Bitcoin As A Vindication Of Mainstream Monetary Economics

Say what you want about the backers of Bitcoin, they managed to create a currency unit that acts in the insane fashion that matches the way money works in mainstream economic models. For anyone with any attachment to reality, it offers a very good real world explanation why the DSGE approach to economics is inherently useless.

Is Bitcoin a Bubble?

The major question my readers probably have is: is Bitcoin a bubble? My response is straightforward: what do you think?

That said, anyone who wants to short the various crypto-currencies should probably pour themselves a stiff drink, and read between the lines from the following theoretical rant. You need to ask yourself: how prudent is it to short something that has a "fair value" that is arbitrarily large?

I was a junior analyst during the dot-com era. The most reliable road to ruin was to pay attention to what internet analysts had to say. It's a speculative vehicle. Ignore stories; read charts.

What Pins Down The Initial Price Level?

If you are even slightly numerate and look at standard DSGE models (that do not include money in the utility function, see below), you see that that they offer a wonderfully complex characterisation of the relationship between the price level from the initial time period and later time periods. That said, there is absolutely nothing that pins down the initial price level. (The Calvo fairy says that some prices will be set from the previous period, which raises various chicken-and-egg questions.)

(Relative prices like wages/goods prices, are pinned down, even in the first period.)

If we are in standard framework, with one (composite) good and money, there is nothing to pin down the exchange rate between money and that good. We know what the rate of change of the good will be, (the ratio of its price between this period and the next), but that's it.

There's a number of ways to deal with this indeterminacy.

• The central bank magically sets the price level. In other words, every Canadian wakes up every morning, and waits for the price level announcement from the Bank of Canada, and then go off to work. This apparently is the consensus opinion.
• The "money in the utility function" kludge. You stick the household's money balance into the utility function. This pins down the relative value between money and the composite good. That said, there is absolutely no microfoundational story to explain this kludge; it's just an arbitrary term introduced to make it possible to fit the model to data. We have no idea where this factor comes from, or how it could change.
• A cash-in-advance constraint. You put an arbitrary limit on how many transactions can be supported by an amount of money. This is pretty much the same thing as assuming that velocity is fixed (or a stable function of something or another). The whole Monetarist nonsense peddled by various hucksters relied upon the apparent stability of velocity in the 1950s.
• The fiscal theory of the price level. You impose a relatively arbitrary governmental budget constraint on your model, you do the mathematics, and you back out that the price level is the level that equates the real value of government debt to the discounted values of future primary surpluses. Although this is the correct mathematical answer, the profession slaps its hands over their ears and goes "la-la-la" when people bring it up. The reason being that the Fiscal Theory of the Price Level makes even stupider predictions than the belief that the central bank arbitrarily sets the price level. For example, the price level was supposed to jump a lot when the Republicans made it clear that they wanted to ram a tax cut through.

The reader would notice that these explanations are either obviously wrong or trivial (the price level is what it is).

Inching Towards the Real World

If we start to take into account the various things that are stripped out of DSGE models, we can start to get a better idea of what pins down the price level.

The first step to notice is that most people have debts denominated in the local currency. Let's say you woke up morning with a house and a car, and a $100,000 mortgage on your house. You have no other fixed ideas about prices. Then imagine that a free market fundamentalist tells you that fiat currency is inherently worthless, and offers you $100,000 for your car. You can think about: do I value the mortgage or the car more? This creates a way of determining the relative value.

However, the fact that we live in a capitalist society offers a better idea of how to pin down the value of a currency. The system is dominated by capitalists. What do capitalists do? For various reasons, people want to think that capitalists shuffle around paper claims on equity. That is the wrong answer. The correct answer is the scarily Marxist one: capitalists exploit employ workers. 

In other words, the value of currency is determined by how much labour a unit of currency commands.

(It should be noted that this leads to the Modern Monetary Theory arguments about price level determination: the Job Guarantee wage creates a nominal anchor for the currency.)

And as I repeatedly note, this breaks down if we start indexing wages to an external unit. A hyperinflation results when the value of the local currency versus the index unit goes to zero.

Back to Bitcoin

The techno-anarcho-crypto-Libertarians who brought us Bitcoin (and whatever other crypto-currencies you want to think of) have taken free market economics to its logical conclusion. They have created a currency unit that has no nominal anchors for value whatsoever.

At the time of writing, almost nobody has debts denominated in Bitcoin. A wage denominated in Bitcoin would probably run afoul of various labour regulations, and I doubt that most wage slaves workers would be willing to work for a fixed Bitcoin wage. (Since most people have fixed expenditures that are north of 90% of their after-tax wage, there is not a lot of room for currency volatility.)

Therefore, the price of Bitcoin is exactly as free as would be predicted by DSGE models. There is no central bank to magically set the price level. There is no government to do the Fiscal Theory of the Price Level thing. Since most non-speculative transactions are just a way to avoid bank intermediation, there is no "Bitcoin-in-advance" constraint. Even if 99.99% of Bitcoin are hoarded, the remaining 0.01% float would be enough to support transactions.

The only thing that will bring this wonderful natural experiment to an end is the inevitable march of energy constraints, or an outraged populace with pitchforks and torches forces the regulators to shut this puppy down.

But in the meantime, mainstream economists should pat themselves on the back for coming up with models that perfectly explain Bitcoin dynamics. Well done!

Addendum: What if We Treat Bitcoin Like a Commodity?

We could come up with a fair value estimate for Bitcoin if we treat it like a commodity (a parallel that the crypto-gold bugs played up in the marketing of this scheme). The fair value is related to the energy cost of mining Bitcoin -- just like mining gold!

If Bitcoin miners hedging programmes were large enough, they might be able to cap the dollar Bitcoin price at the cost of production. This could be aided by large holders who view that as the fair value. However, this will only work if they are willing to sell, and they do not believe their own press releases. (Think about how gold bugs hate the hedging programmes of gold miners.) However, the ability of these hedging programmes to hold a lid on prices when faced by a speculative wave is limited by the size of the programmes, which is probably much smaller than the supply of greater fools.

This cost of production is less useful on the way down. Unless miners want to double down on losing Bitcoin positions, all they can do is slow down mining. (Stopping mining would be putting a fork into this sucker.)

Another possible alternative is that some large actor steps in to create a nominal anchor. A real world commodity producer could offer commodities at a fixed Bitcoin price. Alternative a cartel of large holders could decide to fix a price, and then use their market power to keep trading near the target. However, such price fixing attempts would be susceptible to runs (and/or various anti-cartel regulations).

The problem with offering goods for sale at a fixed BTC price is that your expenses are probably not fixed in BTC terms. It might be possible in some cases, but it would be relatively rare.

I will offer an analysis from my own perspective. For example, if I sold my ebooks on my own sales platform, I could offer them at a fixed BTC price. I could do that relatively safely, since my marginal cost of production is near zero. However, I could not do that for paperback editions, since I do have a relatively large dollar (or GBP/EUR) fixed cost of production. Furthermore, putting the book up for a fixed BTC price would mean that I could not post a USD price, as otherwise I just end up arbing myself. Meanwhile, I would be sitting duck for Revenue Canada. They could use whatever random BTC quote they can get to make it look like I made a fortune selling the books, and I would end up owing a large CAD-denominated tax bill. (The fact that I probably would have translated the profit at different prices could be chalked up as capital losses -- and I would have no corresponding capital gains to offset them with!) Since I am not a complete idiot, I leave the sales to the online retailers. They can sell the books to customers using crypto-kitties if they wish; they just need to send me my fiat currency-denominated royalties.

In any event, if the price stabilises as a result of such forces, it can no longer be treated as a currency using mainstream analysis. The value of Bitcoin would be largely determined by a fairly arbitrary price relationship to an existing fiat currency. Unless energy production costs are expressed in Bitcoin, a linkage to energy costs is actually a linkage to the dollar cost of production and so is not derived from the Bitcoin economy itself. (Although not all energy is produced in the United States, most energy producers have a semi-dollarised economy, or are developed countries whose currencies are relatively stable versus the USD. Compared to the volatility of BTC, energy prices look pretty close to fixed in USD terms.) This is unlike the situation during the Gold Standard, where the cost of mining gold was set in currencies themselves linked to gold.

In any event, mainstream macro theory would revert to having no useful predictive powers.

(c) Brian Romanchuk 2017