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Is Bitcoin the Greatest Economic Experiment of Our Time?

By Dale B. Halling

January 4, 2019

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A number of people literally owe their lives to Bitcoin in Venezuela, where bone-crushing inflation has resulted in people starving to death.

Bitcoin is a cryptocurrency that was created by an alleged “Satoshi Nakamoto” at the height of the financial crises of 2008. Nakamoto, whose real identity is unknown, left no doubt that he (they) was taking aim at the modern banking and monetary system. He included the front page of the Times in the genesis block from that day that screamed “Chancellor on the Brink of Second Bailout for Banks.” In less than ten years, Bitcoin has gone from genesis to being worth $20,000 briefly (now about $3,500 per unit) and used by millions of people around the world to transmit economic value and as a store of value. It is well documented that a number of people literally owe their lives to Bitcoin in Venezuela, where bone-crushing inflation has resulted in people starving to death. Hundreds of thousands of people’s economic lives have been saved in inflation-ravaged countries, such as Argentina, Turkey, Iran and Zimbabwe, by Bitcoin and other cryptocurrencies.

Bitcoin has sparked intense debate, including recently being called the “Evil Spawn of the Financial Crisis” by an executive member of the ECB (European Central Bank). It also caused Paul Krugman, the Nobel Prize-winning economist and New York Times columnist to admit:

“Fiat currencies have underlying value because men with guns say they do. And this means that their value isn’t a bubble that can collapse if people lose faith.”

This is a terrifying admission by Krugman. It seems like something a character right out of Ayn Rand’s novel Atlas Shrugged would have said. The financial elites find Bitcoin and other cryptocurrencies a credible threat to their monopolistic control of money and credit. Overthrowing that monopoly is certainly the goal of many of the early developers and adopters of Bitcoin.

While this is likely to produce some great political theater over the next couple of decades, what is probably more important is that Bitcoin represents one of the greatest economic experiments since Russia adopted communism in 1917.

Some of the important questions this experiment raises are:

  • 1. What is Money?
  • 2. Is Gresham’s Law valid?
  • 3. Is a Deflationary Monetary System bad for the economy?
  • 4. Is the Subjective Theory of Value correct?
  • 5. Is Fractional Reserve Banking Inflationary?

Many of the early adopters, developers, and entrepreneurs in Bitcoin subscribed to libertarian political and Austrian economic theory. As a result, they saw Bitcoin as free-market money that could challenge the central-planning monetary system of central banks, such as the U.S. Federal Reserve.

Two of these early adopters and entrepreneurs are Roger Ver and Eric Voorhees. Both men were in their twenties when they became involved in Bitcoin and both profess that their understanding of Austrian economics influenced their decision to invest in and become involved with Bitcoin. Ver is a colorful character who served time in prison, renounced his U.S. citizenship, and was a millionaire before his involvement in Bitcoin. He was called Bitcoin Jesus for his Bitcoin evangelizing and he invested in many early Bitcoin startups including Bitinstant where Voorhees worked as Director of Marketing. Voorhees went on to create two successful Bitcoin startups. Voorhees, a family man from the United States, now lives in Switzerland. He has the uncanny ability to logically destroy an opponent’s position, while appearing to be talking about something no more important than the weather.

According to Austrian economics, real money must be a good that had exchange value separate from its use as money. Bitcoin does not fit this paradigm.

Despite crediting Austrian economics for their fascination with Bitcoin, their Bitcoin involvement actually put these men in conflict with Austrian economics. According to Austrian economics, real money must be a good that had exchange value separate from its use as money. Bitcoin does not fit this paradigm. While the Bitcoin protocol can be used for other functions, its original value derives only from its use in exchange as money.

The debate is still playing out in the Austrian economics community, with many Austrians critical of Bitcoin. For instance, Peter Schiff, a prominent investor and self-professed Austrian, states that Bitcoin is not money. He goes so far as to call Bitcoin “fool’s gold.” Peter Schiff and Eric Voorhees even had a debate about Bitcoin, which you can find on YouTube here. In the video you can see how calm and polite Voorhees stays, despite Schiff becoming apoplectic. Schiff’s main arguments are that Bitcoin has no “inherent value,” it is not scarce because other cryptocurrencies can and have been created, and that it is not a store of value because its price swings too widely. Ironically, the inherent theory of value is inconsistent with Austrian Economics.

Schiff’s comments go to the very essence of what money is. Until the advent of Bitcoin, only a few “gold bugs” spent any time thinking about the question of what money is. For mainstream economics, this was a settled and boring subject, since money is anything that serves as a medium of exchange, a unit of account, and a store of value. Austrians and gold bugs argue that fiat money is just paper and has no “inherent value.” As a result, they argue that fiat is not a store of value and they have an impressive amount of historical evidence on their side.

The Bitcoin protocol can be used as a permanent immutable record of an event. Voting is one such application of the Bitcoin protocol.

However, Bitcoin raises the question of whether money must be “something” at all. The bitcoin and Satoshi (one 10 millionth of a bitcoin) are units of account, they do not exist except in the distributed ledger of the Bitcoin protocol. You cannot hold a bitcoin and a bitcoin has no value except as a unit of account in the Bitcoin protocol. The Bitcoin protocol has numerous uses other than the obvious use to transfer value. For instance, the Bitcoin protocol can be used as a permanent immutable record of an event. Voting is one such application of this side of the Bitcoin protocol.

Some Bitcoin enthusiasts, including John McAfee, of McAfee antivirus fame, have argued that Bitcoin does have inherent value because it takes energy to create a bitcoin in the form of electricity. This electrical energy is used to compute the complex mathematical functions necessary to create and transfer bitcoin. However, this energy is depleted in the process. You cannot trade a bitcoin in for the energy that was used to create it.

Since bitcoin, the unit, does not exist separate from the Bitcoin protocol and you cannot exchange it for the energy used to create it, Bitcoin does not have any inherent value. Peter Schiff immediately jumps to the conclusion that bitcoin therefore cannot be money. Another way of looking at this question is whether any money has inherent value.

One the first moneys was cuneiforms, clay tokens with writing which showed how much grain a person had deposited with a granary. When a person deposited their wheat in a granary their deposit was recorded on a ledger at the granary and the depositor received a cuneiform or cuneiforms that represented the amount of wheat they deposited. In other words, the cuneiform was a token that was a physical representation of the ledger entry. This protected the depositor from fraud or loss of the ledger. However, if the ledger could not be destroyed or tampered with there would have been little reason for the token. As we will see, the immutability of the Bitcoin ledger is one of its greatest strengths.

The cuneiform had no “inherent value” and only had value because it was a legal claim on a certain amount of grain. Cuneiforms did have “trade value” or economic value and could be traded because they were bearer bonds, like a dollar bill or more accurately they were like banknotes.

Unfortunately, cuneiforms could break and could be counterfeited. In addition, cuneiforms could only be exchanged for grain at the granary that issued them. This led to metals and particularly precious metals being used as money. The historical evidence is that gold and silver were used for trade outside of the local area and cuneiforms were used locally.

Did this mean that gold and silver had inherent value or even economic or trade value separate from their use as money? At the time their only other use would have been jewelry. Most likely the use of gold and silver for jewelry was small compared to its use as money, as it is today. When someone accepts a gold coin in exchange for some goods, their goal is not to turn it into jewelry or to use it to make electronics, but to exchange it for some other goods. If everyone sold their gold that they were not holding to make jewelry or for industrial uses the price of gold would plummet to a small fraction of its price today.

Gold acts as a token of value exchanged like the cuneiform and has no inherent or intrinsic value and also has little economic value separate from its use as a store of value. Actually, the whole idea of intrinsic value makes no sense, since value implies that there must be a valuer. Things cannot have value separate from people who value them. In fact, any good money gets most or all its value from its use as money and has no inherent value.

Eric Voorhees has explained Bitcoin’s value as being its immutability, limited supply, easy transferability, censorship resistance, and its easy divisibility. Bitcoin’s immutability and censorship resistance was demonstrated when the U.S. government got Visa, Mastercard and PayPal to block payments to WikiLeaks in 2010, without a court order. WikiLeaks was still able to receive donations in Bitcoin, which turned out to be a great investment.

Bitcoin’s supply is limited to about 21 million coins, which will be reached sometime around 2140 A.D. Bitcoin has a decreasing rate of increase in the supply built into the protocol. The Bitcoin protocol is distributed and cannot be changed by anyone. Gold on the other hand has had an exponentially increasing supply. New technologies have allowed gold miners to mine gold at even lower prices, which has increased the supply and has been at least part of the reason gold prices have not increased recently. Gold’s above-ground supply is exponentially increasing, while Bitcoin’s increase in supply is slowing exponentially and capped.

Bitcoin is also more easily divisible and transferable than gold. These were the reasons Eric Voorhees cited for why he invested in Bitcoin and became involved with Bitcoin companies. He explained that if something has “value” it will eventually have a price. Similar thoughts seem to have motivated Roger Ver to invest in Bitcoin.

Clearly, Voorhees and Ver see or saw value in Bitcoin that was not reflected in the price and Peter Schiff thinks he see value in gold that is not reflected in the price. This means that all three believe you can spot value separate from the subjective value or price. How can we make sense of this?

The value Voorhees saw in Bitcoin can be called its “objective value,” while its price is its “trade value.” Water has the objective value of providing hydration, which is vital to human life, but its trade value (price) is usually fairly low since water is usually plentiful, meaning its supply is great compared to its demand.

Note that an item, such as food or air, can have no or little trade value but very high objective value. If you are on a deserted island, food has no trade value since there is no one to trade with. However, it has very high objective value to you if food is scarce. Vice versa, gold on a deserted island is likely to have almost no value, since it cannot be used to fulfill any of your needs.

Jewelry and art may have very low objective value but may have very high trade values to people who have met their other objective needs. This is especially true if the art is scarce and prized by many people.

Food and water have objective value, because there are necessary for every human being to live. They do not have inherent value, because that would mean that they would have value even if humans did not exist.

Food and water have objective value, because there are necessary for every human being to live. They do not have inherent value, because that would mean that they would have value even if humans did not exist.

With this in mind Ver and Voorhees saw that Bitcoin had high objective value as money and because it has an objectively defined limited supply, they thought its trade value would increase. They believed that other people would come to recognize Bitcoin’s objective value and that this would increase the demand for it resulting in a higher price.

As Benjamin Graham stated, “In the short run, the market is a voting machine but, in the long run, it is a weighing machine.” In other words, the price in the short run is subjective, but in the long run it is objective. The price of an item is defined by the objective value of the item, and its supply.

The existence of Bitcoin is challenging many notions in economics. It is likely to be one of the greatest economic experiments of our time and provide numerous insights into the ‘dismal science.’

 

 

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