Results for “kareken”
4 found

Some simple Bitcoin economics

That is a new paper by Linda Schilling and Harald Uhlig, here is the abstract:

How do Bitcoin prices evolve? What are the consequences for monetary policy? We answer these questions in a novel, yet simple endowment economy. There are two types of money, both useful for transactions: Bitcoins and Dollars. A central bank keeps the real value of Dollars constant, while Bitcoin production is decentralized via proof-of-work. We obtain a “fundamental condition,” which is a version of the exchange-rate indeterminacy result in Kareken-Wallace (1981), and a “speculative” condition. Under some conditions, we show that Bitcoin prices form convergent supermartingales or submartingales and derive implications for monetary policy.

In this framework, I would attribute the volatility of the recent Bitcoin price to a) sometimes being in the speculative equilibrium or uncertainty about such, b) regulatory uncertainty, and c) uncertainty about the hedging or store of value properties of Bitcoin and other cryptoassets.  If you are interested in other considerations, here is a good Jimmy Song essay on why Bitcoin might be special.  And see this paper by Garratt and Wallace, though unlike with Schilling and Uhlig I am less sure how they are modeling the black/gray market uses for Bitcoin as a transactions medium.

Do it yourself Canadian monetary stimulus, scissors edition

On the Gaspé Peninsula in eastern Quebec, a group of locals and small-business owners have begun to accept an alternative currency—one where $5, $10, $20, $50, even $100 bills, get cut in two, ostensibly reducing their value by half—as a means to promote the local economy.

Confused yet?

Here’s how it works, or, at least, how locals argue it’s supposed to: When someone buys clothes at a Wal-Mart, Zibeau explains, there’s no telling how much of that money will be reinvested in the community. But with stores and locals accepting the cut-up bills, a currency they’ve dubbed the “demi”—French for half—that money can only be spent locally. And because banks don’t accept half a $20 bill, the money would be reinvested right away and not pile up at home (perhaps out of fear that storeowners might just stop accepting the half-bills). This would help keep the economy rolling.

The story is here, via David Siegel.  And ladies and gentlemen…do not try this at home!  No matter what Kareken and Wallace might say…

How and why Bitcoin will plummet in price

My post from yesterday was perhaps not specific enough, so let me outline one possible scenario in which the value of Bitcoin (and other cryptocurrencies) would fall apart.  For purposes of argument, let’s say that a year from now Bitcoin is priced at $500.  Then you want some Bitcoin, let’s say to buy some drugs.  And you find someone willing to sell you Bitcoin for about $500.

But then the QuitCoin company comes along, with its algorithm, offering to sell you QuitCoin for $400.  Will you ever accept such an offer?  Well, QuitCoin is “cheaper,” but of course it may buy you less on the other side of the transaction as well.  The QuitCoin merchants realize this, and so they have built deflationary pressures into the algorithm, so you expect QuitCoin to rise in value over time, enough to make you want to hold it.  So you buy some newly minted QuitCoin for $400, and its price springs up pretty quickly,  at which point you buy the drugs with it.  (Note that the cryptocurrency creators will, for reasons of profit maximization, exempt themselves from upfront mining costs and thus reap initial seigniorage, which will be some fraction of the total new value they create, and make a market by sharing some of that seigniorage with early adopters.)

Let’s say it costs the QuitCoin company $50 in per unit marketing costs for each arbitrage of this nature.  (Alternatively you can think of that sum as representing the natural monopoly reserve currency advantage of Bitcoin.)  In that case both the company and the buyers of QuitCoin are better off at the initial transfer price of $400 and people will prefer that new medium.  Over time the price of Bitcoin will have to fall to about $450 in response to competition.

But of course the story doesn’t end there.  Along comes SpitCoin, offering to sell you some payment media for $300.  Rat-FacedGitCoin offers you a deal for $200.  ZitCoin is cheaper yet.  And so on.

Once the market becomes contestable, it seems the price of the dominant cryptocurrency is set at about $50, or the marketing costs faced by its potential competitors.  And so are the available rents on the supply-side exhausted.

There is thus a new theorem: the value of WitCoin should, in equilibrium, be equal to the marketing costs of its potential competitors.

This theorem will hold even if you are very optimistic about market demand and think that grannies will get in on it.  In fact the larger the network of demanders, the lower the marginal marketing cost may be — a bit like cellphones — and that means even lower valuations for the dominant cryptocurrency.

(It is an interesting question what fixed, marginal, and average cost look like here.  Arguably market participants will not accept any cryptocurrency which is not ultimately and credibly fixed in supply, so for a given cryptocurrency the marginal cost of marketing more at some point becomes infinite.  Marginal cost of supply for the market as a whole is perhaps the (mostly) fixed cost of setting up a new cryptocurrency-generating firm, which issues blocks of cryptocurrency, and that we can think of as roughly constant as the total supply of cryptocurrency expands through further entry.  In any case this issue deserves further consideration.)

Note that the more “optimistic” you are about Bitcoin, presumably you should also be more optimistic about its future competitors too.  Which means the theorem will kick in and you should be a bear on Bitcoin price.  Arguably it’s the bears on the general workability of cryptocurrencies who should be bullish on Bitcoin price because a) we know Bitcoin already exists, and b) we would have to consider that existence an unexpected and unreplicable outlier of some sort.  Yet the usual demon of mood affiliation denies us such a consistency of reasoning, and the cryptocurrency bulls are often also bulls on Bitcoin price, as too many of us prefer a consistency of mood!

In theory

Now, theoretically, you might believe that the current price of Bitcoin already reflects exactly those marketing costs of potential competitors and thus the current equilibrium is stable or semi-stable.  Maybe so, but I doubt that.  The current value of outstanding Bitcoin is about $20 billion or so, and it doesn’t seem it cost nearly that much to launch the idea.  And now that we know cryptocurrencies can in some way “work,” it seems marketing a competitor might be easier yet.  (You will note that by its nature, there are some Bitcoin imperfections permanently built into the system, imperfections which a competitor could improve upon.  Furthermore the longer Bitcoin stays in the public eye, the more likely that an established institution will label its new and improved product LegitCoin and give it a big boost.)

You can think of that $20 billion — or perhaps just some chunk of that? — as a very rough measure of the prize to be won if you can come up with a successful Bitcoin competitor.  Even a fraction of that sum will spur some real effort.

In short, we are still in a situation where supply-side arbitrage has not worked its way through the value of Bitcoin.  And that is one reason — among others — why I expect the value of Bitcoin to fall — a lot.

I thank Brad DeLong for an email query and analysis which sparked this blog post.

Addendum: Maybe I’ll write another post on the possible expected deflationary bias in any cryptocurrency, given that expected price changes usually get compressed into the present and that an overall expected rate of return equality must hold.  And the question of how much an initial issuer can exempt itself from mining costs as a form of reaping upfront seigniorage. and the profit-maximizing way of sharing these gains with early adopters.  Those are two hanging issues with respect to the analysis here, in addition to the matter of cost structure discussed in the parentheses above.  And now go reread Kareken and Wallace (1981).  “=/∞” I think one has to say here.

On the future of Dogecoin, BitCoin, and other cryptocurrencies of the non-realm

An email query from Brad DeLong reminds me of this old Bart Taub paper, “Private Fiat Money with Many Suppliers” (jstor):

A dynamic rational expectations model of money is used to investigate whether a Nash equilibrium of many firms, each supplying its own brand-name currency, will optimally deflate their currencies in Friedman’s (1969) sense. The optimal deflation does arise under an open loop dynamic structure, but the equilibrium breaks down under a more realistic feedback control structure.

There is also Marimon, Nicolini, and Teles (pdf) and the work of Berentsen., all building on Ben Klein’s piece from 1974.  This literature has been read a few different ways, but I take the upshot to be that a) a monopolized private fiat money might be stable in supply, to protect the stream of future quasi-rents, and b) private competing fiat monies will not be stable in overall supply, for reasons of time consistency and also the competitive erosion of available rents.  In other words, when it comes to the proliferation of cryptocurrencies, the more the merrier but not for those holding them.

I don’t agree with the modeling strategy of this 1981 Kareken and Wallace paper on the indeterminacy of equilibrium exchange rates, but still it is another useful starting point.

Addendum: Krugman adds a bit more on Bitcoin, from a friend of his, John R. Levine.  Here is the final bit from Levine:

My current guess is that the Bitcoin bubble will collapse when there is some bad news, e.g., a regulator demands registration of Bitcoin wallets, people try and cash out, and find that that while it’s easy to buy bitcoins, it’s much harder to find people willing to buy back nontrivial amounts, very hard to collect the sales proceeds, and completely impossible without revealing exactly who you are.