Several of us have been asked to write something about Bitcoin and blockchain. I have drawn the short straw, so here it goes.
I think to get our collective heads around this, I should start at the end. Bitcoin is one form of digital money, and the blockchain is a digital ledger. Clear? Now, let’s start at the beginning.
Money is anything that performs the functions of money. Money, then, is anything that is a medium of exchange, a standard of value and a store of value. Please note that this does not include a required role for government.
Richard A. Radford was a flyer for the Royal Air Force during World War II. He was shot down over France and spent the rest of the war trying to escape from prison camps. At war’s end, he wrote a classic article called ‘The Economics of a POW Camp’ where he described the economic system that arose and developed in a camp of prisoners. It is fun to read.
Two things are of interest. Every so often, the Swiss Red Cross would bring packages to the prisoners that contained assorted items. The first thing that would happen as the boxes were being distributed, is that each prisoner would look in their box and then start trading with others. Apparently, barter is basic to the human condition. Next, with time, the cigarettes that came with the Red Cross packages began to serve as money, replacing barter. Barter requires a coincidence of wants — to get what I want from you, I must have something you want. It is costly and difficult. With cigarettes as money, I can get what I want from you by giving you cigarettes because you know that those cigarettes will be accepted in exchange by others. All we need to agree on is the price — the number of cigarettes. With time, every item, like blankets, had prices expressed in cigarettes.
Cigarettes became a medium of exchange and shows the fundamental reason that makes something money — others accept it. I accept money, whatever the form, because I know that you will accept it. Nothing is said of government. The key is acceptance.
The Radford article is cool. All of what we call monetary theory, was found in cigarettes. When the Red Cross brought a new supply of cigarettes, prices in terms of cigarettes would rise (inflation). As the supply of cigarettes decreased (by smoking for example), the money supply declined and prices in terms of cigarettes fell.
There are two types of money in our economy — private and government: coins and currency (cash) are government money and checking accounts are private money created by commercial banks through the system of fractional reserve banking.
The largest part of the money supply is in privately produced checking accounts. As private money is used in transactions, it goes through third parties like commercial banks, other financial institutions, and the Federal Reserve. If you want to keep your transaction private, you need to use cash. Cash transactions are only between a buyer and a seller, and no one else needs to know about it. (We have been binge watching The Sopranos so I will leave out rat informants.)
Where does government fit in? The creation of money needs to be guided by a rule, a monetary regime. Excessive money creation reduces the value of each monetary unit and impacts whether it will be accepted by others. A gold standard, a silver standard, the Federal Reserve are examples of monetary regimes. Yet, a government presence is not necessary for value in acceptance. It is just one way.
Bitcoin was created, it is claimed, by Satoshi Kakamoto. This may be a pseudonym for several founders wishing to be anonymous. Remember that cash transactions are only known between a buyer and a seller and can be secretive (again, see The Sopranos). This is cumbersome. For example, coins and bills must be carried around. But what if the coins and currency could be represented digitally? Things would become much easier. This is the idea behind Bitcoin. It is a digital money that can be traded directly between buyers and sellers, and avoid the third parties present in traditional check transactions.
For Bitcoin to become money, it simply must be accepted by others and be subject to a monetary regime. The Bitcoin regime is very simple. Bitcoins cannot increase (referred to as mined), and the supply of coins is limited to 21 million units. The blockchain is a ledger — an accounting book — that keeps track of Bitcoin transactions. This ledger is observable by everyone and validates Bitcoin acceptance. There must also be on and off ramps. These are places where Bitcoins can be exchanged for more traditional forms of money, like dollars. These ramps form the marketplace which creates a dollar value to a single Bitcoin, like $61,000 per coin unit recorded while I was typing this article. Ramps are everywhere. A few weeks ago, I saw a Bitcoin ATM machine outside of Metter in a run-down gas station, but I could not tell if it was better than other ATMs (Get it?).
These are the principles for Bitcoin to be money. But can it really be money? I think it is true that before anything can really be money, it must have stable and relatively predictable value. The volatility of the dollar price of a single Bitcoin coin would suggest that they will not truly be acceptable in exchange. Also, these price fluctuations compromise the ability of Bitcoin’s to be a standard of value and as a store of value. In theory, Bitcoin may be money but in practice not so much.
While there is much more to discuss, there is nothing new about Bitcoin other than they are new. What is interesting, however, is that the digital world is allowing the development of alternative forms of money.
As a result, there will be competition between them. This competition to me — someone whose intellectual development has not moved too much beyond the Scottish Enlightenment —will be in the long runa good thing.