Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Thursday, November 12, 2015

Bitcoin and central banking

Economic exchange depends critically on secure and trustworthy payment systems. Because payment systems are fundamentally about recording and communicating information, it should come as no surprise that payment systems have evolved in tandem with advancements in electronic data storage and communications. One exciting development of late is Bitcoin--an algorithmic-based, communally-operated money and payment system. I thought I'd take some time to gather my thoughts on Bitcoin and to ponder how central banks might respond to this innovation.

Bitcoin is open-source software designed to govern a money and payment system without the aid of conventional intermediaries like chartered and central banks. The role of chartered banks as payment processors is replaced by a communal consensus protocol (mining), where transaction histories are recorded on an open ledger (the blockchain). The role of a central bank is replaced by a "fixed" money supply rule (Note: nothing is truly "fixed" in Bitcoin since the community could, in principle, "vote" to change program parameters at subsequent dates. This is true, of course, for any system of governance.)
   
Bitcoin is about as close as we have come to digital cash. And because the bitcoin is in relatively fixed supply (or so we think), people sometimes refer to Bitcoin as managing a digital-gold system.

Let's think about cash for a minute.  Cash is a bearer instrument (ownership is equated with possession). Cash payments are made in a P2P manner, without the aid of an intermediary. When I buy my morning coffee, I debit my wallet of cash and the merchant credits her register by the same amount. There is a finality to the transaction (unless my coffee is cold and the merchant values my future business). To the extent that cash is difficult to counterfeit, it solves the double-spend problem. The use of a cash-based payment system is "permissionless" (no application process is needed to open a cash wallet, no personal information needs to be relinquished to open an account). Relatedly, cash is "censorship-resistant," meaning that you can basically spend it as you see fit. Finally, cash is distributed on an invisible ledger, permitting a degree of anonymity. Cash transactions need not leave a paper trail.
     
The digital money issued by banks is different from cash in several respects. One main difference is that transactions between any two traders must be intermediated by a bank. Transactors implicitly trust the bank to do the proper book-keeping and it is this trust that "solves" the double-spend problem for digital bank money. Bank money is not permissionless. One has to make an application for a bank account and, in the process, relinquish a great deal of personal information that one trusts the bank to keep secure. People who are unable to properly identity themselves are denied conventional banking services (up to 1/4 of American households are estimated to be unbanked or underbanked). Bank money is not censorship resistant--banks may not process certain types of payment requests on your behalf. Of course, bank money leaves a digital trail (albeit on a system of closed ledgers) with your identity clearly attached to a particular transaction history.

So what are the benefits of Bitcoin? The benefits are likely to vary from person to person, but in general, I'd say the following. First, it's monetary policy reduces the "hot potato" motive of economizing on money balances--that is, it offers the prospect of being a decent long-run store of value. Second, anyone with access to the internet can access an account (a public/private key pair) for free--like cash, no permission is needed. The public key is like an account number and the private key is like a password. Account balances remain secure as long as the private key remains secure. Third, like cash, no personal information is necessary to open an account, so no need to worry about securing private information. Fourth, like cash, bitcoin is censorship resistant--no one can prevent you from spending/receiving bitcoin from whomever you like. Fifth, bitcoin can offer a greater degree of anonymity than bank deposit money, but less so than cash (unlike cash, the blockchain ledger is visible and public). Sixth, the entire money supply (blockchain) lives on a replicated distributed ledger--it lives simultaneously everywhere--so that "sending money somewhere" means updating the ledger on all computers everywhere. There are no banks, there are no borders. Seventh, the user cost of transferring value is relatively low.

As I said, the extent to which consumers value these benefits likely depends on a host of factors. I see potentially large benefits to relatively poor individuals who have limited access to conventional banking services. It is estimated that up to one in four U.S. households are unbanked or underbanked--people who must rely on high-cost bill-pay, prepaid debit cards, check cashing services, and payday loans. The benefits are likely to be greater for poor individuals living in high inflation regimes that do not have access to interest-bearing (inflation protected) accounts.

What are the costs of Bitcoin? First, it is not a unit of account. Because of its monetary policy and its unstable demand, its value is quite volatile over short periods of time, making it inconvenient as a payment instrument (even if it is a good long-run store of value). Second, it has the same security properties as cash--losing or forgetting your private key is like losing your wallet. One could employ the services of a third-party in this regard, but if so, then why not just use a bank? Third, although the user cost of Bitcoin is presently low, the social cost (primarily in the form of electricity) is high relative to the cost of operating trusted ledgers. Fourth, because of its cash-like properties, bitcoin can also help facilitate illicit trade. (Of course, the same is true of cash.)

How might the advent of Bitcoin influence central bank thinking?

First, the threat of Bitcoin (and of currency substitutes in general) places constraints on monetary policy. In jurisdictions that finance large amounts government spending through the inflation tax, such a constraint may become binding.

Second, to the extent that bitcoin becomes a significant payment instrument (or even the unit of account), it might open the door to financial instability. Experience demonstrates the private sector's desire for maturity transformation or, more generally, the willingness to act on incentives that make funding illiquid assets with short-term debt a preferred balance sheet structure. The same incentives would presumably be in place in a Bitcoin economy. In principle, demand-like liabilities should trade at a risk premium. But in practice, they may not. Especially in times of economic complacency, they are likely to be viewed as close to perfect substitutes in terms of their money properties, just like bank money and cash today (and the way U.S. treasury debt and senior tranches of private-label MBS were viewed as close collateral substitutes in the repo market prior to 2008). The question is what happens if and when there is a "bank-run" or "roll-over crisis" on such a system? The situation is exacerbated if bitcoin is not the unit of account (think of European banks issuing loans denominated in USD). Since federal deposit insurance may not be available and since no LOLR can issue BTC, a classic bank panic is possible. Central banks and fiscal authorities would have to think about what, if anything, to do in such circumstances. One solution may be to impose narrow banking restrictions for banks (and other entities) engaged in bitcoin-denominated maturity transformation.

My own recommendation is for central banks to consider offering digital money services (possibly even a cryptocurrency) at the retail and wholesale level. There is no reason why, in principle, a central bank could not offer online accounts, the same way the U.S. Treasury presently does (www.treasurydirect.gov). These accounts would obviously not have to be insured. They would provide firms with a safe place to manage their cash without resorting to the banking or shadow banking sector. They would give monetary policy an additional instrument--the ability to pay interest on low-denomination money (possibly at a negative rate). To the extent paper money is displaced, there would be large cost savings as well.

It's hard (for me) to see what the downsides are in having a central bank supply digital money. Critics might argue that it leaves people exposed to potentially poor monetary policy. This may be true and, for these people, currency substitutes should be available (including Bitcoin). In terms of payments, critics might argue that central bank accounts will be permissioned accounts, requiring the release of personal information, application efforts, that KYC restrictions will apply (so not censorship resistant) and so on. To address these concerns, a central bank could go one step further and issue a cryptocurrency (Fedcoin) offered at a fixed exchange rate where payments are cleared using a Bitcoin-inspired anonymous communal consensus algorithm. I don't think we can expect anything like this in the near future, but it is technologically possible. Of course, people will complain that Fedcoin will inspire illicit trade, etc. But again, the same is true of regular central bank issued cash.

There is the question of how such an innovation might impact traditional banking models. I'll leave this question for another post. 

21 comments:

  1. > I debit my wallet of cash and the merchant credits her register

    Your debits and credits are reversed as cash on hand is always an asset, and debiting an asset account increases its balance while crediting decreases its balance.

    > it is not a unit of account

    Its a perfectly valid unit of account and can and should be accounted for in exactly the same manner as any other currency is accounted for when multiple currencies are held.

    > the social cost (primarily in the form of electricity) is high relative to the cost of operating trusted ledgers

    This idea has been debunked many times. The cost to operate Bitcoin is and will always be much lower than the cost to operate the worldde basket of currencies and stores of values once you consider mining precious metals, minting and transporting coins and paper currency, and the power requirements to operate the existing financial institutions that it obsoletes.

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    1. Of course, any object could potentially serve as a unit of account. My point is that BTC is not presently a UoA (contracts are not widely denominated in BTC).

      As for the cost of operating bitcoin, I hear many bitcoin advocates (for example, Erik Voorhees) make the claim I reported. I am not enough of an expert to say one way or the other, however.

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  2. Fixed a typo. :-)

    My response:

    > I debit my wallet of cash and the merchant credits her register

    Your debits and credits are reversed as cash on hand is always an asset, and debiting an asset account increases its balance while crediting decreases its balance.

    > it is not a unit of account

    Its a perfectly valid unit of account and can and should be accounted for in exactly the same manner as any other currency is accounted for when multiple currencies are held.

    > the social cost (primarily in the form of electricity) is high relative to the cost of operating trusted ledgers

    This idea has been debunked many times. The cost to operate Bitcoin is and will always be much lower than the cost to operate the world wide basket of currencies and stores of values once you consider mining precious metals, minting and transporting coins and paper currency, and the power requirements to operate the existing financial institutions that it obsoletes.

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  3. So what are the benefits of Bitcoin?

    I agree with your list of benefits other than perhaps the seventh. I don't think there's any guarantee that on-blockchain transactions will remain cheap as Bitcoin attempts to scale to cope with increased adoption. In my view, Bitcoin's core value proposition is that it’s the first form of money that enables both trustless value transfer and storage. Bitcoin enables you to transfer value (including across distance) without having to trust a central intermediary to properly effectuate that transfer (and without needing their permission). And it allows you to store value without having to trust a central issuer of the currency not to arbitrarily expand its supply.

    What are the costs of Bitcoin? First, it is not a unit of account. Because of its monetary policy and its unstable demand, its value is quite volatile over short periods of time…

    I don’t think it’s fair to blame Bitcoin’s current volatility on its "monetary policy." Bitcoin is volatile because it's tiny and still very much an experiment with an uncertain future. In other words, the problem isn't really that Bitcoin is "too volatile to be money." It's that it’s not yet money enough to be not volatile.

    Second, it has the same security properties as cash--losing or forgetting your private key is like losing your wallet. One could employ the services of a third-party in this regard, but if so, then why not just use a bank?

    You can't make a backup of cash (let alone an unlimited number of backups), encrypt it, or use the equivalent of multi-sig or Shamir's secret sharing algorithm to eliminate the loss of that unique physical item as a single point of failure. You CAN do all of those things with Bitcoin. So I'd say there are some very important differences in their respective security profiles. And even if you decide to use a bank-like service with Bitcoin, Bitcoin's programmable nature means that you have more options than you had with fiat, including options that minimize the counterparty risk you're exposed to. You can store a paper bitcoin wallet in a bank's vault just as easily as a gold bar, but you can't encrypt the gold bar or store a backup of that same bar in a second secure location. Nor does fiat allow for M-of-N-type services where the bank is never given complete control of your funds. Finally, even if you expose yourself to some counterparty risk with a "Bitcoin bank," you don't have to expose yourself to central bank counterparty risk.

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  4. Third, although the user cost of Bitcoin is presently low, the social cost (primarily in the form of electricity) is high relative to the cost of operating trusted ledgers.

    I think a proper accounting of the "social cost" of central banking would show it to be far higher.

    Fourth, because of its cash-like properties, bitcoin can also help facilitate illicit trade.

    True, although some of us who vehemently oppose things like the drug war see this aspect of censorship resistance as a benefit.

    The same incentives would presumably be in place in a Bitcoin economy. In principle, demand-like liabilities should trade at a risk premium. But in practice, they may not. Especially in times of economic complacency, they are likely to be viewed as close to perfect substitutes in terms of their money properties, just like bank money and cash today...

    I don't see that scenario as likely. FRB only operates to expand the money supply when the IOUs for money begin to be treated as the equivalent of money. But this will only occur when the IOUs provide a transactional advantage over the actual money sufficient to compensate for the risk of default. Bitcoin IOUs don't provide a significant transactional advantage over actual bitcoins. (Although this may change if bitcoin is not able to scale in a way that keeps on-blockchain transaction fees reasonably low.) Also, there's no system of implicit and explicit governmental guarantees that would back up the issuers of Bitcoin IOUs to make you indifferent as between the two. And even if the government wanted to make such a guarantee, they couldn't do so credibly precisely because they can't simply conjure new bitcoins into existence.

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    1. The BTC IOUs may not have a transactional advantage, but they will bear interest, where BTC money base cannot (interest being financed by the assets the bank BTC liabilities fund in maturity transformation).

      The government may very well bailout holders of BTC liabilities if they are a sufficiently strong political interest. And the government could do it by taxing the general population (whether people get bailed out in USD or BTC wouldn't matter to them).

      Your point on scaling is also worth noting, thanks!

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    2. Thanks for the reply. BTW, my comment above was actually part two of a longer comment. It looks like part one may have been eaten, but here are some of the other points I wanted to address.

      What are the costs of Bitcoin? First, it is not a unit of account. Because of its monetary policy and its unstable demand, its value is quite volatile over short periods of time, making it inconvenient as a payment instrument (even if it is a good long-run store of value).

      I don't think it's fair to attribute Bitcoin's current volatility to its "monetary policy." It's volatile because it's still a very tiny experiment with an uncertain future. Predictions about Bitcoin's future range from it literally becoming worthless at one extreme to "taking over the world" and completely replacing fiat at the other (which obviously implies a future valuation several orders of magnitude higher than the current one). The price discovery process for something like that is necessarily going to be a messy one. Or think of it like this: Bitcoin isn't "too volatile to be money"; it's not yet money enough to be not volatile.

      Second, it has the same security properties as cash--losing or forgetting your private key is like losing your wallet. One could employ the services of a third-party in this regard, but if so, then why not just use a bank?

      You can't make backups of your physical banknotes (or they'll call you a counterfeiter), can't encrypt them, and can't use the equivalent of multi-sig or Shamir's secret sharing algorithm to eliminate the loss of those unique physical items as a single point of failure. You CAN do all of those things with Bitcoin. So I think there are some very important differences in the respective security profiles of Bitcoin and cash. And even if you decide to use a bank-like service with Bitcoin, Bitcoin's programmable nature means that you have more options than you had with fiat, including options that minimize the counterparty risk you're exposed to when you use those services. You can store a paper bitcoin wallet in a bank's vault just as easily as a gold bar, but you can't encrypt the gold bar or store a backup of that same bar in a second secure location. Nor does fiat allow for M-of-N-type services where the bank is never given complete control of your funds. And even if using a "Bitcoin bank" exposes you to some counterparty risk, you're not exposed to central bank counterpary risk.

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  5. If you're happy enough with the Fed's management of money supply, you don't really need a blockchain. So put blockchains aside: What's the material difference between creating this Fedcoin and just telling PayPal they no longer have to comply with KYC laws?

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    1. Michael,

      One issue with your proposal is that the government cannot commit to never seizing Paypal records. If payments were cleared by anonymous nodes on a blockchain, such a commitment is not necessary.

      But you make a valid point nevertheless!

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    2. I don't see how transactions between anonymous PayPal accounts are materially different to users than transactions between anonymous bitcoin addresses.

      The visibility of ledger transaction history actually seems better for PayPal -- tx history is fully public for Bitcoin, but private unless seized for PayPal.

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  6. Hey David,

    Seems to me the best way to think of bitcoin is as a virtual commodity, being such I don't see how its proliferation puts any new constraints on monetary policy. You wouldn't suggest that new oil discoveries place constraints on monetary policy would you? I guess I should rephrase that, they wouldn't put any new constraints or constraints which couldn't be managed with the same tools by which we currently manage constraints.

    The thing is bitcoin still requires dollars/euros etc to be effective, they are purchased with dollars so the dollar/euro is still the ultimate accounting unit. Im not sure it poses much of a problem, except to the people who own bitcoins thinking they are a safer more stable currency....... buyer beware!

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    1. Seems to me the best way to think of bitcoin is as a virtual commodity, being such I don't see how its proliferation puts any new constraints on monetary policy. You wouldn't suggest that new oil discoveries place constraints on monetary policy would you?

      Bitcoin can absolutely be thought of as a commodity. The difference between Bitcoin and something like oil or even gold is that Bitcoin a purely digital commodity. Physical commodities (especially precious metals) might be relatively well-suited to perform the "store of value" function of money thanks to their reliable scarcity. But, from the perspective of a modern global economy, they're not at all well-suited to serve the "medium of exchange" function because of their relatively huge transaction costs. Obviously, you could use gold IOUs as money, but that's far from ideal because it reintroduces counterparty risk. A system of gold IOUs also requires a centralized backer who promises to redeem the IOUs for gold. Centralization means that states who don't like the competition with their own currencies have a single target to attack. (See the story of egold.) Because Bitcoin combines the reliable scarcity of a commodity (and indeed offers perfect scarcity) with the transactional efficiency of a purely digital medium (and does so in a trustless, censorship-resistant manner), it -- at least potentially -- poses a greater competitive threat to state-issued currencies than anything that's come before.

      The thing is bitcoin still requires dollars/euros etc to be effective, they are purchased with dollars so the dollar/euro is still the ultimate accounting unit.

      Of course that's true for now. Unit of account status / success as a direct medium of exchange requires a much, much larger network effect than Bitcoin has now. If Bitcoin is ever going to bootstrap itself to success on that scale, it's not something that will happen overnight.

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  7. You can use anything countable as a unit of account, including fallen leaves and dead guppies. Of course, dead fish don't work very well as a store of value, their value goes from tasty to stinky pretty rapidly. Bitcoin jumped the shark as a store of value (no fishy allusion intended) some time ago when the closest thing that it has to a central authority, the Bitcoin foundation, stopped denominating membership fees in bitcoin and set the price in dollars, although they still accept payment in bitcoin, at whatever the current exchange rate is.

    Without a central bank to keep the value fixed and prevent inflation or deflation, a bitcoin is just another limited-edition collectible, like old master paintings or baseball cards. Does anyone remember pogs? They were very valuable in their heyday, and even look sort of like coins..

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  8. Fractional reserve on the bitcoin blockchain?

    Please tell me more about how you are an expert on BitCoin. lol.

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    1. First, I did not claim to be an expert on Bitcoin.

      Second, I did not say anything about fractional reserve banking on the bitcoin blockchain. The bank liabilities promising redemption in BTC would obviously be off chain.

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  9. I can see why a central bank might want to issue digital currency, but why would it want to issue a cryptocurrency? And, particularly, why would it issue something like Bitcoin, which happens to be an extremely inefficient way of making value transfers? The one problem that Bitcoin solves (uncensorable value transfer) is a problem that neither banks nor central banks have. Fed-PESA? Maybe. Fed-COIN? Pointless. Fed-Pal with open API access? A platform for the new economy.

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    1. David,

      You ask a good question. Let me try to answer it.

      First, the Fed already issues a digital money. Presently, this is in the form of reserves, and only banks can use this type of Fed money (which can be converted into cash of course).

      I would like to see the Fed make its digital money available to everyone, either directly (the way the Treasury does), or indirectly, through segregated bank accounts backed 100% with reserves.

      Fed money is great but it is not digital cash. I define digital cash to be digital money that has the additional cash-like attributes: (1) a bearer instrument, (2) permissionless, (3) censorship-resistant, and (4) low user cost.

      To the extent that the Fed might want to offer a digital cash instrument, how might it do it? This is the question I was trying to answer. And having the Fed issue a Fedcoin object with an exchange rate tied to digital Fed money was just *one* solution I came up with. There may be others.

      Of course, maybe the Fed doesn't want to issue a digital money.

      What is Fed-Pal with open API access? Can you explain?

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  10. > "And because the bitcoin is in relatively fixed supply (or so we think)"

    What do you mean with "so we think"?

    That's a matematically provable statement, and that's not quite common in Economics :)

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    1. What I mean is that Bitcoin is a computer code--a set of instructions with assigned parameter values. These rules and parameter values are subject to change (indeed, the code has evolved over time). There is presently a debate over whether to change block size. In principle, a similar debate could occur at some future date over the money supply.

      Note: it is no accident that Satoshi programmed an inflation tax to finance miner activity in the early stages. I think what people might find is that money creation is an efficient way to financing mining. But we shall see. :)

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  11. I get your point, and of course in theory all the rules of the system could be changed, but just in theory.

    The block size debate should give some hint on that subject: since a trivial change that simply enables to process more transaction (and hence his utility) without absolutely not touching any other aspect is very hard to push, you can imagine the resistance in even only beginning to propose to change some fundamental parameter like coin creation.

    The probability to reach consensus on such a drastic change is completely negligible: it's far simpler to start an altcoin, and indeed that's what it has been done thousand of times.

    The Bitcoin network is extremely resistant to change, maybe to an extent never seen before.

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    1. No, it's not "just in theory." It is reality. The rules of Bitcoin *have* changed over time.

      And given the right circumstances, they *could* change again (in the manner I'm suggesting). This is not theory. This is a fact.

      What you are arguing, correctly I think, is that the contingency in which a majority of interests agree on increasing the money supply parameter is a very low (but not zero) probability event.

      Well, we shall see. History is full of close-to-zero probability events that surprised everyone when they occurred! :)

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