 99 coins are backed by 99 oz, and still, 1 coin=1 oz, even though the stock of coins has fallen. So it’s not really the rise and fall of the stock of coins that maintains the value of the coins. It’s the constancy of the ratio of assets to coins that matters.
But of course if the public desired 1 less coin, and the central bank failed to buy back that 1 unwanted coin, then the public might see this as a loss of backing, and the value of the coin might fall (by a negligible amount, I think). On the other hand, if the public wanted 1 more coin, and the bank failed to issue that new coin (in exchange for 1 oz), then the main result would be a shortage of coins and a hindrance to trade. Coins might start to sell for a slight premium, but there’s still the fact that 100 coins are backed by 100 oz, so the math says 1 coin=1 oz, in spite of the coin shortage.
Squarely rooted:
“if they don’t believe the gov’t will actually redeem the certs, wouldn’t they still trade at discount relative to Ag?”
Right. In this sense the cert’s price and yield includes a risk premium, just like stocks, bonds, or any other financial security.
Ian: “Currencies do not need to be backed by anything other than the confidence that others will continue to support them,..”
I would say: “Currencies do not need to be backed by anything other than the confidence that others will continue to use them as currencies,”
True. I’ve been teaching that for decades, well before Bitcoin came along.
But if some other better currency comes along, people may stop using the worse currency, and people will lose confidence that others will continue to use it.
In what sense could the Bitcoin be considered as being minted? This post is an interesting economic debate on Bitcoins, but it doesn’t discuss the huge sociological aspect to the question as to people’s decisions to purchase and hold minted items. There’s lots of precedent in the activities of private mints. Most are outright rip-offs, yet they still persist. Even the U.S. Mint has warned against Obama coins. http://coins.about.com/od/coinbuyingadvice/a/obama_coins.htm
There is even a lively market for Franklin Mint collectibles on EBay, http://www.ebay.com/gds/Franklin-Mint-Collectibles-Buying-Guide-/10000000177627334/g.htmland and it was only a few years ago that people were amassing portfolios of Beanie Babies to pay for their children’s college education. Was Shakespeare being cynical when he asked, in “Troilus and Cressida,” “What is aught, but as ’tis valued?”
@Jeff:
Majro: yes, that was the JP post I had in mind. He says they did have intrinsic religious/ornamental value.
Nick,
“Doesn’t that defeat the purpose of a currency? If I choose to hold nominal currency over some real good (or equity), then I am presumably doing so because I value the liquidity premium of the currency over the real thing. I can choose to forego that liquidity premium through a loan, time deposit, or other nominal-terms debt instrument, and then I am paid compensation in the form of interest.
That’s incompatible with a positive real return on holding currency. In such a situation, the twinkie investment is a rotten deal. If I do not value liquidity, selling it in the form of a twinkie purchase also loses me the prospective real return, so it’s beneficial for me to sit on the prospective liquidity. This is weakly unstable, in that it’s a positive feedback: if I do not value liquidity, it’s not in my interests to provide it to other people, so the price of liquidity remains the same or increases.”
This I don’t understand because you were stating in your OP that
“2. The issuer of the backed coin could use the returns on those assets to pay interest on the coins. Or to buy back coins so the owners of the coins would see capital gains. Other things equal, people prefer an asset that pays a higher rate of return to one that pays a lower rate of return.”
Your OP is arguing that backed coins would produce more value for their holders and outcompete the backed coins. How does this coin from your OP not also suffer from the same problem? If the backed currency was paying interest to the holders of the currency wouldn’t the backed coins also face problems of liquidity?
You say coins that pay out to holders would outcompete bitcoin because they are backed by assets, I say bitcoin also pays out to its holders as a deflationary currency, and then you say that currencies that incentivize people to hoard have liquidity problems which defeat the purpose of using them as a currency in the first place. I am not really ready to discuss the liquidity problems of deflationary currencies until we have resolved why you think backed currencies are more competitive than unbacked ones.
“What economic data are you using? QE has shown that the real-terms value of a currency is only weakly related to the quantity of its issue, at least under some economic and QE regimes. You’d have a stronger point here if there was hyperinflation going on, but there isn’t.”
I am not talking about what inflation is now but what those that support NGDP targeting (I think this includes you) have called for a move from the fed targeting 2% inflation to something closer to 5%. QE is of this type of stimulus, maybe I misspoke because it’s not technically as aggressive as upping the inflation target but the point is that inflationary monetary policy incentivizes people to move to bitcoin.
In addition we cannot forget that bitcoin is a global currency so it’s demand will be driven by inflationary policies of all central banks. In canada we might have little incentive to risk moving our net worth into bitcoins, but plenty of people live under terrible monetary regimes and their demand will drive the acceptance of bitcoins.
Nick,
“No I don’t. But if the issuer has no assets with which to buy back the coin if demand ever drops, they cannot have an elastic supply curve for the stock of the coin, and so cannot stabilise its value in the face of fluctuations in demand. Somokers stabilise the value of cigarettes in the face of fluctuations in monetary demand (unless the smokers themselves have perfectly inelastic demand curves). Same with the non-monetary demand for gold as with cigarettes.”
What is your theoretical backed coin backed by then? What it’s backed by will effect how volatile it is. If it’s backed by the government then we know the price won’t fluctuate greater than 1% either way under current policy. If it’s backed by gold then it will fluctuate within the range of its price that is accounted for by its value as a currency. Like I said to JPK earlier if non-monetary uses account for only 10% of the price then golds use for non-monetary uses isn’t really that much of a stabilizing force. Gold suffers from the same fluctuations as bitcoin, as we have seen happen in recent fluctuations in the price of gold.
“True. I’ve been teaching that for decades, well before Bitcoin came along.
But if some other better currency comes along, people may stop using the worse currency, and people will lose confidence that others will continue to use it.”
If you are saying this in the OP then it’s kind of confusing why you would link to Cowen and JPK who are essentially disagreeing with your point here. I think that you are saying something fundamentally different from what they are.
I clipped the last copy and paste, my last post is responding to this
I would say: “Currencies do not need to be backed by anything other than the confidence that others will continue to use them as currencies,”
Ian: “What is your theoretical backed coin backed by then?”
Presumably a basket of assets. It would depend on what they wanted to stabilise its price against. And they don’t have to stabilise it precisely against that basket. Having any assets will be better than having no assets, because when you have no assets you can’t buy back any coins if demand for the coins drops.
Majormax,
“I’m not Nick, but the answer is that all other things equal backed currencies have strictly greater utility than unbacked currency.”
“The flipside, of course, is that all other things aren’t equal. History has shown that backing currency with appreciable values of anything can cause outright currency shortages, which then cause illiquidity.”
Suppose you wanted the best of all worlds – real good backing, demand / supply are both market determined, utilitarian value of backing is high, and yet supply of backing is inexhaustible (no shortages). What could possibly fill the bill?
My apologies, I was responding from my iPhone on my bus ride home and I must have confused who was saying what, which is why I was so confused. I’ll just start over and try to salvage my argument
Nick,
I’m wondering about the difference between a “backed” currency and one that you can pay your taxes with. The former can always be exchanged for some particular commodity at a fixed price, but most commodities go up and down in value, so there is a lot of instability. On the other hand, a commodity that is absolutely vital e.g. oxygen in a space station economy, is something different. Since need oxygen in outer space and you need to pay your taxes on earth for similar reasons, some backed currencies are quite different from others. A backed currency that lets you pay your required taxes or buy oxygen for your space suit tank is always going to drive out a backed currency redeemable in Beanie Babies or baseball cards. The fiat currencies that I know of can be used to pay taxes which suggests that they are basically backed currencies with a more valuable backing than most.
P.S. Isn’t bit coin just based on artificial scarcity? It’s like a limited edition print, except they’ve tied in computing power. What happens when the typical smart watch can run all the world’s bit coin computing? What happens if Moore’s Law speeds up or slows down? What if there is an algorithmic breakthrough with quantum computing or P=NP is proven? Bit coin just seems horribly speculative to me.
It is purely speculative. It won’t be adopted unless stable and won’t be stable unless adopted. Speculation is a reason to acquire but not to hold and not as currency. Speculation can be profitable but profit and loss are contrary to stability.
I was always amazed how Bitcoin – a financial asset that is not money-like has gained popularity as a money. It is almost like using shares of Bank of Montreal to buy a cup of coffee. Except that the balance sheet structure of Bitcoin is not similar to Bank of Montreal, but it is very similar to the balance sheet of Twitter. To a first approximation, Twitter and Bitcoin have nothing but popularity on the asset side of the balance sheet, and nothing but equity on the other side of the balance sheet. So make that using shares of Twitter to buy a cup of coffee.
If Twitter started a commercial paper program, and this commercial paper would be used as money in the Silicon Valley, this would not be very strange. Bitcoin could start such a program too, and we could get bitcoin based money that has risk and return characteristics of commercial paper. But this has not happened (yet).
But now I wonder how people are actually using bitcoin. My impression that bitcoin is used in two most important ways, first, as a vehicle to speculate on the future of bitcoin, and second, as a way to participate in illegal transactions. In the old movies we saw how bearer bonds and bearer shares were used in large illegal transactions, so nothing has much really changed, except the risk appetite, people in the old movies preferred to allocate their portfolio to safer anonymous instruments, and now we have a dotcom mania 2.0.
Happy New Year everyone!
I found a couple of comments in spam: Mike and Ian’s, IIRC.
Vaidas: Bank of Canada notes can be thought of as zero-coupon perpetuities bearer bonds/shares in the Bank of Canada.
Mike: on the backing. The fact that money has backing assets doesn’t necessarily mean the issuer will peg its exchange rate against those assets. If a central bank has lots of gold, it could have a fixed peg against gold if it wanted to, but it doesn’t have to. It could use the gold to maintain indirect convertibility with the CPI, and target the CPI, by varying the price of dollars against gold.
Nick,
Bank of Canada notes are bearer bonds, not bearer shares. Bonds and shares are in the opposite ends of the Bank of Canada capital structure spectrum. So for people doing large scale illegal transactions, there are two choices – BoC paper bearer bonds and electronic bitcoin bearer shares.
“The fact that money has backing assets doesn’t necessarily mean the issuer will peg its exchange rate against those assets.”
If there is no peg, this means that the issuer will have at least two classes of different liabilities, one which is safer than the underlying assets, and the second riskier one.
Jeff Y: “Aren’t you just describing derivatives?”
I am describing equity and debt, which in a sense are derivatives of the underlying business. Random quote from the internet:
“debtholders can be regarded as having sold a put option on the market value of the firm; and equityholders’ claim on the firm’s value, net of its debt obligations, resembles a call option”
@Kaleberg:
@Mike Sproul:
“In this sense the cert’s price and yield includes a risk premium, just like stocks, bonds, or any other financial security.”
I agree; and to my mind its that factor that makes the line between “backed” and “unbacked” currencies either very fuzzy or mostly arbitrary. If you have a fiat money, there is some risk the central bank will for whatever reason fail or be unable to meet its promises re: inflation, money supply, or NGDP; similarly, if you have a currency redeemable in metal, there is some risk the central bank or treasury will for whatever reason fail or be unable to meet its promises re: exchanging paper for metal. In both circumstances, the value of the currency is dependent on the nature and credibility of the promises made by the issuer, and the risk is dependent on the same. in that sense all money is about promises and credibility, and metal-redeemable currencies are just one subset of promises. They have their own specific features, certainly, but the only difference I see is that the currency issuer guarantees that they themselves are willing to sell you some asset, other than “services paid for by taxes” and “avoiding legal sanctions,” at a fixed price relative to the currency, as opposed to guaranteeing that third parties will be willing to do so. I guess to me though the terminology of “backing” doesn’t really get at the distinction; I guess I’d call those kinds of currencies “direct-redeemable currencies” and not use the kind of language that implies metal-redeemable currencies are somehow sturdier, worthier, or steadier than those not redeemable in metal.
I agree with this entirely
Assume a currency that is redeemable on demand into (say) gold, at a fixed price of gold that never changes, and has 100% gold reserves. I see that as a limiting extreme case of that currency having backing. We can imagine less extreme cases, where the price fluctuates, where the target price is not the same as the price of the asset held, where there are less than 100% assets.