Bitcoin and another radical Idea on Money

Strangely enough, I stumbled on Bitcoin only a few days ago while checking up on one of the stranger blogs I read from time to time. If you are not familiar with Bitcoin, now it’s about time to become familiar with it.

Funnily enough, it took me only about 10 minutes to be sold on it – simply because I have spent the last three years thinking about the question of how one could create a currency with a fixed base so as to completely eliminate inflation – as well as deflation.

I think I had come up with a rather decent solution, given that I don’t know much about coding, cryptology, networks, or anything else that would actually be required to implement it. Please take the time to read it – not because I want to propose it as an alternative to Bitcoin, but simply because it will make it easier for you to understand why I am so damn impressed by Bitcoin. I thought my system was pretty clever – but it doesn’t hold a candle to Bitcoin.

Here’s my idea:

The basic idea of my system was to have somebody who produces useful products issue a limited number of digital tokens along with their products (similar to Canadian Tire money, but with the difference that after issuing x number of tokens, the issuance would stop).

People would be free to use these tokens to redeem for the company’s products, as well as freely trade them among each other. Every transaction of tokens would go through the company’s central computer, and the company could – and probably would – deduct a tiny fraction of of every transaction as a fee.

My expectation was that the tokens would eventually used by people to buy products other than those manufactured/sold by the issuing company, and thereby broaden the range of goods that can be purchased for it. While still ‘backed’ by the issuing company’s goods/services, the currency would increasingly be ‘backed’ by the goods/services of everybody else who is using the currency to buy goods/services.

The issuing company would take a cut of every transaction, and since the currency would become good for the purchase of goods/services other than those produced by the issuing company, it would be able to use the currency as a profit generator in its own rights.

Eventually, an entire ecosystem of monetary relationships would build around this currency, and it wouldn’t even be necessary for the issuing company to produce goods and services anymore – if enough people are ‘backing’ the currency with their own goods and services, it would make no difference if the original ‘backing’ disappeared. In fact, the original issuing company would be much better off to no longer bother with the nonsense of providing goods and services, but simply focus on continuously improving technical accessibility of its money system, making sure that people can use it with as little effort as possible.

The entire system would probably be based exclusively on electronic transactions, though it is conceivable that somebody would in fact issue bank notes denominated in this money. In case you haven’t noticed, the ‘tokens’ have more in common with physical gold or silver than what we currently think of as money.

All currently existing money systems have a built-in bias towards inflation, since the only way for the issuing body to make a decent profit is a) seigniorage b) old fashioned banking services, and c) inflation – and more often than not, all three at once. Governments generally engage in a) and c), with the predictable result that eventually, the currency will collapse into worthlessness.

The ‘genius’ – if I may be so immodest – of my system is that it creates a money system where the issuing body has an incentive NOT to inflate the money stock, since it makes a profit on every transaction. Inflating the currency would, in the short run, create additional profits, but – why kill the goose that lays the golden egg? In fact, as the currency grows in usage, and the value of each unit increases accordingly, inflating the currency would cut profits.

A company issuing such money would likely develop a way of proving that it is not inflating the currency, which would not be too hard, since it has a very close tap on the total amount of base money floating around: every transaction goes through its central server, and it knows exactly who has how much of the stuff.

[Yes, privacy folks are going to flip out at this point. However,the goal of my system is not to satisfy privacy needs, but the need for having a monetary system that avoids blowing up the economy every few decades (if you’re lucky), and going out of style every century or so (if you’re lucky).

There are simple ways for people to add privacy functions to the system – such as private bank note issuance based on this money – but accepting those bank notes would be economically risky for the same reason that accepting bank notes denominated in gold or silver is risky: the issuing body has every incentive to inflate the currency. That risk could be mitigated by those banks continuously publishing their verifiable holdings in the base currency (which is tracked by the base issuer in any case) as well as the total amount of issued bank notes. I’m not going to belabour this point anymore – anybody with a basic understanding of how markets work can figure out the rest.]

What most excited me about my idea was that it creates a monetary systems governments would be interested in running themselves: the prospect of getting a definite cut of every transaction in the economy should make every finance minister drool: imagine 1% of every monetary transaction goes straight to the coffers of government. Every time anybody buys a candy, a computer, a car, a house, stocks, life insurance, or what have you, the government gets 1%.

Rather than having our money at a bank, we all would have an account on the government’s central server, and a debit card to go with it. We could, of course, have bank account for investment purposes, too. But we wouldn’t need to. And saving money would be easy – all you have to do is not spend it, and as the money grows in value (which it would without inflation), you have more wealth.

The system would also get around the stupidest argument in favour of inflation ever since the first gold smith figured out fractional banking: matching the amount of money to the growing economy. In my system, it would be easy to ‘split’ the money every once in a while to avoid a world in which you need to pay 1/1,000,000 of a money unit to buy a chewing gum. All the issuing authority has to do is multiply all holdings by the desired factor, and – abracadabra, you are back to dealing with sensible amounts. This would probably happen once in a generation, assuming a steady 2-3% growth in productivity.

Some funny things would happen to how we do certain things. For example, when you borrow money, you might find terms of “10 years”, or “5 years”, rather than %. Rather than paying the lender principal plus interest, you simply promise not to pay it back earlier than 10 (or 5) years from now. If you do pay it back earlier, you’ll have to pay a penalty, of course. But, money system build on a fixed base would create a daily vivid illustration of time preference even for the dimmest consumer.

There would also be no need to legally separate deposit banking from investment banking: all banks would be investment banks, because why bother with a debit account at a bank when the government provides it basically for free (except for that transaction fee, of course).

Banks would find themselves in the ugly world of free market competition (a place they haven’t been to for a long time now). Risk would be fully internalized, because they wouldn’t have the deposits of unwitting customers to play with at no risk. Instead, banks would have to compete for people to entrust them with their money for risky investments, while the cash of more cautious folk would be safely tucked away in the central server.

Since money no longer uses value through inflation, there wouldn’t even be much need for ‘investing’ to protect against inflation (which is pretty much the best people can hope for these days – profits are a mere mirage for all but the well-connected or lucky ones).

There would be a significant slowdown of high-risk investment, parasitical investment, and the fraudulent shenanigans that so disrupted the economy in recent years, because financial risk – as I mentioned already – would finally be internalized by those engaging in it.

That’s bad news for the wizards of finance, and the first-in-line profiteers of central bank inflation policies, but its good news for for consumers, and honest folks in general.

And even more beautifully, the system would benefit governments:

– tax evasion would become really difficult (all transactions go through the central server, remember?), nor really necessary (the government is making so much money on the whole transaction business, it can probably slash a lot of taxes and still grow at a steady pace).

– Money laundering would be really, really hard to do for the same reasons. (Governments may continue to issue some cash tokens for practical reasons, thereby reducing these advantages somewhat but – given the increasing spread of handheld digital devices, there really is not much need for that.)

The system could be implemented with relative ease (economically), by converting all current assets and liabilities denominated in a country’s currency, and transferring them to the central server. Yes, this is very vague in terms of defining money, and care would have to be taken to avoid converting derivatives into assets/liabilities. Derivatives should remain derivatives, and let the banks deal with the fall-out. I’m not enough of a finance specialist to sort this all out, but – there is no reason to assume it would not be possible. In the short run, it would leave all the illegitimate advantages gained from the current system in place, but I’m fine with that. It’s not supposed to be a tabula rasa proposal. It’s more about long-term viability.

Yes, this is a nightmare scenario for civil libertarians and privacy folks, and Christian millennialists will have a field-day, but again: this is a proposal for a sustainable monetary system, not a general utopia. It’s no good ranting about ending the FED and such things if you don’t provide the entrenched interests with a practical alternative that provides the same benefits, with less downside.

The ones most opposed to my scheme would be the oligopolistic banks, of course, and their half-witted helpful idiots in and outside of academia (the acolytes of brilliant fools like Keynes, Samuelson, Galbraith, which today include the likes of Mankiw, Krugman, and pretty much the whole lot of public economists, with few notable exceptions – almost none of whom go anywhere near monetary theory).

In any case, what does this have to do with Bitcoin? Well, a number of things: most importantly, Bitcoin shares with my system the most important economic feature: a fixed base for money. One significant problem – not fatal, just inconvenient – is that it does not seem to provide for ‘splitting’: in the long run, a solution will have to be found to deal with the problem of paying 1/1,000,000,000,000,000,000 BTC for a box of matches. This could be achieved through the development of currencies that are based on BTC, but provide more granular units.

The differences, however, are most striking and make me believe that in the long run, BTC is probably the way things should, and will, go: there is no central authority at all. Nobody can muck around with the money supply (provided the code and structure for BTC is practically invulnerable to attack). It’s not just that there is no incentive to inflate, it’s not possible.

In the long-term, transaction costs will go down to the absolute technical minimum (verification providers will find themselves in a very, very competitive market – this alone may become one of the most powerful forces driving the development of ever cheaper processing technology, with chip developers trying to get a cut of the transaction market). Rather than have government change the costs to accommodate foolish fiscal policies, the costs will be determined solely by the cost of providing the service.

It is entirely possible to develop a banking system around BTC: think of BTC as having more in common with gold rather than commodity-based currencies or fiat money, and consider the insecurity of storing ‘wallets’ on your own hard-drive.

A minor draw-back of BTC is that it can and will deflate – there is no possibility to prevent the loss of BTC units over time. The total amount will slowly erode due to accidental or intentional deletions of stored BTC units. This in turn will make the need for effective ‘decimal point management’ more pressing over time. I’m sure there is a technical solution to this, but I’m not sure the originator has thought of this. Maybe I missed it when reading the concept. Again, this is not a fatal flaw, just an inconvenience.

The biggest challenge will be for BTC to reach a critical mass of participants to have a sufficiently broad base of goods and services that can be purchased for it to create sufficient backing to have the currency sustain itself indefinitely. I am not sure this has been achieved so far. If it is true that drug dealers are beginning to use BTC at a significant scale for this purpose, then this problem would be solved rather quickly. Illegal drugs are pretty desirable, and if it is possible to get illegal drugs with BTC, one will be able to trade them for other goods as well (‘backing’ in illegal drugs should be taken seriously from an economic point of view). Besides, drug dealers would only sell drugs for it if they can get other goods and services. In short, the accusation BTC is currently used by drug dealers means that BTC is, in fact, a viable currency already.

Since the design of the currency makes it very, very difficult to shut down usage (Would those dealing with illegal drugs really care they violate some kind of sanction on the use of virtual currency? Would a ban in the US be meaningful in South America, Central and South-East Asia, and Africa?), it is hard to see how BTC could be stopped from gaining a serious foothold in the global economy.

Unless a major flaw in the technical design and operation of BTC leads to a major loss of faith in BTC as a monetary base, BTC is here to stay in a very big way.

And for those who know their economic history, and how state-control over the production of money has shaped the current world order,  it should be easy to see how political implications of Bitcoin could be downright revolutionary. Running a modern State without monopoly control over money could become a little tricky.

I think I just convinced myself to actually go and buy some BTC. Can’t hurt.

By the way, here’s a good video on the topic from the folks at Reason:

Bitcoin & The End of State-Controlled Money: Q&A with Jerry Brito

PostScript 1 – June 19, 2011: As Charles pointed out, the deflation issue really is just a matter of aesthetics. As long as decimal point management is done properly, it won’t even be noticed by anybody but the most attentive.

Also, news coverage of attacks on MtGox, such as this one, fail to appreciate that this has nothing to do with BitCoin itself. Calling the attack on MtGox an attack on Bitcoin makes about as much sense as calling a bank robbery an attack on the dollar.

An attack on Bitcoin would have to involve compromising the integrity of the verification protocol. As long as that does not happen, Bitcoin itself is fine. MtGox may be toast, though.

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5 Responses to Bitcoin and another radical Idea on Money

  1. charley hardman says:

    lost/destroyed bitcoins aside, all currencies not being inflated against growing user populations have per capita deflation, as seen in bitcoins recent exponential per capita deflation. effect is the same as direct deflation.

    • dietwald says:

      True. I think I drew too much attention to what is in the end a purely aesthetic problem. I would prefer a more elegant system that would avoid any change to the overall money stock. In terms of structural economic effects it is unimportant.

      Thanks for the comment… I didn’t realize you actually talk to people :) Cheers.

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  3. dietwald says:

    Which browser are you using?

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