Reflections on Bitcoin

Subverting the concept of “legal currency”

I have been thinking about this question recently: Would Milton Freedman, the great economist who founded the theory of monetarism, support a new thing like Bitcoin?

As an amateur in economics, I cannot give a very confident answer to this question. But I think that another great liberal fighter in the 20th century, Friedrich A. Hayek, who won the Nobel Prize in Economics like Friedman, and his Austrian School of Economics would certainly applaud Bitcoin. In fact, I guess Friedman would probably agree with the basic concept of Bitcoin, but he might make some technical improvements to it. I will talk about this later.

Liberal economists such as Hayek and Friedman have always been vigilant about government power as the greatest potential force for doing evil. They believe that creating inflation through excessive money issuance, thereby covertly plundering people's wealth, is the simplest, least noticeable, and therefore most commonly used means for the government to do evil in the economy. In their view, inflation is actually a hidden tax that cleverly circumvents voter supervision - in constitutional countries, the power to collect taxes is in the hands of parliament.

Therefore, the Austrian School of Economics and Hayek opposed the so-called "fiat currency" system monopolized by the government and advocated returning to the traditional open and competitive monetary system. However, Friedman concluded through his profound research on the monetary history of the United States that the "commodity currency" traditionally supplied by private institutions is difficult to maintain in the modern credit society due to its own supply limitations. His suggestion is to abolish the Federal Reserve's power to independently formulate monetary policy and downgrade it to a currency issuance execution department under the supervision of Congress (similar to a cashier in the financial field), and the issuance of currency will automatically increase year by year at a predetermined fixed ratio linked to GDP growth - for example, 2%. He believes that this will eliminate inflation once and for all.

In my previous article, I briefly explained the characteristics and advantages of Bitcoin, a virtual currency: it is a decentralized currency attempt, and its total amount is constant, which means that no person or organization can create inflation by overissuing currency, thus completely solving Friedman's biggest concern with technical means. At the same time, because it is a point-to-point decentralized transaction, its system will not be completely destroyed, and there is no risk of the central settlement system failure causing the overall transaction system to be paralyzed. In addition, Bitcoin has the following advantages: 1. It circulates globally without borders, bypassing foreign exchange controls; 2. There is no seigniorage, and transactions are simple and cost-effective; 3. It is easy to store (the "electronic wallet" kept by the "private key" password can be kept online or stored offline), and there is no problem of theft and counterfeit currency; 4. Anonymous transactions, maximum privacy protection... ("Bitcoin's "Stress Test", see the "Observer" edition of the Economic Observer published on March 17, 2014)

As a result, Bitcoin has overturned the concept of so-called "legal currency" that was previously issued and monopolized by the government and seemed sacred and inviolable, allowing anarchist geeks who harbor technological utopian ideals to feel unprecedented freedom, equality and openness.

The above advantages of Bitcoin have even been tacitly acknowledged by the European Central Bank. In a survey report on virtual currencies released in October 2012, it explained: "Bitcoin is a decentralized system - at least in theory - there is no central organizer who can destroy the system and run away with the money." The European Central Bank disagrees with the extreme statement of some people that Bitcoin speculation is comparable to a "Ponzi scheme". It believes that no one seems to benefit from this system. As for those who make money from changes in the Bitcoin exchange rate and the miners who work hard to "mine" Bitcoin, their benefits are not unfair.

Bitcoin fans have also pointed out without basis that countries where Bitcoin is popular are all countries with relatively serious inflation (or potential inflation ), the most typical example being Cyprus, which is deeply mired in a sovereign debt crisis. This also proves from the opposite side that Bitcoin is indeed a good practical attempt at Friedman's monetary theory (the essence of monetarism can be summarized in one sentence: "inflation is a monetary phenomenon").

By the way, I have seen many media reports and comments calling Bitcoin "the first decentralized attempt in the history of human currency", which is a serious mistake. On the contrary, the centralized "fiat currency" system led by the government and guaranteed by the state is actually only a hundred years old. Of course, this does not mean that there was no official currency issued by the government in history. Official currencies have a long history, but for most of human history, they are not monopolistic and exclusive, but serve as intermediaries for commodity circulation together with precious metals and private currencies. In most cases, they are often at a disadvantage in the market competition with "hard" commodity currencies such as gold and silver.

In my opinion, the most similar thing to Bitcoin, a "virtual currency" that many people find difficult to understand, is precisely the oldest currency: gold. From the creation and circulation model of Bitcoin, it almost completely imitates the mining and use process of gold, except that it is a kind of "digital gold" in the Internet age.

What makes money money?

This understanding prompts us to further explore the fundamental question of "what is money?" A more accurate way to express this question is: What makes "money" "money"?

When the media and commentators took it for granted that Bitcoin was a "virtual currency," a loyal Bitcoin supporter wrote insightfully: Are the numbers recorded in the magnetic stripes of our bank cards "physical currency" simply because it is issued by the government?

This is indeed very true.

As a medium of exchange for goods (and services), the evolution of money throughout human history can be roughly divided into the following stages:

In the early days of human society, there was no currency and barter was the only way.

As the market scale gradually expanded, when barter was no longer able to handle long-distance, long-term and multi-level commodity exchanges, humans entered the commodity currency stage. The biggest feature of commodity currency is that it has the same value as the goods to be exchanged. It is usually a commodity with stable physical and chemical properties (easy to preserve) and easy to carry. Around the world, many commodities in history - from jewelry, shells to salt and tobacco - have served as currencies, and the most typical of them are of course precious metals such as gold and silver. Therefore, in the commodity currency stage, the creation of currency mainly depends on the discovery and smelting of these precious metal deposits.

But even precious metals still have the disadvantages of being inconvenient to carry (trade) and easy to lose (theft and robbery). More fatally, as Friedman pointed out, the supply of commodity money will be extremely unbalanced due to the excavation of precious metal deposits. In other words, the growth of the amount of money in the market is very unstable, thus causing inflation and deflation from time to time.

Some economic historians have pointed out that the rapid decline of the once invincible Spanish Empire 500 years ago was closely related to the large amount of gold and silver treasures it plundered from the Indians after discovering the New World [ 1.25% Fund Research Report] - when these priceless "trophies" were transported back to the Iberian Peninsula from the American continent in shiploads, it was actually equivalent to issuing a large amount of currency in a short period of time, causing Spain to fall into serious inflation, causing most of the middle and lower classes who could not get a share of the colonial plunder to fall into economic difficulties, and thus triggering a series of social contradictions...

With the establishment of the modern nation-state sovereignty system, the history of human currency has entered the third stage, the era of credit currency, which is the era we are currently in. At this time, whether the currency is made of metal, printed on paper, or recorded in computers and magnetic cards, it itself has no value (or only has a very small value, that is, the material cost of the banknote), and its value in market exchange depends on people's trust in it.

It should be pointed out that in the early stage of credit currency, although the government also issued currency (in China, there were "official currencies" such as "knife coins" issued by the authorities more than 2,000 years ago), private institutions still played a dominant role in currency issuance (in China, money houses have a long history of issuing "silver bills"). There is a free competition relationship between different private currencies and between them and national currencies, and their actual purchasing power is often not completely consistent with their face value due to the different credit ratings of their issuing institutions in the minds of the people.

The so-called "legal currency" currently circulated in countries around the world was born after humans invented the central bank system. Its biggest characteristics are monopoly and compulsion, that is, it can only and must be used in market transactions that are officially recognized and guaranteed. This status is established by the state through laws, and its credit is of course guaranteed by national sovereignty. There are many different opinions in the academic community about when the central bank appeared. It is generally believed that the Bank of England, established in 1694, is the world's first financial institution with the prototype of a central bank. But it is certain that the modern central bank system was born in the early 20th century, marked by the establishment of the Federal Reserve System in the United States at the end of 1913.

It should also be pointed out that although private currency in large-scale circulation no longer exists with the dominance of legal tender, this does not mean that it has completely withdrawn from the stage of history. The "meal ticket" of the unit that almost everyone has used is a kind of "quasi-private currency". Experience also tells us that in large enterprises or universities with tens of thousands of employees (faculty and students), meal tickets can often be used to buy many other goods in the canteen, and are also often used for payment and lending between individuals. In addition, various token shopping coupons , coupons, points cards, and even the "public transportation card" currently available in many large cities in China can all be regarded as "private currency" or "quasi-private currency". In fact, due to many objective reasons, private currency cannot be banned.

The above brief review of the world's monetary history tells us that the essence of currency is credit - what makes "money" "money" is the common confidence that people place in it. From this we can also conclude that "legal tender" is not the only form of currency. The current financial system, in which the central bank monopolizes the issuance of legal tender and its supervision, may not be as sacred and self-evident as many people think. And defining a currency as "physical" or "virtual" is, after all, a false proposition.

Moreover, as the Austrian School and monetarists mentioned above have concluded, compared with commodity currencies mainly issued by private institutions, fiat currencies also have inherent defects that are difficult to overcome - based on basic human nature, we cannot guarantee that any government is responsible at all times, let alone that it is able to take responsibility for its promises under any circumstances. The repeated hyperinflation in modern history has irrefutably proved that the state has no way to fundamentally solve the problem of the stability of the fiat currency value. And the financial and economic crises that are essentially caused by this (look at the situation of the euro in Mediterranean countries!), haven't we seen enough?

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The credit of legal tender is based on the guarantee of national sovereignty, but this is only one side of this shiny coin with the portraits of the king and the president. The other side is the coercion of the state. This means that the public's trust in it is not truly spontaneous and autonomous, but forced to exclude other options. On the contrary, private currency is naturally not mandatory and exclusive because it has no national guarantee. Confidence in it is purely based on the free choice of the market. In addition, because it is highly linked to national sovereignty, legal tender is inevitably accompanied by cumbersome and complicated procedures and the resulting high costs in the process of cross-border payments...

All of these highlight the advantages of private virtual currencies represented by Bitcoin. Therefore, since legal tender and the central bank system are the products of the financial capitalism era in the 20th century, when humans enter the Internet era in the 21st century, why can't there be a new monetary system that is more compatible with it?

Inherent flaws in currency

But as a product of human design rather than the result of natural selection, Bitcoin, like fiat currency, has major flaws.

I have mentioned in my previous article that some people - especially those in the government - regard the anonymity of Bitcoin, the difficulty in tracing it after it is stolen, the difficulty in regulation, and the convenience it provides for illegal transactions (money laundering, drug trafficking, etc.) as sufficient reasons why Bitcoin should not continue to exist. This is obviously logically untenable.

In fact, the opposite of these so-called "shortcomings" is precisely the great strengths that Bitcoin has already shown in cross-border remittances and payments, which even former Federal Reserve Chairman Ben Bernanke has highly praised. As for security issues, just like the theft of property happening all the time around the world, no currency can be completely secure. Bitcoin, which has electronic transaction records, is at least no less secure than cash.

Some people also believe that even if more and more people in the world accept Bitcoin, it is unlikely to be accepted as a reserve currency by governments, and it is unlikely to become a settlement currency for international capital market transactions in the short term, so it does not have the complete functions of a real currency. In my opinion, this kind of comment can only show the ignorance and prejudice of commentators who have deep-rooted "legal currency myths" in their minds about Bitcoin - isn't the original intention of Bitcoin's design to subvert the current legal currency system with the above-mentioned mandatory functions?

The fatal flaw of Bitcoin lies in the unchangeable "mining" formula embedded in its design: first, it has a fixed total of 21 million coins; second, the difficulty of "mining" will become increasingly greater. In fact, as the marginal benefits of "mining" sharply decrease, it is quite doubtful whether all 21 million Bitcoins will eventually be mined. Obviously, this is entirely to imitate the mining model of precious metal deposits such as gold.

But while the extremely smart Satoshi Nakamoto showed amazing mathematical and computer talents, he seemed to lack some basic financial knowledge. If a currency cannot provide a continuous supply, it will have no future. People with some knowledge of finance and economic history know that the gold standard collapsed for this reason. Thanks to the in-depth research of Friedman and others, we now understand more and more clearly that the reason why the Great Depression in the 1930s was so severe was largely related to the constraints of the gold standard - insufficient money supply led to the depletion of liquidity, which in turn caused a large area of ​​the real economy to "lack blood" and die...

According to the current generation rules of Bitcoin, if it becomes the dominant currency in the economy one day in the future, global deflation will inevitably occur. Because in a normal economy, with the improvement of labor productivity, the growth of goods and services output is inevitable. But if the currency circulating in the market cannot grow synchronously, then the purchasing power of the currency will inevitably increase gradually, that is, the money will become more and more valuable. Conversely, the prices of goods and services will gradually fall, which is deflation.

Having experienced the Great Depression and the baptism of Keynesianism, most economists now believe that deflation will cause greater damage to the economy than inflation.

To make matters worse for Bitcoin, since people know that its supply is capped and the day when it will be reached is not far away, people will have a stronger expectation that it will continue to appreciate rapidly. In this case, more and more people will choose to hoard Bitcoin as an investment with a high return rate, rather than using it in daily transactions. This kind of crazy speculation was clearly seen in 2013, long before Bitcoin officially ascended the throne of "global currency", and it will in turn exacerbate the occurrence and degree of deflation.

If Bitcoin really becomes a world currency one day in the future, then after overcoming inflation once and for all, it will bring a harm to the economy that may be more serious than inflation.

In fact, as a currency becomes more and more valuable as an investment, it moves further and further away from its true monetary attributes.

Recently, I have seen some staunch supporters of Bitcoin write articles to refute the "Bitcoin causes deflation theory". They are highly intelligent and have used a lot of professional knowledge in mathematics and economics, and even the most cutting-edge new theories. I think we should admit that, first, the statement that "deflation is harmful to the economy" is far from being an undisputed conclusion; second, the "Bitcoin causes deflation theory" is only a hypothesis that seems to be very likely to be true, after all, it is not a fact that has already happened. However, even if these are put aside, the collapse of the gold standard in the 20th century is an indisputable fact.

In other words, in the future, Bitcoin may become more and more valuable like gold, and in some special stages, generally during economic depressions, it may even show enviable potential for value preservation and appreciation. But this only proves the vitality and value of Bitcoin, a digital virtual wealth, rather than its monetary function. Ironically, it is these advantages that will make it lose its qualification to be among the future currencies, just like the fate of gold in the modern economy.

The exploration of digital virtual currency will continue

Bitcoin's magical performance in the past two years has once again aroused the world's curiosity and expectations about virtual currency, and the above-mentioned inherent defects of Bitcoin have also inspired people's enthusiasm for improving digital virtual currency.

In the past one or two years, there are dozens of versions of virtual currencies similar to Bitcoin, including Litecoin (Chinese name "Litecoin", the most famous among them), DevCoin, NameCoin, PpCoin, altcoin, peercoin, greekyogurtcoin, weezercoin, prolecoin... Some of them have made improvements to Bitcoin, such as setting a larger supply limit or simply allowing unlimited supply increases. However, the vast majority of these virtual currencies have a small number of users and circulation, and are often only used in a small circle in a certain field.

After the People's Bank of China banned financial institutions from handling Bitcoin business in December last year, many people thought that the future of virtual currency in China had come to an end. But in fact, virtual currency has never been unfamiliar to the Chinese. As early as 2002, seven years before the emergence of Bitcoin, the famous Tencent company had developed a virtual currency called "Q Coin", and there may have been no similar products in the West at that time. In 2009, the year when Bitcoin was officially born, Chinese regulatory authorities also made strict restrictions on the use of "Q Coin".

In its research report, the European Central Bank divides virtual currencies into three categories from the perspective of the interaction between virtual currencies and the real economy: closed virtual currencies - which have almost no connection with the real economy and are usually used in games, such as Blizzard Entertainment's World of Warcraft Gold and Linden Laboratory's Linden Dollars; virtual currencies with one-way currency flow (usually inflows) - which can be converted into virtual currencies with cash according to the exchange rate and then used to purchase virtual goods or services. With a few exceptions, they can be used to purchase physical goods or services, such as Tencent's Q coins, Facebook's Facebook Credits, and Amazon's Amazon Coins; virtual currencies with two-way currency flow - similar to other general currencies, they have a buying and selling exchange rate and can support the purchase and sale of virtual and physical goods and services. Bitcoin is a typical example.

According to research by the European Central Bank, in 2011 alone, the volume of virtual currency transactions in the United States reached around US$ 2 billion, exceeding the total GDP of some small countries.

Bitcoin is therefore likely to be the most notable experiment so far in a long line of digital payments and virtual currencies. The recent crisis exposed by the Mt. Gox incident only shows that the changes it has triggered have just begun. Whatever happens, the exploration of digital virtual currencies will continue. As for the fate of Bitcoin, a special virtual currency itself, the most likely possibility is that it will die in competition. By the time the last Bitcoin is mined in 2140, it may have been replaced by other virtual currencies. Of course, the market will decide which or which virtual currency systems will eventually survive and how they survive.

Sometimes, technological change does bring about unstoppable social and economic changes. In most countries in the world, the postal service was once a national monopoly, but the rise of the express delivery industry posed a huge challenge to it. Even if the government strongly prohibits the private express delivery industry in order to maintain the interests of the postal monopoly, it can do nothing about email. By the same token, for digital virtual currencies represented by Bitcoin, the government as a regulator may eventually have to join this revolution, whether actively or passively.

Government involvement can take two different forms:

First, virtual currencies are regulated as an alternative to legal tender. It is reported that financial regulatory authorities in Canada, Singapore and other countries have planned to include Bitcoin in their regulatory scope. In the United States, Benjamin Lawsky, director of the New York State Department of Financial Services, who has been paying close attention to Bitcoin for several years, has also proposed to strengthen the management of virtual currency companies by issuing "bitlicences". The government hopes that this kind of regulation will curb criminal activities such as exchange rate manipulation and money laundering using virtual currencies, and include their impact on market liquidity and inflation in the scope of conventional monetary policy considerations.

Secondly, a more proactive response is to comply with the needs of the Internet era and issue a "digital version" of legal tender. Some economists have proposed that this "digital dollar" or "digital euro" can fully absorb the advantages of Bitcoin's borderlessness, low transaction costs, and convenient transactions. In the future, people in any corner of the world can obtain and use digital legal tender that is guaranteed by the sovereign of the issuing country with just a click of the mouse. They are optimistic that this will be a win-win solution that takes the strengths of Bitcoin and makes up for its weaknesses.

However, there is a paradox that can never be overcome: no matter which way, as long as the government gets involved, Satoshi Nakamoto’s grand ideal will immediately collapse by half - the fundamental purpose of his inventing Bitcoin with so much effort is to get rid of the government.

Just as security and yield are two sides of the same coin, the charm of Bitcoin and the risks it contains are inseparable. From an ultimate perspective, it is difficult to reconcile the freedom, equality, and openness that Satoshi Nakamoto and his fans place on Bitcoin with the strict supervision required by the financial services industry and the reliable services that customers need. I believe this problem also troubled Milton Friedman. Of course, the latter may further believe that the government cannot provide the security and reliability it promises.

In the foreseeable future, legal tender, which is closely linked to national sovereignty, will not disappear. However, the emergence of private virtual currencies based on Internet technology will certainly pose an increasingly powerful challenge to the legal tender system, even if it cannot replace it. This is of great benefit to us in thinking about the nature of currency and then improving it.