The Bitcoin Mania
By Lewis Spellman, PhD
Executive Vice-President and Macro-economist
The mania surrounding Bitcoin and other cryptocurrencies is not unprecedented. In l841, the Scottish journalist Charles Mackay wrote “Extraordinary Popular Delusions and the Madness of Crowds.” No, it was not about manic reactions to elected officials as we are experiencing today but the mania associated with get-rich-quick schemes and the frenzies they produce. The historical episodes included tulip mania of the early 1600s, the Mississippi Bubble (among other land manias), and alchemy, which is perhaps most similar to today’s frenzy of making money by making money.
It’s difficult to find print media today that doesn’t feature commentary on Bitcoin, either regarding its “techie coolness” or various justifications for its purported value. In case you haven’t had your fill just yet, let me turn to some fundamental considerations about private monies to put Bitcoin into context.
For many years dating back to the 1980s, I taught a course that included market considerations in the selection of a private money. The context for the discussion was the reflections of a WWII British POW in a German prisoner camp. The author, R.A. Redford, who had a background in monetary economics, authored “The Economic Organization of a POW Camp,” which was published in the prestigious academic journal Economica in November 1945.
The essence of Redford’s experience was that, in addition to some provisions provided by the German authorities, each prisoner received a weekly Red Cross parcel composed of an identical configuration of goods. Rather than being satisfied with total egalitarianism, an ideal state in the minds of some, the prisoners immediately engaged in riotous barter trade to exchange the goods for which they had low utility for those that were more appealing.
Their bartering process involved seeking out a trader among all prisoners who was offering the cheapest rate for the particular item that a prisoner favored. That’s a lot of searching. Before long, notices of bids and ask prices were posted at both ends of each barracks. But that, too, required a lot of arbitrage work as the prisoners would move from barracks to barracks to find the cheapest price in all of the sub-markets.
To save that time and effort, the prisoners soon established centralized market postings. While this eliminated the legwork associated with prospecting all sellers, trade was still complex, considering the multiple routes one could take to get, say, from jam to butter via other intermediary trades within the price matrix. Soon there evolved a simplified system to state bid and asked prices of each good relative to a single good.
Now that all goods were priced in terms of this single good, the next natural development was to trade each good against the good that measured value. So which good in the Red Cross parcel became both the measure of value and the medium of exchange?
To my surprise, the transaction good that was most acceptable in trade became the cigarette. So what were the considerations that went into choosing the cigarette as the acceptable good for the settlement of payments in private transactions?
The uniformity of the good was paramount, and it needed to be recognizable and uniform enough to be countable, divisible to make change, have a low rate of deprecation per transaction, and hold up in value over time. Furthermore, it needed to be stored at low cost and not easily debased or counterfeited, lest the additional supply reduces its value.
It turns out the cigarette did have debasement costs, as traders would routinely dislodge some tobacco from each end and substitute cheaper pipe tobacco. It ended up that the cigarette was not so standard, and a (paid) third-party appraiser needed to be inserted into each transaction to judge the percentage of the cigarette being offered as compared to a standard “full bodied” cigarette. Because of this cost associated with each transaction, the cigarette became compromised as a medium of exchange. The cost per transaction from the use of a private medium of exchange is a differentiator, both then and now.
It is also of great importance to note that accepting a commodity as a medium of exchange only works if the supply can’t easily be expanded, or else the transaction currency’s value would fall over time. That would occur if its supply expanded faster than the supply of goods. In the case of Bitcoin, much has been made of the supposition that the ultimate supply of Bitcoin is limited, but do we really know if that’s the case?
Moreover, when a manufactured good serves as a medium of exchange, there likely be others who will produce close substitutes. The basic economics governing the incentives to produce either more Bitcoin or other cryptocurrencies is the same as any other manufactured good: the supply will expand as long as the market price of crypto is above the marginal cost of producing more crypto. So, when additional crypto supply comes on the market, the price of the original crypto, Bitcoin, falls. Hence, Bitcoin price appreciation is self-limited by new competitors, just as with any manufactured good. What stops Ford from raising prices is the looming Chevrolet in the background, otherwise known as competition.
But the greater threat to Bitcoin as a medium of exchange is the frictional costs to its use for transaction purposes, much as the POW’s cigarette ran into trouble. Transactions in business require a price record — a feature that is perhaps desirable for those trading in illegal goods, but critical to users in a world that requires a price trail in order to report on income and balance sheets and to moreover to report to governments for tax purposes.
That reporting is not just for capital gains but also for sales tax purposes. Another major limit to cryptocurrencies is that they do not have “legal tender” status. Unless stated otherwise, financial obligations in the US are stated in terms of US dollars, so if you tried to pay off your mortgage in crypto-currency, the debt would not be extinguished in US dollars unless the payee released the dollar debt by contract — yet another frictional cost of cryptocurrency.
In addition to cryptocurrency’s utility as a medium of exchange to facilitate transactions, crypto demand — and hence price — depends on the belief that Bitcoin will keep appreciating relative to the cost of future goods.
That is to say, gold, currency and Bitcoin are all evaluated based on their ability to at least keep up with or beat the overall increase in the price level of goods over time. This causes Bitcoin enthusiasts to buy and hold Bitcoin as a hedge against generalized inflation. But the rising price of one crypto will provide incentives to increase the supply of other crypto, and hence limit its supposed inflation-beating properties. Furthermore, the IRS considers cryptocurrency to be a good, and as such, its appreciation is subject to capital gains, whereas standard currency gains are not.
The basic economics of additional supply dictate that Bitcoin will ultimately be no more valuable than the cost of producing more of it. Its prospects of settling in as a transaction medium hinge on whether the cost of a transactions is below the available alternatives. Given these realities, I would advise those techie-cool Bitcoin holders who believe they’re sitting on the transaction medium of the future to cash in their chips while it still commands a premium price, because there’s a good chance that Bitcoin will eventually go the way of alchemy.
January 22, 2018