Bitcoin as an Economic Entity

Bitcoin is the new peer-to-peer virtual currency that I wrote about previously. This post evaluates Bitcoin as money from an economic point of view. I will write a separate post on technical and security aspects. Economists look at money as three things: a measure of value, a medium of exchange and as a commodity, more commonly and politely stated as a store of value. Here is how Bitcoin measures up to these three function.

One function of money is as a measure of value. When we use money to measure value, we do not mean that the money exists, rather that the asset, good or service is worth or cost the sum of money. Thus when we say that someone is a millionaire, this means that the sum of all they own minus their debts is more than a million dollars. It does not mean that they have a million dollars in bills stuffed into a mattress.

The men with the green eyeshades often talk about this purpose of money as "unit of account", thinking about it as a measure of value gets to the essence more quickly. So, when I am in a computer store trying to decide whether I should buy the $500 laptop or the $1000 laptop, I use money as a comparative measure of value, by asking whether the $1000 laptop is really worth twice the $500 laptop and an absolute measure of value by asking whether I can afford the $1000 laptop that I really want or whether I should make do with the $500 laptop and save the difference for other needs.

For a measure of value, the best currency is the currency we are familiar with, that we are paid in and that we use every day. Anyone who has been abroad knows the difficulty of commerce with an unfamiliar currency. At first, after every transaction the thought lingers in the back of your mind, did we just get a deal, or were we robbed? However, with repeated use you pick up a new currency. By the end of a vacation you are starting to be able to predict what goods and services will cost in the new currency. When I played World of Warcraft (WOW), I quickly learned the value of WOW Gold through having to work with it all the time.

Bitcoin has another problem as a measure of value, its volatile exchange rate with other currencies. Since its introduction, it has appreciated against all other currencies by about 200,000%. Recently, heavy selling on a Bitcoin exchange caused its value to fluctuate between $0.01 and $17.00 over the period of a day. This volatility makes it difficult to use as a measure of value because its value is uncertain. Most currencies are managed by a central bank and one of the purposes of a central bank is to keep the currency stable with respect to other currencies so that it can be safely used for all the three functions on money. On the other hand, the essence of Bitcoin is that it is completely distributed with no central authority. As it is unmanaged, we can expect its exchange rate to be somewhat more volatile than other currencies.

Another function of money is as a medium of exchange. Before money existed, trading was difficult. If I led a cow to market with the intent on trading it for grain, I might come to an agreement with another farmer that my cow is worth 8 sacks of grain, except that I only want one sack of grain the other farmer only has 5 sacks of grain to trade and he does not want a cow anyway. With money, I can sell the cow for money to someone who wants a cow, buy just as much grain as I need and save any leftover money for other transactions in the future. Money as a medium of exchange greases the wheels of commerce by acting as an intermediary and thus removing barriers to trade.

Bitcoin scores high as a medium of exchange. It can be securely and anonymously traded on the internet for other goods and services. Also it is almost infinitely divisible so it serves for small exchanges. There are two caveats. Firstly a Bitcoin transaction takes about 10 minutes to confirm, so sellers may be unwilling to accept it for immediate transactions where there is no recourse. That is, Bitcoin is good for selling Alpacca socks over the internet, but not for selling hot-dogs at Coney Island. As Bitcoin is an internet currency, this is only of concern to someone who sells virtual goods over the internet without recourse. The Bitcoin FAQ addresses this issue, saying:

Do you have to wait 10 minutes in order to buy or sell things with BitCoin? 

No, it's reasonable to sell things without waiting for a confirmation as long as the transaction is not of high value. 

When people ask this question they are usually thinking about applications like supermarkets or snack machines, as discussed in this thread from July 2010. Zero confirmation transactions still show up in the GUI, but you cannot spend them. You can however reason about the risk involved in assuming you will be able to spend them in future. In general, selling things that are fairly cheap (like snacks, digital downloads etc) for zero confirmations will not pose a problem if you are running a well connected node."

The second caveat is that we typically maintain a reserve of any currency that we regularly use as a float to smooth out transactions. Anyone concerned with the volatility of the value of Bitcoin may be unwilling to maintain a float in Bitcoin and therefore not have a convenient reserve of Bitcoin for doing transactions. If Bitcoin continues to have a volatile exchange rate with other currencies and users do not keep a reserve of Bitcoin for doing transactions, it becomes more cumbersome to use and therefore less useful as a medium of exchange. The end result is that Bitcoin is only used when there is no alternative method of payment. The conclusion is that Bitcoin, or any other currencies usefulness as a medium of exchange does depend on it having a reasonably stable value.

The final function of money is as a commodity like Gold, Oil or Frozen Concentrated Orange Juice (FCOJ). Currencies are commodities that are traded like other commodities for good legitimate reasons. For example, a company that contracts to buy a good that is priced in another currency may want to buy insurance against a change in the exchange rate that would cause the good to become more expensive than when they made the original commitment. Financial companies create and sell instruments that provide this insurance and then trade currencies as commodities to protect their position.

First some words about commodities in general. Owning a commodity does not produce any value. Stocks and bonds may pay a dividend, while a commodity does not, so the only reason for owning a commodity as an investor is the hope that its value will increase so that it can be sold at a profit. In practice owning a commodity is an even worse proposition because money is tied up in owning the commodity that could be otherwise earning interest, so even owning a commodity is a losing proposition unless the commodity increases in value. Then there is a cost for every trade which further saps profits. Thus people who are not Bitcoin speculators will not want to hold more Bitcoin than they need for their day to day needs.

Commodity trading creates a market for the commodity that sets its price. The first test of a commodity is that there is a market where the commodity can be traded efficiently. Bitcoin passes this test as there are several markets for Bitcoin, although a recent attack against the MtGox, the largest Bitcoin exchange may reduce confidence. As an example of the efficiency of trading Bitcoin, MtGox charges a 0.65% charge against every trade.

When evaluating a commodity, we consider how it is used to understand the supply and demand that determines its fundamental price. Bitcoin is a fiat currency which has value because people find it useful as a medium of exchange like the other like other fiat currency: Dollar, Pound, Euro or Yen. The key to understanding the value of Bitcoin like any other currency is money supply, the sum of all the money that people keep in their bank accounts and wallet to smooth out their transactions and grease the wheels of commerce as discussed previously. However there is one difference. With other currencies there is a central bank that manages the money supply to keep the value of the currency stable. With Bitcoin, there is no central bank, rather the amount of Bitcoin is circulation is stable. Thus the base value of Bitcoin depends on demand for its money supply.

The base demand for Bitcoin is to use it as a medium of exchange. If more people regularly do Bitcoin transactions and keep it in their wallet to smooth out their transactions, or they tend to keep more Bitcoin in their wallet because they expect to use it for more transactions, there is more demand for the stable supply of Bitcoin and therefore its price rises. Conversely, if less people keep Bitcoin in their wallet or people keep less money in their wallet the price falls. On top of this base demand, there is demand from speculators who expect the price of Bitcoin to rise and therefore hold it in investment level quantities. The base demand for Bitcoin will tend to keep the price stable, while the speculative demand is likely to make the price more volatile.

Another consideration is whether there are any risks associated with owning the commodity. Bitcoin is a virtual currency and a problem with other virtual currencies has been hyperinflation, caused by someone discovering a software bug that allows them to generate huge amounts of the virtual currency without much effort. This has happened in several Massive Multiplayer Online Games (MMOG), but in each case the game has had a central server that hands out money and a game mechanism that is designed with a specific rate of exchange in mind. Bitcoin is different in that it does not have a central authority and it is traded in a free and open market that sets its value. An attack on Bitcoin could reduce its value, however this could be self defeating as it immediately reduces the value of the attack. I will write a separate post on the security considerations, however it is safe to say that as there is a vibrant market for Bitcoin, it is reasonably safe.

In summary, Bitcoin's purpose is to be used as a medium of exchange for transactions over the internet. Its base value comes from small amounts of it being held in a large number of users wallets because they regularly use it as a medium of exchange. If Bitcoin is heavy used as a medium of exchange, this will tend to stabilize its exchange rate against other currencies and make it more useful as a currency when measured against all the functions of money.

Bitcoin, a Peer to Peer Virtual Currency

Bitcoin is a peer-to-peer virtual currency that seems to pop up in the conversation everywhere I look. A virtual currency is is a currency that is created on computers and traded on the internet. A couple of examples of virtual currencies are Linden Dollars in the online world Second Life and Gold in the massive multiplayer online game World of Warcraft (WOW). People in third world countries play WOW to collect WOW Gold and sell it for real money to players in the first world so that they can buy more powerful armor, weapons and spells to use in the game. Bitcoin is different in that its purpose is to be a currency like dollars, euros or pounds, whereas Linden Dollars and WOW Gold are an element of their games and have no real purpose or value outside of the game.

The other aspect of Bitcoin is that it is a peer-to-peer currency. Bitcoin is created by mining for it against a cryptographic algorithm. Once Bitcoins are created they are traded on a peer-to-peer network. When a transaction has taken place, it is broadcast to the peers on the network, they confirm that the transaction is valid and has taken place. The peer computers add the transaction to the history so that the transaction becomes permanent. There is no central authority that creates or manages Bitcoin, it manages itself through its network of peer computers all running the same software.

One feature of Bitcoin that has excited interest is that it promises secure anonymous transactions, like cash, but over the internet. While this may seem like a good thing, it is also a problem as it means that Bitcoin is an extremely useful currency for people who want to get around the law. Bitcoin has the problem that it needs to establish itself as useful currency with a legitimate reason to be. If the major use of Bitcoin turns out to be to abet criminal activity it may find itself under attack from governments that want to suppress it.

I am going to do a couple of posts on Bitcoin, one examining the economic aspects, and the other looking the technical and security aspects. In the mean time here are a number of links on related issues. My interest in a virtual currency comes from several direction. In the past I have written in this blog about both Virtual Goods and Virtual Economies.

A big question at the moment is the whole issue of what is Money. Some politicians, concerned about monetary policy have called for a return to the Gold standard, which has resulted in others asking this question. This American Life did a Podcast on that subject and came to the conclusion that Money is much more ephemeral than we may think. Planet Money did a related story where they looked at the small Pacific island of Yap where they used giant round stones as money. When a stone changes hand because of a payment, as the stone is large and heavy, the stone remains where it is and everyone on the island just knows it belongs to someone different. If you think that is strange, it is not that different from the way we manage gold. The gold bars sit in a bank vault and their ownership is digital bits recorded on a disk that is revolving at 7200 RPM. When the gold changes hands, a new record of ownership is written to the disk, however the gold remains exactly where it is. I will have to write more about virtual goods in real economies another time.

The Fable of the Good King and the Bad King

A long time ago there were two countries. Each country had a King. One King was a good King and the other King was a bad King as we will find out. Now, as you all know a Kings main job is to go out and make war on his enemies. It is the reason that Kings exist. If a king is not out making war against his enemies, he will go out hunting and make war on the animals of the forest. A good war will enlarge the kingdom, enhance the King fame and gives him more subjects to rule over. But before a King can make war, he should make sure that his subjects provided for. For while the subjects of a King owe everything that they have to their King, the King is also responsible for the welfare and good being of his subjects.

There are many parts to taking care of subjects: making good laws, passing down sound judgements, but the most important one is making sure that the granaries are filled in times of plenty. For as surely as fat times follow lean times, lean times follow fat times. In times of plenty, the excess harvest should be saved so that in times of need the subjects do not starve. Subjects who are starving are weak and cannot praise their King nor defend his kingdom.

Now in our two countries, these were years of plenty, and the Kings knew that they would go to war. The good King also knew that it was his duty to make sure the granaries were filled, and so he did. However, the bad King wanted to win the battle so badly that he sold off all the grain in his granaries to buy expensive war machines. A little incident happened, it was blown up into a huge crisis and the two countries went to war. Each King assembled his army and let it to the battleground at the border of their countries as had happened so many times before. The armies were evenly matched and they fought all day. At the end of the day the army of the bad King held its ground and he was declared the victor. The expensive war machines had helped, but less than hoped for. However, both armies were so weakened and exhausted by the fight that they turned around and went home, as they had so many times before.

The years after this battle were years of want. The harvest had failed and both kingdoms suffered. However, the kingdom of the bad King suffered much more than the kingdom of the good King for there was no grain in their granaries. When the little incident happened that blew up into a huge crisis, both Kings assembled their armies and marched to the battleground on the border. This time the good King won the battle because his men were stronger.

The good King advanced his army into the country of the bad King. They may not be able to take the whole country, but the good King had to let his men do a little rape and pillage as a reward for winning the battle. The bad King realizing his precarious position came out to parley with the good King. The bad King had nothing to offer the good King but some used war machines and the hand of his daughter in marriage. The good King accepted that the daughter of the bad King should should marry his son and that when the two Kings has passed on the greater battleground in the sky, the son of the good King would rule both countries. Thus the two kingdoms would become one united country. A country that would be large and strong enough to make war on the countries on the far side of the mountains.

The moral of this story is that in times of plenty, make sure that the granaries are filled, for as surely as fat times follow lean times, lean times follow fat times, and the best protection against lean times are full granaries. On this matter, a King must beware of false council. When times are good, the false council will say "What could possibly go wrong? The times are fat and everyone is happy. Make the populace more happy by selling off the grain in the granary and rewarding the citizens each according to what they have contributed." Even worse, when times are lean the false council will say "Times are awful and getting worse, we must take the grain out of the peoples mouths and put in in the granaries for the harvest next year could be even worse than this year." The point of a granary or any store of wealth is to save the excess during the fat years so that they can be used during the lean years.

The Big Short

What is the best way to write an uplifting book about the recent financial crisis? In his new book, The Big Short, Michael Lewis has taken the approach of following the winners, the people who saw that the bubble would burst and made a huge sums of money by betting on it bursting. Along the way we also meet some of the people who took the other side of the bet and lost big. When you compare these two groups, the losers come across as your average every day kind of person while the winners area strange group of outsiders.

The book follows three groups of people. There is the Frontpoint Partners hedge fund led by Steve Eisman, who as a stock analyst had been best known for correctly trashing companies that he followed. Then there is Mike Burry, a one eyed doctor living in San Jose who took up investing because it allowed him to get away from having to interact with other people. Finally there are the guys at the garage band hedge fund who turn $100,000 in to more than $100 million and whose main problem is being taken seriously by the big Wall Street Firms.

Along the way we see scenes of madness from the financial machine that created the bubble. There is the explanation for why a Mexican strawberry picker with no English and an income of $14,000 per year could be loaned every penny he needed to buy a house for $724,000 in Bakersfield California. As it turns out, because he had no debt and no credit history, he has a relatively high credit rating, and that credit rating was needed to balance out the low credit rating of some deadbeat American when their home loans were packaged together with many others into a mortgage bond.

Another scene is the American Securitization Forum, the annual conference of the of the subprime mortgage industry. In early 2007 the conference takes place in the Venetian Hotel in Las Vegas. The Frontpoint Partners and the garage band hedge fund are both there trying to get more information to substantiate their huge bets against the subprime mortgage market. By this time the cracks were beginning to show. For example, the CEO of the Option One mortgage corporation gave a reassuring speech even although Option One was in trouble because they had made loans to people who could not afford to make even the first payment on the loan. When his partner asks "Who takes out a home loan and doesn't make the the first payment?" Steve Eisman responds "Who the #$%^ lends money to people who can't make the first payment?"

Michael Lewis knows what he is talking about in writing about Wall Street because he started his career as a bond salesman for Salomon Brothers as hilariously told in his first book, Liar's Poker. In The Big Short he successfully continues that tradition. The Big Short is full of interesting characters, amusing insights, clear explanations and some genuine tension as towards the end you wonder whether the hero's will get their big payoff or whether Wall Street will totally collapse taking down everybody with them. Like of his other books, The Big Short is highly recommended.

How Data is Changing the Study of Economics

Andrew Leonard in How The World Works recently posted on how computers and the availability of data is changing the study of Economics, and I have to agree. There are a number of forces that are converging to make this happen right now.

Open Government initiatives are making more data available and the internet makes it easier to get the data. Emerging movements like the Open Data Commons emulate the Open Source movement that has made software more available. The Open Data movements are concerned to not only make the data more openly available but to make the data better by providing tools to manage it and inspection so that problems with the data can be corrected.

Web sites to make data available have been around for some time. For example, Numbary.com exists to make public data more available. Sites like Many Eyes and Swivel allow the user to upload data sets and analyze them. You do not need to find your own data sets because you can go to these sites and play around with data sets that others have uploaded.

Several popular books have shown us what can be done. The best known example is Freakonomics, which takes a number of interesting data sets and shows us how they can be analyzed to tell interesting and sometimes quite startling stories. Less flamboyant and more educational is Super Crunchers, subtitled "why thinking-by-numbers is the new way to be smart".

Leonard suggests that the rise of large scale data analysis will displace the old guard who sit in their ivory towered and built model. I have to disagree. The economic model is the explanation of what is happening, the result of analysis. Building a model to explain some aspect of the data or behavior that is brought to light by the data is the result of Analytics. More and better data means that the models will be better, more definitive and most importantly in a fractious discipline, more defensible.

Predatory Lending

While the practice of Predatory Lending is difficult to define, it is easy to see the results, people stuck with high priced loans that they cannot get out of. Today I saw a couple of references to an article in the Washington Post that reports more than half of of the mortgages in the US have an interest rate that is greater than 6% while for the last year the mortgage interest rate has been hovering around 5%. This means that over half the homeowners in the US are unable to refinance their mortgages to take advantage of a lower interest rate.

Many people think of predatory lending as something like payday lending to the poor. In practice it happens at all levels of the economy. At the highest level there are the exploits of the "economic hit man" whose job was to enable the selling of economic development loans to poor countries that could ill afford them. Recently, the economic woes of Greece may have been exacerbated by clever derivative swaps from Goldman Sachs, designed to hide the true nature of the debt that it owed.

Predatory housing loans inflamed the housing bubble, sticking the middle classes with high priced loans cleverly disguised with low initial teaser rates. Now the middle classes are stuck with loans that they cannot refinance because their houses are underwater or because they do not have a job, a good enough job or the credit rating for the refinance to go ahead. This is a yet further drag on the economy, already in recession. As the Washington Post article says:

"More refinancing activity would have helped household budgets, but also the national economy because homeowners might have spent some of the extra cash they pocketed, giving the recovery an added lift."

Homeowners do have an option. As Roger Lowenstein writes in the New York Times "Walk Away From Your Mortgage". Part of his argument is that banks are walking away from their mortgage obligations, and the American people should not feel obliged to behave better than the corporations who sold them their home loans in the first place. I would add to that argument that much of the vitality of the US economy comes from labor mobility. Having people stuck in a home that they cannot sell because their loan is underwater and unable to get a job nearby is yet another drag on the economy.

Free: The Future of a Radical Price

For some time I have intended to write a post on the economics of media now that the cost of manufacturing it has gone to nothing. Today I discovered that Chris Anderson, editor of Wired and author of The Long Tail" has written a book on the subject called "Free: The Future of a Radical Price", available in July. I will write a post after reading the book, here is an outline of what I expect it to say.

Firstly, as the TechCrunch post says, "As products go digital, their marginal cost goes to zero." It is now economic to give the product away, and make it up on volume. Closely related is the network effect, the more widespread that some piece of media is, the more "valuable" that it becomes. Barriers to media becoming widespread reduce the likelihood that it is seen or heard. Cost is definitely a barrier.

Moreover, putting a price on your media item creates the opportunity for others to price for free and undercut you. A good example is craigslist. It may not be quite what you think of as media, but craigslist is in the process of decimating the newspaper industry by destroying their market for classified advertisements. Craigslist makes their money by selling access to narrow niche markets, so it seems to fit in perfectly with Anderson's thesis.

In the past I have written about the future of music and how musicians are moving to make their money from performance rather than from record sales. As goes music, so goes all media. My sister is currently writing a book. This last week she told me that she expects to make her living from touring to lecture on the books contents rather than from book sales.

Virtual Worlds - Real Metrics

Avoid hyperinflation! This was the salient piece of advice for running a virtual economy that I got from Bill Grosso's talk to the April meeting of the SDForum Emerging Technology SIG. The talk was entitled "Virtual Worlds and Real Metrics". Bill is CTO of TwoFish, a startup that provides virtual economies to online worlds. Bill has an undergraduate degree in Economics, so he has both academic knowledge and the practical experience of seeing the insides of virtual economies in online worlds.

In case you are wondering what a virtual economy is, two leading examples are found in World of Warcraft and Second Life. Both are massive multiplayer online (MMO) worlds. World of Warcraft is a fantasy game based on combat where players receive rewards for gameplay. The economy greases interactions between players and allows them to exchange rewards. Although it is not the primary point of the game, the World of Warcraft economy is estimated to be larger than many small countries around the world. Second Life is an online world where you can establish a second life for yourself. Like all the other aspects of Second Life, the economy is intended to provide a virtual reflection of a real economy.

Although it is attractive to think that virtual economies are like real economies, Bill spent quite some time disabusing us of this notion. Unlike real money, virtual money may have different costs in different localities, sometimes you get a bulk discount on large purchases of virtual money and in some cases old money may expire. Another issue is that money does not circulate in the same way are real money. In the real world money, once set free, circulates from person to person, business to business. In a virtual world, money is usually created by the game, flows through a player and then back to the game. It seems that the degree to which money circulates between players is a good measure of how "real" the economy is in a virtual world.

For measuring money velocity, virtual worlds do have an advantage. In the real world, statisticians estimate the money supply, then estimate the total number of number of transactions in the economy and divide one by the other to get money velocity. In a virtual world, the man behind the curtain sees into every players wallet and every transaction. The calculation of money velocity is exact. Moreover, by linking demographics and other knowledge to players you have a Business Intelligence analytics wonderland, precise reports on every aspect of the economy that can be used for all sorts of marketing purposes.

Hyperinflation has been and always will be a pitfall of virtual economies. It can come from bad design of the virtual economy, but is it more likely to come from players finding and exploiting bugs in the game, and there are always bugs in a game. Eternal vigilance is the price for avoiding hyperinflation, so the analytics reports are an important part of managing this part of the economy as well.

Notes from the Dismal Science

Over the Christmas break, I have been reading "The Return Of Depression Economics" by Paul Krugman. There are good reasons why they call Economics the Dismal Science. The worse the financial situation becomes, the more there is to analyze, discuss and comment on. These are exciting times to be an Economist. I will report more on the book later, in the mean time here are some thoughts on the Dismal Science.

To my delight, the current Wikipedia entry on the Dismal Science calls it a derogatory alternative name for Economics and tries to contrast it with the "The Gay Science", the title of a book by the philosopher Nietzsche. The "Gay Science" of the books title is apparently the technique of poetry writing. It also claims that the first reference to Dismal Science is in a pamphlet published by Thomas Carlyle. The problem with all this is that the dates do not match up. The best known dismal economist is Malthus who published the first version of his pamphlet on the impending doom of population explosion in 1798. The Carlyle pamphlet was published in 1849 and Nietzsche's The Gay Science was published in 1882.

One interesting thing about Malthus is his use of mathematical models to explain his thesis. His argument was that population growth is exponential while the growth in food supply is linear, leading future generations to have more and more people fighting for proportionally less food. Nowadays economists still use mathematical models to explain their positions, although they have now graduated to sometimes using differential equations to make their point. In my time, I have known several applied mathematicians. Their models are always second order differential equations and they always oscillate, just like our financial fortunes.

Another branch of mathematics with relevance is Game Theory. Derivative trading is a zero sum game. That is, one persons gain is another persons loss. I believe that bond trading is also a zero sum game as well. In a properly open market with good information, trading in bonds and derivatives should be a straightforward and relatively low profit enterprise. For at least 20 years, as depicted first in Bonfire of the Vanities and Liar's Poker, it has been exactly the opposite. The market players have conspired to hide information and keep the market inefficient so that they can reward themselves with enormous profits from trading.

Note that derivative and bond trading is only a zero sum game when they do not default. Adding defaults makes bond trading a manly game where the best can win. Thus, are defaults necessary to justify the the profits and bonuses that Wall Street firms have been paying? Is it a matter of: "It is not enough to succeed, others must fail"? Could it be that these ridiculous collateralize debt obligation bonds were deliberately created so that some of them would fail?