(This essay was published in Hong Kong Economic Journal on 15 January 2014)


When Bitcoin first appeared as a digital cryptocurrency in 2009 it was viewed cautiously by lawmakers and regulators in the United States. But Bitcoin was enthusiastically embraced in China, quickly fuelling a surge in its value to record highs until the Chinese authorities began to move against its use. Since then its value has dropped precipitously. Why was there such enthusiasm in China? To answer this, we need to consider the nature of cryptocurrencies.


A cryptocurrency is a digital medium of exchange. Bitcoin was the first cryptocurrency to begin trading, but there are numerous other cryptocurrencies that are also available. Cryptocurrencies are designed according to the principles of cryptography. Anyone can issue such a cryptocurrency but, by design, the total amount of a cryptocurrency that will eventually be issued is capped. Through prior agreement a cryptocurrency is stored on different computers in a distributed, decentralized, and secure manner. Any attempt to circumvent its security is prohibitively costly, if not impossible.


The creators of cryptocurrency will, for reasons of profit maximization, exempt themselves from upfront mining costs and thus reap initial “seigniorage”, which is some fraction of the total new value they create. They will make a market by sharing some of that seigniorage with early adopters.


Cryptocurrencies therefore can be regarded as a form of privately issued fiat money. In contrast to almost all other existing types of government issued fiat money, the total amount of a privately issued digital cryptocurrency that will enter into circulation is capped. This avoids inflation, but as a cryptocurrency grows in popularity and the amount in circulation approaches its finite cap, then deflation will occur.


Bitcoin, for example, is rigidly designed to be introduced into the system at a mathematically predictable rate that is completely independent of any economic activity for which Bitcoins might be used. New Bitcoin production is supposed to take place at an exponentially decreasing rate so the production decreases by 50% every four years. As a result, the number of Bitcoins in existence will effectively flatten out at 21 million in about 2040 – if anybody is still using the Bitcoin system by then.


Bitcoins and Deflation

The finite cap is equivalent to having a very rigid monetary policy determined solely by the software that resides on the computers of everyone who is participating in the system.


Now what does this rigid monetary policy mean for the future value of Bitcoin as a medium of exchange? That depends on whether the producers of goods and services who accept Bitcoins in payment continue to grow or settle into a small niche economy of loyal enthusiasts. Let us assume they continue to grow and that the volume of goods bought and sold with Bitcoins continues to increase. If this happens then it is very likely the Bitcoin economy will be hit by a deflationary spiral. This feature will make Bitcoin a poor long-term candidate for an alternative medium of exchange with a stable value.


At first blush, deflation might appear to be an attractive thing for those holding it because the currency appreciates in value as the price of goods and services continually fall. There are, however, two negative implications. First, if prices are falling then the incentive to hoard currency increases. The currency itself becomes an appreciating investment vehicle for its owner so long as it is not spent. For an economy as a whole, widespread hoarding of currency is bad news because the real economy can become negatively impacted. Second, as economic transactions become “demonetized” in the Bitcoin economy its value as a currency drops.


For these two reasons, the Bitcoin software does not appear to be a well-designed currency system for a growing economy. I believe the Bitcoin designer built these deflationary prospects into the system as an intended feature. To see why this is likely to be the case consider another curious feature of the Bitcoin system, which its designers call “mining”.


The new Bitcoins introduced into the system are not simply distributed evenly among all Bitcoin users like a “helicopter drop”. They are awarded to miners. In principle, anyone can become a miner. But successful mining requires the application of substantial computing power and computing speed. And the miners must bear the cost of mining themselves.


In a thriving Bitcoin economy, deflation will arrive earlier and one would like to become a miner as early as possible. Early Bitcoin miners, who acquire the currency when the pace of Bitcoin creation is high, could profit handsomely when the deflationary phase kicks in. They would then be able to collect enormous appreciation in values. It would be in their interest to offload the Bitcoins before deflationary expectations broadly settle in and people begin to hoard currency; and the risk from some “demonetization” appears. So it appears the designers of Bitcoin were combining a mining system with a deflationary architecture to help build a market that would make them rich quickly.


Competing Private Fiat Moneys                  


Bitcoin may not be a well-designed digital cryptocurrency, but can better ones be designed that possess better properties as a potential medium of exchange? The idea of privately issued fiat money was floated by Professor F A Hayek (Nobel Laureate in Economics 1974) as an alternative to government issued fiat money. Hayek was concerned that governments were prone to debase the value of the currency they issued and thus cause inflation. As a consequence, the public, who hold government produced fiat currency, was at risk. History has proven that governments cannot be trusted, including and perhaps especially, democratically elected governments.


Hayek’s proposal called for privately issued, competing fiat currencies. That is, to allow individual firms to issue pieces of paper that were not backed up by any production or consumption good. In a sense, Hayek wanted to privatize central banking. The private issuers would be driven by a profit motive to collect seigniorage revenues obtained from issuing fiat money, whose marginal cost of production was zero.


Hayek reasoned that a profit maximizer could conceivably be better disciplined than a government to preserve the value of the money he issued as it would be a lucrative source of income. The free market would provide the optimal quantity (and variety!) of monetary products. Just as the forces of competition lead to low prices and superior quality in every other line, so too would competition in the “fiat money industry” lead to monies that were infinitely better than their government-produced counterparts.


For example, the private monies would be far more stable in their purchasing power, harder to counterfeit, and available in more convenient denominations. At the very least, they would provide competition to impose discipline on the government to behave responsibly or risk losing clients. For this to happen it was necessary to remove government obstacles to the private issue of fiat moneys.


A small body of academic literature has appeared to examine Hayek’s proposal. These were often considered as curiosity pieces of theoretical modelling that explored the properties of a system with private fiat money. This literature can be interpreted in many different ways. A simple summary can be taken to mean that (1) a monopolized private fiat currency might produce a stable supply of currency to protect its value into the future, and (2) private competing fiat currencies would not provide a stable supply of currency because of the competitive erosion of available revenues and because of the time inconsistency problem (this latter feature will be elaborated later).


Contestable Markets for Cryptocurrencies


To illustrate why private competing fiat currencies cannot provide a stable supply of currency, one can outline a scenario in which the value of Bitcoin (or any other cryptocurrencies) would fall apart. Let us first assume that a year from now Bitcoin is priced at $500. Suppose Ah Bun wants some Bitcoin to purchase furniture. He then finds someone who will sell him Bitcoin for about $500.


But then another cryptocurrency issuer Citcoin Company appears with its own algorithm and offers to sell his Citcoin for only $400. Will Ah Bun accept such an offer? Citcoin is cheaper, but will its purchasing power be less than Bitcoin? The Citcoin Company realizes this, so they build deflationary pressure into the algorithm, and everyone expects Citcoin to rise in value over time, enough to make you want to hold it. So Ah Bun and others buy Citcoins for $400, and its price begins to rise. Very soon Ah Bun will be able to purchase furniture with it.


Assume that it costs the Citcoin Company $50 in per unit transaction costs to undertake each such arbitrage activity. This implies both the company and the buyers of Citcoin are better off at the initial transfer price of $400 and people will prefer to use Citcoins instead of Bitcoins.


But the story does not end here. Very soon Ditcoin Company will appear, offering to sell us another digital medium of exchange for $300. Then there is Eitcoin Company that offers us a deal for $200. Fitcoin is even cheaper. And so on.


Once the market becomes contestable, the price of the dominant cryptocurrency will be set at around $50, or the transaction cost faced by potential competitors in affecting arbitrage transactions. At which point all the available revenue from seigniorage on the supply of private fiat money will be exhausted. This result will hold even when the market demand for such currencies becomes very large. It is of course possible, and perhaps likely, that the larger the network of users of cryptocurrencies, the lower will be the cost of making arbitrage transactions. This implies that the valuation of the dominant cryptocurrency will become even lower.


So if you are optimistic about the demand for Bitcoins then you should also be pessimistic about the future value of Bitcoin. As long as the private fiat money market is contestable, then the value of all cryptocurrencies will have to drop once supply side arbitrage starts working. Indeed, one would expect the value of Bitcoin and other cryptocurrencies to fall a lot.


In principle, this should have been foreseen by all astute participants in the market. Issuers and holders of cryptocurrencies can only gain if they are able to offload it to some sucker before their value drops to the level of the cost of making arbitrage transactions. In theory it is of course possible to keep on holding Bitcoin in anticipation of appreciation in value because of its deflationary potential. But this assumes that Bitcoin continues to be a medium of exchange and one can always find a buyer for it. This is of course an uncertain proposition once private markets for cryptocurrencies become contestable. Private issuers supply fiat money to make profit, but at the end profit cannot be assured. This is the time inconsistency problem of competitive private fiat moneys that we raised earlier.


Of course a private monopolist supplier of fiat currency can behave responsibly to provide a stable supply of fiat currency. But under free entry, only a natural monopolist can survive. It is not evident that issuers of cryptocurrencies possess such qualities.


If the private supply of fiat currency is theoretically problematic as a proposition, what explains the emergence of the Bitcoin phenomenon? And why was it embraced so enthusiastically in China?


Bitcoin as a currency and a means of payments has certain advantages over the existing bank-centered payments system. Put simply, it allows some legal transactions to take place at a lower cost, with greater simplicity and flexibility; not to mention illegal ones. Part of the cost advantage is the lower cost of making payments for cross border transactions. The higher cost of using the existing bank-centered payments system can ultimately be traced to the regulatory costs imposed on the financial system.


The regulatory cost of making payments are especially cumbersome and costly in China’s highly regulated system. This makes Bitcoin a very attractive alternative medium of exchange for Chinese clients, who are operating in an economy that has grown significantly in the past 30 years and who want to be serviced by a far more efficient financial and payments system. The huge demand for Bitcoin, other than for purely speculative purposes, reflects an underlying dissatisfaction with the Renminbi. The popularity of Bitcoin therefore appears as a threat to China’s banking and payments system. No wonder China has reacted quickly to curb its spread. The real lesson of the Bitcoin experience for China is that its financial system needs to reform.




Friedrich A Hayek, The Denationalization of Money, pamphlet, (1978).

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