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minorman
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Education: Engineer (Ms. Sci. Eng.) and PhD My investment interests are focused on the global "macro picture" - with particular emphasis on resources and commodities. I am only interested in long-term positions - typically 4-10 years.
  • Paul Krugman's take on Bitcoin 2 comments
    Sep 8, 2011 12:17 AM
    Today, Nobel prize winning economist, Paul Krugman has published his thoughts on Bitcoin

    If you don't know what the word "Bitcoin" means you might want to take a little time to go to the bitcoin wiki, or read my previous instablog on the topic.

    Krugman's piece is quite short, so I've pasted it here:

    ---
    Golden Cyberfetters

    Over the past few months a number of people have asked what I think of Bitcoin, an attempt to create a sort of private cybercurrency. Now Alexander Kowalski at Bloomberg News directs me to this Jim Surowiecki article on Bitcoin, which is very interesting.

    My first reaction to Bitcoin was to say, what’s new? We have lots of ways of making payments electronically; in fact, a lot of the conventional monetary system is already virtual, relying on digital accounting rather than green pieces of paper. But it turns out that there is a difference: Bitcoin, rather than fixing the value of the virtual currency in terms of those green pieces of paper, fixes the total quantity of cybercurrency instead, and lets its dollar value float. In effect, Bitcoin has created its own private gold standard world, in which the money supply is fixed rather than subject to increase via the printing press.

    So how’s it going? The dollar value of that cybercurrency has fluctuated sharply, but overall it has soared. So buying into Bitcoin has, at least so far, been a good investment.

    But does that make the experiment a success? Um, no. What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin.

    Bear in mind that dollar prices have been relatively stable over the past few years – yes, some deflation in 2008-2009, then some inflation as commodity prices rebounded, but overall consumer prices are only slightly higher than they were three years ago. What that means is that if you measure prices in Bitcoins, they have plunged; the Bitcoin economy has in effect experienced massive deflation.

    And because of that, there has been an incentive to hoard the virtual currency rather than spending it. The actual value of transactions in Bitcoins has fallen rather than rising. In effect, real gross Bitcoin product has fallen sharply.

    So to the extent that the experiment tells us anything about monetary regimes, it reinforces the case against anything like a new gold standard – because it shows just how vulnerable such a standard would be to money-hoarding, deflation, and depression.

    ---

    While it is clear that Krugman has taken the time to study the basis of what bitcoin is and its (brief) history - it is also very clear that his take-home message is that bitcoin, like gold, would be bad as a replacement for USD etc. because it "pays" to hoard it and therefore the economy dies a deflationary death.

    The argument put forth: That deflation leads to hoarding (which strangles trade) which, in turn, leads to more deflation and so on and so on is seductive, but also misleadingly simplistic.
    It is certainly true, that deflation is poison for the economy - but not because of hoarding. The real reason is that our monetary system is based on debt - it is not based on value. This is the key reason why deflation is such a disaster with our current system. Allow me to elaborate slightly:

    In our current monetary system, nearly every single Dollar (or any other currency) is brought into existence when someone, somewhere signs a so-called loan agreement. Example: When you buy a house (but don't have enough for 100% down payment) you "borrow" money from a bank. What really happens is that the bank creates the money to buy the house out of thin air and lends it to you. How? The bank just expands its balance sheet: You now owe the bank the amount $XYZ, so your signed IOU is written on the asset side of the ledger and the bank owes whoever sold the house $XYZ so that is written on the liability side. But now, the bank owns your IOU which according to commercial law is a saleable document worth $XYZ times the probability that you will honor your obligation to pay. Therefore a house (a real asset) was bought with nothing but promises-to-pay (also known as credit or checkbook money) from you to the bank, and from the bank to the seller. 
    However, for you to be able to pay back your so-called "loan", money must be available for you to earn - therefore if the total money supply (available credit) is shrinking some existing loan takers will default - by way of mathematical certainty. Simply put: The money to repay the loans ceases to exist since deleveraging means that old loans are repaid (destruction of old debt=money) - faster than new loans are issued (creation of new debt=money)). This is the core reason that "deleveraging" (i.e. deflation) is a disaster with our debt money system. Hoarding of money is irrelevant when discussing why debt-money systems crash under deflation!

    On the other hand.
    If we (still) had a value based monetary system, where some (e.g. fixed) amount of money was circulating with no fractional-reserve banking to leverage the system (e.g. with a 1:1 gold standard) deflation would occur whenever the total economy grew in size because the same amount of money would be chasing more goods and services (and conversely, inflation would occur if the economy shrank). 
    In this situation, deflation would be a good thing (holding money would be like holding stock in the general economy giving a return in case of a prosperity). No more defaults would occur under deflation than under inflation (because there is no destruction of money).

    And this is what Krugman does not understand (or at least never discusses).
    Unlike USD et al., Bitcoins are not created against matching pledges of debt and therefore, like gold, they represent value instead of debt. No-one forces you to accept promise-to-pay bitcoin (unlike with "real" money where courts must enforce privately issued signed (debt) contracts making them essentially equivalent to cash) so there should be little or no demand for such "paper" bitcoin. This is why fractional reserve banking shouldn't catch on with bitcoin.
    Why would you accept a bank's IOU-bitcoin (i.e. bank statements etc.) when you can store your own money (bitcoin) on your own computer, on your smartphone, printed out on paper, etc. etc.?

    So to summarize. Krugman gets the problems with bitcoin dead-wrong. In fact, what he points out as bitcoin's key problem is perhaps its greatest strength! A value-based currency with a fixed money supply, is a great alternative to the pervasive debt-based fiat ditto. This is also why gold is trading ever higher. There is demand for something that can't be "inflated away".

    There are other problems with bitcoin, however, but they are slightly more technical and Krugman is excused for missing them.

     

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Comments (2)
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  • simonbarber
    , contributor
    Comments (4) | Send Message
     
    Two counter arguments.

     

    1. Even though you don't have the destruction of money with bitcoin in the same way you do with fractional reserve banking, you will still see deflation as the size of the economy grows. This will make it impossible for some people to pay their bitcoin denominated debt. Given this I suspect people will avoid denominating debt in bitcoin, and use it only for making payments, priced in realtime.

     

    2. Bitcoin IOUs already exist and are commonly used. The main bitcoin exchange issues them (mtgox vouchers), with one significant advantage over real bitcoins - since they are centrally controlled a transaction in these vouchers can clear immediately, unlike bitcoin where it takes some period of time to be certain that the coins you have received have not been double spent. These vouchers are only one possible solution to immediate transactions, there are several others being worked on.
    25 Nov 2011, 01:50 PM Reply Like
  • minorman
    , contributor
    Comments (222) | Send Message
     
    Author’s reply » Hello simonbarber and welcome to SA!

     

    I agree completely with your first point. Taking on debt in Bitcoin seems exceedingly dangerous, but already happens when people margin-trade on Bitcoinica.

     

    It is true that mtgox issues promise-to-pay Bitcoin (although these are supposedly backed 100% by existing Bitcoin - ie. full-reserve banking). I think that these have legitimate use for point-of-sale payment in Bitcoin insofar as mtgox acts more as an escrow service than a bank in a traditional sense.
    For any *real* (larger) transactions in Bitcoin, however, I think people will prefer waiting for a couple of transaction confirmations on the blockchain over trusting promise-to-pay Bitcoin like mtgox vouchers or similar debt-based instruments.
    Again - what do I need a "bank" for if I transact in Bitcoin?

     

    In any case, I think we agree that Krugman is wrong. Bitcoin is not flawed because of deflation.

     

    Ironically, in the spring, when Bitcoin was going up in price everyone was saying (like Krugman) that Bitcoin would fail because of deflation.
    In the fall, when Bitcoin was "crashing"/correcting everyone said that it would fail because of rampant inflation!
    25 Nov 2011, 04:57 PM Reply Like
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