The Fiat Emperor Has No Clothes

By Jon Matonis
Forbes
Thursday, April 18, 2013

http://www.forbes.com/sites/jonmatonis/2013/04/18/the-fiat-emperor-has-no-clothes/

A piece from Paul Krugman in The New York Times this week criticizes bitcoin for being antisocial and for not having a State-controlled supply while secretly admiring its powerful abstractness.

As a complicit minion in the State’s appropriation of the monetary unit, Krugman perpetuates ‘The State Theory of Money’ myth that the sovereign’s power to collect taxes and declare legal tender imbues a currency with ultimate value.

While that may be a reason to acquire a certain amount of government fiat currency, it is a transitory value because in the end it is still based on a State-sanctioned illusion. Anyone who has visited a weekend flea market has noticed the old coin and currency collector displays filled with past experiments in national fiat money. Those paper notes were at one time valued for something too.

We don’t want a pristine monetary standard untouched by human frailty as Krugman claims. We want freedom in the monetary standard untouched by the politicizing process.

In a Krugman world, centralized management of the money supply is preferable to a market-based outcome because the academically-informed economists will serve the best interests of the economy at large. However, our monetary overlords possess no special knowledge or secret sauce that justifies dictatorial control over money any more than it would justify dictatorial control over the market for something like soda beverages or dog food. Trust in mathematics trumps trust in central bankers.

The question of political control over a monetary system is the greatest litmus test for discovering those that seek control over others. Usually, it will be cloaked in terms like full employment, price stability, temporary stimulus, quantitative easing, and economic growth, but manipulation of the money supply serves only to favor the issuers of that particular monetary unit.

Money has a lot in common with religion. At some level, it requires a huge leap of faith. Yes, a belief in gold requires this too as the non-monetary value assigned to gold is probably no more than 5% of its market price. However, this is also what makes bitcoin the ultimate social money because for its value it merely requires others, not the law. Money is already the most viral thing on the planet and the network effect exponentially reinforces that.

Krugman actually struggles to assert that bitcoin is antisocial because he cites economist Paul Samuelson who once declared that money is a “social contrivance,” not something that stands outside society. Samuelson is absolutely correct on that point and bitcoin stands firmly within society. It is no one’s right to question why some place value on bitcoin and some do not since all value is subjective. The rationale for assigning value to bitcoin is as varied as the human fabric itself.

In this context, society can be defined as those mutual users willing to agree to a medium of exchange and a store of value. Since bitcoin, just as the Internet, recognizes no political boundaries, Krugman resists seeing the global monetary unit as something social. Krugman sees society only as a multitude of aggregated fiefdoms where he is the emperor’s cherished tailor.

Though, just like the untainted child in the Hans Christian Andersen fairy tale, some of us are beginning to notice. It’s not the illusion itself that so offends our sensibilities, but more the notion that a competitive illusion is not to be permitted. If a free market illusion voluntarily agreed to from the bottom up is so desperately feared, then the protectors of the State-sanctioned illusion must not have the most benevolent of motives in store for us plebeians.

I don’t know about you, but I for one can stand up and exclaim: “the fiat emperor has no clothes!” What if more of us did?

Bitcoin Obliterates "The State Theory Of Money"

By Jon Matonis
Forbes
Wednesday, April 3, 2013

http://www.forbes.com/sites/jonmatonis/2013/04/03/bitcoin-obliterates-the-state-theory-of-money/

Once you get past the childish title, the recent bitcoin piece from Karl Denninger raises some issues that warrant consideration from bitcoin economists. Denninger is an intelligent student of the capital markets and his essay deserves a serious reply.

The economic contribution of his essay is that it represents the thesis advanced by German economist Georg Friedrich Knapp in The State Theory of Money (1924), an expose advocating the Chartalist approach to monetary theory claiming that money must have no intrinsic value and strictly be used as tokens issued by the government, or fiat money. Today, modern-day chartalists are from the school of thought known as Modern Monetary Theory (MMT).

Without getting into the intrinsic value debate, this is where I strongly depart from Denninger, because if we accept the thesis that all money is a universal mass illusion, then a market-based illusion can be just as valid or more valid than a State-controlled illusion. What Denninger and Greenbackers and MMT supporters reject is the notion that monetary illusions themselves are a competitive marketplace, falsely believing that only the State is in a ‘special’ position to confer legitimacy in monetary matters.

Regarding this issue of State-sanctioned legitimacy, bitcoin as a cryptographic unit seeks and gains legitimacy through the free and open marketplace. It is not a governmental instrument of legal tender that requires regulatory legitimacy and coercion by law in order to gain acceptance.

Therefore, the path to widespread adoption of bitcoin hinges on three primary market-based developments: (a) robust and liquid global exchanges similar to national currencies that can offer risk management via futures and options, (b) more user-friendly applications that mask the complexities of cryptography from users and merchants, and (c) a paradigm shift towards “closing the loop” such as receiving source payments and wages in bitcoin to eliminate the need for conversion from or to national fiat.

Even after graciously accepting Denninger’s definition of what the ideal currency would be (which I don’t) and searching for any economic nuggets of value, his arguments can be distilled into four main criticisms of bitcoin as a monetary instrument. First, bitcoin does not provide cash-like anonymity. Second, bitcoin transactions take too long for confirmations to be useful in everyday transactions. Third, bitcoin exhibits irreversible entropy.  Fourth, the decoupling of the stateless bitcoin from the obligation of monetary sovereigns is considered a fatal weakness.

Now that we identified the objections, let’s take these in order.

On the first point surrounding bitcoin anonymity, Denninger only embarrasses himself with this criticism. By default, bitcoin may not offer anonymity and untraceability like our paper cash today, but it is better described as user-defined anonymity because the decision to reveal identity and usage patterns resides solely with the bitcoin user. This is far superior to a situation where users of a currency are relegated to seeking permission for their financial privacy which is typically denied by the monetary and financial overlords. Also, his capital gains tax issue is a non-starter because it’s a byproduct of a monopoly over money.

His second criticism of a lack of utility in the ‘goods and service preference’ due to timing of sufficient block chain confirmations has some merit. However, advances have been made in the use of green addressing techniques that solve the confirmation delay problem by utilizing special-purpose bitcoin addresses from parties trusted not to double spend.

Denniger’s third criticism that bitcoin exhibits irreversible entropy is confusing. Typically, entropy refers to a measure of the unavailable energy in a closed thermodynamic system that is also usually considered to be a measure of the system’s disorder. In the case of bitcoin, I suspect Denninger is taking it to mean the degradation of the matter in the universe because of his explicit comparison to gold. While it is true that bitcoins lost or forgotten are ultimately irretrievable, I view that as a feature not a bug because it is the prevailing trait of a digital bearer instrument. Two bitcoin digital attributes that make it superior to physical gold are its ability to create backups and its difficulty of confiscation. Furthermore, the number of spaces to the right of the decimal point (currently eight) is immaterial to bitcoin’s suitability as a monetary unit.

Now for the big and final one. Denninger asserts that monetary sovereign issuers possess not only the privilege, but the obligation, of seigniorage, which Denninger refers to as bi-directional since sovereigns have the responsibility of maintaining a stable price level during times of both economic expansion and economic contraction. As a product of Hayekian free choice in currency, market-based bitcoin is decentralized by nature and poses a false comparison to the century-old practice of central bank monetary manipulation. Fear not deflation.

Governments have appropriated the monetary unit for their own benefit by declaring it the only preferred monetary unit for payment of taxes to the State. Believing that governments have sincere and good intentions in administering the monetary system is akin to believing in fairy tales. Control of the monetary system serves one and only one interest — the unlimited expansion of the sovereign’s spending activity to the detriment of the unfortunate users of that monetary unit. Decentralized Bitcoin obliterates this sad state of affairs.

Denninger’s biased and establishment preference for a monetary sovereign serves only to harm his analysis because it undeniably closes him off from alternative, and usually superior, free-market monetary arrangements. More damaging, however, is the fact that it places him outside of the mainstream in free banking circles and squanders his remaining quasi-libertarian credibility as a champion of markets.

Cyprus Goes Cashless The Hard Way

By Jon Matonis
Forbes
Sunday, March 24, 2013

http://www.forbes.com/sites/jonmatonis/2013/03/24/cyprus-goes-cashless-the-hard-way/

The rolling crisis in Cyprus should reach a crescendo this week. If the parliament votes yes on some type of deposit confiscation, it would mean the people of Cyprus have elected to go “all in” on the euro and link their fate with the fate of the single currency.

When given a clear opportunity to leave the eurozone, Cypriots will probably decide to stay rather than rebuild their banking infrastructure from scratch.

With the latest maneuverings and after going full-circle with a range of alternatives, it appears that European bailout terms could be met by a 20-25% levy on deposits only in excess of the guaranteed 100,000 euros. Cypriot Finance Minister Michael Sarris said yesterday that a deposit levy was back on the table as a way to come up with the 5.8 billion euros needed by the new March 25th deadline for the larger rescue amount to be approved.

Writing for SkyNews, Ed Conway described the raid on bank deposits as “a step across the financial Rubicon.” Indeed, it has ramped up expectations as to what is now within the range of options for other EMU member states. Politely calling it a levy or deposit tax doesn’t alter the fact that it still amounts to brazen theft. Others have called it legalized bank robbery.

The Statist quote of the day goes to Naomi Fowler, Taxcast producer for Tax Justice Network, who said, “I think Cyprus is a cautionary tale to citizens that their government’s adventures in tax havenry will cost them dearly.” She advocates for global penalties against the provision of financial privacy which to this observer warps the very meaning of the word justice.

“Only put money in the banking system that you can afford to lose,” advises financial commentator Max Keiser. This is no more true than last weekend in Cyprus when bank depositors had electronic transfers blocked and were initially told to prepare for a confiscatory levy of up to 9.9% of their deposit balances across the board. The government then ordered banks to keep ATMs stocked since cash and credit cards were the only remaining methods of transacting. However, it is not clear how much longer the credit cards will be functioning in the country.

With banks in Cyprus now scheduled to re-open on March 26th after eight days of consecutive closure, this would make the Cypriot banking-system shutdown tied with the U.S. (March 6-13th, 1933) for longest number of shutdown days, following only first place Argentina (April 20-29th, 2002) at 10 days. Should the crisis extend beyond eight days and the European Central Bank pulls the liquidity it has been pumping into Cypriot banks, the ATMs may become cashless.

“The future of the euro zone has been put on the line for a few billion euros. Yet, the assumption of Cyprus not being a systemic risk rests on a single expectation: that it stays in the euro zone,” according to Stephen Fidler at The Wall Street Journal. “Should it exit, all bets are off.” However, other countries should be sufficiently discouraged from taking that route if they see live television images of a full-blown banking panic and an economic collapse within an EU member nation.

For now, the general attitude among the troika appears to be let’s experiment with Cyprus and if things go badly, it’s not such a long-term big deal because Cyprus is too small to matter. That could prove to be an optimistic fantasy.

With capital controls to prevent a mass exodus from Cyprus banks now fait accompli regardless of the bailout decision, Jeremy Warner at the Telegraph says that it is the end of the single currency in all but name:

Yet the point is that if capital controls are introduced, it basically makes Cypriot euros into a national currency, rather than part of wider monetary union. The capital controls will severely limit your ability to get your euros out of Cyprus, rending them essentially worthless in the wider eurozone. It would be a bit like telling Scots they can’t spend their UK pounds in England. Monetary union is many things, but above all it is about free movement of money and a uniform value wherever it is spent. When these functions are disabled, then you cease to be part of a single currency.

The era of free capital movement is behind us. Capital controls are about government keeping your money within easy reach should they ever want it. A decentralized and nonpolitical currency like Bitcoin starts to look attractive by providing a safer destination for wary depositors, allowing them to store their money securely in a digital account on their own computers, away from the big governments and politicians’ reach. It is possible to purchase bitcoins in Cyprus at LocalBitcoins.com.

“Money flows to where confidence exists” says Alan Safahi, CEO of ZipZap, Inc., a global cash network with over 700,000 locations in the world. “As bitcoin gains more acceptance, consumer confidence increases and more money will flow to bitcoins, causing a continuous rise in price due to limited supply which then increases consumer confidence even more,” adds Safahi.

As this trend continues, ZipZap, which processes more purchases of bitcoin than any other cash network stands to benefit tremendously from this trend. “The growth opportunity is not limited to Europe. We are seeing a significant increase in volume in the past few days from consumers in the U.S.,” says Safahi.

The emerging trend towards bitcoin as a flight to safety seems to be accelerating despite the recent regulatory guidance from FinCEN (Financial Crimes Enforcement Network). As part of the Treasury Department, FinCEN’s guidance on enforcement would extend traditional money laundering rules to most types of virtual currencies, including bitcoin. Although bitcoin proponents emphasize that a test case has not emerged yet.

“It’s almost a badge of respect when the Treasury starts regulating you,” said James Rickards, author of Currency Wars. “You must be doing something right.”

“Gold is a great way to preserve wealth, but it is hard to move around,” added Rickards. “You do need some kind of alternative and Bitcoin fits the bill. I’m not surprised to see that happening.”

A Critique of Patrik Korda's 'Bitcoin Bubble 2.0'

By Peter Šurda
Economics of Bitcoin
Wednesday, March 6, 2013

http://www.economicsofbitcoin.com/2013/03/re-bitcoin-bubble-20-by-patrik-korda.html

Patrik Korda recently published a critique of Bitcoin: http://seekingalpha.com/instablog/7761841-patrik-korda/1616371-bitcoin-bubble-2-0. I get agitated when I disagree with others, so I wrote a rebuttal.

Competition under the network effect

Korda's first argument is that because it is easy to create a new cryptocurency, they will compete each other out of the market, kinda "race to the bottom", ending up with a hyperinflation and a collapse. However, he does not seem to understand the network effect, one of the most important aspects of money. The network effect both allows that money actually exists in the first place, as well as creates switching costs. As JP Koning said, "liquidity is sticky".

The problem with Korda's argument becomes more apparent because he himself shows a counterexample. He quotes Mises in explaining that silver has been replaced by gold and this demonetised silver. This explains how competition works under the presence of a strong network effect: the expected long term state is where a small number (maybe even one) media of exchange are the dominant ones, and other market players are far less liquid. For the same reason, a situation where there is a large number of competing cryptocurrencies without clear dominant players is not a stable state, rather a small number of dominant players will emerge.

The network effect is recognisable in particular with immaterial goods: there are a small dominant number of general purpose operating systems (Windows, iOS, Linux), a small dominant number of languages (Mandarin and English dominate, then Spanish and Hindi follow after a gap, and those four account for about half of the world population (I'm approximating, as people can speak more than one language)), there is only one dominant general purpose communication protocol (what we commonly call "the internet"), and so on. Surely, the composition of the dominant players can change, but it is a relatively slow process that does not magically happen overnight. Surely, there are a myriad of minor players, but there always tend to be a low number of dominant players.

If I said that everyone can create their own language, therefore without barriers to entry, everyone would end up with their own language and the ability to communicate would collapse, you'd surely think that I'm a moron.

Another important factor related to the network effect is path dependence. This means that the order in which choices are made influences the end result. This can mean, for example, the first mover advantage. Bitcoin is the first practically usable cryptocurrency, so it has a head start against others. And surely, JP Koning has a useful infographic showing that the market capitalisation of Bitcoin, the first mover, far outstrips the market capitalisation of others (by a factor of 100, at the time of making the graphic). This is also consistent with my claim from above that there typically is a small number of dominant players. Even though there is government interference in the choice of media of exchange (what we call fiat monies), international trade is affected significantly less than national, and we still have a small amount of major players (the USD and Euro).

I'm not arguing here that Bitcoin can't be replaced by something else, but that the scenario described by Korda makes no sense.

Usability

Korda makes the argument that Bitcoin is only usable with electricity and smart phone, but this is incorrect. Bitcoin is the first form-invariant medium of exchange, and can be used in almost any imaginable form, without having to rely on a middleman. Something like this never existed before in the history. People that criticise Bitcoin from this point of view tend to confuse implementation with the fundamentals.

Mises' Regression theorem

Korda, unfortunately, missed the core point of Graf's article. Even if there appears to be a wide disagreement on what the regression theorem actually says, we can be pretty sure about what it doesn't say. It doesn't say what happens to a medium of exchange after it becomes medium of exchange (and Robert Murphy concurs). It only talks about what happens before it becomes a medium of exchange. It does not say what happens between a medium of exchange becoming a medium of exchange and it becoming money, and it does not say what happens after it becomes money. It also does not talk about the scope of usage as a medium of exchange, how many people use it for something else than a medium of exchange, which media of exchange are sustainable, or any such invention that is frequently ascribed to it in particular by critics of Bitcoin. So unless Korda decides to mimick Smiling Dave and claim that Bitcoin is not a medium of exchange (and neither are gold, blue chip stocks or US bonds), the objection with respect to regression theorem is methodologically flawed.

Can Bitcoin become money?

Similarly as in the section about the regression theorem, Korda conflates medium of exchange (whatever is used in indirect exchange) and money (the most liquid good, and thus by implication, the most liquid medium of exchange). I consider the question of Bitcoin becoming money irrelevant for the near future. I have the same opinion as Vijay Boyapati, I think that if Bitcoin becomes money, that would be an unprecedented success. It would be the end of fiat money, and possibly also the state. But the implied criticism of Korda is a false dichotomy: either Bitcoin is money, or it's useless. I dub this fallacy money or nothing (and chicks for free). Contrary to this dichotomy, there is a wide range on the liquidity scale which is called "secondary media of exchange" (Mises) or "quasi monies" (Rothbard), that do provide, through liquidity, useful services. Bitcoin's further advantage is the decrease of transaction costs, which can be practically utilised as long as some level of liquidity persists. It already can be utilised now. There already are plenty of situations where the switch to Bitcoin improves utility. The criticism is like saying that unless everyone learns English, it makes no sense to learn it. Or even better, that it makes no sense to get an email address unless everyone uses email already.

Classification according to ToMC

As I wrote in my thesis, as Bitcoin is not money (yet), merely a medium of exchange, it is impossible to use the classification system of Mises to classify Bitcoin. If it becomes money, then we would have a classification problem. How to solve it I leave open in this post, as I consider it merely a theoretical question with no practical relevance. In my thesis I present options for solving it.

Now, Korda claims that Bitcoin is token money. However, going upwards from the bottom of the graphic in Mises' ToMC Appendix B, Bitcoins are not token money, because they are not fiduciary media, because they are not money substitutes. The Austrians use two definitions of money substitutes (I explain the difference between the two in my thesis):

• absolutely secure and immediately payable claims to money (in the narrower sense)
• things that act as full substitutes to money (in the narrower sense) from economic point of view

Irrespective of which of these definitions is correct, Bitcoins, clearly, are neither, as there is no underlying "money in the narrower sense". So the attempt of Korda to provide a classification of Bitcoin failed.

Anonymity

This is a complicated question, I just want to dissolve some unclarities. While some information about Bitcoin transactions is recorded in the blockchain, and publicly available, this information does not include any references to the identity of the parties involved in the transaction. While a vector analysis can reveal some relationships hidden upon first look, there are on the other hand many other things that can be done to obfuscate this. Examples are mixers (either explicit ones or ones that can do that function indirectly, e.g. Satoshi Dice), and some features that have not been fully implemented yet, e.g. transaction rewriting, or proposals for new opcodes.

From economic point of view, the "perfectness" of Bitcoin's anonymity is not the relevant question. The relevant question is whether this is significantly (from the point of view of users) better than the alternatives, and if it presents a significant cost increase for the attacker (e.g. the state). I'll leave this one open too, I'll just add that for transactions that do not involve a physical meeting of the trading parties, anything else than cryptocurrencies is highly unlikely to provide a comparative advantage over Bitcoin from the perspective of anonymity.

Bubble

Korda seems to think that the question of the Bitcoin price being a bubble is important. I on the other hand consider it completely irrelevant. The relevant question is if Bitcoin decreases transaction costs, and the answer is that it does. Whether the price changes are a bubble or not does not change the answer to the question whether it has a comparative advantage against other media of exchange. The price is irrelevant (thanks for the slogan, Tony). Emphasising the bubble is kind of like saying that when the dot com bubble burst, this must mean that the internet is unsustainable and must collapse.

Almost all critiques of Bitcoin entirely ignore transaction costs. It's like arguing that there's no point in internet if we already have the library, the post office and the TV. According to the logic of these critiques, the businesses will decide to forego a highly profitable opportunity of providing services that increase the efficiency of social interaction and their potential customers are going to forego a reduction of costs of these interactions. Instead, the arbitrary judgement of these critics concludes that the target market is somewhere entirely elsewhere (in barter in a village, for example), and at the same time that arbitrary target market is not a good match for Bitcoin. It baffles me all the time. But I hear it all the time too. People have fixed ideas about what they think money should do, and when Bitcoin doesn't fit into that scope, they don't understand it. It is difficult to recognise a paradigm shift while it's happening, but it is always obvious after it already has taken place. I guess some people just have to endure having their brains in an ignorant state while the market structure changes around them and those with more foresight are able to increase the efficiency of their business operations (and increase their profit).

My recommendation for serious economic analysis of Bitcoin is to ignore the price as much as possible, as long as there is one (i.e. the price is higher than zero). It's simply not relevant.

Conclusion

Regrettably, Korda's criticism contains many flaws. Hopefully I manged to address them. My most important argument is that one should be careful to avoid mixing theoretical and empirical issues. To summarise my counterarguments:

• Due to network effect, the market structure will move towards a small number of dominant cryptocurrencies, so there's no hyperinflation
• Whether Bitcoin can become money is not important, as using it is already advantageous now, as a medium of exchange. If it ever becomes money, that would really rock though.
• Non-economists do not understand the regression theorem and invent their own versions of it which are nonsensical
• Bitcoin is not token money as it never was a money substitute
• Bitcoin is pseudonymous, and has a comparative advantage against competitors from this point of view
• The price of Bitcoin is irrelevant

Reprinted with permission.

Read part 2 of the critique: "The classification and the future of Bitcoin"
Read part 3 of the critique: "Is Bitcoin a money substitute?"
Read part 4 of the critique: "Response to Korda's Mises.org article"

How Cryptocurrencies Could Upend Banks' Monetary Role

By Jon Matonis
American Banker
Friday, March 15, 2013

http://www.americanbanker.com/bankthink/how-cryptocurrencies-could-upend-banks-monetary-role-1057597-1.html

Peter Šurda

I recently had a fascinating chat with the economist Peter Šurda to discuss how nonpolitical cryptocurrencies like bitcoin could alter the future of fractional reserve banking.

Peter is also a software developer experienced in the online payments industry and will present at the Bitcoin 2013: The Future of Payments conference in San Jose in May. His 2012 master's thesis at Vienna University of Economics and Business was entitled Economics of Bitcoin: Is Bitcoin an Alternative to Fiat Currencies and Gold? He's an abstract thinker, but the implications of his work are tantalizing: that digital money like Bitcoin opens up possibilities for banking without central planners or a lender of last resort, where interest rates and reserve requirements are driven purely by the market.

The debate between the full reserve bankers and the fractional reserve bankers is an old one and it has been explored in depth by the Austrian school of economics. More recently, the debate has been broadened to include the dynamics of introducing the bitcoin cryptocurrency, which is the functional equivalent of digital gold, since its supply is predictable and fixed. (There are currently 10.9 million bitcoins in circulation with a total fixed supply of 21 million expected to be mined before 2140, 99% of them by the year 2032.) The Austrian school economist Michael Suede and the technologist Eli Gothill have speculated that fractional reserve banking can indeed appear within a bitcoin monetary environment. This is where we join up with Peter.

JON MATONIS: I enjoyed your blog post, "Market Forces and Fractional Reserve Banking." Do you consider fractional reserve banking to be compatible with Austrian economics?

PETER ŠURDA: First of all, I would like to separate fractional reserve banking and credit expansion. On one hand, there are ways of increasing the money supply, in the broader sense, which do not require fractional reserve banking or changes in the monetary base such as a system based on the principle of mutual credit like LETS [local exchange trading systems], or a fiat currency that uses bitcoin as reserves (i.e. they are not claims in the sense that Ludwig von Mises uses them, but they act as full substitutes). From the opposite direction, fractional reserve banking does not necessarily lead to credit expansion.

I agree with the full reservists that credit expansion has the effects described by the Austrian Business Cycle Theory. However, I agree with the free bankers that fractional reserve banking is not necessarily a violation of property rights and other ways of increasing the money supply also are not necessarily a violation of property rights.

So I think that the economic and legal analysis are two separate issues and need to be addressed separately. I avoided the legal analysis in my thesis and concentrated on Austrian Business Cycle Theory and policy issues, but in an earlier draft I have several pages about legal aspects too, and I discussed the topic with [the legal theorist] Stephan Kinsella.

JON MATONIS: How does a nonpolitical cryptocurrency like bitcoin alter the landscape in the "full reserve" versus "fractional reserve" banking debate?

PETER ŠURDA: Austrians have made arguments in the past that lead to the conclusion that fractional reserve banking does not necessarily lead to credit expansion, even though they never explicitly formulated it this way and might not have realized the connection. The reason is that if credit instruments do not decrease transaction costs over the monetary base, they are unlikely to act as a part of the money supply. Bitcoin shows that this is not only a hypothetical but empirically possible to implement. With Bitcoin, it is much less likely that credit expansion will occur.

In other words, we need to separate two things. Why do people want to hold fractional reserve banking instruments, which may include the interest payments as one of the reasons, and why do people want to use fractional reserve banking instruments as a medium of exchange which, I argue, requires that the fractional reserve banking instruments decrease transaction costs. That they historically manifested themselves through a common instrument is an empirical quirk and not an economic rule. The ability to loan money is beneficial. Contrary to many Austrians, I agree that maturity transformation can be beneficial, and if the loan ends up being a liquid instrument, it also can be beneficial. But if it is so liquid that it becomes a part of the money supply, that's when it has a detrimental effect on the economy.

For full reservists, Bitcoin shows that the question of fractional reserve banking is less important than they thought. Fractional reservists, on the other hand, need to think about the nature of the mechanisms equilibrating the money supply. I tried to explain the issue to [the economists] George Selgin and David Glasner in comments on their websites, but I wasn't successful in getting my point through.

JON MATONIS: If bitcoin is digital gold, does that portend a future where a bitcoin standard (akin to the gold standard) can emerge or partial bitcoin backing for other currencies?

PETER ŠURDA: They probably can emerge, but the more important question is whether they would be preferred to bitcoin. Only something that provides a significant improvement would be preferred. I only know two potential candidates for that: Ripple and OpenTransactions.

JON MATONIS: In a bitcoin world, is fractional reserve banking only possible with offline substitutes (such as physical coins or cards, which can be traded hand-to-hand, containing the private key to a bitcoin address) or an intentional "fork" in the block chain ledger?

PETER ŠURDA: Hypothetically, the reserves can be offline and the substitute can be a clearing system like Ripple, so there are other possibilities too. But if I understand your point correctly, offline "substitutes" might have a higher chance of actually becoming full substitutes because they might have more obvious advantages.

JON MATONIS: As the recent block chain fork episode demonstrates, there is a need for offline bitcoin transactions to continue. Is this demand sufficient for a money substitute to evolve, such as offline substitutes with full or partial bitcoin backing?

PETER ŠURDA: This is primarily an empirical question, so we can't be completely sure about that. I think the probability for this is significantly lower than with the currencies that we've known historically. The end result is also path-dependent; for instance, it depends on how quickly bitcoin matures and/or adapts to changes compared to the potential substitute.

Fractional reserve banking does not come into existence magically. It must follow economic rules. With gold and similar commodities, fractional reserve banking comes into existence for these reasons: On the demand side, there is a demand for money substitutes, because they provide something that money proper does not; and on the supply side, money substitutes carry maintenance costs for the issuer (e.g. storage of gold) and these need to be offset somehow. The issuer can charge on holding (e.g. demurrage of bank notes), transacting (e.g. check clearing), or, obviously, externalize the costs through fractional reserves. From the point of view of an individual user, fractional reserve banking appears to be the least costly alternative. So obviously fractional reserve banking wins.

Putting it together: If there is a general demand for money substitutes, this leads to fractional reserve banking. Unless it's illegal. Then it might not. Solution: Have money which does not lead to the creation of money substitutes. Bitcoin shows that at least hypothetically, this is possible. I might even go a bit further and make this statement: If on a free market money substitutes do not develop even though there is no legal or technical obstacle for them, it means that the choice of money is Pareto-optimal since no change in the monetary system leads to an increase in utility.

JON MATONIS: Does a demand for positive return on bitcoin balances lead to an environment of competitive bank lending with risk-adjusted interest rates? And will this lead to an environment of fractional reserve banking with depositors offered higher interest rates in exchange for the additional risk premium of running a fractional portfolio?

PETER ŠURDA: Yes, I would say it does, but until there are industry niches that primarily use bitcoin, it is probably not much different from gambling.

This might lead to negotiable credit instruments with maturity-mismatching or maturity transformation, depending on which economic school you use for terminology. However, I don't think this feature alone is sufficient for these instruments to be accepted as full substitutes whereas George Selgin appears to think it is. Now, whether to call such a situation "fractional reserve banking" even though no credit expansion occurs is unclear. I lean towards yes, but there could be other interpretations.

JON MATONIS: How do you see bitcoin changing interest rate structures and lending practices?

PETER ŠURDA: Using Bitcoin for loans only makes sense for those businesses that use bitcoin as a unit of account, unless, of course, you're just speculating on the market but don't actually sell any goods or services. I think this will only occur at much higher levels of liquidity or until we can be quite sure that it deserves the label "money." Until these higher levels of liquidity are reached, the price of bitcoin will probably be quite volatile, which reduces the likelihood that people use it as a unit of account.

However, there could be niche market segments that use bitcoin as a primary medium of exchange and [bitcoin] mining is the most obvious candidate. For these, the unit of account function would make sense even if the global market penetration is lower.

Assuming one of these thresholds is crossed and the money supply remains inelastic (i.e. no significant credit expansion), the interest rate of bitcoin should be a good reflection of the time preference of those market participants that use it as a unit of account. Bitcoin also makes it much easier for lending to occur in a decentralized manner, I think. Rather than a small number of "too big to fail" institutions, we should see smaller specialized teams that act as facilitators without owning the liabilities or being liable themselves.

JON MATONIS: Can a free market fractional reserve system (as opposed to a central banking fractional reserve system) coexist with full reserve banking? Or will one drive out the other?

PETER ŠURDA: I think that if money substitutes emerge, fractional reserve banking will out-compete 100% reserve banking in the market. I deal with this a bit in an earlier draft of the thesis. If they don't emerge, on the other hand, we'll have a money supply equivalent to the monetary base and debt will not cause changes in the money supply. It would be viewed as merely highly liquid credit. I don't think they can coexist for a long time assuming the same underlying money in the narrower sense, of course.

Bitcoin: Financial Deepening and Currency Internationalization

By JP Koning
Moneyness
Thursday, February 21, 2013

http://jpkoning.blogspot.com/2013/02/financial-deepening-and-currency.html

Much of the conversation about bitcoin adoption focuses on its use in goods and services transactions. Breaking bitcoin news, for instance, draws attention to the fact that the Internet Archive will be giving employees the option to be paid in bitcoin. This focus on brick & mortar transactions means that the role that bitcoin financial instruments—stocks, bonds, and derivatives—have to play in promoting bitcoin adoption often gets overshadowed.

I'm currently reading Barry Eichengreen's Exorbitant Privilege which goes into the mechanics of what it takes to create a truly international currency. Eichengreen points out that prior to World War I the dollar played a negligible role relative to the pound sterling in world markets, but by the mid 1920s it was the dominant unit for invoicing payments and denominating bonds. Eichengreen's theory is that the US dollar became the world's go-to currency because of the emergence of a very specific financial instrument—the banker's acceptance.

An acceptance is much like a bill of exchange, a financial instrument I explained in my last post. Say a merchant decides to pay for a shipment of goods with a personal IOU, or bill. If a bank first "accepts" the bill i.e. if it agrees to vouch for the IOU, then this gives the bill more credibility. It is now a banker's acceptance.

According to Eichengreen, around 1908 or 1909, a concerted effort to foster the growth of the US acceptance market began. Up till then, US banks had been prohibited from dealing in acceptances and branching abroad—both these limitations would be removed by new legislation. To promote liquidity and backstop the acceptance market, the Federal Reserve, established in 1914, was given authority to buy and sell acceptances via open market operations. Furthermore, these acceptances could legally "back", or collateralize, the Fed's note issue. This feature was particularly helpful. Although the Fed was also legally permitted to purchase government securities, government securities could not "back" the note issue. Acceptances, therefore, became the more flexible and preferred asset for Fed open market operations, at least until 1932 when the limitations on government collateral were removed. According to Eichengreen, the Fed was the largest investor in the acceptance market and sometimes held the majority of outstanding issues on its balance sheet.

By the mid-1920s foreign acceptances denominated in dollars exceeded those denominated in sterling by a factor of 2:1 and more central banks held US forex reserves than sterling. London was on the way out, and New York on the way in. By 1929, the amount of outstanding foreign public bonds denominated in dollars (excluding the Commonwealth) exceeded sterling bonds. The lesson here is that a key step in the sequence of internationalizing a currency is getting it to be used in financial markets. This involves the development of deep, liquid, and accessible markets in securities denominated in that currency.

What sort of financial deepening do we see in the bitcoin universe, and how might we compare it to the dollar's emergence in the 1910s and 20s?

There are a number of healthy signs of financial deepening. I count five competing bitcoin securities exchanges that provide a forum for trading bitcoin-denominated stocks and bonds. These include Cryptostocks, BTCT, MPEx, Havelock, and Picostocks. A sixth, LTC-Global, provides a market in litecoin securities, a competing altchain. Holders of bitcoin needn't cash out of the bitcoin universe in order to get a better return. Instead, they can buy a bond or a stock listed on any of these exchanges.

The largest publicly-traded company in the bitcoin universe is SatoshiDice, a bitcoin gambling website listed on MPEx. With 100 million shares outstanding and a price of 0.006 BTC, SatoshiDice's market cap is ~600,000 BTC which comes out to around $17 million. SatoshiDice IPOed last year at 0.0032 BTC. With bitcoin only trading at $12 back then (it is now worth $29), the entire company would have been worth $4 million. Given today's $17 million valuation, SatoshiDice shareholders have seen a nice return over a short amount of time—much of it provided by bitcoin appreciation.

While SatoshiDice certainly provides some depth to bitcoin financial markets it has the potential to shallow them out too. Because MPEx charges large fees to trade on its exchange, a few of the competing exchanges have created what are called SatoshiDice "passthroughs". Much like an ETF, a passthrough holds an underlying asset—in this case SatoshiDice shares on MPEx—and flows through all dividends earned to passthrough owners. As a result, investors can get exposure to SatoshiDice without having to pay MPEx's expensive fees. BTCT, for instance, lists two different SatoshiDice passthroughs (GSDPT and S.DICE-PT) which together account for more trading volume than all other stocks and bonds listed on BTCT.

SatoshiDice's sheer size is to some extent problematic since Bitcoin financial markets are not as deep as they might appear. Should something ever happen to SatoshiDice, a big part of the bitcoin financial universe's liquidity will be wiped out, and this would ripple out across the entire field of bitcoin securities. The same might have happened to banker's acceptances in their day, except for one difference—the Fed was willing to back the acceptance market up. In the bitcoin universe, there's no buyer of of last resort to provide liquidity support to SatoshiDice shareholders.

Another impediment to deeper bitcoin markets is the hazy legality of the bitcoin securities exchanges. The first major bitcoin securities exchange, GLBSE, was closed in October 2012 with no prior warning. According to this article, potential regulatory and tax liabilities convinced GLBSE's founder to shut it down on his own behest. If any of the existing bitcoin exchanges were to grow too noticeable, one could imagine the SEC (or its equivalent) knocking on their door and forcing the exchange-owner to pull the plug. This sort of regulatory uncertainty can only dampen the liquidity and depth of bitcoin financial markets.

US authorities, on the other hand, didn't need to heed the rules when they built the banker's acceptance market. They created the rules. If financial deepening in the Bitcoin universe is to proceed it will happen despite regulations and not because of them.

The last headwind to bitcoin financial deepening is bitcoin's volatility. Eichengreen writes that the seesawing of the pound sterling during the war period encouraged financial markets to search for a more stable unit in which to express debts. The pound had always been anchored to gold (or silver), but it was unpegged from its century's long gold tether when the war broke out. Although it was repegged in January 1916, this time to the dollar, this did not secure confidence in the sterling's value since the peg was dependent on American support. When this support was withdrawn at war's end, sterling fell by a third within a year. Through all of this, the dollar continued to be defined in terms of gold, a feature which no doubt attracted issuers.

Bitcoin, on the other hand, has more than doubled in just two months. Back in June 2011, it fell by 50% in just two days. Like pound sterling during the war, bitcoin's lack of stability will do little to promote deeper financial markets.

Although I've stressed the difficulties that bitcoin markets face in developing more depth, the sheer amount of financial innovation I'm seeing from those involved in the various bitcoin securities exchanges is impressive. I wish them the best. The more they build up bitcoin securities markets, the better an alternative bitcoin presents to competing currency units.

[Disclaimer: I am long SatoshiDice and several bitcoin mining stocks.]

Reprinted with permission. 

Finance Without Fingerprints

American Banker aired this encouraging financial privacy video on Friday, February 15, 2013:
 

Physical cash is on its way out and won't be missed, but even in an all-digital future the option of anonymous, untraceable consumer payments must remain, Executive Editor Marc Hochstein argues. Bitcoin and past digital cash schemes show it is technically feasible and that banks can play a role. But regulations and the industry's conservatism augur poorly for payment privacy, and a frank and open debate will be required.

Related Articles:
A Dystopian Vision of Banking from the 'Mad Men' Era
Why Some Payments Should Remain Anonymous 

Will Banks Ever Be Digital Privacy 'Heroes'?

Market Forces and Fractional Reserve Banking

By Peter Šurda
Economics of Bitcoin
Monday, January 21, 2013

http://www.economicsofbitcoin.com/2013/01/market-forces-and-fractional-reserve.html

Ralph Musgrave made a blog post "Lawrence White Tries to Argue for Fractional Reserve Banking" where he criticises some of the arguments made by Lawrence White in testimony on his fractional-reserve banking. I tend to agree with many of the things Ralph wrote, but here I'll concentrate on one aspect where I disagree.

Ralph writes:

"In fact there is no reason to suppose that “payment services” provided by a fractional reserve bank are any cheaper or “more economic” than those provided by a full reserve bank. That is, the ACTUAL COSTS (clearing cheques, issuing bank statements, etc) are the same in both cases. However, fractional reserve offers depositors interest on their deposits. And if you deduct that interest from the costs of payment services, then of course the cost of those services could be said to be reduced. But the reality is that this is just cross-subsidisation of one bank activity by another." [emphasis original]

Ralph missed several things here.

Storage costs

The first one (which I cannot find explicitly in White's testimony), is that holding less than 100% reserves decreases storage costs. Even if the "excess" reserves were used in a different manner than loaned out, FRB would still have lower operating costs. Storage costs are a subset of what I call "maintenance costs of money substitutes". One might argue that if a withdrawal request arises in excess of reserves, the transaction costs of facilitating redemption (e.g. sale of assets) would be higher in an FRB. But the operational issues of redemption are not a feature specific to FRB. Even in a full reserve system, as long as branch operations are allowed, it is still possible that someone wants to withdraw more than the available reserves in that specific branch. The withdrawal would still have to be postponed and either the reserves transported from another branch, or some assets sold (the latter might be still chosen even in a full reserve banking if it has lower transaction costs, which is entirely possible).

Bank notes

The second thing is mentioned by White: "The other bank payment instrument, redeemable banknotes circulating in round denominations, simply cannot exist without fractional reserves. Banknotes are feasible for a fractional-reserve bank because the bank doesn’t need to assess storage fees to cover its costs. It can let the notes can circulate anonymously and at face value, unencumbered by fees, and cover its costs by interest income. An issuer of circulating 100% reserve notes would need to assess storage fees on someone, but would be unable to assess them on unknown note-holders. There are no known historical examples of circulating 100% reserve notes unencumbered by storage fees."

 Now, I have a minor addition here, it is hypothetically possible to create a bearer instrument with demurrage (e.g. stamps) even on a 100% reserve banking. Whether there is a practical merit in that I will leave open, but I'll ignore it for the time being, in order to explain the argument of White. So, let me reformulate White's argument: In a metallic monetary system, as long as people prefer bank notes to coins, FRB will emerge. This is a straightforward logical necessity. Irrespective of what people think about legitimacy of FRB, in this particular case it is an unavoidable consequence of consumer demand. Why might people prefer bank notes to coins? I'll address that right away.

Why are substitutes substitutes?

Here it gets a bit tricky, because anti-FRB-ists, when criticising FRB, tend to "objectivise the boundaries of goods". They argue that an instrument issued by the bank is treated by the users of that good as a substitute because they think it's the same good (i.e. it is a claim, an ownership title). But this is a non-sequitur. The best refutation of this assumption are so called "complementary currencies", in particular those of type "mutual credit". Mutual credit are a form of circulating medium of exchange which is derived from a "normal" money (e.g. the USD or EUR), but they are not based on deposit banking. Some of the more popular examples are WIR and TEM.

In other words, a subsitute medium of exchange (money substitute) does not need to be a claim. Mutual credit is not even convertible into the base money. This leaves the question open: why are then some goods accepted as a substitute medium of exchange? The Austrians know this, but magically, when talking about FRB, they forget about it. They are accepted as substitutes because they decrease transaction costs. Practically all of the anti-FRB Austrians realise this, but only when not talking about FRB: Rothbard, Hoppe, Salerno, de Soto.

So what are money substitutes? Money substitutes are copies of the monetary base. They are persistently causally related to the original (e.g. by a peg, by using the same name, etc.), and they act as substitutes from economic point of view. And, at the latest since Kinsella's Against Intellectual Property, the Austrians increasingly come to the realisation that copying is not per se a violation of property rights. Analogously, creating an instrument which is subsequently then accepted as a substitute by the market is not, per se, a violation of property rights either.

Cross-subsidising

Now that we have clarified what are money substitutes, we can look at cross-subsidising. The instruments issued by the banks are copies. They have two important features that distinguish them from the originals:

1. They have lower transaction costs
2. They allow credit expansion

Here the error of anti-FRBists becomes apparent. They do not realise that the instruments are goods separate from the original. They draw the boundaries of goods based on their own desires, not based on how these goods are treated by the market. The result of banking is a new good, that unifies lower transaction costs with credit expansion. Even if they don't like it, this is the economic fundamental of the banks' activities.

Since this new good, this copy, satisfies both the demand for lower transaction costs and credit expansion, these two activities economically manifest themselves as one. The merging of these two activities by the bank is simply a response to this unified demand. As long as this new good, copy, satisfies both demands, the activities of the bank are economically inseparable. Therefore, there is no cross-subsidising, similarly as the manufacturing of tires is not cross-subsidising the manufacturing of chassis as long as people demand the whole car, even if some people have a fetish for the tires and want to ban car assembly.

How to fix this?

Unlike the free banking branch of the Austrian school, I actually agree with the gold standard branch that credit expansion [EDIT: and I mean any credit expansion] leads to distortions, such as the business cycle. So I'm at odds with both of them, as I argue that FRB is economically detrimental, yet not a violation of property rights, but a consequence of market forces. I could just end here, leaving everyone baffled and annoyed. But this blog is called "Economics of Bitcoin". And here it comes in.

To explain why, I'll first start with a quote by none other than professor White, in Competitive Payments Systems and the Unit of Account:

"Coinage reduces transaction costs compared to simple exchange, because of authentication and weighing. Bank liabilities also reduce transaction costs. But these are empirical factors, and not something inherent in all possible monetary systems."

Now, putting it all together, if the transaction costs of monetary base are sufficiently low, money substitutes do not emerge, and thus there is no credit expansion. Bitcoin shows that such a system is empirically possible. It "fixes" credit expansion without "fixing" FRB. Is that a hack? No. Money substitutes are a hack, and credit expansion is a result of that. Bitcoin shows that a proper solution is possible.

Reprinted with permission.

Egypt Imposes New Cash Controls At Border

By Jon Matonis
Forbes
Thursday, December 27, 2012

http://www.forbes.com/sites/jonmatonis/2012/12/27/egypt-imposes-new-cash-controls-at-border/

Currency controls are now in place and there is a ban on traveling with more than $10,000 in cash. Egyptian officials are becoming worried as savings account withdrawals increase in the face of a depreciating pound and public rumors of central bank confiscation of deposits.

On Tuesday, Presidential spokesperson Yasser Ali confirmed the government's decision which limits all travelers from "bringing foreign currency into the country or carrying it out to only $10,000." Ali added that "any funds over US$10,000 must be transferred electronically" and the decision also forbids sending cash through the mail.

Previously under the original law, any amounts above $10,000 or their equivalent in foreign currencies simply had to be declared to authorities.

With foreign investors and tourists holding back now, the post-revolutionary Egyptian government of Mohamed Morsi is finding it difficult to maintain control over its finances and budget deficit. As a result, Egyptian officials have delayed the high-level talks that are necessary to secure a $4.8 billion loan from the International Monetary Fund (IMF).

New thinking at the International Monetary Fund now accepts that capital controls are sometimes necessary to prevent destabilizing capital flows. It is not clear from the IMF Survey if this new view would apply to the control of outflows from Egypt which has seen its foreign currency reserves fall from $36 billion in 2010 to $15 billion today dangerously close to the IMF's recommended coverage of three month's of imports. Estimates put hard currency reserves at just about $4 billion.

After visiting one exchange office that had run out of dollars, Cairo resident Mahmoud Kamel said, "I want to exchange money because I'm afraid the Egyptian pound will not have any value soon."

Furthermore, due to the cumulative limit of $100,000 in effect from nearly two years ago, many wealthier Egyptians have maxed out and are unable to send money abroad.

The Central Bank of Egypt said Tuesday that the Egyptian pound was trading at 6.20 per U.S. dollar compared to 6.00 during the first half of the year. Without necessary currency reserves to fund imports, it is likely that the pound will fall in value sharply.

Fear Not Deflation

By Jon Matonis
Forbes
Sunday, December 23, 2012

http://www.forbes.com/sites/jonmatonis/2012/12/23/fear-not-deflation/

We should not be afraid of deflation. We should love it as much as our liberties.  --Jörg Guido Hülsmann

Deflation in the context of bitcoin has been cited frequently in the popular press as a detriment to its widespread adoption. For example, famed Keynesian economist Paul Krugman ridiculed the bitcoin cryptocurrency saying "it reinforces the case against anything like a new gold standard – because it shows just how vulnerable such a standard would be to money-hoarding, deflation, and depression."

Krugman could not be more wrong. Deflation is not a problem in the traditional monetary system and it will not be a problem in the bitcoin economy.

As over 99% of bitcoin's possible 21 million coins will be mined by 2031, the fixed mild inflation will effectively cease and a period of non-inflation will commence. Although the supply of cryptographic money will be relatively static with the exception of attrition through permanently lost coins, I will refer to the monetary phenomenon as deflation because as bitcoin's asset value increases compared to political numéraires, its effect on price expression will be seen as deflationary.

Contrary to the central banking and political class insistence that deflation must be prevented at all costs, an economy with a monetary unit that increases in value over time provides significant economic benefits such as near zero interest rates and increasing demand through lower prices. Let's look at some remarks from leading thinkers on deflation.

In responding to an article in The Economist, Doug Casey points out that "in a free-market economy, without central banks and without fractional reserve banking, both inflation and deflation as chronic events are really not possible." Casey states:

"Deflation is actually a good thing, because in a deflation prices drop and money becomes more valuable, so deflation encourages people to save money. Deflation rewards the prudent saver and punishes the profligate borrower. The way a society, like an individual, becomes wealthy is by producing more than it consumes. In other words, by saving, not borrowing. And during a deflation, when money becomes more valuable, everybody wants money. They want to save. Whereas during an inflation, you want to get rid of the money. You want to consume. You want to spend. But you don’t become wealthy by spending and consuming; you become wealthy by producing and saving."

Jörg Guido Hülsmann is a German economist and author of Deflation and Liberty, an important monograph that demolishes the myth of monetary intervention to prevent the cleansing effects of deflation. Hülsmann writes:

"Deflation is not inherently bad, and that it is therefore far from being obvious that a wise monetary policy should seek to prevent it, or dampen its effects, at any price. Deflation creates a great number of losers, and many of these losers are perfectly innocent people who have just not been wise enough to anticipate the event. But deflation also creates many winners, and it also punishes many 'political entrepreneurs' who had thrived on their intimate connections to those who control the production of fiat money.

Deflation puts a break--at the very least a temporary break--on the further concentration and consolidation of power in the hands of the federal government and in particular in the executive branch. It dampens the growth of the welfare state, if it does not lead to its outright implosion. In short, deflation is at least potentially a great liberating force. It not only brings the inflated monetary system back to rock bottom, it brings the entire society back in touch with the real world, because it destroys the economic basis of the social engineers, spin doctors, and brain washers."

Former president of the Mises Institute, Doug French, writes in the essay In Defense of Deflation:

"Lower prices increase demand; they do not reduce or delay it. That's why more and more people own flat-screen TVs, cellular telephones, and laptop computers: the prices of these goods have fallen, and people with lower incomes can afford them. And there are more low-income people than high-income people."

In A Plea for (Mild) Deflation, George Selgin rightly distinguishes between malign demand-driven deflation which is an unfortunate secondary effect of a central bank-manipulated, inflationary malinvestment phase and benign deflation which is the result of an increase in productivity:

"The Great Depression dealt a near-fatal blow to such common-sense thinking about prices and the price level. A new generation of economists became so obsessed with avoiding the bad kind of deflation that they all but forgot about the good kind. Followers of Keynes advocated inflationary policies, which have been the norm ever since. Having paid penance for the Great Depression by suffering through six decades of inflation, it is time for us to revive old-fashioned logic concerning the potential benefits of deflation.

Recognition of the possibility of benign deflation should have a salutary effect on the thinking of the world’s central bankers. By helping them to overcome their fear of falling prices, it will encourage them to deal a deathblow to the worldwide scourge of inflation. But that is only the beginning. Once the possibility of benign deflation is fully appreciated, zero inflation itself will come to be recognized as an overly expansionary policy—that is, as a mere steppingstone on the way to something even better."

Fear not deflation. Ultimately, the market will reach an equilibrium between investment and savings because in the absence of an equilibrium the benefits of a savings-only strategy would evaporate. Proper economic growth through sound investments will lead to a productivity-driven deflation.

The Gloom of Central Banking

By Tuur Demeester
MacroTrends.be
November 2012

Gloom of Central Banking  

Introduction

On october 29th, the ECB published a 55-page report titled “Virtual Currency Schemes”. With this dysphemistic title, the central bank refers to private, unregulated initiatives of virtual currency. With 183 references in the text, it seems obvious that specifically the fast growing peer to peer currency Bitcoin is under scrutiny.

In what follows, I sketch an evolution of how central banks—the monopolists of the current fiat money paradigm—have dealt with the threat of free market competition coming from the internet, and how they are now reacting to the sudden appearance of an enigmatic rival.

Be warned that this is a subjective take on the issue. People from central bank and government circles will no doubt accuse me of being unbalanced and unfair in my interpretations and conclusions. So be it. my goal here is to scrape off the veneer of these reports and thus catch a glimpse of what may actually be happening behind the closed doors of Basel and Brussels.

Bitcoin, Dollars and Pot-Banging Protests in Argentina

By The Blue Market

Thursday, October 18, 2012

http://thebluemarket.wordpress.com/2012/10/18/bitcoin-dollars-and-pot-banging-protests-in-argentina/

200.000 people in the Plaza de Mayo

This post is a peep into the underground exchange markets for dollars and bitcoins in Argentina. For the last couple of weeks, I have experienced the informal exchange of bitcoin and dollars on first hand in Buenos Aires. Furthermore, I have realized how both locals and expats may reap significant gains by using bitcoins as a medium of exchange.

Inflation and Monetary Restrictions

Before we dive into the details of the underground markets in Argentina, let me try to paint the picture of the current economic situation in Argentina.

For several years the Argentine inflation rate has been bumping around 25-30% per annum, according to figures published by independent institutions. The Argentine government doesn’t recognize the independent estimates and has allied with INDEC, the National Statistics Institute, to calculate inflation figures 2-3 times lower than the independent figures. The interesting fact is that the peso’s fixed exchange rate with the dollar is only taking into account INDEC’s inflation rate of 8-12%, causing overvaluation of the peso by not incorporating the true higher inflation rate. INDEC is indeed a neat implementation of an Orwellian “Ministry of Truth”, and the magic calculations have raised concerns with IMF who is threatening to expel Argentina from the organization.

Naturally the high inflation rate has caused capital flight out of Argentina, and every Argentine with a bit of savings is looking to exchange their pesos into something more secure. In order to stop the capital flight and fortify the central bank’s reserves, the government has implemented strict measures to prevent Argentines from obtaining foreign currencies. For example, only if you are travelling abroad are you allowed to exchange pesos for dollars legally, but there is a limit of 100$ per day abroad. Recently the government also imposed a 15% tax on all foreign credit card purchases, and a 50% custom duty on any goods which Argentines purchased abroad. Aside from the outrageous taxes, this legislation completely flashes your personal banking details to government officials, who can then snoop on your shopping list.

The complex regulatory environment has caused Paypal to suspend all domestic transactions in Argentina. Ebay and Amazon has followed suit with similar restrictions.

The Blue Dollar

In Argentina the dollar you care about is blue. The reason is that the difficulty for locals to acquire dollars through traditional means has fueled a secondary dollar exchange market. The unofficial exchange rate, known as the “blue dollar rate”, is approximately 25% higher than the official rate.

For expats, it’s a no-brainer that you are being ripped-off by withdrawing cash at ATMs from established banks, where the withdrawal is conducted at the official exchange rate currently around $ARS 4.70 pesos per dollar. In comparison, if you exchange USD on the “blue market” you get around $ARS 6.20  pesos per dollar.

Luckily before travelling to Argentina, my girlfriend and I were tipped off to this news and carried along dollars in cash when entering the country. One can exchange dollars at the blue market rate simply by heading to Bs. Aires main shopping street, Calle Florida. Here lots of street vendors are drifting around advertising their business to anyone who looks like a potential customer. The street vendors here are known as arbolitos by locals. Arbolitos means “little trees”, a reference to the street vendors are full of “green leaves”. If you are looking to exchange dollars the street vendors will quickly approach you and provide a quote. If you accept the quote, you just head to a nearby jewelry or electronics shop and complete the transaction.

Above approach is generally safe but I wasn’t too keen on exchanging dollars with street vendors. Instead I posted a small note on an online forum and got in contact with a couple living in Buenos Aires, who were eager to exchange dollars for pesos at the blue market rate. The snapshot below is the result of this exchange – and what an underground dollar market looks like.

The Bitcoin Hero

The dollars we brought into Argentina are soon running out, and we have been looking for alternatives to increase our dollar reserves. One approach is to cross the border to Uruguay – but you have the hassle of ATM withdrawal limits and the risk of travelling with lots of cash. There is also a service called Xoom, which allows you to transfer money from abroad to various pick-up locations in Bs. Aires. The magic of Xoom is that they somehow manage to provide the blue dollar exchange rate. Unfortunately they also require a US bank account to use its services.

Another possibility is Bitcoin, a new electronic currency, which has been flourishing online for the last couple of years. In our situation Bitcoin has turned out to be a great vehicle to transfer money into Argentina and achieve the blue dollar exchange rate. I completed my first bitcoin to pesos transaction last week and gained 25% in comparison to the official exchange rate.

The way it works is that you simply buy some bitcoins online through one of the many bitcoin exchanges. Mt.Gox is by far the largest but there are local alternatives as well, such as Bitcoin Nordic. Once you have your bitcoins you identify an Argentine who is on the market for bitcoins at the blue dollar rate. Given the economic situation there are lots of Argentines who are looking to get rid of pesos in exchange for other more secure assets.

In my case I circulated a note to Eudemocracia’s bitcoin mailing list announcing that I was interested in selling bitcoins. The price I offered was the Mt.Gox USD price converted to pesos at the blue USD exchange rate. Based on the number of replies this was an attractive offer, and after some email correspondence, I agreed  to meet up with one contact and conduct the transaction. After getting the agreed pesos in cash I made a one-click transfer of bitcoins to his online bitcoin wallet. A bitcoin transfer is instant and non reversible, and the picture below shows how we could confirm completion of the transaction on the spot.

Because of the dollar restrictions and the escalating inflation the demand for bitcoins in Argentina is greater than our personal need for pesos. Therefore, if you are an expat or just travelling through I encourage you to explore bitcoin as an alternative to finance your stay. Not only will you get a 25% higher exchange rate but you will also help locals protect their savings from being hollowed by inflation.

I believe the bitcoin adventure is just kicking off in Argentina. Also I’m keen to see how the 200.000 Argentines demonstrating for libertad in the Plaza de Mayo might use bitcoin to fight the monetary restrictions themselves. Maybe it’s an even better approach than banging a pot?