Tag Archives: digital currencies

The Economic Functions of Bitcoin

The economic functions of the bitcoin network causes it to behave like a central bank. This has a few effects: bitcoins (the payment unit) behave like stock due to the fixed, known supply of units being subject to open market operations. What happens when the market price of bitcoin changes is the velocity of bitcoin falls into disequilibrium until a new equilibrium is found. This is why the transaction volume of bitcoin its extraordinarily high during the bubble cycle, both on the way up, and on the way down. From this observation we can see the velocity of bitcoin also serves as the price finding mechanism for the immediate price of bitcoin. Before we dive in deeper, lets first take a look at how bitcoin acts as a private bank in the digital world.

Bitcoin: The Private Bank for The Digital World

If bitcoin was a private bank it would have the following maxim as its monetary policy:      

  • Whomever secures the Network shall be reward 50 bitcoin with each new block. This amount shall decrease by 1/2 every 210,000 blocks until it cannot be halved any longer.

This is the issuance of bit-coins, the currency unit, is made from the electrical energy spent mining bitcoins. We can see the monetary inflation schedule for bitcoin below. The supply of bitcoins is 100% totally fixed–the only way that new coins can be created is through solving a specific block, and the reward for that is drops every 4 years.  

bitcoin supply growth over time

bitcoin supply growth over time

In order to have a money system that needs no central authority, Satoshi made bitcoin based upon rules that are fixed and secured by the mining process. This allows for a system where all bitcoin units are known at all times, thus making the double spend problem solved.

trinityIf bitcoin is a central bank, it would have to solve the impossible trinity problem that all central banks face (except the U.S. but that is a different story). Bitcoin accomplished this by creating a computer program with an independent monetary policy that humans cannot interfere with. The block reward, how the competition for the block reward is done, and the fixed supply of units are all parts of the bitcoin program that cannot be changed.

Anyone with a bitcoin address can use bitcoin, and it is impossible to know who is controlling each address, so bitcoin must be freely exchangeable. This means that the ‘sacrifice’ that bitcoin has made in terms of the impossible trinity is that it has no fixed exchange rate–the market must find an exchange rate based upon bitcoin’s perceived value, and the number of units available to the market. This free flow of capital from any sources is what allows for bitcoin to have been worthless just a few years ago, and why it could be worth $10,000s per coin one day. The free flow of capital is what creates the total elasticity that bitcoin experiences. 

Bitcoin and Deflation

When economist have called bitcoin deflationary they are referring to its economic property of rising in value over time. This is due to the restricted supply of bitcoins while there is increasing demand for them. This is similar to how if you had bought Apple stock in 1980 during its IPO you would have paid $22 per share. Due to the restricted supply of Apple stock and the increase in demand, today it is valued at $520 per share–and that is after 3 splits.

apple price

You could say that Apple stock “deflated” in value.

This occurred while the supply of the stock (# of shares) of Apple increased–it inflated. On three different occasions Apple had their stock split increasing the total number of Apple stocks there were. Again, this is due to the dramatic increase in demand for the stock. This is the kind of deflation that Bitcoin is experiencing overall, despite the volatile ride bitcoin has had over the last few year.

Why Deflation Supposedly Bad

Deflation is bad according to modern monetary theorist who charade as economist because contemporary economies are based upon debt. Fractional reserve banking and debt cannot exist without one another, so when deflation happens, it happens to debt as well. This means the real value of debt becomes harder to service, which means defaults, and bankruptcy will increase. In 1931, Irving Fisher  presented his theory on debt-deflation, which explains this process in greater detail.

This kind of deflation does not happen with bitcoin. There is no need to service ‘debt-bitcoin’ with bitcoin, so debt deflation does not happen. If this were true, we would see a similar collapse in the velocity of bitcoin during deflationary episodes, but in fact we see the opposite. The velocity of bitcoin increases correlatively to the price change of bitcoin in the short-term.

The Price of bitcoin

The price of bitcoin is derived from the total utility of the bitcoin network. In otherwords, bitcoin’s value is specifically tied to how many people are in the network, how useful the network is, and what the perceived value of bitcoin is. This is similar to how Twitter and Facebook have created social value that has translated into real economic value; which is reflected in the stock price of both of these companies. Without their userbases, each one of these networks would be worthless. All networks have a hidden utility that translates into direct economic value. 

The value of bitcoin is based in part off of this network abstraction. In order for price discovery to happen individuals need to use their subjective preference to decide how much each bitcoin is worth, and how much the network itself is worth. This is how the general, long-term price levels for bitcoin are discovered.

The short-term price is discovered according to network externality, such as exchange failures, or political issues. An example would be how bitcoin is ‘more expensive’ in Argentina because of the high rate of inflation that the peso is experiencing. Another would be the dramatic drop in price, and then recovery after the Silk Road was shut down. These network externalities, unlike fiat money, causes for great volititly in the price because there is no goverment to fix the price of bitcoin; only the market. The price of bitcoin reponds to these events through change, which causes for the velocity of bitcoin to increase until a new equilibrium is found.

The Velocity of Bitcoin

Due to the fixed supply of bitcoin, the only way that the price can be adjusted is in one way: through exchange and transaction. This is why during the most volatile times of bitcoin, we see a higher transaction volume. This applies to both increases as well as decreases in the price. Due to the fixed supply of bitcoin, the only way someone can acquire bitcoins is to mine them, or to buy them. Thus if the price of bitcoin is to increase or decrease in ANY WAY, an exchange or transaction must take place for that value to be accounted into the market.

Conclusion

Bitcoin’s deflation is similar to a technology stock where individuals are making real gains though holding a risky asset while it grows. Because bitcoin has a fixed monetary supply that cannot be manipulated, the price of each bitcoin is determined through supply and demand mechanisms. This is reflected in the increase of the velocity of bitcoin. If bitcoin were facing true currency deflation, we would not see the velocity of money decrease.

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Next: Gresham’s Law and Bitcoin

Hayek’s Promise

In his final treatise on economics, titled “The Denationalization of Money” Fredrick Von Hayek wrote about his idea of what a world with ‘Free Money’ would look like. He believe that money that if money was independent of nation-states (like BTC) that it could fundamentally change the world for the better, and liberate people from the oppression and tyranny of the monopoly on money. He based these ideas off of some of the principals of Silvio Gesell–radical economist and anarchist. His principals were the bases of the ‘Worgl Miracle’ which essentially reversed the depression in the town of Wörgl, Austria in the 1930s. One of the concepts that Hayek wrote of based on these theories was the ‘Swiss ducat’ theory of how to operate a free-money bank in a fiat currency system. This is about the possible function of how a bank like this could work in the bitcoin economy.

This is not a bank for bitcoin, but a competitive economic mode that facilitates the purchasing power of different currencies and leverages them against one another using free-market principals. Essentially, these are bitcoins and alt-coins. They forces free-market functions on to the economy by allowing one currency to hedge against one another (BTC/LTC), and digital currencies against fiat currencies using their deflationary properties to their advantage.

How?

As the bank what I do is I sell shares, or ‘bits’ as I like to call them, at their current market value. So today, you come in and buy a share for $120–the market price of what bitcoin is trading at today. In exchange I offer you an IOU for 1 BTC, and you will pay this loan back over the course of however long you choose–here is the kicker–you pay back the loan in dollars at the amount that you paid for the IOU with 1% in USD.

What this does it it offers the same possibility as buying a home back in the 1980s. For example, my mother paid $68,000 for our family home in 1982–today it is worth $425,000. Now, if we are looking at only purchasing power we’ll see that the the house should only be worth $178,000. It is worth more because of the additional intrinsic value of the property, along with the limited, finite supply of property in this desired area.

The intrinsic value of real estate is defined as the net present value of all future net cash flows which are foregone by buying a piece of real estate instead of renting it in perpetuity. These cash flows would include rent, inflation, maintenance and property taxes
BTC is a more extreme case of this because unlike property, we can know the exact number of BTC in circulation, and how many more bitcoins will be added to the economy and when. We can use these facts to leverage Bitcoin’s future purchasing power against its purchasing power today.

The reason this can work is because of BTC deflationary effect of having a predictable, fixed supply, but has limitless economic capacity. When we look at the value over time for bitcoin, one can see that the long time span one looks at the more likely it is that bitcoins value will gain against fiat currencies. This is because of the fundamental functions of both Bitcoin and fiat currencies. Bitcoin has a fixed 21 million coins EVER. Fiat currencies can guarantee that over time, they will expand the money supply, mean that there will be MORE dollars at a later date no matter what. Currently the Fed has announced their plans to devalue the dollar by 33% over the next 20 years . Due to these facts, the longer of a time span that we look across, the more likely we are to see bitcoin gaining value against all fiat currencies.

Bitcoin’s USD value will increase as long as there is growth in the BTC economy outpaces the supply–and that supply is fix. We know that only 25 new coins can enter into circulation every 10 minutes. We also know what the approximate market value of those 25 new coins will be when they are introduced into the economy.

The purpose of the bank–to assume the risk for holding the assets that are Bitcoins. Furthermore, through watching the blockchain, the volume of transaction, and the velocity of transaction over time, and historic gains and losses over time, along with the knowledge of how many coins are in circulation, how many coins will be added in the future, means that we can have pretty good projections about whether the value of BTC is going to go up or down based on its real economic value, and not just speculation.

So how does it work?

You come in and we sell you an IOU for one bitcoin. This ‘bit’ is $120–the market value of bitcoin today. Over time, you repay that loan to me. For the sake of this, let us say $10 a month. So when May 2014 rolls around, you have paid off your IOU for the Bit, I give you your bitcoin in return. The difference is now that bitcoin is worth $500–which you paid $120 for one year ago. And the way that the bank profits is through assuming the risk of holding BTC in case the price ever does go down, and for whatever gains are taken, the bank will take 1%. So we get 0.01 of your bitcoin for holding it (our profit), and you win for taking out the IOU because your $120 IOU is now worth $495.

Furthermore, if upon the completion of the payment, or hell, even partial payment, one could ‘refinance’ their loan with The Bank. So because the bank is holding the BTC, we can refinance at the market value at the time of refinancing. So if you have paid 50% off of your IOU (so 6 months have passed–it’s DEC 2013) and now the value of BTC is say, $240. One could refi, and now as the bank I give you $240, and the 12 month cycle starts all over again. One is using the equity in their bitcoin and its deflationary nature to hedge against fiat inflation, and the lost of purchasing power of the dollar.

More importantly, is that we can build applications that create these financial instruments for automated, program-oriented banking. Similar to Bitcoin’s protocols, that means that no one can cheat at banking! If you lock yourself into a 12-month CD, the program application is what locks you in—not a person. The program can also have you pay a penalty to exit the deal, if you choose to do so, or other functions. And this is just one of many examples; there is a whole world of financial instruments that we can build that function off of programs that both yield profit and ensures security, safety, and most importantly, no one can cheat at it! This works because it functions on the same trust as bitcoin–trust in the programming and protocols that ensure no one is cheating at, or rigging the system for their gains and others losses through corruption.

These are simply my own thoughts and ideas, and I could be wrong about some of this. But please, tell me your thoughts on this and if my logic is correct. Because if I’m right, we are in for a radical new way of doing finance and commerce.

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Next: The Revolution of Bitcoin Banking