Some recent mumblings on CoinDesk on the idea of a cryptocurrency whose value is stabilized with a built-in prescription that manages its supply provoked me to write this article on why this is a vain dream. There is a common fallacy which says that price stability is required in order for a currency to function as a form of money. The way people use terms like store of value and unit of account presumes stability. However, I will show that in an unstable world, a stable currency is counterproductive and furthermore that an unstable currency serves the traditional purposes of money, to the extent that they can be meaningfully defined in unstable conditions.
First of all, it is impossible, long-term, to expect an algorithm to maintain the stability of a currency. There will always be money to be made by predicting the algorithm’s future effect on supply, and once people have learned to do so then the algorithm necessarily ceases to achieve its desired results. For someone who gains by anticipating such an algorithm is not producing something valuable that other people want to buy, so he must be gaining off of other investors, who are losing. That means other people holding the currency, which means that the currency cannot possibly be stable—either it is dropping in price, or the supply is rapidly declining. (The outcome would depend on the details of the prescription.) This can continue until the market cap of the currency goes to zero. In order to succeed at manipulating the price to keep it stable, the prescription must never allow traders to adapt to it. It must continually be smarter than everyone else. This is not something anyone can reliably guarantee, especially a Bitcoin startup (if history is any guide). This is the same reason that attempts to create crypto-equities that track the price of gold or dollars and other things through protocols like ProtoShares and Mastercoin won’t work. It is also why the federal reserve is traditionally so secretive, why the chairman tries to talk without saying anything, and why his or her every move is so deeply scrutinized.
Stability is about as real as the fountain of youth, love potions, or perpetual motion machines. It is not to be found anywhere in the universe but for some reason people act as if such a thing could somehow exist. Prices reflect the availabilities of things that we actually can have, so maybe we should all stop searching for chimera of stability and accept that if the world is unstable, than prices ought to be unstable too. Otherwise prices could not serve the function of enabling people to coordinate the allocation of scarce resources.
Right now the world is deciding whether it wants Bitcoin to be its money. That’s kind of a big change, and it’s pretty reasonable that Bitcoin would be volatile. Will Bitcoin take over or will it drop to nothing? Fundamentally we don’t know and the rapid changes in Bitcoin’s price reflect the confusion and self-doubt in the minds of real people trading it, and this is exactly what they should be doing because without price signals, there could be no Bitcoin adoption. Bitcoin’s exponential growth is a very strong signal, and if Bitcoin were stable, there would be no such signal. There would be no dedicated community of enthusiasts because no one would have any particular reason to want it to be adopted other than the company issuing it. And that company could not offer any value with its stable currency because it cannot unilaterally create liquidity, which is the fundamental thing that makes a currency useful.
What actually makes for a good store of value? The problem with this term is that it is a terrible metaphor. When we store a physical object, typically we shut it away from other people in another object, like a box or something. But what if I had a box that, like Tinkerbell’s magic, only existed if other people believed in it? That’s what a store of value is like. Value is not a physically real thing, like the box. It is an expectation about how much people want something. The whole idea of storing value is absurd. It’s like some kind of dream logic. The only way that a good can “store value” is if everyone wants it so badly that it will be snapped up even at a tiny discount.
This does not mean that anything can be a good store of value. Everyone could treat, say, plastic poker chips as a good store of value and they would only behave like one until people realized that they were easy to manufacture. But suppose there were another metal which had similar properties to gold: it was durable, rare and difficult to extract, and distinctive enough to be difficult to counterfeit. However, the state of our science was such that it was only just being identified by chemists. This new metal would certainly not have a stable value initially upon its discovery because it would take time for the world to learn about it, but it would be perfectly rational for the chemists who did understand it to buy up as much as they could until the rest of the world had got wind of it. Once this metal’s properties were understood by the whole population, then it really could “store value” because everyone else would be using it for the same purpose.
Stability occurs (to the extent that it can happen at all) once everyone has not only learned of the favorable properties of the good but has learned that everyone else also knows of those properties. If I know that Bitcoin is both scarce and unforgeable, I may still be scared to put my money in it because I may fear that other people won’t treat it like a store of value. Furthermore, everyone could think this way at the same time, and the market therefore still behave fearfully. This is why people must be convinced that everyone else believes in Bitcoin too. People today are both coming to terms with Bitcoin’s properties and are confused about how much the rest of the market believes in them. Hence there is fear and volatility. Nonetheless, Bitcoin cannot be counterfeited and its supply is not likely to change, no matter what else happens in the future. This is the best that can be done, as far as engineering goes, to design something to be a store of value. The rest is up to everyone else, not the engineer. Thus, if Bitcoin is going to succeed, then it’s a good store of value.
Now, what about Bitcoin as a unit of account? Unlike store of value, this is actually a really good term, but unfortunately people do not take it literally. When people say unit of account, they seem to want something that will reliably measure wealth somehow, or that things can be priced in without having to be constantly updated. But these are just other ways of chasing the siren song of stability. Here too, if the world is changing then prices should be changing, and one can only imperfectly compare one’s wealth at different times. Really, one can only compare different alternatives which would have taken place over the same time.
Yet there is a worthwhile definition of ‘unit of account’ under these circumstances. It is very simple: a unit of account is something such that to gain it is considered to be profit and to lose it is considered to be loss. Anything can serve this function, but the reason we would especially want to use liquid goods as a unit of account is that when we are liquid we don’t have to think too far into the future. Thus, acquiring a liquid good serves as a reasonable end point to any venture. When you’re sitting on a huge pile of cash, you know that you’ll be fine for some time no matter what happens. Whereas if we were on a barter system with no highly liquid goods around, then one would have to think much further ahead in order to assess the success of a venture. Thus, thinking of profits and losses in terms gaining or losing a liquid good is essential to being able to divide the entire future into manageable tasks—as long as one is gaining that liquid good, one is doing things correctly. Of course, when things are changing so much that the money good itself might shift, then one has to pick which medium of account to use. So once again, Bitcoin is a great unit of account—if it’s going to win. In that case everyone should be trying to get as much as possible of it right now, with the expectation of it being very liquid in the future.
Finally, what about Bitcoin as a medium of exchange? I don’t think this function of Bitcoin is controversial. Of course Bitcoin is a good medium of exchange. My problem with this function of money is the way people treat it in relation to the others. People sometimes think that medium of exchange should be the primary function of money, as opposed to using it as a store of value. For example, this is an assumption behind Tim Swanson’s concern trolling about Bitcoin hoarding. However, it is impossible for a good to function as a medium of exchange unless there is already demand for it as a store of value. If I’m going to give someone bitcoins in exchange for something, there has to be someone, somewhere, who wants bitcoins. And he has to want to store them, even if for only a short time because of everyone tried to spend their bitcoins immediately, that would drive the price down to zero. Furthermore, the more that people want to store bitcoins, and the higher goes its value, the more liquid bitcoins consequently become and the more trade they enable.
Thus, Bitcoin is the kind of money that works in an unstable world, which is the only kind that we know of, and it is a good store of value, unit of account, and medium of exchange, to the extent that these terms make sense amid great uncertainty. When people say “Bitcoin isn’t a good store of value or unit of account” what they really mean is “Bitcoin isn’t being adopted yet”, which is not a valid complaint. Bitcoin has the right properties for the world’s money, and the more the world comes to terms with this, the more stable it will become.