Bitcoin‘s monetary bluff

Bitcoin graffiti outside the Institute of Social Sciences, University of Vienna
Source: Beat Weber

Most Bitcoin supporters may no longer beat the drum to threaten government-back money. But, this challenge is certainly the most interesting aspect for economists.

Economists may have their own internal disagreements about money, but in general they agree on a definition based on three functions: Unit of account, means of payment, store of value. Bitcoin’s concept, on the other hand, assumes that current money would be rejected if there only was an alternative like Bitcoin. This assumption is covered over by lots of technical discussion, but does not delve into the economics and definition and function of money itself.

In economics, the unit of account is usually perceived as a public monopoly. All prices in the Euro area are denominated  in Euro, in Pounds in the UK, in Dollar in the US etc. Thereby, consumers can compare prices easily within currency areas. A currency works like a language for the economy. Once a language is established among a community, a new language will find it very hard to displace it, because people shy the cost of switching as long as the current language “works“. In general, people do not have to be forced to stick with their first language (indeed forcing them could prove quite useless if it were necessary). Apart from exceptions due to severe monetary crisis (e.g. hyperinflation), the same goes for the prevailing unit of account.

While there is usually only one unit of account in a currency area, there are many issuers of means of payment, but all are denominated in the prevailing currency unit. Money, the ultimate means of payment, is issued by public authorities (notes and coins), but most retail payments are made by transfer of bank account balances among individuals and firms, not cash. These balances come into existence as a by-product of private banks’ credit creation, and certify a claim on notes and coins that can be used instead of cash in payments on the retail level. Beyond that, IOUs of other private debtors could also be used as means of payment as long as their promises to pay are considered credible by users. Bitcoin is one among many other private means of payment, although it entails some peculiarities.

The third function of money is to serve as store of value. Holding cash is a way for individuals to transfer purchasing power over time while retaining maximum liquidity. In economic history, coin manipulation in the interest of creating income for the state could shatter this quality. Such manipulation was prevalent before the capitalist state discovered the benefits of promoting economic development and regular taxation. In the modern economy, central banks as issuers of money are guided by a public mandate to stabilize money’s purchasing power and contribute to overall economic stability in their issuing behaviour.

Libertarian proclaimers of Bitcoin as an alternative monetary system tend to underappreciate this transformation. From such a stance against the perceived dangers of manipulation, three peculiar features of Bitcoin’s “monetary system“ result: “Money“ in Bitcoin is not issued as liability by an issuer rather,  it is a pure asset to be “discovered“ by miners. It is denominated in its own unit of account. And it has a fixed supply.

These features represent a divergence from common practice in current monetary systems.

The unit of account tends to be a monopoly in any currency area because it is more convenient for users to compare prices in the same unit. By offering a competing unit of account of unstable value in relation to existing units, Bitcoin enhances choice for users in a way comparable to the invention of a private language. More precisely: a private language that consists of a strictly limited number of words of unstable meaning: Not very attractive to learn unless it gets you access to an attractive community or enables you to express things which cannot be expressed in the prevailing language. As a result, there are no commodities on offer worth mentioning that are priced in Bitcoin. In general, merchants that accept Bitcoin denominate their prices in official currency and vary the Bitcoin price according to the current exchange rate.

Use of Bitcoin for the second function of money, as a means of payment, is made unattractive by its own design. When supply is fixed, and the community of Bitcoin users is expected to grow, Bitcoin’s value in terms of official currency can be expected to rise over time. Therefore, holders of Bitcoin have an incentive to hoard the currency, and use official currency for transactions instead. Exceptions are transactions where use of official currency might be unwarranted due to costs or traceability, e.g. small denomination online payments and illicit transactions.

Concerning the store of value function of money, its supply can be adjusted to variations in economic activity in the current system: Central bank interest rate policy influences the terms of credit creation, whose by-product is creation of means of payments. Issuers of means of payment guarantee relative stability of value. In Bitcoin, fluctuation in economic activity concerning Bitcoin results in fluctuation of Bitcoin’s value. There is no issuer able or interested in guaranteeing any stability. As a result, Bitcoin does not provide for a stable store of value.

As a result, institutions such as the ECB governing the current monetary system do not perceive Bitcoin as an economic threat. Bitcoin may be a compelling solution for the problem of finding agreement among mutually distrustful parties, but it does not enable them to govern a substitute for money in a way that provides the qualities most users of money expect. While the system seems able to generate economic activity (mining, exchange rate transactions, various business models for related services etc.), Bitcoin must be expected to serve more as speculative asset than as a substitute for money.

Statements of authorities on Bitcoin therefore usually stress risks to consumers from using Bitcoin as payment system and its possible use for illicit transactions. But that‘s it. Bitcoin does not break new monetary ground, despite its claimed “challenge to a monopoly“ rhetoric or claims of a general “tendency towards diversification“ of money. Nobody uses it as unit of account. It is one among many other private means of payment in the economy. Due to its inherent instability, there are few incentives to use it instead of official currency outside of special niches, and it is a poor store of value.

Some voices from within central banks located in world financial centres have speculated on whether some features of Bitcoin technology could be adopted by monetary authorities (see commentary by the BoE and David Andolfatto). But it is clear that any such solution would require a break with some of the cornerstones of the existing Bitcoin project’s monetary design. Whether a selective cooptation could result in something useful remains unclear at this stage. So far, Bitcoin’s challenge to current money is more or less a bluff.

Beat Weber is an economist employed at Oesterreichische Nationalbank, the central bank of Austria. He is co-editor of "The Political Economy of Financial Regulation“ (Edward Elgar) and author of several articles on related subjects. His recent research focuses on a critical engagement with all kinds of monetary reform proposals. The views expressed in this comment are his own and do not necessarily represent the views of his employer.