The Bitcoin Central Bank’s Perfect Monetary Policy
TheMisesCircle.org is no longer being updated. Please see the current version of this article at NakamotoInstitute.org.
The following post provides an analytical framework so that critics and proponents of Bitcoin’s monetary policy can engage in a constructive debate.
Bitcoin has a central bank called the “Bitcoin network,” which we will refer to as the Bitcoin Central Bank (BCB). This central bank issues a currency called “bitcoins” and processes the transfer of bitcoins between accounts. The BCB’s rule-based monetary policy was set at its creation and its independence is secured by the distributed nature of the underlying network. This non-discretionary monetary policy can best be described as asymptotic money supply targeting (AMST).
The BCB issues bitcoins to a network of sub-contractors called “miners” who perform the proof-of-work calculations that secure the BCB’s independence and process payments. The seigniorage subsidizes the payment system instead of benefiting the issuer or the seller/recipient of bonds transacted in open market operations. Proof-of-work seigniorage (PoWS) and AMST work synergistically to cause three monetary phenomena:
- Rational economic agents hold a balance of bitcoins even if they have no bitcoin-denominated liabilities.
- The market sets exchange rates and interest rates, without exception.
- Fractional reserve banking cannot develop, so liquidity traps are impossible.
First, it is rational for economic agents to hold as many bitcoins as they can afford to lose (i.e. without materially impairing their ability to consume or invest). The BCB can offer lower transaction costs than any competitor by orders of magnitude because of the PoWS subsidy. This deep competitive advantage gives economic agents the expectation that it will be adopted as a method of payment and that its exchange rate liquidity will increase. This expectation has repeatedly proven to be true so the desire to hold bitcoins has increased, as indicated by the exchange rate and Internet search volume.
The Market Sets Exchange Rates and Interest Rates
The exchange rate volatility is a byproduct of the BCB choosing independent monetary policy (AMST) and free capital flow over a fixed exchange rate within the Impossible Trinity. Economic agents overcome their cognitive biases to acquire bitcoins in waves due to the word-of-mouth marketing of the currency. For some it takes one exposure to Bitcoin to “get it” while others follow the lead of trendsetters or finally succumb to their regret-aversion bias. Either way, these waves of adopters have a destabilizing effect on the exchange rate: speculators are unsure of the amplitude or wavelength of adoption, and amateurish punters let their excitement as well as subsequent fear overwhelm them. The BCB does not intervene to stabilize these intermittent hype-cycles because steady appreciation of the exchange rate would allow for an even greater buildup of speculative excesses and the BCB would lose the confidence that AMST gives to long-term holders of bitcoins.
Bitcoin’s interest rates are based on the arbitrage between the expected return of holding bitcoins versus the expected return of lending them out. The expected return of holding bitcoins is completely tied to its expected future exchange rate because bitcoins are currently a pure vehicle currency. The heterogeneous expectations of bitcoin holders regarding the exchange rate has led to the development of marginal lending operations. However, the vast majority of bitcoin holders expect exchange rate appreciation at rates far greater than any borrower is willing to pay. Bitcoins will continue to be hoarded and bitcoin-denominated credit markets will continue to be under-developed until either the expectations of bitcoin-holders adjust downward or are met. The BCB does not need to take action to break the current equilibrium state since the hoarders’ expectations will be met given Bitcoin’s proven superiority to legacy payment networks and stores of value.
Fractional Reserve Banking Cannot Develop
Fractional reserve banking entails the creation of new money that is fungible with already preexisting money, i.e. it can be used interchangeably within the currency’s payment systems. This is impossible with Bitcoin. The BCB enforces the strictest deposit regulations in the world by requiring full reserves for all accounts. This is the digital equivalent of the Chicago Plan or the Austrian 100% reserve gold standard. Under this regulatory regime, money is not destroyed when bank debts are repaid, so increased money hoarding does not cause liquidity traps, instead it increases real interest rates and lowers consumer prices. This is a self-stabilizing cycle as higher interest rates incentivize hoarders to invest, while deflation increases consumption due to the wealth-effect on hoarders. The BCB prevents lending out of deposits so that it can properly target money supply and avoid the destabilizing effects of commingling the credit and payment systems.
The positive properties of AMST and PoWS combined make it certain that, absent a technological problem, Bitcoin will be adopted as the global currency. For a deeper understanding of the market process involved in becoming global currency I would recommend reading Konrad Graf’s explanation of hyper-monetization and Peter Šurda’s liquidity analysis of bitcoins. The Bitcoin Central Bank will be the longest lasting institution of its kind thanks to the anti-fragile independent monetary policy it has set in stone.
The last graphic is a terrific explanation of why bc is a real thing..
“The BCB enforces the strictest deposit regulations in the world by requiring full reserves for all accounts.”
I think what the author means here is that because the blockchain is publicly inspectable, depositors at, for instance, Coinbase, would be able to see if Coinbase lends out their money. But companies such as Coinbase do not use the blockchain to keep track of customer accounts and balances. They actually mix all customer coins across one or more Bitcoin addresses so noone can know exactly what happens to their deposit by looking at the blockchain. (One of the reasons for doing this is cold storage security.)
So it’s not true that fractional reserve banking cannot develop. A company such as Coinbase could choose to lend out some of the bitcoins stored with them, while at the same time offering all depositors to withdraw at any time. Then fractional reserve banking in bitcoins is born.
“A company such as Coinbase could choose to lend out some of the bitcoins stored with them, while at the same time offering all depositors to withdraw at any time. Then fractional reserve banking in bitcoins is born.”
Such a business would quickly default, as they cannot grow the supply of bitcoins nor can they turn to a central bank to obtain any more. And there will be no fractional reserve on any bitcoins one stores directly in a wallet only they can access.
They would only default in case of a run on the bank (Coinbase), and then only if they couldn’t themselves borrow bitcoins from some other company.
Are you saying there has never been fractional reserve banking in other commodities such as gold?
Gold does not possess a perfect ledger record of every transaction. One cannot be aware even of how much gold exists in the world precisely, much less how much any one bank had in its vaults.
And it is not difficult, as it is with gold, to store vast quantities of bitcoin without a bank type organization.
Ok, so tell me exactly how many bitcoins Coinbase currently holds.
They could be running fractional reserves right now, and we would have no way of seeing it.
BTW, we are not discussing whether people would use a fractional reserve bank in Bitcoin while they have alternatives. The article said that fractional reserve banking would be IMPOSSIBLE in Bitcoin, and I’m arguing for the possibility of it.
I would change “impossible” for “more difficult” or “not systematic”.
you just don’t understand how fractional reserve banking works; they create out of thin air more money; you give them $1000, they will lend out $9000, as if there’s all of a sudden $10.000
with bitcoin they can’t do that; they cannot create the extra money; coinbase cannot lend out the same bitcoin twice, while that’s what fractional banking does; they constantly create out of thin air more money
lets go to gold to explain it; I store 1 kg of gold, I get 1 ticket for 1kg, they then borrow my 1kg of gold to somebody else, but they give just a ticket (money) not the gold, and then they borrow it again to somebody else, but not the gold, just a ticket, that’s how they create up to 10 tickets supposedly worth 10×1=10kg of gold … while there is only 1 kg of gold … that cannot with bitcoins, when they lend it out, its gone, they cannot lend it out to 9 other people, like the banks do now
kind of, they could indeed lend out other people money, but they cannot fraction it; they cannot lend out more than what they actually store.
If I deposit 10 bitcoins with Coinbase, my account balance with Coinbase will say 10 bitcoins.
Then, if Coinbase went into the business of lending bitcoins, they could credit your account with 1 bitcoins without debiting my account. Now I would act like I have 10 bitcoins, you would act like you had 1 bitcoins, so in total we would act like we had 11 bitcoins, while only 10 bitcoins existed.
what about the liquidity trap that the top 100 BTC holder hold 20% of BTC and growing?
That’s hoarding, which is good ( http://themisescircle.org/blog/2013/02/19/end-the-fed-hoard-bitcoins/ ). Read about what a liquidity trap is here: http://en.wikipedia.org/wiki/Liquidity_trap
Deflation is not beneficial to rational economic calculation, nor is inflation. Businesses want a money that is predictable. Business requires rational economic calculation for long term planning.
Bitcoin can prevent fractional reserve lending but it’s irrelevant because litecoin exists and it’s convertable and there 100 others waiting to become convertable.
If you think Bitcoin and litecoin are market based prices how did both arbitrary tokens reach parity with gold and silver respectively concomitantly? That’s extremely unlikely.
I’m a currency trader and the hyperbolic trends of all tokens have been too perfect to represent human supply and demand.
“I’m a currency trader and the hyperbolic trends of all tokens have been too perfect to represent human supply and demand.”
Must have been the Borg then. Very insightful comments, you must make a lot of money trading currencies.
In the strictest sense, Fractional Reserve Banking is impossible. However, all that is necessary to circumvent this obstacle is:
1 – Exchange Bitcoins to a “Ledger” Bitcoin Balance
2 – Provide the software for the consumer to spend Bitcoins by sweeping money from their “ledger” balance on demand
Since banking DOES require a trusted 3rd party, a ledger balance of how many bitcoins that you own is very easy to accomplish. Then if the Bank issues its own “app” that allows their customers to “spend” their bitcoin balances, you have decoupled the “currency” from the “payment network”.
As for liquidity, it makes no difference at all about how many addresses have how many Bitcoins. That fact does NOT change liquidity but CAN change the market price should they decide to sell large quantities.
My only caution is that Bitcoin may NOT be a great store of value, in the long term (which is how you always measure store of value). Cryptography, hardware, connectivity, etc all point to an evolutionary process that is almost certain to require changes that may indeed make Bitcoins that you have today worthless. As long as we use a store of value horizon in months, then you are probably OK.
It is an excellent analysis, if you accept the assumptions (which are reasonable), but the assumptions may quickly need to be changed.
Saying Bitcoins are issued by an Algorithm, and completely ignoring the cost of developing and running miners, is akin to saying that gold/silver is issued by nuclear fusion. Saying Bitcoin security is cryptographic means basically nothing because security is dependent on the weakest link: the user or exchange actually handling the wallets.
Yes, I should have placed a two page explanation of proof of work in that box instead of “algorithm”. Good point.
Re: security, saying it is cryptographic means basically everything because fiat and precious metals can also be attacked through side channels / human engineering. We’re looking for contrast, not commonality.
Yes, I should have placed a two page explanation of proof of work in that box instead of “algorithm”. Good point.
Re: security, saying it is cryptographic means basically everything
because fiat and precious metals can also be attacked through side
channels / human engineering. We’re looking for contrast, not
Great read thank you. I have reposted it on blog.litetree.com
Thanks, I appreciate it. You should also check out this one: http://themisescircle.org/blog/2013/08/22/the-problem-with-altcoins/
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