Bitcoin System: Some Additional Problems

By Eric Tymoigne

In my last post, I argued that the fair price of a bitcoin as a monetary instrument is zero BTC; a bitcoin contains no promise in terms of income, in terms of convertibility, in terms of maturity, or any other. As a commodity, I have no idea what its fair price is. BOA says it is $1300. I will let those who find utility in the bitcoin payment system and speculators decide how much they are willing to pay in USD for a number credited on their screen in BTC. All I can tell you is: “money does not grow on trees.” Money is not a natural occurrence, it is a man-made financial devise. It looks like the bitcoin creator’s views on money were shaped by the old and erroneous idea that “gold is money.” Gold was at best a collateral embedded in a monetary instrument (gold coin), the metal itself was never money. In today’s blog, I will focus on three other issues with the bitcoin system that prevent it to work well as a monetary system. While I explain what ought to happen to make the bitcoins work properly as a monetary instrument, I am not sure it can be done.

1-     The supply of bitcoins is inelastic

If a monetary instrument works properly, its supply changes with the quantity demanded. It goes up when there is more demand for it, and down when there is less demand for it. Think of bank accounts. When people need more funds for transactions they can apply for a bank advance. When people are bearish about the future, they can repay their bank advances and the outstanding amount bank accounts declines. The same is true for government currency via the automatic stabilizers of fiscal policy, the central bank clearing and settlement mechanisms, and the lender of last resort. When the economy is doing poorly, government spending rises automatically and tax revenues decline, and the central bank may help by providing reserves on demand to banks to maintain their liquidity. When the economy is doing well and people can rely on banks to sustain their financial needs, non-discretionary government spending declines, tax revenues rise (given tax rate, i.e. no increase in tax burden), and central-bank advances to banks are repaid.

The bitcoin supply is fixed in terms of flow (BTC 25 per 10 minutes now) and in terms of maximum outstanding amount (BTC 21 millions). It cannot be increased in function of the demand for bitcoins. In addition, it is not redeemable (either through conversion or by handing it back to the issuer), i.e. it cannot be decreased in function of the demand for bitcoins.

If it were possible to change the injection and destruction mechanisms to make the bitcoin supply perfectly elastic, they could easily be created and destroyed at will. Bitcoins can be created out of thin air. This is a great quality but as the saying goes “with great power comes great responsibility.” The fact that bitcoins can be created at will only means that there is no need to care about “running out of money;” this takes care of the financial side of economic problems in terms of availability of funds (a central point of MMT). However, easiness of creation does not mean one should not be careful with the way bitcoins are injected (that is another central point of MMT). Banks must perform underwriting (we saw what happens when they do not). Government have budgetary procedures. The supply of bitcoin is provided arbitrarily.

2-     The supply of bitcoin is arbitrary

The reward structure of miners is not based on the difficulty of solving the problem. Why are miners paid BTC 25 now? Why did they get a pay cut from BTC50 to BTC 25 and why will pay cuts continue? I have no idea. The consequence is that the maximum amount of bitcoin will be reached in in 2140. Why aiming for 2140? I have no idea. It does not make any economic sense.

In addition, the supply of bitcoin is based on a bonanza, think lottery winnings, rather than the needs of the payment system for more bitcoins. That does not promote a smoothly working of the payment system.

3-     There is no deposit insurance, no lender of last resort, and fraud does occur and it is difficult to offset its consequences.

The payment system is subject to frauds in terms of accounting frauds (here and here), in terms of ponzi schemes, and in terms of thefts (here). Recently the following occurred: “The largest Bitcoin payment processor in Europe, BIPS, said last month that it was hacked and that it lost about $1 million worth of Bitcoins, including coins that were in the personal online wallets of customers. The company, which is still in business, said this week that it would be “unable to reimburse Bitcoins lost unless the stolen coins are retrieved.” (here).

If one compares the traditional payment system with the bitcoin payment system on equal footings (i.e. no regulation), are frauds and thefts more prone in the traditional payment system? I.e. is the bitcoin payment system intrinsically safer? I cannot tell you. Accounting fraud seems pretty hard to do but is not impossible, others seem more feasible.

The main point here is that you are on your own when you enter this payment system. The price of bitcoins will drop dramatically in the future. Why and when this will happen is anybody’s guess and is irrelevant. All that is known is that the structure of the system is flawed and needs to change (you do not ask your mechanic when your brakes will fail if he tells you they need to be changed). For example, the value of bitcoins may drop dramatically in terms of USD as people figure out that their savings in BTC is no as safe as they thought, and as they try to leave the bitcoin system all at once. In that case, their savings valued in USD would decline dramatically.

At the moment I do not see the need for a deposit insurance and lender of last resort. Debt-deflations are not possible in the bitcoin system for now because there is no debt written in BTC. The risk of contagion is also small given the limited size of this payment system. There can be a deflation (“bubble popping”) but not a debt-deflation. This, of course, assumes that no BTC-debt exists. I do not know for sure. We have had the shadow banking system, now we have shadow payment systems (Bitcoin and others) that financial professionals seem to enjoy using (see comment in my previous post).

20 Responses to Bitcoin System: Some Additional Problems

  1. I think that bitcoins represent the macroeconomic illiteracy rampant in the world today. With a fixed amount of bitcoins, it has inflation built-in. The early adopters are the ones that will get rich off this system (perhaps this is why they invented it). The only major reason why a person would use them that I can see is for privacy purposes (i.e. money laundering, drug purchases, evading taxes, etc.). Why would any legitimate user or producer want to use it, especially with it’s wild price swings?

    • A fixed amount of money is supposed to cause deflation in an expanding economy, not inflation. The early adopters can get rich only if it gains wide acceptance. As per MMT, anyone create money; the problem is getting it accepted. The early adopters of bitcoin seem to have done a fantastic job of getting their money accepted. Bitcoin doesn’t have much privacy, since every transaction is logged forever in a publicly accesible block chain. Of course the log doesn’t have the IP address, but since the bitcoin address is recorded forever, it might be possible, at a later date, for an interested party to map all the bitcoin transactions to individuals who conducted them.

      Those who are betting on the bitcoin are those who believe money can come into existence by mutual acceptance of wider public and not just from those who have a monopoly on resources or coercive power. It is a completely different paradigm from any other that we have seen so far. At the moment it has acquired the status of an asset rather than money and hence the wild fluctauations in its valuation in terms of fiat currencies. But it will probably stabilise in value and when it does, its utility as a payment instrument is most likely to be felt first in cross-national payments, especially in the case of electronically delivered items/services.

      • GRP said:

        Those who are betting on the bitcoin are those who believe money can come into existence by mutual acceptance of wider public and not just from those who have a monopoly on…coercive power.

        But hasn’t that been the utopian vision of classical economics from day one? In the make-believe world of the libertarian true believer, the economy somehow, as if by magic, becomes separated from and operates in a separate universe, apart from the polity.

        But as you acknowledge, “It is a completely different paradigm from any other that we have seen so far.”

        • Libertarians believe in commodity money, not something that has no inherent value like fiat money or bitcoin. Bitcoin has some properties each of commodity money and fiat money.

          I find it amusing when goldbugs deny that fiat currencies are money because they don’t have some properties they insist “money” should have. It is equally amusing to see MMTers deny that cryptocurrencies like bitcoin are not money because they don’t have some properties “necessary” for them to be “money”.

          The person on the street is not waiting for self-styled experts on what money should be, before they accept it as payment for goods and services. Anything that gains a high degree of acceptability in a society is money. At the moment few holding bitcoins will pay for goods and services available in fiat currencies using bitcoins even if they are accepted as payment. But should any fait currency experience a high level of inflation and become unpopular with providers of goods and services as a means of payment, bitcoin might just become the reference currency to price the goods and services in.

          Bitcoin is the “foreign” currency that savers that are worried about inflation of their own currency and historically trusted foreign currencies are trying to put their money in.

    • Robert, on Reddit, a social media site you may or may not have heard of, people can “tip” each other any amount of USD (usuall small ones, ~1-10 USD), by writing a simple reply comment like “+/u/bitcointip RobertM $5”.

      Please tell me, how exactly can I do this without using bitcoin today, when the user who sends the money and the one who receives it can be in different countries (which are not even public for that matter), and for small amounts? Is this a legitimate use or not?

  2. I think there is another issue – as transactions increase the block chain gets larger and scaling becomes a challenge.

    Restricted transaction rates during early adoption of BC were designed to keep the block chain from getting too large too fast.


    Some of the solutions considered include dedicated servers to process transactions and reduce transaction latency.

    What this could mean is the peer-to-peer “community” aspect of Bitcoin gives way to organizations dedicated to providing scaling infrastructure. Of course it is already starting with mining consortiums.

    In another world, we might call such organizations “banks”.

  3. Eric, I’ve been enjoying your articles on Bitcoin lately. I just checked Mt.Gox (12-9-13) and the the price is back down to about $850-$900 after dropping from $1,220 to as low as $650 from Dec 4th to 7th. It’s like watching a roller coaster ride. Keep up the good work.

  4. Yes, they are commodities.

    Bitcoins are virtual Pet Rocks (TM) with a self-imposed rarity-premium built in. They have value but no utility. Their value is essentially entertainment-value with a dash of prestige-value, as in “I’m the only one in my office football pool who has a BitCoin Wallet.” Not all fads end quickly or fail to profit someone (think Beanie Babies). But all such fads eventually end badly for the ultimate “greater fools”. The fact that some sellers (traders, really) will accept Bitcoins is no more intellectually enlightening than the fact that a lot of people once bartered for, and bought, Beanie Babies.

  5. Charles Fasola

    Thank you sir for your reality based assessments of Bitcoin. I have been arguing the same points for months with Max Keiser, a huge promoter of Bitcoin and one whose mind has been permanently captured by the gold-bugs of the world who cannot accept the fact that money need not be backed by a commodity. As I’ve stated numerous times to Keiser and his disciples “Bitcoin is nothing more than a speculative computer game for tech geeks to play”. It seems very funny that many of the same folks who believe money must be backed by something physical support a so-called alternative currency surely backed by nothing but electrons.

    • The reality is that humans don’t do reality very well.

      The Bitcoin phenomenon is like a window that opens onto human nature. It’s revelatory. It’s like a trip through any modern-day casino. As you point out, it explores the nexus between man’s tangible life and his intangible life, between something as concrete as gold bullion on the one extreme and “nothing but electrons” on the other. And yet some people manage to convince themselves that “nothing but electrons” is just as, or even more, tanglibe than gold bullion. The majority of us, however, most of the time (but it can’t be said all of the time) stop somewhere short of this.

      The neuroscientist V.S. Ramachandran explores the subject in this enlightening lecture, where he cites examples where the human mind has completely departed from tangible reality. He theorizes that it has something to do with the workings of the brain:

      Modernism is based upon the premise that man is a rational animal, rational being man’s ability to perceive reality and then fashion it to maximize human flourishing. Classical, and even more so neoclassical, economics have very narrow definitions of what “human flourishing” and “rationality” mean, which are given carnality in a cartoon known as homo economicus.

      The problem is that entirely too many people believe this cartoon character called homo economicus is real. Homo economicus, however, is yet one more creation of the human mind. “We are illogical and therefore unjust beings from the first, and we can know this: that is one of the greatest and most insoluble disharmonies of existence,” Nietzsche wrote in Menschliches, Allzumenschliches.

      I’m not sure I’m as pessimistic as to the human project as Nietzsche was, but certainly he comes as close to the truth as the neoclassical economists do.

      Someone who stakes out a position somewhere between Nietzsche and the neoclassical economists’ messianic faith in “instrumental rationality” is the social psychologist Jonathan Haidt. “[S]ometimes we can use controlled processes such as reasoning to override our initial intuitions,” he says. “I just think this happens rarely.” ( )

      Our experience of the past few decades, nevertheless, has demonstrated that Max Weber was clairvoyant when he predicted that the tendency to give instrumental rationality precedence over all other forms of thinking, feeling, and valuing would lead us into “an icy-cold, polar night.”

  6. Great series!

    Theres lot of people offering bitcoin loans. Just google it. So I guess we’ll se debt deflation.

  7. Samuel Conner

    This article is quite helpful in understanding bitcoin:

    The point of paying “miners” is to incentivize their contribution of computing power to the distributed procedures required to authenticate the transactions chain, without which a decentralized system such as bitcoin cannot work. I speculate that the coded geometrical decline in the “payout” is intended to track with the geometrical growth of computation power into the future so that the reward per “CPU-hour” for contributing to the transaction chain validation does not explode.

    While it’s technically ingenious, Eric’s objections to it as a widespread currency system remain.

  8. Isn’t Bitcoin the ultimate confidence game, or at least the best one since the Sting?

    Sure a few will make out like bandits, however, like the game of snake in golf , the last one holding the snake is SOL.

  9. Posted this yesterday at PragCap :

    “One of the reasons the Fed has been created was “to furnish an elastic currency”.(Fed.Res.Act 1913)
    The quantity of BitCoin is per definition fixed. So with BTC we turn the time nearly 100 years back. BTC is acting more like a goldstandard. BTC is in it’s Great Depression, there is deflation everywhere. (see the price of the dollar in BTC, take the inverse of the graph)
    To solve this problem(s), BTC needs to become more like our current monetary system, which we already have, so why then we should need BTC?
    And what to think of all those alternative digital coins?
    Same as all those different banknotes in circulation when FDR has to clean up the mess?
    Nobody seems to notice this?”

    Seems like i find my answer here.

    • Money supply in the US had been elastic for over a century before the establishment of the Fed. Fractional Reserve Banking led to the elastic supply of money, when commodity money was the standard. The Fed was established to prevent the frequent bank failures that the fractional reserve system led to. The Fed too was on a glod standard until 1933 and until 1971 for foreign holders of US$.

      Volume of any particular cryptocurrency may be fixed, but the total volume of units in all possible cryptocurrencies is infinite. If Bitcoin can become money so can LiteCoin, QuarkCoin and a zillion other possible cryptocurrecies. The only quetion would be how would they gain acceptance? The answer would be in the same way as Bitcoin did.

      • When you have FRB you put a ratio of backing on your money supply so it is always limited by this. To remove the limit you have to remove the backing.
        That’s why the Fed couldn’t do much in 1933 to save the banks.
        Even the fiat USD had a constraint after Bretton Woods. (redeemable in gold only for Central Banks) That’s why Nixon had to close the gold window. A constraint is a constraint, no matter how it is formulated. It’s always your limit and so it’s always your trouble.

        A zillion of currencies with a constraint is a zillion of the same problem.

        How they gain acceptance?
        Why should i hold any currency at all?
        Somebody told me that a particular currency is necessary to pay your taxes in a particular country.

  10. I was wondering if the fact that bitcoins are (near) infinitely divisible in any way effects the need for supply to change as more is demanded?

    • When you divide a BTC, you don’t make more BTC’s, you only make smaller pieces of BTC.
      If you have 1 dollar and you divide it in 100 penny’s, you still have only 1 dollar.

      An elastic money supply means the quantity of money can go up but also down (if needed) in the UNIT of account of that money.

  11. Where there is a bull market today with low interest rates and availability to credit there will be debt behind the bull market, it creates leverage. leverage and greed will be involved. So yes there is a debt involved in this speculation.
    Gold has always been money, when gold backed paper money (as a warehouse certificate) you had the best of both worlds, store of value and medium of exchange.
    There is no store of value with bit coin, just medium of exchange