Thoughts on Bitcoins

Satoshi Nakamoto.  Know the guy?  Or it could be a woman?  No one apparently knows.  All  we know is that Nakomoto created the digital currency Bitcoin in 2008.

Bitcoins are catching on as a means to transact globally as well as a speculative vehicle, given their volatility.  Some people see bitcoins as money of the future.  Uncontrolled by central bankers, they are limited in supply to a specified amount to be available at a given future date.  Bitcoin comes into existence by computers solving problems, referred to as mining the currency.  Bitcoin miners have the incentive to create ever faster chips to solve the problems involved in mining the currency.

Some of you may  have questions.  Let me take a shot at anticipating some of them.

First off, are Bitcoins money?  Well, partly so and partly not depending on conventional definitions. Conventionally, money is defined in two ways.  First, money is defined as that set of assets acceptable for the payment of goods and services in the economy.  Bitcoin is on the way to satisfying this requirement.  The list of companies willing to take payment in Bitcoin is clearly expanding.

The second definition is by function, and three functions are typically listed.  The first function is medium of exchange, and we've already said Bitcoin is acceptable in a lot of places.  The second function is that money is used to price goods and services.  If you go to Tokyo, you'll find coffee costs 400 Yen.  In New York coffee is $4.00.  OK, clearly the Yen and the dollar are money.  As far as I know, nothing is priced today in Bitcoin.

 I just recently heard an interview on the radio of the CEO of Overstock.com, who is a huge proponent of Bitcoin. The interviewer asked him how he handles the risk of receiving Bitcoin given its volatility and he responded. "Oh, we immediately convert the Bitcoin into dollars."  This CEO has a big problem with the value of the dollar but immediately jumps into dollars by converting his bitcoins?  OK then.  It  indicates to me the fear of trying to find a chair when the music stops.

A third function is that money has to be a store of value.  Clearly you can forego consumption today by putting $100 in your dresser drawer and have purchasing power in the future. The same can be done with Bitcoin, albeit as an account on some mobile device.  Your Bitcoin may be worth $30 or $300 in the near future, sort of like some stocks.

Another question is whether bitcoins should be regulated?  Should bitcoin players be protected from themselves?  To me, a sign post saying the ice is thin and could be hazardous is sufficient.  This reminds me of  the infamous "liar loan" type of mortgages from 2006.  Bitcoin users should be warned but not expect taxpayers to bail them out when and if their market implodes.  As far as I know, no one jumped to the aid of the late comers to the beanie baby fad.

What About the Fed?

Presumably Nakamoto (or whomever or whatever) created Bitcoin out of disenchantmet (I'm being polite here) with central bankers.  Central bankers represent power and have been a target for conspiracy theorists since even before the present incarnation of the U.S. Fed in 1913.  And, not without reason. Big banking has a history of abusing power and engineering games where, in the end, the average person suffers.

In agreement with the bitcoiners, I am not a fan of the U.S. Fed.  Along with Bitcoin advocates, I believe the Fed should control the amount of money in the economy and let the market determine the price of that money (i.e., interest rates).

Still, though, I think Bitcoin advocates misrepresent and fail to understand in an important way how the Fed operates.  I'll get some push back here, but let me give a simple example.  In the file of "repeat something often enough and people will believe it," there is the notion that the Federal Reserve creates money out of thin air.

First off, where did this notion arise?  It probably comes from a prescription, offered tongue in cheek, for an instance where economy needed stimulation, such as the 1930s, to drop money from a helicopter. In fact, Bernanke mentioned this and got hit with the moniker of "Helicopter Ben."  But this isn't, contrary to public opinion, how the Fed gets money into the system.

Instead, the Fed typically buys Treasury securities.  Hmm...think of this. It is trading a liquid asset (a demand deposit) for a non-liquid asset (a Treasury security).  Where did the Treasury security come from?  Someone had forgone income, saved, and bought a Treasury security.  When banks get the deposit, they have funds to lend.  Who do they lend to?  Those with good prospects of paying back the loan with interest.

I'm not saying this process can't have problems.  Indeed, with a fiscal policy gone bonkers, it can potentially set the stage for rampant inflation.  The point is that it is not the same as willy nilly writing checks to big banks, as is commonly perceived. 

Contrast this with a different setup in relation to bitcoins.  Suppose I had a riddle and I said that I will create "Robert Bucks" to the tune of $10,000 for every person who could solve that riddle.  Suppose, further, that Robert Bucks became acceptable for a medium of exchange.  Surely there is a significant  economic difference between the Robert Bucks setup and what the Fed does, and I would argue that the Robert Bucks situation is close to how bitcoins operate.

My bottom line is that bitcoins are a fad, and the ever-present "gold rush" part of the population speculating as an easy way to get rich will end up otherwise.