“Kee” Points with Jim Kee, Ph.D.

  • Bitcoin


I suppose it’s time to revisit bitcoin (with the help of STMM analysts Josh Taenzler and Michael Nance) because it is dominating the news. When bitcoin first surfaced I mentioned that legal tender laws, which determine what is legally valid for meeting a financial obligation, might limit its success as a currency, and I still think that is the case. What follows is an attempt to get at some of the economics of bitcoin, as opposed to the arcane technical aspects, which are better suited for software engineers.

A quick Money 101: Money naturally evolved to solve the “double coincidence of wants.” If you are a blacksmith or a butcher and you need your roof repaired, you need to find not only a roofer, but a roofer who needs what you have, which is blacksmith work or the services of a butcher. Money solves this dilemma by allowing both of you to offer your services for some commonly accepted medium of exchange. A good medium of exchange has the properties of being valuable (you don’t have to haul huge amounts of it around for exchange), which means it is scarce; it has to be divisible for different sizes of exchanges (a piece of candy or an entire house); it has to be fairly stable in value, and it has to be easily verifiable. For these reasons gold has historically emerged as a source of money. Silver isn’t as good because typically it takes several pounds of silver to equal the worth of an ounce of gold. And other precious metals either aren’t as easy to verify as gold, or they have other (e.g. industrial) uses which makes their value more susceptible to underlying supply and demand shifts, resulting in great fluctuations in their values. In extraordinary circumstances other items have served as money, such as cigarettes in prisoner of war camps, or even hard drives in the case of the collapsing communist countries in which the official currency became worthless.

Bitcoin futures began trading on Sunday, December 10, 2017 at the Chicago Board of Options Exchange (Cboe) and will begin trading on December 18 on the Chicago Mercantile Exchange (CME). Considered a “cryptocurrency” or digital asset, bitcoin is not a tangible asset or coin (even though often pictured as such) but rather a virtual currency.

Bitcoin is believed to have been developed by an individual working under the alias Satoshi Nakamoto in 2008. Nakamoto’s great innovation was blockchain technology, a type of distributed ledger technology. Distributed ledger basically means that every transaction (purchase or sale) that has ever taken place is recorded in full (on a “ledger”) and updated or synchronized on each participant’s computer (“distributed”). That is different from a centralized ledger where a central authority (e.g. a bank) determines which transactions are posted and valid and which can even halt or shut-down transactions (Hashloops LLP).

The currency is created through a process known as “mining,” which means using sophisticated computers to solve complex mathematical problems, basically validating the ledger. That task increases as the network of users and transactions grow, and miners are awarded “coins” for their contribution to the computing power required, which gets greater and greater over time. That’s why almost all bitcoin miners now are basically institutions with vast computing resources. For the purposes of economic analysis the salient point is that the supply of bitcoins is limited (which is written into the program), and was ostensibly meant to mimic gold, with increasing effort required to gain successive bitcoins just as finding more gold gets more difficult over time (i.e. as the easy finds get exhausted).

You can buy bitcoins on many exchanges, such as Coinbase, and the current price is about $17,300 per coin (you can also buy just fractions of a bitcoin). That’s considerably greater than the $900 or so it took to buy one at the beginning of the year, hence the hubbub. Some economists, like Tyler Cowen who writes the popular blog “The Marginal Revolution,” think bitcoin could be a legitimate substitute for gold in its capacity to hedge portfolios (no obvious correlations to other assets). Others, like Nobel Laureate Joseph Stigletz, think it should be outlawed because it circumvents official government currency channels and can facilitate illegal or black market transactions that are difficult to track and trace (because the transactions are encrypted). I don’t really buy the correlation argument, because there really isn’t enough data yet to have confidence in that. And its great volatility, which is a characteristic of commodities in general, calls into question by many (but not all) financial economists whether any of the correlation data would be meaningful.

John Cochrane at the University of Chicago has looked at two sources of demand for bitcoin, one a “fundamental” demand, the other a “speculative” demand. To understand the first, or fundamental demand, think of why anyone would desire to hold dollar bills when they could hold one-year Treasury bonds and earn interest. The reason is that they might need money for transactions before a year is up, which means that dollar bills have what economists call a “convenience yield.” Cochrane points out that digital currencies like bitcoin have a convenience yield because of their ability to be used for hard-to-trace transactions, like illegal activities (drug money laundering), circumventing a country's capital controls (moving money out of the country), or “ransomware” (hacking and blocking access to a computer or accounts unless a sum of money is paid). The other source of demand for digital currencies would be speculative demand, which means you own it because you think it will go up in value, even if you feel it could ultimately be worthless. I think it is safe to say that the run-up in value of bitcoin this year has been driven primarily by this speculative demand. Foreign money flows are thought to play a part as well, though they are difficult or impossible to trace. The development of competing digital currencies, which we are seeing, is a natural constraint on how high bitcoin can go in the long run.

In general economists are skeptical of bitcoin’s specific longevity, but bullish on digital currencies in general because they are “easy-to-store, hard-to-steal, and hard-to-counterfeit” (former Stanford economist Robert McMillan).They also provide validation for transactions much more cheaply than conventional banks, credit card companies, or other payment processors, which is why the blockchain technology behind digital currencies is considered to be a “disruptive” technology to the financial services industry.

I go back to Finance 101, which basically asserts that you should not talk about return without talking about risk in the same sentence. Anything that can increase in value by multiples so quickly can decline in value just as quickly. That makes bitcoin more of a speculation than an investment, something to dabble in rather than to buy with money committed to important long-term goals (like retirement). As for its “moneyness” based upon the tenants outlined above, bitcoin is certainly verifiable, divisible, and has some built-in scarcity. It lacks stability, and competing digital currencies call into question its real scarcity. And the ability of governments to restrict its use as an acceptable means of payment (i.e. legal tender laws) add uncertainty to its use as a medium of exchange. These all translate into the obvious risks to bitcoin (I’m sure there are others), and history has plenty of examples of things that made some people rich quickly, and bankrupted others just as quickly. Sir Issac Newton went broke speculating on The South Sea Company, which allegedly led him to state, “I can calculate the movement of stars, but not the madness of men.” Substitute “the cash flow of a company or the coupon payment on a bond” for the movement of the stars and you’ve got it.