The classification and the future of Bitcoin (another Re: Patrik Korda)

A short while ago I wrote a post where I made some arguments regarding an earlier article about Bitcoin by Patrik Korda. Patrik and I had a long session in the comment section after the article and I’d thought I’d provide a followup. I hope I don’t misrepresent his position, but I think I have a pretty good idea by now.

Patrik looks like a smart chap, he makes plenty of reasonably arguments, and it turns out that we actually agree on a very large proportion of arguments about economics and Bitcoin in specific. He can make on topic responses, which is not that common in internet debates. Nevertheless, in some important issues we disagree and I think these merit a closer assessment.

Classification of Bitcoin

However, should it develop into money, it could present a problem. Bitcoin is not and never was a money substitute, never had a special legal status, nor was it a claim against anybody, nor was a commercial commodity. Therefore, it would not fit into any of the subcategories of the classification.

Now, merely because we cannot classify something, that does not really mean that there is an actual empirical problem. In Antifragile, Nassim Nicholas Taleb argues that the inability to formulate knowledge verbally is not a valid reason for ignoring this knowledge. I remember that during my studies I read something similar. Tacit knowledge still has an important role in our activities, and ignoring it decreases our ability to make sound decisions. It’s funny that I agree with Taleb, because I’m usually pretty anal about getting the definitions right and I go mental when people cannot formulate coherently.

The issue here, however, is not some abstract classification for its own sake, so that I know what shelf to put books about Bitcoin into in a library. The purpose of the classification system provided by Mises is to assist in the economic analysis of trade, money supply, price building, liquidity and so on. From this perspective, if we insist that we must keep the number of categories the same that Mises used, the economically closest category of Bitcoin would be commodity money.

There are several reasons for this. First of all, Bitcoin never was a claim against anyone (credit) (or, if we use the second definition of money in the broader sense, it never was a nearly perfect substitute to any other money). Patrik claims that if Bitcoin trades against fiat money, it means it’s a money substitute, and the issue of a exchange rate is irrelevant. However, the Austrian economists disagree:

• Rothbard in Austrian Definitions of the Supply of Money (referring to Mises):

Because, as he pointed out, bank demand deposits were not other goods and services, other assets exchangeable for cash; they were, instead, redeemable for cash at par on demand. Since they were so redeemable, they functioned, not as a good or service exchanging for cash, but rather as a warehouse receipt for cash, redeemable on demand at par as in the case of any other warehouse. Demand deposits were therefore “money-substitutes” and functioned as equivalent to money in the market. Instead of exchanging cash for a good, the owner of a demand deposit and the seller of the good would both treat the deposit as if it were cash, a surrogate for money.

Bluechip stocks, for example, can be easily sold for money, yet no one would include such stocks as part of the money supply. The operative difference, then, is not whether an asset is liquid or not (since stocks are no more part of the money supply than, say, real estate) but whether the asset is redeemable at a fixed rate, at par, in money. Credit instruments, similarly to the case of shares of stock, are sold for money on the market at fluctuating rates. The current tendency of some economists to include assets as money purely because of their liquidity must be rejected; after all, in some cases, inventories of retail goods might be as liquid as stocks or bonds, and yet surely no one would list these inventories as part of the money supply. They are other goods sold for money on the market.
[emphasis added]

• Michael Pollaro in Money Supply Metrics – The Austrian Take:

To paraphrase the Austrian masters, money substitutes are perfectly secure and IMMEDIATELY convertible, PAR VALUE claims to standard money which, by virtue of this immediate convertibility substitute FULLY for standard money in individual’s cash balances, and as such, are used by individuals as a surrogate for cash – namely, a thing that all other goods and services are traded for, the final payment for such goods and services on the market.
[emphasis added]

• and finally, the urquelle of all, Mises in The Theory of Money and Credit:

The special suitability for facilitating indirect exchanges possessed by absolutely secure and immediately payable claims to money, which we may briefly refer to as money substitutes, is further increased by their standing in law and commerce.
[emphasis added]

Admittedly, he does not use the term “par value” here, but later, he points out to the difference in price when differentiating between credit money and money substitutes:

A third category may be called credit money, this being that sort of money which constitutes a claim against any physical or legal person. But these claims must not be both payable on demand and absolutely secure [i.e. the criteria that Mises uses to define money substitutes, ed]; if they were, there could be no difference between their value and that of the sum of money to which they referred, and they could not be subjected to an independent process of valuation on the part of those who dealt with them.
[emphasis added]

Bitcoin is not a claim, nor is it treated at par with anything else. It is, to use Mises’ terms, subjected to an independent process of valuation. It therefore cannot be a money substitute according to Mises. The issue is exacerbated because Patrik refuses to answer the question who is Bitcoin a claim against, i.e. who is obligated to redeem it (I’m sticking to Misesian terminology here, I disagree with the Austrians that money substitute must be a claim, but that just means I put more relaxed restrictions on Patrik than Mises would).

This eliminates the option of classifying Bitcoin as a money substitute, but also credit and fiat money (as according to my interpretation of the regression theorem, these have to begin as money substitutes), and the only option remaining is commodity money. Another reason for classifying Bitcoin as commodity money is the inelasticity of supply. Detlev Schlichter made the same argument, and the paper of George Selgin can probably also be interpreted from this perspective. Yet another alternative approach is that with commodity money, the marginal production costs and the market price tend to be close to each other (and Bitcoin fits here too).

If we insist on the Misesian definition, then we’re stuck with the controversial question of whether Bitcoin is, or was, a commodity. I don’t want to get into that. The alternatives that I provide might or might not mean it’s a commodity, but I think it gets the economic fundament of both gold and Bitcoin more accurately. But we should at least be able to say that Bitcoin is a quasi-commodity, or that it’s a commoditised service, if we insist on using “commodity”.

Bitcoin is not the only medium of exchange that shows the Misesian definitions inadequate. For example, the old Somali Shillings still work as money. They do not have a special legal status anymore, they just used to have one in the past (that is how they obtained their initial value). So they used to be fiat money, but they evolved into something which a strict Misesian can’t classify (quasi-commodity money, as Selgin suggests). The old Somali Shillings have been counterfeited so much that their production price is close to their market value. During the inflation the supply was elastic but now that the market price has dropped it’s not elastic anymore. We see on this example that the removal of the legal status causes them to eventually gain features similar to the “real” commodity money. Another example of insufficient classification system are various complementary currencies, mutual credit, LETS, or privately issued scrip like Ithaca Hours or BerkShares. Now, these are technically not money yet, merely media of exchange (same situation as Bitcoin), but if they ever developed into money, the question of classification would arise (I use a bit more relaxed definition than Mises, so to me, they would then count as money substitutes).

I think that rather than insisting on a particular umbrella classification system, the classification should be done from the perspective which is most relevant for a particular context. In most economic debates, I tend to agree with Schlichter and Selgin that the elasticity of supply is the most relevant criterion. But I presented several other options too, they might be more suitable for different situations.

The future of Bitcoin

BTW I would be caution of not calling the increased price a bubble. The relevant factor for monetisation is liquidity and I haven’t seen an improvement of liquidity (measured as bid/ask elasticity of Mt. Gox as laid out in my thesis), however I didn’t analyse data after beginning of January (I don’t have the full data set yet), so I am not making a final statement.

This post is not publicly available but I’m sure people who have access to it can confirm that I’m not making this up.

However, Patrik makes a second argument too. He claims that this is relevant for the future of Bitcoin. And here is where we disagree. In the previous article, I argued that due to the network effect, I expect a small number of dominant cryptocurrencies to emerge, even if their relative market share and composition changes. Patrik however seems to have a more fundamental argument, in that the market shares will change quickly and unpredictably. This I also do not hold realistic, and will attempt to address it in this section.

This section will be a bit more loose than normally. I’m not going to make a “hard” argument, merely point out to factors Patrik missed and that might be relevant. First I will formulate a “rule of thumb” for how I think the network effect behaves under competition, and then I’ll explain it on the examples presented by Patrik, and some of my own.

1. If a protocol is technologically better suited to fulfill the requirements of the users, it will take the leading role
2. Friction could prevent a change in the market share if the advantage is not sufficient
3. If protocols are technologically too similar to provide advantages vis-a-vis each other, a lagging one won’t overtake the leading one (path dependence)
4. State interference can count as technological advantage
5. Multihoming (using of more than one standard simultaneously) is only possible to a certain extent, and can’t affect the fundamental issues long term

The example Patrik uses are P2P protocols. Let’s take a look at the history of the leaders (I’m approximating):

1. 1999-2001: Napster. First mover advantage.
2. 2001-2004: Kazzaa (FastTrack protocol). Won over Napster because Napster shut down.
3. 2004-2007: eDonkey. I think it won because it was less centralised and Kazzaa was hostile against third party clients.
4. 2007+ BitTorrent. I think it won because it is less centralised, and open source. BitTorrent is the only one that actually gained wider industry acceptance (e.g. Blizzard downloader uses it).

Summary