Will Bitcoin Grow Up to Be a Currency? Focus on low volatility

Will Bitcoin Grow Up to Be a Currency? focus on low volatility

Bitcoin can be an investment or money, but it can’t be both.

But unlike gold or stocks or housing or other real assets, money’s primary value depends not on intrinsic value but on something else — liquidity.
“Liquidity” is a loose term. In general, it means your ability to quickly and easily trade something for other things. Houses are not very liquid, since it can take months to sell one. Stocks are more liquid. But money should be the most liquid thing of all; you should be able to use it to pay for anything, at any time. If you can’t, you should switch to a new, more liquid form of money, and stick your old, less liquid money in a vault somewhere.

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Two big things have happened in the cryptocurrency world recently. The first is that there are now two competing versions of bitcoin: bitcoin core and bitcoin classic. There is quite a lot of argument about which will become more popular. The second development is that the price of bitcoin — now known as bitcoin core — rose a lot in late 2015:

bitcoin graph

This has raised the expectations  of many cryptocurrency buffs that bitcoin will replace the fiat money printed by central banks.

But when I read these debates, I see a lot of misunderstanding. Whether people are talking about which version of bitcoin will prevail, or whether cryptocurrency in general will replace fiat currency, they keep making the same error.

That error is the assumption that long-term value is what makes a currency good. The truth is it’s almost the opposite.

Most people I meet — including tech people, many of whom are big bitcoin fans — haven’t had much contact with monetary economics. Many of them tend to assume that in order for a currency to be valuable, it has to be backed by some valuable commodity — gold, for example. Without backing, the folk theory goes, money is intrinsically worthless — just pieces of paper.

In this view, money is comparable to a stock certificate — a placeholder that marks ownership of something intrinsically valuable. It implicitly equates the word “money” with value.

But unlike gold or stocks or housing or other real assets, money’s primary value depends not on intrinsic value but on something else — liquidity.

“Liquidity” is a loose term. In general, it means your ability to quickly and easily trade something for other things. Houses are not very liquid, since it can take months to sell one. Stocks are more liquid. But money should be the most liquid thing of all; you should be able to use it to pay for anything, at any time. If you can’t, you should switch to a new, more liquid form of money, and stick your old, less liquid money in a vault somewhere.

This means that money with no real asset backing it can be perfectly good. All you need is for other people to accept it for close to the same value that you got it for. As long as people can be counted on to take your money, the money is good. No gold required.

In the Great Depression, alternative theories of money were put to the test. Before that episode, the U.S. and European economies adhered to a gold standard — national currencies could be exchanged for gold. As growth collapsed, some countries experimented with going off the gold standard, hoping that this might end the deflation that was thought to be hurting growth.

None of the countries that abandoned the gold standard suffered hyperinflation, nor did their currencies collapse. Instead, as Ben Bernanke and Harold James noted in a 1990 paper, the countries that abandoned the gold standard soon began to recover. Here, courtesy of Brad DeLong’s blog, is a chart of the major transatlantic economies and their experience in the Depression:

gold standard chart

The colored lines represent post-gold standard industrial production. Japan was an early mover, and had the quickest recovery, while the U.S. and Germany stayed with the gold standard for longer and did worse.

Skeptics will note that although liquidity is the primary source of money’s value, it isn’t the only source. You also need money to hold its value over short periods of time. There’s a lag between when you get money and when you spend it. You’d like the value of what you exchanged for the money to be very close to the value of the things you spend the money on a little while later.

So if you want money to be a good short-term store of value, you need it to have low volatility. That’s the main reason high inflation is bad, actually. It also tends to be very volatile, making money’s value more uncertain in the short term, which gets in the way of money doing its job.

That’s why central banks try very hard to maintain their inflation-fighting credibility. If people believe that the central bank might decide to devalue the currency at any time, then they will have an incentive to abandon the currency for alternative forms of payment, like bitcoin, gold or a foreign currency. Fears of central bank irresponsibility could thus become self-fulfilling prophecies.

The currencies of rich countries such as the U.S. and Japan are remarkably stable in value. Here is a chart of the U.S. consumer price index, a measure of the value of the dollar:

CPI graph

As you can see, both inflation and the volatility of inflation rarely changed dramatically month to month, especially after the mid-1990s. People expect this state of affairs to continue — they think the dollar isn’t risky in the short term. And that is why the U.S. dollar remains a good form of money. Compare this to bitcoin’s price, which gyrates all over the place!

Now, in the financial world, we expect low risk to come at a price: poor long-term returns. And in fact, the value of the U.S. dollar decreases over time, at a very slow consistent rate. That’s exactly what finance would predict — in exchange for being a good short-term store of value, good money is a terrible long-term investment.

So for people who want to make bitcoin replace fiat currency, I have some advice: focus on low volatility. Instead of getting people excited about investing in bitcoin, focus on finding a way to stabilize the amount of real consumption goods that people can buy with each bitcoin. My suggestion? Peg the currency to the price of a Big Mac.

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