The Fiat Emperor Has No Clothes

By Jon Matonis
Forbes
Thursday, April 18, 2013

http://www.forbes.com/sites/jonmatonis/2013/04/18/the-fiat-emperor-has-no-clothes/

A piece from Paul Krugman in The New York Times this week criticizes bitcoin for being antisocial and for not having a State-controlled supply while secretly admiring its powerful abstractness.

As a complicit minion in the State’s appropriation of the monetary unit, Krugman perpetuates ‘The State Theory of Money’ myth that the sovereign’s power to collect taxes and declare legal tender imbues a currency with ultimate value.

While that may be a reason to acquire a certain amount of government fiat currency, it is a transitory value because in the end it is still based on a State-sanctioned illusion. Anyone who has visited a weekend flea market has noticed the old coin and currency collector displays filled with past experiments in national fiat money. Those paper notes were at one time valued for something too.

We don’t want a pristine monetary standard untouched by human frailty as Krugman claims. We want freedom in the monetary standard untouched by the politicizing process.

In a Krugman world, centralized management of the money supply is preferable to a market-based outcome because the academically-informed economists will serve the best interests of the economy at large. However, our monetary overlords possess no special knowledge or secret sauce that justifies dictatorial control over money any more than it would justify dictatorial control over the market for something like soda beverages or dog food. Trust in mathematics trumps trust in central bankers.

The question of political control over a monetary system is the greatest litmus test for discovering those that seek control over others. Usually, it will be cloaked in terms like full employment, price stability, temporary stimulus, quantitative easing, and economic growth, but manipulation of the money supply serves only to favor the issuers of that particular monetary unit.

Money has a lot in common with religion. At some level, it requires a huge leap of faith. Yes, a belief in gold requires this too as the non-monetary value assigned to gold is probably no more than 5% of its market price. However, this is also what makes bitcoin the ultimate social money because for its value it merely requires others, not the law. Money is already the most viral thing on the planet and the network effect exponentially reinforces that.

Krugman actually struggles to assert that bitcoin is antisocial because he cites economist Paul Samuelson who once declared that money is a “social contrivance,” not something that stands outside society. Samuelson is absolutely correct on that point and bitcoin stands firmly within society. It is no one’s right to question why some place value on bitcoin and some do not since all value is subjective. The rationale for assigning value to bitcoin is as varied as the human fabric itself.

In this context, society can be defined as those mutual users willing to agree to a medium of exchange and a store of value. Since bitcoin, just as the Internet, recognizes no political boundaries, Krugman resists seeing the global monetary unit as something social. Krugman sees society only as a multitude of aggregated fiefdoms where he is the emperor’s cherished tailor.

Though, just like the untainted child in the Hans Christian Andersen fairy tale, some of us are beginning to notice. It’s not the illusion itself that so offends our sensibilities, but more the notion that a competitive illusion is not to be permitted. If a free market illusion voluntarily agreed to from the bottom up is so desperately feared, then the protectors of the State-sanctioned illusion must not have the most benevolent of motives in store for us plebeians.

I don’t know about you, but I for one can stand up and exclaim: “the fiat emperor has no clothes!” What if more of us did?

Government Fees, Parking Tickets May Soon Be Paid in Bitcoin

By Jon Matonis
PaymentsSource
Monday, April 8, 2013

http://www.paymentssource.com/news/government-fees-parking-tickets-may-soon-be-paid-in-bitcoin-3013753-1.html

While some call Bitcoin an “existential threat to the state,” local governments could soon embrace the digital currency and payment system as a practical alternative to credit and debit cards.

E-Gov Link, an Ohio company that helps municipalities accept payments online for parking tickets, permits, and the like, now allows its customers to take bitcoin. Noting that "credit card purchases tend to carry high transaction costs due to the middleman and due to the high costs of fraudulent online purchases," E-Gov President Bill Nadler emphasized in a press release, "having a payment option that doesn’t carry that heavy transactional cost is definitely a plus." Bitcoin transactions can be processed at a fraction of the cost of other payment methods because they avoid the interchange structure of the legacy card processors.

Aside from the benefits to merchants, bitcoin payment choices have significant benefits to consumers who may have already received bitcoin from others in the sale of products or services and do not necessarily want to convert out of the digital currency. Broadening merchant acceptance expands the "network effect" of a young currency and starts to make Bitcoin viable as an end-to-end payments system.

"We know the bitcoin community is passionate about using bitcoin for payments, and will be demanding it of their local governments," said Nadler. "We’re happy to be here to answer the call, as municipalities scramble to find partners to help them with bitcoin."

Naturally, the use of bitcoin in local government settings will not be leveraging its optional anonymity properties, thus demonstrating bitcoin's overall flexibility when compared to physical cash.

"We look at bitcoin as a competitive advantage," says Jerry Felix, Vice President of Software Development at E-Gov Link. The company sees it as a natural evolution for governments to accept bitcoin as the currency gains popularity and like in other merchant categories, supporting bitcoin first creates a first-mover advantage. E-Gov Link focuses on integrating bitcoin payments into the shopping cart experience while relying on payment processor BitPay to manage the bitcoin wallets and currency conversion.

"We have customers across the U.S., in over 30 states. We're dealing with small and medium sized municipalities – cities, towns, townships, villages, and counties, and we provide web solutions for them," adds Felix. Marquee client examples for the web solutions provider include municipalities like Niagara Falls, N.Y., and Skokie, Ill.

For now, a municipality has to step forward and ask E-Gov Link to enable bitcoin payments – which is peculiar because other payment methods are not selectively disabled.

It would be far more interesting for these local governments to make it known to citizens that the bitcoin payment choice is an option. Still, the offering from E-Gov Link is a major step in that direction because bitcoin first has to be a viable option for the local government. Whether bitcoin demand is merchant-driven or consumer-driven, one thing is clear. Greater merchant choices and new payment categories contribute to the increasing value of the Bitcoin network.

Payments to government entities stand as one of the primary economic lynchpins for the preferred monetary unit. The obligation of the political authority to accept tax payments in government fiat currency is what underlies its value. While this E-Gov Link move does not cover tax payments demanded in a particular monetary unit, it can be seen as a precursor to a political authority expressing a preference for payments in a digital currency.

Bitcoin Obliterates "The State Theory Of Money"

By Jon Matonis
Forbes
Wednesday, April 3, 2013

http://www.forbes.com/sites/jonmatonis/2013/04/03/bitcoin-obliterates-the-state-theory-of-money/

Once you get past the childish title, the recent bitcoin piece from Karl Denninger raises some issues that warrant consideration from bitcoin economists. Denninger is an intelligent student of the capital markets and his essay deserves a serious reply.

The economic contribution of his essay is that it represents the thesis advanced by German economist Georg Friedrich Knapp in The State Theory of Money (1924), an expose advocating the Chartalist approach to monetary theory claiming that money must have no intrinsic value and strictly be used as tokens issued by the government, or fiat money. Today, modern-day chartalists are from the school of thought known as Modern Monetary Theory (MMT).

Without getting into the intrinsic value debate, this is where I strongly depart from Denninger, because if we accept the thesis that all money is a universal mass illusion, then a market-based illusion can be just as valid or more valid than a State-controlled illusion. What Denninger and Greenbackers and MMT supporters reject is the notion that monetary illusions themselves are a competitive marketplace, falsely believing that only the State is in a ‘special’ position to confer legitimacy in monetary matters.

Regarding this issue of State-sanctioned legitimacy, bitcoin as a cryptographic unit seeks and gains legitimacy through the free and open marketplace. It is not a governmental instrument of legal tender that requires regulatory legitimacy and coercion by law in order to gain acceptance.

Therefore, the path to widespread adoption of bitcoin hinges on three primary market-based developments: (a) robust and liquid global exchanges similar to national currencies that can offer risk management via futures and options, (b) more user-friendly applications that mask the complexities of cryptography from users and merchants, and (c) a paradigm shift towards “closing the loop” such as receiving source payments and wages in bitcoin to eliminate the need for conversion from or to national fiat.

Even after graciously accepting Denninger’s definition of what the ideal currency would be (which I don’t) and searching for any economic nuggets of value, his arguments can be distilled into four main criticisms of bitcoin as a monetary instrument. First, bitcoin does not provide cash-like anonymity. Second, bitcoin transactions take too long for confirmations to be useful in everyday transactions. Third, bitcoin exhibits irreversible entropy.  Fourth, the decoupling of the stateless bitcoin from the obligation of monetary sovereigns is considered a fatal weakness.

Now that we identified the objections, let’s take these in order.

On the first point surrounding bitcoin anonymity, Denninger only embarrasses himself with this criticism. By default, bitcoin may not offer anonymity and untraceability like our paper cash today, but it is better described as user-defined anonymity because the decision to reveal identity and usage patterns resides solely with the bitcoin user. This is far superior to a situation where users of a currency are relegated to seeking permission for their financial privacy which is typically denied by the monetary and financial overlords. Also, his capital gains tax issue is a non-starter because it’s a byproduct of a monopoly over money.

His second criticism of a lack of utility in the ‘goods and service preference’ due to timing of sufficient block chain confirmations has some merit. However, advances have been made in the use of green addressing techniques that solve the confirmation delay problem by utilizing special-purpose bitcoin addresses from parties trusted not to double spend.

Denniger’s third criticism that bitcoin exhibits irreversible entropy is confusing. Typically, entropy refers to a measure of the unavailable energy in a closed thermodynamic system that is also usually considered to be a measure of the system’s disorder. In the case of bitcoin, I suspect Denninger is taking it to mean the degradation of the matter in the universe because of his explicit comparison to gold. While it is true that bitcoins lost or forgotten are ultimately irretrievable, I view that as a feature not a bug because it is the prevailing trait of a digital bearer instrument. Two bitcoin digital attributes that make it superior to physical gold are its ability to create backups and its difficulty of confiscation. Furthermore, the number of spaces to the right of the decimal point (currently eight) is immaterial to bitcoin’s suitability as a monetary unit.

Now for the big and final one. Denninger asserts that monetary sovereign issuers possess not only the privilege, but the obligation, of seigniorage, which Denninger refers to as bi-directional since sovereigns have the responsibility of maintaining a stable price level during times of both economic expansion and economic contraction. As a product of Hayekian free choice in currency, market-based bitcoin is decentralized by nature and poses a false comparison to the century-old practice of central bank monetary manipulation. Fear not deflation.

Governments have appropriated the monetary unit for their own benefit by declaring it the only preferred monetary unit for payment of taxes to the State. Believing that governments have sincere and good intentions in administering the monetary system is akin to believing in fairy tales. Control of the monetary system serves one and only one interest — the unlimited expansion of the sovereign’s spending activity to the detriment of the unfortunate users of that monetary unit. Decentralized Bitcoin obliterates this sad state of affairs.

Denninger’s biased and establishment preference for a monetary sovereign serves only to harm his analysis because it undeniably closes him off from alternative, and usually superior, free-market monetary arrangements. More damaging, however, is the fact that it places him outside of the mainstream in free banking circles and squanders his remaining quasi-libertarian credibility as a champion of markets.

How Cryptocurrencies Could Upend Banks' Monetary Role

By Jon Matonis
American Banker
Friday, March 15, 2013

http://www.americanbanker.com/bankthink/how-cryptocurrencies-could-upend-banks-monetary-role-1057597-1.html

Peter Šurda

I recently had a fascinating chat with the economist Peter Šurda to discuss how nonpolitical cryptocurrencies like bitcoin could alter the future of fractional reserve banking.

Peter is also a software developer experienced in the online payments industry and will present at the Bitcoin 2013: The Future of Payments conference in San Jose in May. His 2012 master's thesis at Vienna University of Economics and Business was entitled Economics of Bitcoin: Is Bitcoin an Alternative to Fiat Currencies and Gold? He's an abstract thinker, but the implications of his work are tantalizing: that digital money like Bitcoin opens up possibilities for banking without central planners or a lender of last resort, where interest rates and reserve requirements are driven purely by the market.

The debate between the full reserve bankers and the fractional reserve bankers is an old one and it has been explored in depth by the Austrian school of economics. More recently, the debate has been broadened to include the dynamics of introducing the bitcoin cryptocurrency, which is the functional equivalent of digital gold, since its supply is predictable and fixed. (There are currently 10.9 million bitcoins in circulation with a total fixed supply of 21 million expected to be mined before 2140, 99% of them by the year 2032.) The Austrian school economist Michael Suede and the technologist Eli Gothill have speculated that fractional reserve banking can indeed appear within a bitcoin monetary environment. This is where we join up with Peter.

JON MATONIS: I enjoyed your blog post, "Market Forces and Fractional Reserve Banking." Do you consider fractional reserve banking to be compatible with Austrian economics?

PETER ŠURDA: First of all, I would like to separate fractional reserve banking and credit expansion. On one hand, there are ways of increasing the money supply, in the broader sense, which do not require fractional reserve banking or changes in the monetary base such as a system based on the principle of mutual credit like LETS [local exchange trading systems], or a fiat currency that uses bitcoin as reserves (i.e. they are not claims in the sense that Ludwig von Mises uses them, but they act as full substitutes). From the opposite direction, fractional reserve banking does not necessarily lead to credit expansion.

I agree with the full reservists that credit expansion has the effects described by the Austrian Business Cycle Theory. However, I agree with the free bankers that fractional reserve banking is not necessarily a violation of property rights and other ways of increasing the money supply also are not necessarily a violation of property rights.

So I think that the economic and legal analysis are two separate issues and need to be addressed separately. I avoided the legal analysis in my thesis and concentrated on Austrian Business Cycle Theory and policy issues, but in an earlier draft I have several pages about legal aspects too, and I discussed the topic with [the legal theorist] Stephan Kinsella.

JON MATONIS: How does a nonpolitical cryptocurrency like bitcoin alter the landscape in the "full reserve" versus "fractional reserve" banking debate?

PETER ŠURDA: Austrians have made arguments in the past that lead to the conclusion that fractional reserve banking does not necessarily lead to credit expansion, even though they never explicitly formulated it this way and might not have realized the connection. The reason is that if credit instruments do not decrease transaction costs over the monetary base, they are unlikely to act as a part of the money supply. Bitcoin shows that this is not only a hypothetical but empirically possible to implement. With Bitcoin, it is much less likely that credit expansion will occur.

In other words, we need to separate two things. Why do people want to hold fractional reserve banking instruments, which may include the interest payments as one of the reasons, and why do people want to use fractional reserve banking instruments as a medium of exchange which, I argue, requires that the fractional reserve banking instruments decrease transaction costs. That they historically manifested themselves through a common instrument is an empirical quirk and not an economic rule. The ability to loan money is beneficial. Contrary to many Austrians, I agree that maturity transformation can be beneficial, and if the loan ends up being a liquid instrument, it also can be beneficial. But if it is so liquid that it becomes a part of the money supply, that's when it has a detrimental effect on the economy.

For full reservists, Bitcoin shows that the question of fractional reserve banking is less important than they thought. Fractional reservists, on the other hand, need to think about the nature of the mechanisms equilibrating the money supply. I tried to explain the issue to [the economists] George Selgin and David Glasner in comments on their websites, but I wasn't successful in getting my point through.

JON MATONIS: If bitcoin is digital gold, does that portend a future where a bitcoin standard (akin to the gold standard) can emerge or partial bitcoin backing for other currencies?

PETER ŠURDA: They probably can emerge, but the more important question is whether they would be preferred to bitcoin. Only something that provides a significant improvement would be preferred. I only know two potential candidates for that: Ripple and OpenTransactions.

JON MATONIS: In a bitcoin world, is fractional reserve banking only possible with offline substitutes (such as physical coins or cards, which can be traded hand-to-hand, containing the private key to a bitcoin address) or an intentional "fork" in the block chain ledger?

PETER ŠURDA: Hypothetically, the reserves can be offline and the substitute can be a clearing system like Ripple, so there are other possibilities too. But if I understand your point correctly, offline "substitutes" might have a higher chance of actually becoming full substitutes because they might have more obvious advantages.

JON MATONIS: As the recent block chain fork episode demonstrates, there is a need for offline bitcoin transactions to continue. Is this demand sufficient for a money substitute to evolve, such as offline substitutes with full or partial bitcoin backing?

PETER ŠURDA: This is primarily an empirical question, so we can't be completely sure about that. I think the probability for this is significantly lower than with the currencies that we've known historically. The end result is also path-dependent; for instance, it depends on how quickly bitcoin matures and/or adapts to changes compared to the potential substitute.

Fractional reserve banking does not come into existence magically. It must follow economic rules. With gold and similar commodities, fractional reserve banking comes into existence for these reasons: On the demand side, there is a demand for money substitutes, because they provide something that money proper does not; and on the supply side, money substitutes carry maintenance costs for the issuer (e.g. storage of gold) and these need to be offset somehow. The issuer can charge on holding (e.g. demurrage of bank notes), transacting (e.g. check clearing), or, obviously, externalize the costs through fractional reserves. From the point of view of an individual user, fractional reserve banking appears to be the least costly alternative. So obviously fractional reserve banking wins.

Putting it together: If there is a general demand for money substitutes, this leads to fractional reserve banking. Unless it's illegal. Then it might not. Solution: Have money which does not lead to the creation of money substitutes. Bitcoin shows that at least hypothetically, this is possible. I might even go a bit further and make this statement: If on a free market money substitutes do not develop even though there is no legal or technical obstacle for them, it means that the choice of money is Pareto-optimal since no change in the monetary system leads to an increase in utility.

JON MATONIS: Does a demand for positive return on bitcoin balances lead to an environment of competitive bank lending with risk-adjusted interest rates? And will this lead to an environment of fractional reserve banking with depositors offered higher interest rates in exchange for the additional risk premium of running a fractional portfolio?

PETER ŠURDA: Yes, I would say it does, but until there are industry niches that primarily use bitcoin, it is probably not much different from gambling.

This might lead to negotiable credit instruments with maturity-mismatching or maturity transformation, depending on which economic school you use for terminology. However, I don't think this feature alone is sufficient for these instruments to be accepted as full substitutes whereas George Selgin appears to think it is. Now, whether to call such a situation "fractional reserve banking" even though no credit expansion occurs is unclear. I lean towards yes, but there could be other interpretations.

JON MATONIS: How do you see bitcoin changing interest rate structures and lending practices?

PETER ŠURDA: Using Bitcoin for loans only makes sense for those businesses that use bitcoin as a unit of account, unless, of course, you're just speculating on the market but don't actually sell any goods or services. I think this will only occur at much higher levels of liquidity or until we can be quite sure that it deserves the label "money." Until these higher levels of liquidity are reached, the price of bitcoin will probably be quite volatile, which reduces the likelihood that people use it as a unit of account.

However, there could be niche market segments that use bitcoin as a primary medium of exchange and [bitcoin] mining is the most obvious candidate. For these, the unit of account function would make sense even if the global market penetration is lower.

Assuming one of these thresholds is crossed and the money supply remains inelastic (i.e. no significant credit expansion), the interest rate of bitcoin should be a good reflection of the time preference of those market participants that use it as a unit of account. Bitcoin also makes it much easier for lending to occur in a decentralized manner, I think. Rather than a small number of "too big to fail" institutions, we should see smaller specialized teams that act as facilitators without owning the liabilities or being liable themselves.

JON MATONIS: Can a free market fractional reserve system (as opposed to a central banking fractional reserve system) coexist with full reserve banking? Or will one drive out the other?

PETER ŠURDA: I think that if money substitutes emerge, fractional reserve banking will out-compete 100% reserve banking in the market. I deal with this a bit in an earlier draft of the thesis. If they don't emerge, on the other hand, we'll have a money supply equivalent to the monetary base and debt will not cause changes in the money supply. It would be viewed as merely highly liquid credit. I don't think they can coexist for a long time assuming the same underlying money in the narrower sense, of course.