The Bitcoin Standard
Bitcoin solves a problem that has persisted for all of humanity’s existence: how to move economic value across time and space. In order to understand Bitcoin, we must first understand money, and to understand money, there is no alternative to the study of the function and history of money.
A good that assumes the role of a widely accepted medium of exchange is called money. Being a medium of exchange is the quintessential function that defines money, and there is nothing in principle that stipulates what should or should not be used as money. Any person choosing to purchase something not for its own sake, but with the aim of exchanging it for something else, is making it de facto money. Throughout human history, many things have served the function of money: gold and silver, most notably, but also copper, seashells, large stones, salt, cattle, government paper, precious stones, and even alcohol and cigarettes in certain conditions. People’s choices are subjective, and there is no “right” and “wrong” choice of money. There are, however, consequences to their choices. Free-market monetary competition is ruthlessly effective at producing sound money, as it only allows those who choose the right money to maintain considerable wealth over time.
Carl Menger, the father of the Austrian school of economics, came up with an understanding of the key property that leads to a good being adopted freely as money on the market, and that is salability—the ease with which a good can be sold on the market whenever its holder desires, with the least loss in its price. The relative salability of goods can be assessed in terms of how well they address the three facets of the problem of the lack of coincidence of wants: their salability across scales, across space, and across time. The problem of coincidence of wants emerges in sophisticated and larger economies when what you want to acquire is produced by someone who doesn’t want what you have to sell. There are three dimensions to the problem.
First, there is a lack of coincidence in scales: what you want may not be equal in value to what you have and dividing one of them into smaller units may not be practical (i.e. wanting to sell a house for shoes). A good that is salable across scales can be conveniently divided into smaller units or grouped into larger units, thus allowing the holder to sell it in whichever quantity he desires.
Second, there is a lack of coincidence of locations: you may want to sell a house in one place and buy a house in another location. Salability across space indicates an ease of transporting the good, and this has led to good monetary media generally having high value per unit of weight.
Third, there is a lack of coincidence in time frames: what you want to sell may be perishable but what you want to buy is more durable and valuable, making it hard to accumulate enough of your perishable goods to exchange for the durable good at one point in time (i.e. it’s not easy to accumulate enough apples to be exchanged for a car at once). The first two characteristics—salability across scales and salability across space—are not very hard to fulfill by a large number of goods that could potentially serve the function of money. It is the third element, salability across time, which is the most crucial.
A good’s salability across time refers to its ability to hold value into the future, allowing the holder to store wealth in it, which is the second function of money: store of value. For a good to be salable across time it has to be immune to rot, corrosion, and other types of deterioration (i.e. don’t store your wealth in fish or apples). Physical integrity through time, however, is a necessary but insufficient condition for salability across time, as it is possible for a good to lose its value significantly even if its physical condition remains unchanged. For the good to maintain its value, it is also necessary that the supply of the good not increase too drastically during the period during which the holder owns it. The relative difficulty of producing new monetary units determines the hardness of money: money whose supply is hard to increase is known as “hard money,” while “easy money” is money whose supply is amenable to large increases.
We can understand money’s hardness through understanding two distinct quantities related to the supply of a good: 1) the stock, which is its existing supply, consisting of everything that has been produced in the past, minus everything that has been consumed or destroyed; and 2) the flow, which is the extra production that will be made in the next time period. The ratio between the stock and flow is a reliable indicator of a good’s hardness as money, and how well it is suited to playing a monetary role. A good that has a low stock-to-flow ratio is one whose existing supply can be increased drastically if people start using it as a store of value. Such a good would be unlikely to maintain its value if chosen as a store of value. The higher the ratio of the stock to the flow, the more likely a good is to maintain its value over time and thus be more salable across time.
Throughout history, whenever a natural, technological, or political development resulted in quickly increasing the new supply of a monetary good, the good would lose its monetary status and be replaced by other media of exchange with a more reliably high stock-to-flow ratio. For example, seashells were used as money when they were hard to find. When new technology made the importation and catching of seashells easy, societies that used them switched to metal or paper money. Today, when a government increases its currency’s supply, its citizens shift to holding foreign currencies, gold, or other more reliable monetary assets. The twentieth century provided us an unfortunately enormous number of such tragic examples, particularly from developing countries. The monetary media that survived for longest are the ones that had very reliable mechanisms for restricting their supply growth—in other words, hard money. Competition is at all times alive between monetary media, and its outcomes are foretold through the effects of technology on the differing stock-to-flow ratio of the competitors.
While people are generally free to use whichever goods they please as their media of exchange, the reality is that over time, the ones who use hard money will benefit most, by losing very little value due to the negligible new supply of their medium of exchange. Those who choose easy money will likely lose value as its supply grows quickly, bringing its market price down. Whether through prospective rational calculation, or the retrospective harsh lessons of history, the majority of money and wealth will be concentrated with those who choose the hardest and most salable forms of money.
Beyond the stock-to-flow ratio, another important aspect of a monetary medium’s salability is its acceptability by others. The more people accept a monetary medium, the more liquid it is, and the more likely it is to be bought and sold without too much loss. In social settings with many peer-to-peer interactions, as computing protocols demonstrate, it is natural for a few standards to emerge to dominate exchange, because the gains from joining a network grow exponentially the larger the size of the network (i.e. Facebook, IMAP/POP3 protocol, HTTP, etc.). Further, wide acceptance of a medium of exchange allows all prices to be expressed in its terms, which allows it to play the third function of money: unit of account. In an economy with no recognized medium of exchange, each good will have to be priced in terms of each other good, leading to a large number of prices, making economic calculations exceedingly difficult. In an economy with one medium of exchange, all prices of all goods are expressed in terms of the same unit of account. Only with a uniform medium of exchange acting as a unit of account does complex economic calculation become possible, and with it comes the possibility for specialization into complex tasks, capital accumulation, and large markets. Having a single medium of exchange allows the size of the economy to grow as large as the number of people willing to use that medium of exchange. The larger the size of the economy, the larger the opportunities for gains from exchange and specialization, and perhaps more significantly, the longer and more sophisticated the structure of production can become. For example, the gold standard allowed for unprecedented global capital accumulation and trade by uniting the majority of the planet’s economy on one sound market-based choice of money.
To understand how commodity money—like gold—emerges, we have to understand the easy money trap. A money that is easy to produce is no money at all, and easy money does not make a society richer; on the contrary, it makes it poorer by placing all its hard-earned wealth for sale in exchange for something easy to produce. Any time a person chooses a good as a store of value, he is effectively increasing the demand for it beyond the regular market demand, which will cause its price to rise. This is the anatomy of a market bubble: increased demand causes a sharp rise in prices, which drives further demand, raising prices further, incentivizing increased production and increased supply, which inevitably brings prices down, punishing everyone who bought at a price higher than the usual market price. Investors in the bubble are fleeced while producers of the asset benefit.
For anything to function as a good store of value, it has to beat this trap: it has to appreciate when people demand it as a store of value, but its producers have to be constrained from inflating the supply significantly enough to bring the price down. Such an asset will reward those who choose it as their store of value, increasing their wealth in the long run as it becomes the prime store of value, because those who chose other commodities will either reverse course by copying the choice of their more successful peers, or will simply lose their wealth.
The clear winner in this race throughout history has been gold, which maintains its monetary role due to two unique physical characteristics that differentiate it from other commodities: first, gold is so chemically stable that it is virtually impossible to destroy, and second, gold is impossible to synthesize from other materials and can only be extracted from its unrefined ore, which is extremely rare in our planet. This means that the existing stockpile of gold held by people around the world is the product of thousands of years of gold production, and is orders of magnitude larger than new annual production. Over the past seven decades, this growth rate has always been around 1.5%, never exceeding 2%. Only silver comes close to gold in this regard, with an annual growth rate historically around 5-10%, rising to around 20% in the modern day.
It is this consistently low rate of supply of gold that is the fundamental reason it has maintained its monetary role throughout human history, a role it continues to hold today as central banks continue to hold significant supplies of gold to protect their paper currencies. History shows that human civilizations flourished in times and places where sound money, such as gold, was widely adopted, while unsound money all too frequently coincided with civilizational decline and societal collapse.
There are countless examples, but one of the more compelling lessons comes from the effect that the demonetization of silver had on nations that were using it as a monetary standard in the 19th and 20th centuries. In Florence in 1252, the city minted the florin (~3.5 grams of pure gold), the first major European sound coinage since Julius Caesar’s aureus. This adoption of a sound monetary standard gave citizens the freedom to work, produce, trade, and flourish. Florence’s rise made it the commercial center of Europe, with its florin becoming the prime European medium of exchange, allowing its banks to thrive across the entire continent. Venice was the first to follow Florence’s example with its minting of the ducat, of the same specifications as the florin, in 1270, and by the end of the 14th century, more than 150 European cities and states had minted coins of the same specifications as the florin, allowing their citizens the dignity and freedom to accumulate wealth and trade with a sound money that was highly salable across time and space, and divided into small coins, allowing for easy divisibility. With the economic liberation of the European peasantry came the political, scientific, intellectual, and cultural flourishing of the Italian city-states, which later spread across the European continent.
Following the introduction of the florin, more and more Europeans adopted gold and silver for saving and trade. Given that they were used physically, silver and gold complemented each other: gold’s high stock-to-flow ratio meant it was ideal as a long-term store of value and a means of large payments, but silver’s lower value per unit of weight made it easily divisible into quantities suitable for smaller transactions and for being held for shorter durations. However, two particular technological advancements would move Europe and the world away from physical coins and in turn help bring about the demise of silver’s monetary role: the telegraph (first deployed commercially in 1837), and the growing network of trains allowing transportation across Europe. With these two innovations, it became increasingly feasible for banks to communicate with each other, sending payments efficiently across space when needed and debiting accounts instead of having to send physical payments. This led to the increased use of bills, checks, and paper receipts as monetary media instead of physical gold and silver coins.
More nations began to switch to a monetary standard of paper fully backed by, and instantly redeemable into, precious metals held in vaults. Some nations would choose gold, and others would choose silver, in a fateful decision that was to have enormous consequences. Britain was the first to adopt a modern gold standard in 1717, under the direction of physicist Isaac Newton, who was the warden of the Royal Mint, and the gold standard would play a great role in advancing its trade across its empire worldwide. The economic supremacy of Britain was intricately linked to its being on a superior monetary standard, and other European countries began to follow it. The more nations officially adopted the gold standard, the more marketable gold became and the larger the incentive became for other nations to join. With these media being backed by physical gold in the vaults and allowing payment in whichever quantity or size, there was no longer a real need for silver’s role in small payments. The death knell for silver’s monetary role was the end of the Franco-Prussian war, when Germany extracted an indemnity of ₤200mm in gold from France and used it to switch to a gold standard. With Germany now joining Britain, France, Holland, Switzerland, Belgium, and others on a gold standard, the monetary pendulum had swung decisively in favor of gold, leading to individuals and nations worldwide who used silver to witness a progressive loss of their purchasing power and a stronger incentive to shift to gold.
India witnessed a continuous devaluation of its silver-backed rupee compared to gold-based European countries, which led the British colonial government to increase taxes to finance its operation, leading to growing unrest and resentment of British colonialism. By the time India shifted the backing of its rupee to the gold-backed pound sterling in 1898, the silver backing its rupee had lost 56% of its value in the 27 years since the end of the Franco-Prussian war. For China, which stayed on the silver standard until 1935, its silver (in various names and forms) lost 78% of its value over the period. The history of China and India, and their failure to catch up to the West during the 20th century, is inextricably linked to this massive destruction of wealth and capital brought about by the demonetization of the monetary metal these countries utilized. Domestic money was easy for foreigners, and was being driven out by foreign hard money, which allowed foreigners to control and own increasing quantities of the capital and resources of China and India during the period. This is a historical lesson of immense significance, and should be kept in mind by anyone who thinks his refusal of Bitcoin means he doesn’t have to deal with it. History shows it is not possible to insulate yourself from the consequences of others holding money that is harder than yours.
Since then, gold has fallen into the hands of increasingly centralized banks. With this, it gained salability across time, scales, and location, but lost its property as cash money, making payments in it subject to the agreement of the financial and political authorities issuing receipts, clearing checks, and hoarding the gold. It has thus fallen prey to a major problem of sound money: individual sovereignty over money and its resistance to government centralized control.
Government money is similar to primitive forms of money and commodities other than gold, in that it is liable to having its supply increased quickly compared to its stock, leading to a quick loss of salability, destruction of purchasing power, and impoverishment of its holders. The problem with government-provided money is that its hardness depends entirely on the ability of those in charge to not inflate its supply. Only political constraints provide hardness, and there are no physical, economic, or natural constraints on how much money government can produce. Cattle, silver, gold, and seashells all require serious effort to produce them and can never be generated in large quantities at the drop of a hat, but government money requires only the fiat of the government.
History has shown that governments will inevitably succumb to the temptation of inflating the money supply. Whether it’s because of downright graft, “national emergency,” or an infestation of inflationist schools of economics, government will always find a reason and a way to print more money, expanding government power while reducing the wealth of the currency holders. The government can always print money and so faces no real constraints on its spending, which it can use to achieve whichever goal the electorate sets for it. This is a huge problem in many nations today because constantly increasing supply means a continuous devaluation of the currency, expropriating the wealth of the holders to benefit those who print the currency, and those who receive it earliest.
A few reasons keep government money as the prime money of our time. First, governments mandate that taxes are paid in government money, which means individuals are highly likely to accept it, giving it an edge in its salability. Second, government control and regulation of the banking system means that banks can only open accounts and transact in government-sanctioned money, thus giving government money a much higher degree of salability than any other potential competitor. Third, legal tender laws make it illegal in many countries to use other forms of money for payment. Fourth, all government moneys are still backed by gold reserves, or backed by currencies backed by gold reserves.
For those who worship government power and take joy in totalitarian control, such as the many totalitarian and mass-murdering regimes of the twentieth century, this monetary arrangement was a godsend. But for those who valued human liberty, peace, and cooperation among humans, it was a depressing time with the prospects of economic reform receding ever more with time and the prospects of the political process ever returning us to monetary sanity becoming an increasingly fanciful dream. As Friedrich Hayek put it: “I don’t believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we can’t take it violently out of the hands of government, all we can do is by some sly roundabout way introduce something that they can’t stop.”
Speaking in 1984, completely oblivious to the actual form of this “something they can’t stop,” Friedrich Hayek’s prescience sounds outstanding today.
Three decades after he uttered these words, and a whole century after governments destroyed the last vestige of sound money that was the gold standard, individuals worldwide have the chance to save and transact with a new form of money, chosen freely on the market and outside government control. In its infancy, Bitcoin already appears to satisfy all the requirements necessary: it is a highly salable free-market option that is resistant to government meddling.
Money and Time Preference
Sound money is chosen freely on the market for its salability, because it holds its value across time, because it can transfer value effectively across space, and because it can be divided and grouped into small and large scales. It is money whose supply cannot be manipulated by a coercive authority that imposes its use on others.
The importance of sound money can be explained for three broad reasons: first, it protects value across time, which gives people a bigger incentive to think of their future, and lowers their time preference. The lowering of the time preference is what initiates the process of human civilization and allows for humans to cooperate, prosper and live in peace. Second, sound money allows for trade to be based on a stable unit of measurement, facilitating ever-larger markets, free from government control and coercion, and with free trade comes peace and prosperity. Further, a unit of account is essential for all forms of economic calculation and planning, and unsound money makes economic calculation unreliable and is the root cause of economic recessions and crises. Finally, sound money is an essential requirement for individual freedom from despotism and repression, as the ability of a coercive state to create money can give it undue power over its subjects, power which by its very nature will attract the least worthy, and most immoral to take its reins.
Sound money is a prime factor in determining individual time preference, an enormously important and widely neglected aspect of individual decision making. Time preference refers to the ratio at which individuals value the present compared to the future. Human beings’ lower time preference allows us to curb our instinctive and animalistic impulses. Only through a lower time preference can a human decide to take time away from hunting and dedicate that time to building a spear or fishing rod that cannot be eaten itself (capital goods), but can allow him to hunt more proficiently. This is the essence of investment: as humans delay immediate gratification, they invest their time and resources in the production of capital goods which will make production more sophisticated or technologically advanced and extend it over a longer time-horizon. In other words, investment raises the productivity of the producer.
Not only does investment require delaying gratification, it also always carries with it a risk of failure, which means the investment will only be undertaken with an expectation of a reward. The lower an individual’s time preference, the more likely he is to engage in investment, to delay gratification, and to accumulate capital. The more capital is accumulated, the higher the productivity of labor, and the longer the time horizon of production. For a demonstration of the importance of time preference, take a second to Wikipedia the Stanford marshmallow experiment.
A low time preference society is one in which individuals bequeath their children more than what they received from their parents. It is a civilized society where life is improving, and people live with a purpose of making the next generation’s lives better. As society’s capital levels continue to increase, productivity increases and, along with it, the quality of life. With the security of their basic needs assured, and the dangers of the environment averted, people turn their attention toward more profound aspects of life than material well-being and the drudgery of work. They cultivate families and social ties; undertake cultural, artistic, and literary projects; and seek to offer lasting contributions to their community and the world. Civilization is not about more capital accumulation per se; rather, it is about what capital accumulation allows humans to achieve, the flourishing and freedom to seek higher meaning in life when their base needs are met, and most pressing dangers averted.
There are many factors that come into play in determining the time preference of individuals. Security of people in their person and property is arguably one of the most important. However, the factor affecting time preference that is most relevant to our discussion is the expected future value of money. In a free market where people are free to choose their money, they will choose the form of money most likely to hold its value over time. The better the money is at holding its value, the more it incentivizes people to delay consumption and instead dedicate resources for production in the future, leading to capital accumulation and improvement of living standards.
The move from money that holds its value or appreciates to money that loses its value is very significant in the long run: society saves less, accumulates less capital, and possibly begins to consume its capital; worker productivity stays constant or declines, resulting in the stagnation of real wages, even if nominal wages can be made to increase through the magical power of printing ever more depreciating pieces of paper money. In modern economies, government-issued money is inextricably linked to artificially lower interest rates, which is a desirable goal for modern economists because it promotes borrowing and investing. But the effect of this manipulation of the price of capital is to artificially reduce the interest rate that accrues to savers and investors, as well as the one paid by borrowers. The natural implication of this process is to reduce savings and increase borrowing. At the margin, individuals will consume more of their income and borrow more against the future.
A theoretically ideal money would be one whose supply is fixed, meaning nobody could produce more of it. The only noncriminal way to acquire money in such a society would be to produce something of value to others and exchange it with them for money (i.e. Galt’s Gulch). As everyone seeks to acquire more money, everyone works more and produces more, leading to improving material well-being for everyone, which in turn allows people to accumulate more capital and increase their productivity. Such a money would also work perfectly well as a store of value, by preventing others from increasing the money supply; the wealth stored into it would not depreciate over time, incentivizing people to save and allowing them to think more of the future. With growing wealth and productivity and an increased ability to focus on the future, people begin to reduce their time preference and can focus on improving non-material aspects of their life, including spiritual, social, and cultural endeavors. This helps explains why civilizations prosper under a sound monetary system, but disintegrate when their monetary systems are debased.
The track record of the 46-year experiment with unsound money bears out this conclusion. Savings rates have been declining across developed countries, dropping to very low levels, while personal, municipal, and national debts have increased to levels which would have seemed unimaginable in the past. Only Switzerland, which remained on an official gold standard until 1934, and continued to back its currency with large reserves of gold until the early 1990s, has continued to have a high savings rate, standing as the last bastion of low-time-preference Western civilization with a savings rate in the double digits, as every other Western economy has plummeted into the single digits and even to negative savings rates in some cases. The average savings rate of the seven largest advanced economies was 12.66% in 1970, but has dropped to 3.39% in 2015.
While savings rates have plummeted across the western world, indebtedness continues to rise. The average household in the West is indebted by more than 100% of its annual income, while the total debt burden of the various levels of government and households exceeds GDP by multiples, with significant consequences. Such numbers have been normalized as Keynesian economists assure citizens that debt is good for growth and that saving would result in recessions. One of the most mendacious fantasies that pervades Keynesian economic thought is the idea that the national debt “does not matter, since we owe it to ourselves.” Only a high-time-preference disciple of Keynes could fail to understand that this “ourselves” is not one homogeneous blob but is differentiated into several generations—namely, the current one which consume recklessly at the expense of future ones.
Many pretend this is a miraculous modern discovery from Keynes’s brilliant insight that spending is all that matters, and that by ensuring spending remains high, debts can continue to grow indefinitely and savings can be eliminated. In reality, there is nothing new in this policy, which was employed by the decadent emperors of Rome during its decline, except that it is being applied with government-issued paper money. Indeed, paper money allows it to be managed a little more smoothly, and less obviously than the metallic coins of old. But the results are the same.
The twentieth century’s binge on conspicuous consumption cannot be understood separately from the destruction of sound money and the outbreak of Keynesian high-time-preference thinking, in vilifying savings and deifying consumption as the key to economic prosperity. The reduced incentive to save is mirrored with an increased incentive to spend, and with interest rates regularly manipulated downwards and banks able to issue more credit than ever, lending stopped being restricted to investment, but has moved on to consumption. Credit cards and consumer loans allow individuals to borrow for the sake of consumption without even the pretense of performing investment in the future. It is an ironic sign of the depth of modern-day economic ignorance fomented by Keynesian economics that capitalism—an economic system based on capital accumulation from saving—is blamed for unleashing conspicuous consumption—the exact opposite of capital accumulation Capitalism is what happens when people drop their time preference, defer immediate gratification, and invest in the future. Debt-fueled mass consumption is as much a normal part of capitalism as asphyxiation is a normal part of respiration.
This also helps explain one of the key Keynesian misunderstandings of economics, which considers that delaying current consumption by saving will put workers out of work and cause economic production to stall. Keynes viewed the level of spending at any point in time as being the most important determinant of the state of the economy because, having studied no economics, he had no understanding of capital theory and how employment does not only have to be in final goods, but can also be in the production of capital goods which will only produce final goods in the future. He would also have understood that the only cause of economic growth in the first place is delayed gratification, saving, and investment, which extend the length of the production cycle and increase the productivity of the methods of production, leading to better standards of living. Friedrich Hayek once said, “The cause of waves of unemployment is not ‘capitalism’ but governments denying enterprises the right to produce good money.”
Debt is the opposite of saving. If saving creates the possibility of capital accumulation and civilizational advance, debt is what can reverse it, through the reduction in capital stocks across generations, reduced productivity, and a decline in living standards. Whether it is housing debt, Social Security obligations, or government debt that will require ever-higher taxes and debt monetization to refinance, the current generations may be the first in the western world since the demise of the Roman Empire (or, at least, the Industrial Revolution) to come into the world with less capital than their parents. Rather than witness their savings accumulate and raise the capital stock, this generation has to work to pay off the growing interest on its debt, working harder to fund entitlement programs they will barely get to enjoy while paying higher taxes and barely being able to save for their old age.
This move from sound money to depreciating money has led to several generations of accumulated wealth being squandered on conspicuous consumption within a generation or two, making indebtedness the new method for funding major expenses. Whereas 100 years ago most people would pay for their house, education, or marriage from their own labor or accumulated savings, such a notion seems ridiculous to people today. This sort of arrangement can last for a while, but its lasting cannot be mistaken for sustainability, as it is no more than the systematic consumption of the capital stock of society—the eating of the seed crop. When money was nationalized, it was placed under the command of politicians who operate over short time-horizons of a few years, trying their best to get reelected. It was only natural that such a process would lead to short-term decision making where politicians abuse the currency to fund their reelection campaigns at the expense of future generations. In a society where money is free and sound, individuals have to make decisions with their capital that affect their families in the long run.
Capitalism’s Information System
Money’s primary function as a medium of exchange is what allows economic actors to engage in economic planning and calculation. As economic production becomes more sophisticated, it becomes harder for individuals to make production, consumption, and trade decisions without having a fixed frame of reference with which to compare the value of different objects to one another. This property, the unit of account, is the third function of money after being a medium of exchange and store of value. To understand the significance of this property to an economic system, we again turn to the work of Austrian economists.
The Use of Knowledge in Society, by Fredrich Hayek is arguably one of the most important economic papers to have ever been written. Hayek explained that contrary to popular and elementary treatments of the topic, the economic problem is not merely the problem of allocating resources and products, but more accurately, the problem of allocating them using knowledge that is not given in its totality to any single individual or entity. Economic knowledge of the conditions of production, the relative availability and abundance of the factors of production, and the preferences of individuals, is not objective knowledge that can be fully known to a single entity. Rather, the knowledge of economic conditions is by its very nature distributed and situated with the people concerned by their individual decisions. Every human’s mind is consumed in learning and understanding the economic information relevant to them. Highly intelligent and hardworking individuals will spend decades learning the economic realities of their industries in order to reach positions of authority over the production processes of one single good. It is inconceivable that all these individual decisions being carried out by everyone could be substituted by aggregating all that information into one individual’s mind to perform the calculations for everyone. Nor is there a need for this insane quest to centralize all knowledge into one decision maker’s hands.
In a free market economic system, prices are knowledge, and the signals that communicate information. Each individual decision maker is only able to carry out her decisions by examining the prices of the goods involved, which carry in them the distillation of all market conditions and realities into one actionable variable for that individual. In turn, each individual’s decision will in turn play a role in shaping the price. No central authority could ever internalize all the information that goes into forming a price or replace its function.
To understand Hayek’s point, picture the scenario of an earthquake badly damaging the infrastructure of a country that is the world’s major producer of a commodity, such as the 2010 earthquake in Chile, which is the world’s largest producer of copper. As the earthquake hit a region with extensive copper mines, it caused damage to these mines and to the seaport from which they are exported. This meant a reduction in the supply of copper to the world markets and immediately resulted in a 6.2% rise in the price of copper. Anybody in the world involved in the copper market will be affected by this, but they do not need to know anything about the earthquake, Chile, or the conditions of the market in order to decide how to act. The rise in the price itself contains all the relevant information they need. Immediately, all the firms demanding copper now have an incentive to demand a smaller quantity of it, delay purchases that weren’t immediately necessary, and find substitutes. On the other hand, the rising price gives all firms that produce copper anywhere around the world an incentive to produce more of it, to capitalize on the price rise.
With the simple increase in the price, everyone involved in the copper industry around the world now has the incentive to act in a way that alleviates the negative consequences of the earthquake: other producers supply more while consumers demand less. As a result, the shortage caused by the earthquake is not as devastating as it could be, and the extra revenue from the rising prices can help the miners rebuild their infrastructure. Within a few days, the price was back to normal. As global markets have become more integrated and larger, such individual disruptions are becoming less impactful than ever, as market makers have the depth and liquidity to get around them quickly with the least disruption.
To understand the power of prices as a method of communicating knowledge, imagine that the day before the earthquake, the entirety of the global copper industry stopped being a market institution and was instead put under the command of a specialized agency, meaning production is allocated without any recourse to prices. How would such an agency react to the earthquake? Of all the many copper producers worldwide, how would they decide which producers should increase their production and by how much? Further, how will the planners decide on which consumers of copper should reduce their consumption and by how much, when there are no prices allowing these consumers to reveal their preferences?
No matter how much objective data and knowledge the agency might collect, it can never know all the dispersed knowledge that bears on the decisions that each individual carries out, and that includes their own preferences and valuations of objects. Prices, then, are not simply a tool to allow capitalists to profit; they are the information system of economic production, communicating knowledge across the world and coordinating the complex processes of production. Any economic system that tries to dispense with prices will cause the complete breakdown of economic activity and bring a human society back to a primitive state.
Prices are the only mechanism that allows trade and specialization to occur in a market economy. Trade allows producers to increase their living standards through specialization in the goods in which they have a comparative advantage—goods which they can produce at a lower relative cost. Only with accurate prices expressed in a common medium of exchange is it possible for people to identify their comparative advantage and specialize in it. Specialization itself, guided by price signals, will lead to producers further improving their efficiency in the production of these goods through learning by doing, and more importantly, accumulate capital relevant to their production and thus increase their marginal productivity in it, allowing them to decrease their marginal cost of production, and trade with those who accumulate capital to specialize in other goods.
While most understand the importance of the price system to the division of labor, few get the crucial role it plays in capital accumulation and allocation, for which we need to turn to the work of Ludwig von Mises, another Austrian School economist. In his 1922 book, Socialism, Mises explained the quintessential reason why socialist systems must fail, and it was not the commonly held idea that socialism simply had an incentive problem (i.e. why would anyone work if everyone got the same rewards regardless of effort?). Given that lack of application to one’s job was usually punished with government murder or imprisonment, socialism arguably overcame the incentive problem successfully, regardless of how bloody the process. After a century in which around 100 million people worldwide were murdered by socialist regimes, this punishment was clearly not theoretical, and the incentives to work were probably stronger than in a capitalist system. There must be more to socialist failure than just incentives, and Mises was the first to precisely explicate why socialism would fail even if it were to successfully overcome the incentive problem by creating “the new socialist man.”
The fatal flaw of socialism that Mises exposed was that without a price mechanism emerging on a free market, socialism would fail at economic calculation, most crucially in the allocation of capital goods. Capital production involves progressively sophisticated methods of production, longer time horizons, and a larger number of intermediate goods not consumed for their own sake, but only produced so as to take part in the production of final consumer goods in the future. Sophisticated structures of production only emerge from an intricate web of individual calculations by producers of each capital and consumer good buying and selling inputs and outputs to one another. The most productive allocation is determined only through the price mechanism allowing the most productive users of capital goods to bid highest for them. The supply and demand of capital goods emerges from the interaction of the producers and consumers and their iterative decisions.
In a socialist system, government owns and controls the means of production, making it at once the sole buyer and seller of all capital goods in the economy. That centralization stifles the functioning of an actual market, making sound decisions based on prices impossible. Without a market for capital where independent actors can bid for capital, there can be no price for capital overall or for individual capital goods. Without prices of capital goods reflecting their relative supply and demand, there is no rational way of determining the most productive uses of capital, nor is there a rational way of determining how much to produce of each capital good. In a world in which the government owns the steel factory, as well as all the factories that will utilize steel in the production of various consumer and capital goods, there can be no price emerging for steel, or for the goods it is used to produce, and hence, no possible way of knowing which uses of steel are the most important and valuable. How can the government determine whether its limited quantities of steel should be utilized in making cars or trains, given that it also owns the car and train factories and allocates by diktat to citizens how many cars and trains they can have? Without a price system for citizens to decide between trains and cars, there is no way of knowing what the optimal allocation is and no way of knowing where the steel would be most necessary. Central planners can never know the preferences of each individual nor allocate resources in the way that satisfies that individual’s needs best.
Further, when the government owns all inputs into all the production processes of the economy, the absence of a price mechanism makes it virtually impossible to coordinate the production of various capital goods in the right quantities to allow all the factories to function. Scarcity is the starting point of all economics, and it is not possible to produce unlimited quantities of all inputs; trade-offs need to be made, so allocating capital, land, and labor to the production of steel must come at the expense of creating more copper. In a free market, as factories compete for the acquisition of copper and steel, they create scarcity and abundance in these markets and the prices allow copper and steel makers to compete for the resources that go into making them. A central planner is completely in the dark about this web of preferences and opportunity costs, of trains, cars, copper, steel, labor, capital, and land. Without prices, there is no way to calculate how to allocate these resources to produce the optimal products, and the result is a complete breakdown in production.
And yet all of this is but one aspect of the calculation problem, pertaining merely to the production of existing goods in a static market. The problem is far more pronounced when one considers that nothing is static in human affairs, as humans are eternally seeking to improve their economic situation, to produce new goods, and find more and better ways of producing goods. The ever-present human impulse to tinker, improve, and innovate gives socialism its most intractable problem. Even if the central planning system succeeded in managing a static economy, it is powerless to accommodate change or to allow entrepreneurship. How can a socialist system make calculations for technologies and innovations that do not exist, and how can factors of production be allocated for them when there is yet no indication whether these products can even work? The capitalist system is not a managerial system. It is an entrepreneurial system.
The point of this exposition is not to argue against the socialist economic system, which no serious adult should take seriously in this day and age after the catastrophic, bloody, and comprehensive failure it has achieved in every society in which it has been tried over the last century. The point rather is to explicate clearly the difference between two ways of allocating capital and making production decisions: prices and planning. While most of the world’s countries today do not have a central planning board responsible for the direct allocation of capital goods, it is nonetheless the case in every country in the world that there is a central planning board for the most important market of all, the market for capital. A free market is understood as one in which the buyers and sellers are free to transact on terms determined by them solely, and where entry and exit into the market are free: no third parties restrict sellers or buyers from entering the market, and no third parties stand to subsidize buyers and sellers who cannot transact in the market. No country in the world has a capital market that has these characteristics today.
The capital markets in a modern economy consists of the markets for loanable funds. As the structure of production becomes more complicated and long-term, individuals no longer invest their savings themselves, but lend them out, through various institutions, to businesses specialized in production. The interest rate is the price that the lender receives for lending their funds, and the price that the borrower pays to obtain them. In a free market for loanable funds, the quantity of these funds supplied, like all supply curves, rises as the interest rate rises. In other words, the higher the interest rate, the more people are inclined to save and offer their savings to entrepreneurs and firms. The demand for loans, on the other hand, is negatively related to the interest rate, meaning that entrepreneurs and firms will want to borrow less when the interest rate rises. The interest rate in a free market for capital is positive because people’s positive time preference means that nobody would part with money unless he could receive more of it in the future. A society with a lot of individuals with low time preference is likely to have plenty of savings, bringing the interest rate down and providing for plenty of capital for firms to invest, generating significant economic growth for the future. As a society’s time preference increases, people are less likely to save, interest rates would be high, and producers find less capital to borrow. Societies that live in peace and have secure property rights and a large degree of economic freedom are likely to have low time preference as they provide a strong incentive for individuals to discount their futures less.
But this is not how a capital market functions in any modern economy today, thanks to the invention of the modern central bank and its incessant interventionist meddling in the most critical of markets. Central banks determine the interest rate and the supply of loanable funds through a variety of monetary tools, operating through their control of the banking system. A fundamental fact to understand about the modern financial system is that banks create money whenever they engage in lending. In a fractional reserve banking system similar to the one present all over the world today, banks not only lend the savings of their customers, but also their demand deposits. In other words, the depositor can call on the money at any time while a large percentage of that money has been issued as loan to a borrower. By giving the money to the borrower while keeping it available to the depositor, the bank effectively creates new money and that results in an increase in the money supply. This underlies the relationship between money supply and interest rates: when interest rates drop, there is an increase in lending, which leads to an increase in money creation and a rise in the money supply. On the other hand, a rise in interest rates causes a reduction in lending and contraction in the money supply, or at least a reduction in the rate of its growth.
Whereas in a free market for capital the supply of loanable funds is determined by the market participants who decide to lend based on the interest rate, in an economy with a central bank and fractional reserve banking, the supply of loanable funds is directed by a committee of economists under the influence of politicians, bankers, TV pundits, and sometimes, most spectacularly, military generals.
Any passing familiarity with economics will make the dangers of price controls clear and discernable. Should a government decide to set the price of apples and prevent it from moving, the outcome will be either a shortage or a surplus and large losses to society overall from overproduction or underproduction. In the capital markets, something similar happens, but the effects are far more devastating as they affect every sector of the economy, because capital is involved in the production of every economic good.
It is first important to understand the distinction between loanable funds and actual capital goods. In a free market economy with sound money, savers have to defer consumption in order to save. Money that is deposited in a bank as savings is money taken away from consumption by people who are delaying the gratification that consumption could give them in order to gain more gratification in the future. The exact amount of savings becomes the exact amount of loanable funds available for producers to borrow. The availability of capital goods is inextricably linked to the reduction of consumption: actual physical resources, labor, land, and capital goods will move from being employed in the provision of final consumption goods to the production of capital goods. The marginal worker is directed away from car sales and toward a job in the car factory; the proverbial corn seed will go into the ground instead of being eaten.
Scarcity is the fundamental starting point of all economics, and its most important implication is the notion that everything has an opportunity cost. In the capital market, the opportunity cost of capital is forgone consumption, and the opportunity cost of consumption is forgone capital investment. The interest rate is the price that regulates this relationship: as people demand more investments, the interest rate rises, incentivizing more savers to set aside more of their money for savings. As the interest rate drops, it incentivizes investors to engage in more investments, and to invest in more technologically advanced methods of production with a longer time horizon. A lower interest rate, then, allows for the engagement of methods of production that are longer and more productive: society moves from fishing with rods to fishing with oil-powered large boats.
A modern economy with a central bank is built on ignoring this fundamental trade-off and assuming that banks can finance investment with new money without consumers having to forgo consumption. As the central bank manages the money supply and interest rate, there will inevitably be a discrepancy between savings and loanable funds. Central banks are generally trying to spur economic growth and investment and to increase consumption, so they tend to increase the money supply and lower the interest rate, resulting in a larger quantity of loanable funds than savings. At these artificially low interest rates, businesses take on more debt to start projects than savers put aside to finance these investments. In other words, the value of consumption deferred is less than the value of capital borrowed. Without enough consumption deferred, there will not be enough capital, land, and labor resources diverted away from consumption goods toward higher-order capital goods at the earliest stages of production. There is no free lunch, after all, and if consumers save less, there will have to be less capital available for investors. Creating new pieces of paper and digital entries to paper over the deficiency in savings does not magically increase society’s physical capital stock; it only devalues the existing money supply and distorts prices.
This shortage of capital is not immediately apparent, because banks and the central banks can issue enough money for the borrowers—that is, after all, the main perk of using unsound money. In an economy with sound money, such manipulation of the price of capital would be impossible: as soon as the interest rate is set artificially low, the shortage in savings at banks is reflected in reduced capital available for borrowers, leading to a rise in the interest rate, which reduces demand for loans and raises the supply of savings until the two match.
Unsound money makes such manipulation possible, but only for a short while, of course, as reality cannot be deceived forever. The artificially low interest rates and the excess printed money deceive the producers into engaging in a production process requiring more capital resources than is actually available. The excess money, backed by no actual deferred consumption, initially makes more producers borrow, operating under the delusion that the money will allow them to buy all the capital goods necessary for their production process. As more and more producers are bidding for fewer capital goods and resources than they expect there to be, the natural outcome is a rise in the price of the capital goods during the production process. This is the point at which the manipulation is exposed, leading to the simultaneous collapse of several capital investments which suddenly become unprofitable at the new capital good prices; these projects are what Mises termed malinvestments—investments that would not have been undertaken without the distortions in the capital market and whose completion is not possible once the misallocations are exposed. The central bank’s intervention in the capital market allows for more projects to be undertaken because of the distortion of prices that causes investors to miscalculate, but the central bank’s intervention cannot increase the amount of actual capital available. So these extra projects are not completed and become an unnecessary waste of capital. The suspension of these projects at the same time causes a rise in unemployment across the economy. This economy-wide simultaneous failure of overextended business is what is referred to as a recession.
Only with an understanding of the capital structure and how interest rate manipulation destroys the incentive for capital accumulation can one understand the causes of recessions and the swings of the business cycle. The business cycle is the natural result of the manipulation of the interest rate distorting the market for capital by making investors imagine they can attain more capital than is available with the unsound money they have been given by the banks. Contrary to Keynesian animist mythology, business cycles are not mystic phenomena caused by “animal spirits” whose cause is to be ignored as central bankers seek to try to engineer recovery. Economic logic clearly shows how recessions are the inevitable outcome of interest rate manipulation in the same way shortages are the inevitable outcome of price ceilings.
When the central bank manipulates the interest rate lower than the market clearing price by directing banks to create more money by lending, they are at once reducing the amount of savings available in society and increasing the quantity demanded by borrowers while also directing the borrowed capital toward projects which cannot be completed. Hence, the more unsound the form of money, and the easier it is for central banks to manipulate interest rates, the more severe the business cycles are. A capitalist system cannot function without a free market in capital, where the price of capital emerges through the interaction of supply and demand the decisions of capitalists are driven my accurate price signals. The central bank’s meddling in the capital market is the root of all recessions and all the crises which most politicians, journalists, academics, and leftist activists like to blame on capitalism. Only through the central planning of the money supply can the price mechanism of the capital markets be corrupted to cause wide disruptions in the economy.
Whenever a government has started on the path of inflating the money supply, there is no escaping the negative consequences. If the central bank stops the inflation, interest rates rise, and a recession follows as many of the projects that were started are exposed as unprofitable and have to be abandoned, exposing the misallocation of resources and capital that took place. If the central bank were to continue its inflationary process indefinitely, it would just increase the scale of misallocations in the economy, wasting even more capital and making the inevitable recession even more painful.
The relative stability of sound money, for which it is selected by the market, allows for the operation of a free market through price discovery and individual decision making. Unsound money, whose supply is centrally planned, cannot allow for the emergence of accurate price signals, because it is by its very nature controlled. The reason that price controls must fail is not that the central planners cannot pick the right price, but rather that by merely imposing a price—any price—they prevent the market process from allowing prices to coordinate consumption and production decisions among market participants, resulting in inevitable shortages or surpluses. Equivalently, central planning of credit markets must fail because it destroys markets’ mechanisms for price-discovery providing market participants with the accurate signals and incentives to manage their consumption and production.
The Great Depression is a prime example. The 1920s witnessed very fast economic growth, which would lead to a drop in prices. There was also heavy monetary expansion, caused by the U.S. Federal Reserve attempting to help the Bank of England stem the flow of gold from its shores, which was in turn caused by the Bank of England inflating instead of letting wages adjust downward. The net effect of a rise in the money supply and fast economic growth was that the price level did not rise a lot, but that asset prices rose heavily—mainly housing and stocks; the increased money supply had not translated to a rise in consumer good prices because it had mainly been directed by the Federal Reserve to stimulate the stock and housing markets. The money supply expanded by 68.1% over the period of 1921-29 while the gold stock only expanded by 15%. It is this increase of the dollar stock, beyond the stock of gold, which is the root cause of the Great Depression. The monetary expansion of the 1920s generated a massive bubble of illusory wealth in the stock market. As soon as the expansion slowed down, the bubble was inevitably going to burst. Once it burst, this meant a deflationary spiral where all the illusory wealth of the bubble disappears. As wealth disappears a run on banks is inevitable as banks struggle to meet their obligations. This exposes the problem of having a system of fractional reserve banking—it’s a disaster waiting to happen. Given that, it would have been appropriate for the Fed to guarantee people’s deposits—though not guarantee the losses of businesses and the stock market. Leaving the banks alone to suffer form this, allowing the liquidation to take place and prices to fall, is the only solution. It is true that this solution would have involved a painful recession—but that is exactly why the monetary expansion should not have happened in the first place. Attempting to avert the recession by pouring more liquidity into it will only exacerbate the distortions which caused the crisis in the first place. The monetary expansion created illusory wealth that misallocated resources, and that wealth must disappear for the market to go back to functioning properly with a proper price mechanism. It was this illusory wealth that caused the collapse in the first place. Returning that illusory wealth to its original location is simply reassembling the house of cards again and preparing it for another, bigger and stronger fall.
The abandonment of the gold standard in 1914 through the suspension and limitation of exchanging paper money for gold by most governments began the period Hayek named Monetary Nationalism. Money’s value stopped being a fixed unit of gold, which was the commodity with the highest stock-to-flow ratio, and hence the lowest price elasticity of supply, keeping its value predictable and relatively constant. Instead, the value of money oscillated along with the vagaries of monetary and fiscal policy as well as international trade. Lower interest rates or increased money supply would drop the value of money, as would government spending financed by central banks lending to the government. While these two factors were nominally under the control of governments, who could at least delude themselves into thinking they could manage them to achieve stability, the third factor was a complex emergent outcome of the actions of all citizens and many foreigners. When a country’s exports grew larger than its imports (a trade surplus), its currency would appreciate on the international exchange markets, whereas it would depreciate when its imports grew larger than exports (trade deficit). Policymakers, instead of taking this as a sign to stop tinkering with the value of money and allow people the freedom to use the least volatile commodity as money, took it as an invitation to micromanage the smallest details of global trade.
The combination of floating exchange rates and Keynesian ideology has given our world the entirely modern phenomenon of currency wars: because Keynesian analysis says that increasing exports leads to an increase in GDP, and GDP is the holy grail of economic well-being, it thus follows, in the minds of Keynesians, that anything that boost exports is good. Because a devalued currency makes exports cheaper, any country facing an economic slowdown can boost its GDP and employment by devaluing its currency and increasing its exports. There are many things wrong with this worldview. Reducing the value of the currency does nothing to increase the competitiveness of the industries in real terms. Instead, it only creates a one-time discount on their outputs, thus offering them to foreigners at a lower price than locals, impoverishing locals and subsidizing foreigners. It also makes all the country’s assets cheaper for foreigners, allowing them to come in and purchase land, capital, and resources in the country at a discount. In a liberal economic order, there is nothing wrong with foreigners buying local assets, but in a Keynesian economic order, foreigners are actively subsidized to buy the country at a discount. Further, economic history shows that the most successful economies of the postwar era, such as Germany, Japan, and Switzerland, grew their exports significantly as their currency continued to appreciate. They did not need constant devaluation to make their exports grow; they developed a competitive advantage that made their products demanded globally, which in turn caused their currencies to appreciate compared to their trade partners, increasing the wealth of their population. It is counterproductive for the countries importing from them to think they can boost their exports by simply devaluing the currency. They would be destroying their people’s wealth by simply allowing foreigners to purchase it at a discount. It is no coincidence that the countries that have seen their currencies devalue the most in the postwar period were also the ones that suffered economic stagnation and decline. Effectively, each country is impoverishing its citizens in order to boost its exporters and raise GDP numbers, and complaining when other countries do the same.
None of this would be necessary if only the world were to be based on a sound global monetary system that serves as global unit of account and measure of value, allowing producers and consumers worldwide to have an accurate assessment of their costs and revenues, separating economic profitability from government policy. Hard money, by taking the question of supply out of the hands of governments and their economist-propagandists, would force everyone to be productive to society instead of seeking to get rich through the fool’s errand of monetary manipulation.
Sound Money and Individual Freedom
Governments believe that when there is a choice between an unpopular tax and a very popular expenditure, there is a way out for them—the way toward inflation. This illustrates the problem of going away from the gold standard. Money supply management is the problem masquerading as its solution; the triumph of emotional hope over hard-headed reason; the root of all political free lunches sold to gullible voters. It functions like a highly addictive and destructive drug, such as crystal meth or sugar: it causes a beautiful high at the beginning, fooling its victims into feeling invincible, but as soon as the effect subsides, the come-down is devastating and has the victim begging for more. This is when the hard choice needs to be made: either suffer the withdrawal effects of ceasing the addiction, or take another hit, delay the reckoning by a day, and sustain severe long-term damage.
There are today two government-approved mainstream schools of economic thought: Keynesians and Monetarists. It’s important to understand the different rationales for the two schools of thought in order to understand how they can both arrive at the same conclusion and be equally wrong. Keynes was a failed investor and statistician who never studied economics but was so well-connected with the ruling class in Britain that the embarrassing drivel he wrote in his most famous book, The General Theory of Employment, Money, and Interest, was immediately elevated into the status of founding truths of macroeconomics. His theory begins with the (completely unfounded and unwarranted) assumption that the most important metric in determining the state of the economy is the level of aggregate spending across society. When society collectively spends a lot, the spending incentivizes producers to create more products, thus employing more workers and reaching full-employment equilibrium. If spending rises too much, beyond the capacity of producers to keep up, it would lead to inflation and a rise in the overall price level. On the other hand, when society spends too little, producers reduce their production, firing workers and increasing unemployment, resulting in a recession. Recessions, for Keynes, are caused by abrupt reductions in the aggregate level of spending, which he blamed on “animal spirits.”
Freed from the restraint of having to find a cause of the recession, Keynes can then happily recommend the solution he is selling. Whenever there is a recession, or a rise in the unemployment level, the cause is a drop in the aggregate level of spending and the solution is for the government to stimulate spending, which will in turn increase production and reduce unemployment. There are three ways of stimulating aggregate spending: increasing the money supply, increasing government spending, or reducing taxes. Reducing taxes is generally frowned upon by Keynesians. It is viewed as the least effective method, because people will not spend all the taxes they don’t have to pay—some of that money will be saved, and Keynes absolutely detested saving. Saving would reduce spending, and reducing spending would be the worst thing imaginable for an economy seeking recovery. It was government’s role to impose high time preference on society by spending more or printing money. Seeing as it is hard to raise taxes during a recession, government spending would effectively translate to increasing the money supply. This, then, was the Keynesian Holy Grail: whenever the economy was not at full employment, an increase in the money supply would fix the problem. There is no point worrying about inflation, because as Keynes had “showed” (i.e. baselessly assumed) inflation only happens when spending is too high, and because unemployment is high, that means spending is too low. There may be consequences in the long run, but there was no point worrying about long-term consequences, because “in the long run, we are all dead,” as Keynes’s most famous defense of high-time-preference libertine irresponsibility famously stated.
The other main school of government-approved economic thought in our day and age is the Monetarist school, whose intellectual father is Milton Friedman. The percentage of economists who are actually Monetarists is miniscule compared to Keynesians, and they largely agree with Keynesians on the basic assumptions of the Keynesian models. However, Monetarists generally oppose Keynesian efforts to spend money to eliminate unemployment, arguing that in the long run, the effect on unemployment will be eliminated while causing inflation. Instead, Monetarists prefer tax cuts to stimulate the economy, because they argue that the free market will better allocate resources than government spending. However, the central tenet of Monetarist thought is for the pressing need for government to prevent collapses in the money supply and/or drops in the price level, which they view as the root of all economic problems. A decline in the price level, or deflation as the Monetarists and Keynesians like to call it, would result in people hoarding their money, reducing their spending, causing increases in unemployment, causing a recession. Most worryingly for Monetarists, deflation is usually accompanied by collapses in the banking sector balance sheets, and it thus follows that central banks must do everything possible to ensure that deflation never happens (i.e. 2002 speech by Ben Bernanke entitled Deflation: Making Sure “It” Doesn’t Happen Here).
The sum total of the contribution of both these schools of thought is the consensus taught in undergraduate macroeconomics courses across the world: that the central bank should be in the business of expanding the money supply at a controlled pace, to encourage people to spend more and thus keep the unemployment level sufficiently low. Should a central bank contract the money supply, or fail to expand it adequately, then a deflationary spiral can take place, which would discourage people from spending their money and thus harm employment and cause an economic downturn. The creed of Keynes, which is universally popular today, is the creed of consumption and spending to satisfy immediate wants. By constantly expanding the money supply, central banks’ monetary policy makes saving and investment less attractive and thus it encourages people to save and invest less while consuming more. The real impact of this is the widespread culture of conspicuous consumption, where people live their lives to buy ever-larger quantities of crap they do not need. When the alternative to spending money is witnessing your savings lose value over time, you might as well enjoy spending it before it loses value.
In contrast to these two schools of thought stands the classical tradition of economics, commonly referred to today as the Austrian School. The Austrian theory of money posits that money emerges in a market as the most marketable commodity and most salable asset, the one asset holders can sell with the most ease, in favorable conditions. An asset that holds its value is preferable to an asset that loses value, and savers who want to choose a medium of exchange will gravitate toward assets that hold value over time as monetary assets. Network effects mean that eventually only one, or a few, assets can emerge as media of exchange. For Ludwig von Mises, the absence of control by government is a necessary condition for the soundness of money, seeing as government will have the temptation to debase its money whenever it begins to accrue wealth as savers invest in it.
By placing a hard cap on the total supply of bitcoins (only 21,000,000 bitcoins will ever exist), Satoshi Nakamoto was clearly unpersuaded by the arguments of the standard macroeconomics textbook and more influenced by the Austrian school, which argues that the quantity of money itself is irrelevant, that any supply of money is sufficient to run an economy of any size, because the currency units are infinitely divisible, and because it is only the purchasing power of money in terms of real goods and services that matters, and not its numerical quantity. Murray Rothbard once wrote, “A world of constant money supply would be one similar to that of much of the eighteenth and nineteenth centuries, marked by the successful flowering of the Industrial Revolution with increased capital investment increasing the supply of goods and with falling prices for those goods as well as falling costs of production.”
According to the Austrian view, if the monetary supply is fixed, then economic growth will cause prices of real goods and services to drop, allowing people to purchase increasing quantities of goods and services with their money in the future. Such a world would indeed discourage immediate consumption as the Keynesians fear, but encourage saving and investment for the future where more consumption can happen. A society which constantly defers consumption will actually end up being a society that consumes more in the long run than a low savings society, since the low-time-preference society invests more, thus producing more income for its members. Even with a larger percentage of their income going to savings, the low-time-preference societies will end up having higher levels of consumption in the long run as well as a larger capital stock.
A currency that appreciates in value incentivizes saving, as savings gain purchasing power over time. Hence, it encourages deferred consumption, resulting in lower time preference. A currency that depreciates in value, on the other hand, leaves citizens constantly searching for returns to beat inflation, returns that must come with a risk, and so leads to an increase in investment in risky projects and an increased risk tolerance among investors, leading to increased losses. Further, an economy with an appreciating currency would witness investment only in projects that offer a positive real return over the rate of appreciation of money, meaning that only projects expected to increase society’s capital stock will tend to get funded. By contrast, an economy with a depreciating currency incentivizes investment in projects that offer positive returns in terms of the depreciating currency, but negative real returns . These projects that do not offer positive real returns effectively reduce society’s capital stock, but they are nonetheless a rational alternative for investments because they reduce their capital slower than the depreciating currency. These investments are what Ludwig von Mises terms malinvestments—unprofitable projects and investments that only appear profitable during the period of inflation and artificially low interest rates, and whose unprofitability will be exposed as soon as inflation rates drop and interest rates rise, causing the bust part of the boom-and-bust cycle. As Mises puts it, “The boom squanders through malinvestment scarce factors of production and reduces the stock available through overconsumption; its alleged blessings are paid for by impoverishment.”
In a sound monetary system, any business that survives does so by offering value to society, by receiving a higher revenue for its products than the costs it incurs for its inputs. The business is productive because it transforms inputs of a certain market price into outputs with a higher market price. Any firm that produces outputs valued at less than its inputs would go out of business, its resources freed up to be used by other, more productive firms, in what economist Joseph Schumpeter termed creative destruction. Government-issued unsound money, however, can stall this process, keeping unproductive firms undead but not truly alive, the economic equivalent of zombies or vampires drawing on the resources of the alive and productive firms to produce things of less value than the resources needed to make them.
Additionally the classical liberal conception of government is only possible in a world with sound money, which acted as a natural restraint against government authoritarianism and overreach. As long as government had to tax its people to finance its operations, it had to restrict its operations to what its subjects deemed tolerable. The more onerous the taxation and impositions of the government, the more likely the population is to refuse to pay taxes, make tax collection costs rise significantly, or rise up against the government and replace it, whether by ballot or bullet. Sound money, then, enforced a measure of honesty and transparency on governments, restricting their rule to within what was desirable and tolerable to the population. It allowed for society-wide honest accounting of costs and benefits of actions, as well as the economic responsibility necessary for any organization, individual, or living being to succeed in life: consumption must come after production.
Unsound money, on the other hand, allows governments to buy allegiance and popularity by spending on achieving popular objectives without having to present the bill to their people. Government simply increases the money supply to finance any harebrained scheme it concocts, and the true cost of such schemes is only felt by the population in years to come when the inflation of the money supply causes prices to rise, at which point the destruction of the value of the currency can be easily blamed on myriad factors, usually involving some nefarious plots by foreigners, bankers, local ethnic minorities, or previous or future governments. Unsound money is a particularly dangerous tool in the hands of modern democratic governments facing constant reelection pressure. Modern voters are unlikely to favor the candidates who are upfront about the costs and benefits of their schemes; they are far more likely to go with the scoundrels who promise a free lunch and blame the bill on their predecessors or some nefarious conspiracy. Democracy thus becomes a mass delusion of people attempting to override the rules of economics by voting themselves a free lunch and being manipulated into violent tantrums against scapegoats whenever the bill for the free lunch arrives via inflation and economic recessions. Unsound money has eradicated the notion of trade-offs and opportunity costs from the mind of individuals thinking of public affairs.
Unsound money makes government power potentially unlimited, with large consequences to every individual, forcing politics to the center stage of their life and redirecting much of society’s energy and resources to the zero-sum game of who gets to rule and how. Sound money, on the other hand, makes the form of government a question with limited consequences. A democracy, republic, or monarchy are all restrained by sound money, allowing most individuals a large degree of freedom in their personal life.
Bitcoin represents the first truly digital solution to the problem of money, and in it we find a potential solution to the problems of salability, soundness, and sovereignty. Bitcoin has operated with practically no failure for more than ten years, and if it continues to operate like this for the next ninety, it will be a compelling solution to the problem of money, offering individuals sovereignty over money that is resistant to unexpected inflation while also being highly salable across space, scale, and time.
The introduction of metallurgy produced solutions to the problem of money that were superior to beads, shellfish, and other artifacts. Then, the emergence of regular coinage allowed gold and silver coins to emerge as superior forms of money to irregular lumps of metal. Then, gold-backed banking allowed gold to dominate as the global monetary standard and led to the demonetization of silver. From the necessity of centralizing gold arose government money backed by gold, which was more salable in scale, but with it came government expansion of the money supply and coercive control which eventually destroyed money’s soundness and sovereignty. Every step of the way, technological advances and realties shaped the monetary standards that people employed, and the consequences to economies and society were enormous. Societies and individuals who chose a sound monetary standard, such as the Romans under Caesar, the Byzantines under Constantine, or Europeans under the gold standard, benefited immensely. Those who had unsound or technologically inferior money, such as West Africans using glass beads or the Chinese on a silver standard in the nineteenth century, paid a heavy price. Bitcoin represents a new technological solution to the money problem, born out of the digital age, utilizing several technological innovations that were developed over the past few decades and building on many attempts at producing digital money to deliver something which was almost unimaginable before it was invented.
Satoshi Nakamoto’s motivation for Bitcoin was to create a “purely peer-to-peer form of electronic cash” that would not require trust in third parties for transactions and whose supply cannot be altered by any other party. In other words, Bitcoin would bring the desirable features of physical cash (lack of intermediaries and finality of transactions) to the digital realm and combine them with an ironclad monetary policy that cannot be manipulated to produce unexpected inflation to benefit an outside party at the expense of holders. Nakamoto succeeded in achieving this through the utilization of a few important though not widely understood technologies: a distributed peer-to-peer network with no single point of failure, hashing, digital signatures, and proof-of-work.
Nakamoto removed the need for trust in a third party by building Bitcoin on a foundation of very thorough and ironclad proof and verification. It is fair to say that the central operational feature of Bitcoin is verification, and only because of that can Bitcoin remove the need for trust completely. Every transaction has to be recorded by every member of the network so that they all share one common ledger of balances and transactions. Whenever a member of the network transfers a sum to another member, all network members can verify the sender has a sufficient balance, and nodes compete to be the first to update the ledger with a new block of transactions every ten minutes. In order for a node to commit a block of transactions to the ledger, it has to expend processing power on solving complicated mathematical problems that are hard to solve but whose correct solution is easy to verify. This is the proof-of-work system, and only with a correct solution can a block be committed and verified by all network members. While these mathematical problems are unrelated to the Bitcoin transactions, they are indispensable to the operation of the system as they force the verifying nodes to expend processing power which would be wasted if they included fraudulent transactions. Once a node solves the proof-of-work correctly and announces the transactions, other nodes on the network vote for its validity, and once a majority has voted to approve the block, nodes begin committing transactions to a new block to be amended to the previous one and solving the new proof-of-work for it. Crucially, the node that commits a valid block of transactions to the network receives a block reward consisting of brand-new bitcoins added to the supply along with all the transaction fees paid by the people who are transacting.
This process is what is referred to as mining, analogous to the mining of precious metals, and is why nodes that solve proof-of-work are known as miners. This block reward compensates the miners for the resources they committed to proof-of-work. Whereas in a modern central bank the new money created goes to finance lending and government spending, in Bitcoin the new money goes only to those who spend resources on updating the ledger. Nakamoto programmed Bitcoin to produce a new block roughly every ten minutes. At the birth of the network, the block reward was programmed to be 50 bitcoins per block. Roughly every four years, or after 210,000 blocks have been issued, the block reward drops by half. The first halving happened on November 28, 2012, after which the issuance of new bitcoins dropped to 25 per block. On July 9, 2016, it dropped again to 12.5 coins per block, and will drop to 6.25 in 2020. According to this schedule, the supply will continue to increase at a decreasing rate, asymptotically approaching 21 million coins sometime around the year 2140, at which point there will be no more bitcoins issued.
The quantity of bitcoins created is preprogrammed and cannot be altered no matter how much effort and energy is expended on proof-of-work. This is achieved through a process called difficulty adjustment, which is perhaps the most ingenious aspect of Bitcoin’s design. As more people choose to hold Bitcoin, this drives up the market value of Bitcoin and makes mining new coins more profitable, which drives more miners to expend more resources and solve proof-of-work problems. More miners means more processing power, which would result in the solutions to the proof-of-work being arrived at faster, thus increasing the rate of issuance of new bitcoins. But as the processing power rises, Bitcoin will raise the difficulty of the mathematical problems needed to unlock the mining rewards to ensure blocks will continue to take around ten minutes to be produced.
Difficulty adjustment is the most reliable technology for making hard money and limiting the stock-to-flow ratio from rising, and it makes Bitcoin fundamentally different from every other money. Whereas the rise in value of any money leads to more resources dedicated to its production and thus an increase in its supply, as Bitcoin’s value rises, more effort to produce bitcoins does not lead to the production of more bitcoins. Instead, it just leads to an increase in the processing power necessary to commit valid transactions to the Bitcoin network, which only serves to make the network more secure and difficult to compromise. Bitcoin is the hardest money ever invented: growth in its value cannot possibly increase its supply; it can only make the network more secure and immune to attack.
Bitcoin’s supply is made up of a maximum of 21,000,000 coins, each of which is divisible into 100,000,000 satoshis, making it highly salable across scales. Bitcoin also has far superior salability across versus other forms of money because the digital ledger is accessible by anyone worldwide with an Internet connection.
For every other money, as its value rises, those who can produce it will start producing more of it. Whether it is Rai stones, seashells, silver, gold, copper, or government money, everyone will have an incentive to try to produce more. The harder it was to produce new quantities of the money in response to price rises, the more likely it was to be adopted and widely used, and the more a society would prosper because it would mean individuals’ efforts at producing wealth will go toward serving one another, not producing money, an activity with no added value to society because any supply of money is enough to run any economy. Gold became the prime money of every civilized society precisely because it was the hardest to produce, but Bitcoin’s difficulty adjustment makes it even harder to produce. A massive increase in the price of gold will, in the long run, lead to larger quantities being produced, but no matter how high the price of bitcoins rises, the supply stays the same and the security of the network only increases.
The security of Bitcoin lies in the asymmetry between the cost of solving the proof-of-work necessary to commit a transaction to the ledger and the cost of verifying its validity. It costs ever-increasing quantities of electricity and processing power to record transactions, but the cost of verifying the validity of the transactions is close to zero and will remain at that level no matter how much Bitcoin grows. To try to commit fraudulent transactions to the Bitcoin ledger is to deliberately waste resources on solving the proof-of-work only to watch nodes reject it at almost no cost, thereby withholding the block reward from the miner. As time goes by, it becomes increasingly difficult to alter the record, as the energy needed is larger than the energy already expended, which only grows with time. This highly complex iterative process has grown to require vast quantities of processing power and electricity but produces a ledger of ownership and transactions that is beyond dispute, without having to rely on the trustworthiness of any single third party.
No single entity is relied upon for maintaining the ledger and no single individual can alter the record on it without the consent of a majority of network members. What determines the validity of the transaction is not the word of a single authority, but the software running the individual nodes on the network. Should an attacker succeed in altering the record, he would be highly unlikely to gain any economic benefit from it, as compromising the network would probably reduce the value of bitcoins to close to nothing. In other words, to destroy Bitcoin, an attacker needs to expend very large sums of money with no return at all. And in fact, even if such an attempt succeeded, the honest nodes on the network can effectively go back to the record of transactions before the attack and resume operation. The attacker would then need to continue incurring significant running costs to keep attacking the consensus of the honest nodes. The real protection of the Bitcoin network at any point in time is that the value of its tokens is entirely dependent on the integrity of the network. Any attack that succeeds in altering the blockchain, stealing coins, or double-spending them would be of little value to the attacker, as it would become apparent to all network members that it is possible to compromise the network, severely reducing demand for using the network and holding the coins, crashing the price. In other words, the defense of the Bitcoin network is not just that attacking it has become expensive, but that the attack succeeding renders the attacker’s loot worthless. Being an entirely voluntarily system, Bitcoin can only operate if it is honest, as users can very easily leave it otherwise. The distribution of the Bitcoin processing power, and the strong resistance of the code to change, combined with the intransigency of the monetary policy, are what has allowed Bitcoin to survive and grow in value to the extent to which it has today.
Bitcoin is an embodiment of Nassim Taleb’s idea of antifragility, which he defines as gaining from adversity and disorder. Bitcoin is not just robust to attack, but it can be said to be antifragile on both a technical and economic level. While attempts to kill Bitcoin have so far failed, many of them have made it stronger by allowing coders to identify weaknesses and patch them up. Further, every thwarted attack on the network is a notch on its belt, another testament and advertisement to participants and outsiders of the security of the network. A global team of volunteer software developers, reviewers, and hackers have taken a professional, financial, and intellectual interest in working on improving or strengthening the Bitcoin code and network. Any exploits or weaknesses found in the specification of the code will attract some of these coders to offer solutions, debate them, test them, and then propose them to network members for adoption. The only changes that have happened so far have been operational changes that allow the network to run more efficiently, but not changes that alter the essence of the coin’s operation.
A great example of Bitcoin’s antifragility came in September 2017, after the Chinese government announced the closure of all Chinese exchanges that traded Bitcoin. Whereas the initial reaction was one of panic that saw the price drop by around 40%, it was only a matter of hours before the price started recovering, and within a few months the price had more than doubled from where it was before the government’s ban. While banning exchanges from trading Bitcoin could be viewed as an impediment to Bitcoin’s adoption through a reduction in its liquidity, it seems to have only served to reinforce Bitcoin’s value proposition. More transactions started happening off exchanges in China, with volume on websites like localbitcoins.com exploding. It may just be that the suspension of trading in China caused the opposite of the intended effect, as it drove Chinese to hold onto their Bitcoin for the long term rather than trade it for the short term.
Ralph Merkle, inventor of the Merkle tree data structure, which is utilized by Bitcoin to record transactions, had a remarkable way of describing Bitcoin: “Bitcoin is the first example of a new form of life. It lives and breathes on the internet. It lives because it can pay people to keep it alive. It lives because it performs a useful service that people will pay it to perform. It lives because anyone, anywhere, can run a copy of its code. It lives because all the running copies are constantly talking to each other. It lives because if any one copy is corrupted it is discarded, quickly and without any fuss or muss. It lives because it is radically transparent: anyone can see its code and see exactly what it does. It can’t be changed. It can’t be argued with. It can’t be tampered with. It can’t be corrupted. It can’t be stopped. It can’t even be interrupted. If a nuclear war destroyed half our planet, it would continue to live, uncorrupted. It would continue to offer its services. It would continue to pay people to keep it alive. The only way to shut it down is to kill every server that hosts it. Which is hard, because a lot of servers host it, in a lot of countries, and a lot of people want to use it. Realistically, the only way to kill it is to make the service it offers so useless and obsolete that no one wants to use it. So obsolete that no one wants to pay for it. No one wants to host it. Then it will have no money to pay anyone. Then it will starve to death. But as long as there are people who want to use it, it’s very hard to kill, or corrupt, or stop, or interrupt.”
With this technological design, Nakamoto was able to invent digital scarcity. Bitcoin is the first example of a digital good that is scarce and cannot be reproduced infinitely. While it is trivial to send a digital object from one location to another in a digital network, as is done with email, text messaging, or file downloads, it is more accurate to describe these processes as “copying” rather than “sending,” because the digital objects remain with the sender and can be reproduced infinitely. Bitcoin is the first example of a digital good whose transfer stops it from being owned by the sender. Beyond digital scarcity, Bitcoin is also the first example of absolute scarcity, the only liquid commodity (digital or physical) with a set fixed quantity that cannot conceivably be increased. Until the invention of Bitcoin, scarcity was always relative never absolute. With its absolute scarcity, Bitcoin is highly salable across time, which is a critical point on Bitcoin’s role as a store of value.
By extrapolating the growth rates of the main global reserve currencies’ broad money supply and gold over the past 25 years into the next 25 years, the supply for gold will increase by 52%, the Japanese yen by 64%, the Swiss franc by 169%, the U.S. dollar by 272%, the euro by 286%, and the British pound by 429%. In contrast, the bitcoin supply will only increase by 27%. With its supply growth rate dropping below that of gold by the year of 2025, Bitcoin has the supply restrictions that could make it have considerable demand as a store of value; in other words, it can have salability across time. Its digital nature that makes it easy to safely send worldwide makes it salable in space in a way never seen with other forms of money, while the divisibility of each bitcoin into 100,000,000 satoshis makes it salable in scale. Further, Bitcoin’s elimination of intermediary control and the near-impossibility of any authority debasing or confiscating it renders it free of the main drawbacks of government money. As the digital age has introduced improvements and efficiencies to most aspects of our life, Bitcoin presents a tremendous technological leap forward in the monetary solution to the indirect exchange problem, perhaps as significant as the move from cattle and salt to gold and silver.
Being new and only beginning to spread, Bitcoin’s price has fluctuated wildly as demand fluctuates, but the impossibility of increasing the supply arbitrarily by any authority in response to price spikes explains the meteoric rise in the purchasing power of the currency. When there is a spike in demand for bitcoins, bitcoin miners cannot increase production beyond the set schedule like copper miners can, and no central bank can step in to flood the market with increasing quantities of bitcoins, as Greenspan suggested central banks do with their gold. The only way for the market to meet the growing demand is for the price to rise enough to incentivize the holder to sell some of their coins to the newcomers. This helps explain why in ten years of existence, the price of a bitcoin has gone from $0.000994 on October 5, 2009, in its first recorded transaction to ~$5,000 today.
What is Bitcoin Good For?
The eternal dilemma humans face with their time concerns how to store the value they produce with their time through the future. While human time is finite, everything else is practically infinite, and more of it can be produced if more human time is directed at it. In all human history, we have never run out of any single raw material or resource, and the price of virtually all resources is lower today than it was in past points in history, because our technological advancement allows us to produce them at a lower cost in terms of our time (read economist Julian Simon’s The Ultimate Resource). Whatever object humans chose as a store of value, its value would rise, and because more of the object can always be made, others would produce more of the object to acquire the value stored in it.
For the first time, humanity has recourse to a commodity whose supply is strictly limited. No matter how many people use the network, how much its value rises, and how advanced the equipment used to produce it, there can only ever be 21,000,000 bitcoins in existence. There is no technical possibility for increasing the supply to match the increased demand. Should more people demand to hold Bitcoin, the only way to meet the demand is through appreciation of the existing supply. Because each bitcoin is divisible into 100 million satoshis, there is plenty of room for the growth of Bitcoin through the use of ever-smaller units of it as the value appreciates. This creates a new type of asset well-suited for playing the role of store of value.
Until Bitcoin’s invention, all forms of money were unlimited in their quantity and thus imperfect in their ability to store value across time. Bitcoin’s immutable monetary supply makes it the best medium to store the value produced from the limited human time, thus making it arguably the best store of value humanity has ever invented. To put it differently, Bitcoin is the cheapest way to buy the future, because Bitcoin is the only medium guaranteed not to be debased, no matter how much its value rises.
As the first form of digital cash, Bitcoin’s first and most important value proposition is in giving anyone in the world access to sovereign base money. Any person who owns Bitcoin achieves a degree of economic freedom which was not possible before its invention. Bitcoin holders can send large amounts of value across the planet without having to ask for the permission of anyone. Bitcoin’s value is not reliant on anything physical anywhere in the world and thus can never be completely impeded, destroyed, or confiscated by any of the physical forces of the political or criminal worlds. The significance of this invention for the political realities of the twenty-first century is that, for the first time since the emergence of the modern state, individuals have a clear technical solution to escape the financial clout of the governments they live under.
The modern nation-state, with its restrictive laws, high taxes, and totalitarian impulses, has grown to a level of burdensome repression of its citizens’ freedom comparable to that of the Church of the European Middle Ages, and just as ripe for disruption. With its heavy burden of taxation, personal control, and rituals, the costs of supporting the Church became unbearable for Europeans, and newer more productive political and economic forms of organization emerged to replace it and consign it to insignificance. The rise of machinery, the printing press, capitalism, and the modern nation-state birthed the age of industrial society and modern conceptions of citizenship.
Five hundred years later, it is industrial society and the modern nation-state that have become repressive, sclerotic, and burdensome while new technology eats away at its power. New forms of organization will emerge from information technology, destroying the capacity of the state to force citizens to pay more for its services than they wish. The digital revolution will destroy the power of the modern state over its citizens, reduce the significance of the nation-state as an organizing unit, and give individuals unprecedented power and sovereignty over their own lives. We can already see this process taking place. Whereas the printing press allowed the poor of the world to access knowledge that was forbidden them and monopolized by the churches, it still had the limitation of producing physical books which could always be confiscated, banned, or burned. No such threat exists in the cyber-world, where virtually all human knowledge exists, readily available for individuals to access without any possibility for effective government control or censorship. Similarly, information is allowing trade and employment to subvert government restrictions and regulations, as best exemplified by companies like Uber and Airbnb, which have not asked for government permission to introduce their products successfully and subvert traditional forms of regulation and supervision. Modern individuals can transact with others they meet online via systems of identity and protection built on consent and mutual respect, without any need for resort to coercive government regulations. The emergence of cheap forms of telecommunication online has also subverted the importance of geographic location for work. Producers of many goods can now choose to be domiciled anywhere they prefer while the products of their labor, which are becoming increasingly informational and nonmaterial, can be transferred globally instantaneously. Government regulations and taxes are becoming less powerful as individuals can live or work where it suits them and deliver their work via telecommunication.
As more and more of the value of economic production takes the form of nontangible goods, the relative value of land and physical means of production declines, reducing returns on violently appropriating such physical means of production. Productive capital becomes more embodied in the individuals themselves, making the threat of violently appropriating it increasingly hollow, as individuals’ productivity becomes inextricably linked to their consent. There was one final piece of the puzzle of digitization that had been missing, and that is the transfer of money and value. Even as information technology could subvert geographic and governmental controls and restrictions, payments continued to be heavily controlled by governments and the state-enforced banking monopolies.
If Bitcoin continues to grow in value and gets utilized by a growing number of financial institutions, it will become a reserve currency for a new form of central bank. These central banks could be primarily based in the digital or physical worlds, but it is becoming worth considering if national central banks should supplement their reserves with Bitcoin. In the current monetary global system, national central banks hold reserves mainly in U.S. dollars, euros, British pounds, IMF Standard Drawing Rights, and gold. These reserve currencies are used to settle accounts between central banks and to defend the market value of their local currencies. Should Bitcoin’s appreciation continue in the same manner it has experienced over the past several years, it is likely to attract the attention of central banks with an eye on the future.
If Bitcoin continues to appreciate significantly, it will provide the central bank more flexibility with their monetary policy and international account settlement. But perhaps the real case for central banks owning bitcoin is as insurance against the scenario of it succeeding. Given that the supply of bitcoins is strictly limited, it may be wise for a central bank to spend a small amount acquiring a small portion of bitcoin’s supply today in case it appreciates significantly in the future. If bitcoin continues to appreciate while a central bank doesn’t own any of it, then the market value of their reserve currencies and gold will be declining in terms of Bitcoin, placing the central bank at a disadvantage the later it decides to acquire reserves.
Bitcoin is still viewed as a quirky Internet experiment for now, but as it continues to survive and appreciate over time, it will start attracting real attention from high-net-worth individuals, institutional investors, and then, possibly, central banks. The point at which central banks start to consider using it is the point at which they are all engaged in a reserve bank run on Bitcoin. The first central bank to buy bitcoin will alert the rest of the central banks to the possibility and make many of them rush toward it. The first central bank purchase is likely to make the value of Bitcoin rise significantly and thus make it progressively more expensive for later central banks to buy it. The wisest course of action in this case is for a central bank to purchase a small share of Bitcoin. If the central bank has the institutional capacity to purchase the currency without announcing it, that would be an even wiser course of action, allowing the central bank to accumulate it at low prices.
Bitcoin can also serve as a useful reserve asset for central banks facing international restrictions on their banking operations, or unhappy at the dollar-centric global monetary system. The possibility of adopting Bitcoin reserves might itself prove a valuable bargaining chip for these central banks with U.S. monetary authorities, who would probably prefer not to see any central banks defect to Bitcoin as a method of settlement, because that would then entice others to join.
While central banks have mostly been dismissive of the importance of Bitcoin, this could be a luxury they many not afford for long. As hard as it might be for central bankers to believe it, Bitcoin is a direct competitor to their line of business, which has been closed off from market competition for a century. Bitcoin makes global processing of payments and final clearance available for anyone to perform at a small cost, and it replaces human-directed monetary policy with superior and perfectly predictable algorithms, the modern central bank business model is being disrupted. Central banks now have no way of stopping competition by just passing laws as they have always done. They are now up against a digital competitor that most likely cannot be brought under the physical world’s laws. Should national central banks not use Bitcoin’s instant clearance and sound monetary policy, they would leave the door open for digital upstarts to capture more and more of this market for a store of value and settlement. Should it achieve some sort of stability in value, Bitcoin would be superior to using national currencies for global payment settlements, as is the case today, because national currencies fluctuate in value based on each nation’s and government’s conditions, and their widespread adoption as a global reserve currency results in an “exorbitant privilege” to the issuing nation. An international settlement currency should be neutral to the monetary policy of different countries, which is why gold played this role with excellence during the international gold standard. Bitcoin would have an advantage over gold in playing this role because its settlement can be completed in minutes, and the authenticity of the transactions can be trivially verified by anyone with an Internet connection, at virtually no cost. Gold, on the other hand, takes more time to transport, and its clearance relies on varying degrees of trust in intermediaries responsible for settling it and transferring it.
The demand for Bitcoin stems from the need of individuals all over the world to carry out transactions that bypass political controls and to have an inflation-resistant store of value. For as long as political authorities impose restrictions and limitations on individuals transferring money, and for as long as government money is easy money whose supply can be easily expanded according to the whims of politicians, demand for Bitcoin will continue to exist, and its diminishing supply growth is likely to lead to its value appreciating over time, thus attracting ever-larger numbers of people to use it as a store of value.