Unfortunately, Buiter starts talking about Bitcoin, making false analogies between the cryptocurrency and gold. He should have just focused on gold.
As it turns out, both gold and Bitcoin do share some important characteristics. I've written about this here: Why Gold and Bitcoin Make Lousy Money.
The false analogy is in equating the mining of gold with the mining of bitcoin. Paul Krugman made the same mistake here: Adam Smith Hates Bitcoin. Here is the offending passage in Buiter's notes:
John Maynard Keynes once described the Gold Standard as a “barbarous relic”. From a social perspective, gold held by central banks as part of their foreign exchange reserves merits the same label, in our view. The same holds for gold held idle in private vaults as a store of value. The cost and waste involved in getting the gold out of the ground only to but it back under ground in secure vaults is considerable. Mining the ore is environmentally damaging, especially if it involves open pit mining. Refining the gold causes further environmental risks. Historically, gold was extracted from its ores by using mercury, a toxic heavy metal, much of which was released into the atmosphere. Today, cyanide is used instead. While cyanide, another toxic substance, is broken down in the environment, cyanide spills (which occur regularly) can wipe out life in the affected bodies of water. Runoff from the mine or tailing piles can occur long after mining has ceased.
Even though, from a social efficiency perspective, the mining of new gold and the costly storage of existing gold for investment purposes are wasteful activities, they may be individually rational. The same applies to Bitcoin. Its mining is socially wasteful and environmentally damaging.No, no, no and no. This analogy is all wrong.
Let me be clear about this. Bitcoin costs zero to produce. If one had control over the protocol, one could instantly and costlessly create as many bitcoins as one wanted. No environmental waste, no effort needed. The same is not true of gold.
But wait a minute, you might say. Doesn't mining for bitcoins require effort, consume resources, etc.? The answer is, yes, it does. But this fact does not make the analogy correct (though one can certainly understand why the analogy seems to be correct). Let me explain.
The purpose of gold miners is to prospect for gold. The purpose of Bitcoin miners is not to prospect for bitcoins. The purpose of Bitcoin miners is to process payment requests. A bank teller also processes payment requests. To say that miners are mining for bitcoin is like saying that tellers are mining for dollars. Understand? Let me try again.
Gold miners prospect for gold. But they do not necessarily get paid in gold. In fact, if they work for gold companies, they are likely to get paid in dollars. But they could get paid in gold, or anything else, for that matter. How they get paid does not take away their basic function, which is to discover new gold.
Bitcoin miners, like bank tellers, process payments. Miners, like tellers, want to get paid for the service they provide. It really does not matter how they are paid. As it turns out, miners are paid in the form of newly-issued bitcoins (as well as old bitcoins offered as service fees by transactors). But this does not mean that they are "mining for bitcoin" any more than a bank teller is "mining for dollars."
But isn't mining for bitcoin "wasteful?" In a sense, yes, but again, the "waste" here is not the same as the waste associated with commodity money. Again, let me explain.
We live in a "second-best" world, where people lie and cheat. In a first-best world, money would not even be necessary (see my post here: Evil is the Root of All Money). It is unfortunate that we need Bitcoin miners (and tellers) to process payments. But the resources consumed in this process are necessary, given the safeguards that have to enforced to ensure the integrity of the payment system.
The waste associated with mining gold is that in principle, gold money can be replaced by paper money (and please, do not give some weird "out of thin air" argument; see here.) Paper money, like Bitcoin, and unlike gold, is (near) costless to produce.
Note: Of course, the limit on the supply of bitcoin is determined by a community consensus on following the protocol that adopts the 21M limit. Bitcoin advocates argue that this "hardwired" protocol that governs the supply of bitcoin is more reliable and less prone to political manipulation relative to existing central banking systems. This all may be true, but does not take away from my argument above concerning the false analogy between gold and bitcoin.
It seems you've got a scoop here, Dave, since every article I've read on Bitcoin mining discusses the resources expended in the mining, with no mention of mining as a byproduct of payments processing. Can you source this?
ReplyDeleteI think this is well-known in the Bitcoin community. I think Tim Swanson's book covers a lot of ground: http://www.ofnumbers.com/the-anatomy/
DeleteYou can use as a source the bitcoin whitepaper itself, if you wish.
DeleteVery simply, you take a bunch of transactions, add a special transaction from no-one to yourself, use a computationally expensive process to notarize it, and publish that block. If you've followed the rules (for instance, not given yourself more money from nothing than the protocol allows), and you're the first to do it successfully (a question of luck), then your peers in the network will collectively agree on your block as the next block in the chain.
Once that happens, all blocks accepted in the future will build on your block, and thus implicitly assert that they recognize the transfers in it. You have to wait some number of blocks (50, I think) to spend the reward you gave yourself from nothing, though. If you try to spend it before, any block including that transaction would be rejected.
This is hardly a scoop, this is basic about how bitcoin works. But it's good to see a federal reserve economist gets it :)
Thanks, Harald. I know this is hardly a scoop, but it is surprising how the misconception remains present even among those who should know better (and I include some members of the Bitcoin in this group).
DeleteGood post. I expect you could compare it to the cost of preventing counterfeit notes and coins circulating undetected?
ReplyDeleteBut is there a cheaper way to verify the transaction is legit? If there is something inherent in the structure of Bitcoin that makes it more costly to verify, we might say that it is wasteful. Is there a Common Resource problem in "mining", with too many (or potentially too few?) miners all chasing the same fish?
Nick,
DeleteYes, one could compare it to any activity that ensures the integrity of the monetary/payment system.
Is there a cheaper way? The current protocol uses what is called "Proof of Work" and there is very much something like a common resource problem here, with "overinvestment" in computing power (relative to first-best). But the community is working on alternatives, like Proof-of-Stake. But at present, there appear to be trade-offs. Cheaper protocols are also less secure, at least for now. But I expect a big break through in the not to distant future.
David, You are very kind to Mr. Buiter. I find a lot of inaccuracies in his paper, from the incorrect use of the non arbitrage principle to the use of statements such as "most jewelry gold is an investment" (doesn't he have a significant other?).
ReplyDeleteIf you care, read my complete critique @ https://claudiomigliore.wordpress.com/2014/12/01/on-buiter-bubbles-bullion-bitcoin-and-baloney/
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ReplyDeleteNice writing and fun to read!
ReplyDeleteMining is the cheapest way to acquire bitcoin, so it does not only carry the payment task. At the same time, mining cost decide a baseline of exchange rate: If it cost nothing to mine a coin, there will be no one buying (everyone will be mining them instead), thus drop its exchange rate to zero, like many late alt-coins
By the way, money out of thin air is crime, promise is just a promise, you could default any time. For governments that pay the old promise with a new promise, that is actually an ever lasting scam, unfortunately this kind of scam has become the norm in today's financial world, but they all based on the people's trust of fiat money's value, which is only based on trust, nothing else, it is very fragile