Econ 101: The Value of Money

During a discussion of Bitcoin with friends, it became clear to me that it might be helpful if I explained some fundamentals of how the value of money is determined. Like most everything else, money’s value is ultimately determined by its supply and demand.

Demand for money reflects the public’s need to keep an inventory of it in order to use it for making payments.  Bitcoin are generally held as a speculative asset rather than for payments as almost no one will accept them in payment. “Cryptocurrencies-the bitcoin phenomena”

The supply of money is determined by those who created it, generally central banks. Generally central banks issue their currency, thus increasing its supply, by lending it (generally to banks) or by buying assets, generally their government’s debt.  When anyone holding that currency no longer wants it and has the right to redeem it, the central bank takes it back in exchange for the asset it purchased in the first place, thus reducing the money supply.  Under the gold standard, currency was redeemed for gold.  The rules governing a central bank’s issuing and redeeming its currency defines the nature of its monetary regime.  That is the topic of this econ 101 lesson.

As none of us has ever redeemed our currency, it is understandable that my friends confused spending their money with redeeming it.  Spending it transfers it to someone else without changing its supply, while redeeming it reduces its supply.  Cryptocurrencies add a new category to our discussion of money.  As noted by “a billionaire hedge-fund manager… cryptocurrencies are a ‘limited supply of nothing.’”  “Crypto skeptics growing”

As discussed further below, the supply of Bitcoin increases slowly and steadily over time as determined by an unchangeable formula and Bitcoin cannot be redeemed for anything.  The U.S. dollar and virtually every other national currency in the world grow at more erratic rates as determined by their issuing central banks.  So what makes the value of the dollar relatively stable over long periods of time?  The fall in its value by about 8% over the last month is nothing compared to bitcoin’s fall of 23% over the same period and over 50% over the last half year.  Over the past 15 years the dollar’s value has declined less than 2% each year.  Unlike Bitcoin, dollars are widely accepted for payments that are denominated in dollars, including our taxes, and thus held (demanded) to make such payments.  Almost no Bitcoins are held to make payments as almost no one will accept them for payments.  But I want to focus on a currency’s supply.

There are fundamentally three broad approaches to determining the supply of a currency.  Historically, the supply of most currencies were determined by fixing their price to what they could be redeemed for, such as gold or silver. I have called such a system for regulating money’s supply, a hard anchor. “Real SDR Currency Board”  The value of a currency can be fixed (the price set) to something real such as gold or a basket of goods.  A country with a strict gold standard, which the U.S. never really had, issues its currency (dollars) whenever anyone wants to pay the fixed gold price for more of them.  If the dollar price of gold in the market rises above its official price, there would be an arbitrage profit from buying gold from the central bank at its lower official price.  Such gold could be resold in the market at the higher price.  But the key point is that this mechanism (what I call currency board rules) of redeeming currency reduces its supply and thus reduces prices in this currency in the market (deflation).  Several of the monetary systems I helped establish, work in this way (Bulgaria and Bosnia and Herzegovina). “One Currency for Bosnia”

The most common system of monetary control today is for the central bank to determine its currency’s supply by buying or selling it in the market (the Federal Reserve can buy treasury bills, etc. to increase the supply of dollars).  Most central banks today adjust their money supplies in an effort to achieve an inflation target (a much more complicated subject). “Czech National Bank: Inflation Targeting in Transition Economies”  Generally they do so by setting an intermediate target for a short-term interest at which market participants (banks) can borrow from the central bank.  Such fiat currencies, such as the U.S. dollar, are not redeemable but are widely accepted in payment for goods, services and debts.

This brings us to Bitcoin.  The supply of Bitcoin is determined by a formula that predetermines its gradual growth to 21 million by 2140.  There are currently about 19 million in existence.  The supply is increased by giving them to successful miners for verifying the legitimacy of each transaction (another complicated subject).  Thus, the issuer (the formula) received services (protection against double spending the same coin) but no assets such as gold or treasury bills for creating and issuing new Bitcoins.  Once created, an issued bitcoin can never be redeemed (i.e. the outstanding supply can never be reduced).  When you spend or give away your Bitcoins you are circulating them to other holders, not redeeming them.

When my imaginary aunt Sally discusses Bitcoin and cryptocurrencies more generally, she tends to mix up the marvelous new payment technologies for paying my dollars all over the world with private money such as Bitcoin and Tether.  She also doesn’t seem to quite understand that most money has always been privately produced including the U.S. dollars that we spend in various ways (occasionally even by handing over cash).  “A shift in monetary regimes”

But these distinctions are critical when considering what role the government should play in our monetary system.  The truly amazing technical progress we have experienced and the dramatic increase in the standard of living of the average person it has delivered over the last century was made possible by a government that provided a general framework in which we, the consuming beneficiaries of this progress, could make informed choices.  Our government, wisely, generally did not make such decisions for use.

With that in mind consider “a letter addressed to Senate Majority Leader Charles E. Schumer (D-N.Y.), Senate Minority Leader Mitch McConnell (R-Ky.), House Speaker Nancy Pelosi (D-Calif.) and other congressional leaders, [from 26 influential technology personalities that] outlined what it described as potentially grave dangers of cryptocurrencies.” They are absolutely correct to expose and condemn the technical and economic weaknesses of blockchain technology—the distributed ledger with which Bitcoin claims to avoid the need for trusted third parties to record and document payment transaction (as happens on a centralized ledger when you pay from your bank deposit). 

But the fact that foolish people invest in Bitcoin and other cryptocurrencies does not justify our government prohibiting and restricting them from doing so.  The government requires the banks in which we put our money to publish properly audited financial statements of the assets backing our deposits and to set minimum capital requirements to protect against the possible loss of bank asset value (e.g., loan defaults).  Cryptocurrencies claiming redeemability at a stable value (so called stable coins) should similarly be required to disclose the rules by which they operate and the composition and value of the assets backing their digital coins.  In short, government regulations should help us decide what we want to buy and/or hold without restricting the ability of fintech pioneers to explore and innovate products to offer.

Overly restrictive regulations create incentives for incumbents to create barriers to competition.  Large and intrusive governments tend toward corruption.  The Federal Reserve System seems quite aware of these risks as it cautiously explores whether to compete with the private sector in developing a central bank digital currency.  “Econ 101-Central  Bank digital currency-CBDC”

So when considering the government’s role in money and payments be sure to clearly distinguish money from payment technology and limit government to setting the rules of the game that maximize the ability of private consumers to make wise choices. But perhaps the biggest policy decision of all is how the government should determine/regulate the supply of its currency, most of which is privately created.  I support a currency whose value is fixed to something real (a hard anchor) and whose supply is determined by the market via currency board rules.  “A libertarian money”  

A Libertarian Money

Some people claim that libertarians like cryptocurrencies like bitcoin because they do not rely in any way on government. Perhaps those people meant “anarchists” because libertarians (to be safe perhaps I should just refer to my own views though I know that they are widely shared by other libertarians) accept the critical importance of government in defining and protecting property rights and personal safety. Bitcoin and most other cryptocurrencies do not satisfy the requirements for a good libertarian money because they do not satisfy the requirements for good money. This note explains why this is so and defines what is good libertarian money.

Are Cryptocurrencies the Answer?

Economists note the incredible power of markets and market prices in directing our scarce resources (our labor, capital, and technology) to their best uses. But prices are expressed in terms of money. The presumption, and actual reality, is that within each market prices are expressed in terms of the same money. It would not facilitate our choices if apples were priced at $6 per bushel and oranges at 3 bitcoin per bag. Presently, virtually nothing is priced in bitcoin. In addition, sellers don’t generally accept payment in a currency other than the one in which the good’s price is expressed, thus very few sellers will accept bitcoin in payment. Moreover, you can only accept bitcoin in payment if you have a bitcoin account together with the software required (a bitcoin wallet).

None of these are insurmountable barriers to growth in the use of bitcoins, but they do require strong incentives for putting up with and/or overcoming them. I explained the basics of bitcoins value in the following blog in 2014: “Cryptocurrencies-the bitcoin phenomena”   One incentive would be to replace the established currency in a market (a country’s legal tender) that has very unstable value (think Venezuela, Argentina, Brazil at various times in their histories). Another would be the need for anonymity (as is achieved with paper currency) that an illegal drug dealer or a political dissident in a repressive regime might require and find convenient.

Bitcoin’s claim to eliminate the trusted third party (bank accounting systems) required by existing electronic (digital) payments with bank deposits, is particularly attractive to libertarians.  But this claim is a gross exaggeration. To prevent the double spending of the same bitcoin, each transaction must be verified by so called miners (third parties you don’t need to trust) which takes five to ten minutes and very large amounts of electricity to process as miners race to solve increasingly difficult mathematical puzzles. Also, all transactions are very public on block chains, though accounts may be held under pseudonyms and are thus described as pseudo-anonymous.

Though actual bitcoin transactions have been made easier via the development of software wallets, many assign their bitcoins to exchanges (trusted third parties).  “The future of bitcoin exchanges”  The loss of a bitcoin owner’s password to his account is fatal and final. Those bitcoins are lost forever. But more deadly to the use of bitcoin as money (unit of account and medium of payment) is the volatility of its value.  The price of a bitcoin has ranged from just under $30,000 to over $67,500 over the last year. It is currently $39,268. Thus, payments of bitcoin generally involve temporarily purchasing them with dollars or some other stable currency and then exchanging them back to dollars as quickly as possible after receipt. The costs of these exchanges are often overlooked when claiming that bitcoin transfers are cheaper than traditional means of electronic payments. Most buyers and sellers of bitcoin are indulging in a form of gambling.

The Libertarian Alternative

There are monetary regimes, however, that satisfy libertarian preferences for minimal government involvement and manipulation. The Constitution of the United States provides the authority for such a regime in Article I Section 8 “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;” The classical gold standard was such a system. However, its “rules” were diluted when taken over by central banks. Moreover, the practice of actually buying and storing gold distorted its market price and was costly, flaws that are avoided in the system I propose below.

In the U.S. today, as well as every other country in the world, there are thousands of private companies that create and offer their own currency. Most of them are banks. While that would seem to make libertarians happy, thousands of individual bank producers of money would not constitute an efficient monetary system without rules and mechanisms for linking them into what we think of as one currency–in our case the U.S. dollar.

While the dollars deposited in my bank are my bank’s liability, I am protected from the bank’s failure by deposit insurance. Your bank accepts my deposits in my bank because my bank credits your bank’s account with the Federal Reserve (by debiting its account with the Fed). In short, the deposits at thousands of different banks are accepted by every other bank because they are all ultimately claims on the Fed. This is similar to the gold standard in which the money created by thousands of banks were accepted everywhere because they were redeemable for a well-defined amount of gold.

Libertarians want a currency and monetary system that can’t be manipulated by the government (central bank).  The dollar is now a fiat currency (redeemable for nothing–except a claim on, i.e., deposit with, the Federal Reserve). Thus, its supply is determined by the Fed’s judgement of what is needed for “price stability and maximum sustainable employment.” We libertarians want a currency that we each individually control the supply of. In short, we want a currency with a hard anchor (which was the case for the gold standard) supplied according to currency board  rules (which historically were violated by central banks nominally anchored by gold). Currency board rules require the currency issuer to sell or repurchase its currency at its fixed price in response to public demand. Any number of private producers of dollars redeemable at an officially fixed price for a well-defined anchor (gold, aluminum, a basket of goods, etc.) would result in a money supply determined by the public that was consistent with and appropriate for its fixed price to the anchor and that was fully interchangeable. The central bank would be passive. It would have no monetary policy (beyond the fixed price for the anchor). This seems like libertarian heaven.

I led the IMF teams that established the Central Bank of Bosnia and Herzegovina, which follows currency board rules. I have written a book about that experience:   “One Currency for Bosnia-Creating the Central Bank of Bosnia and Herzegovina”   or  “Amazon– One Currency for Bosnia” I also participated in Bulgaria’s adoption of currency board rules. The currencies of both countries are anchored to the Euro and their currency experiences have been outstanding. Their money supplies are basically regulated by market arbitrage. If the market exchange rate of the Bulgarian lev to the Euro rises above its official rate, it would be cheaper for the banks that issue lev to buy Euros from the Bulgarian National Bank thus reducing the supply of lev in the market and lowering its market price for Euro. See my blog on Bulgaria’s experience: “Bulgaria and the Chicago Plan

A Libertarian International Reserve Currency

What about cross border payments? In brief, cross border transactors have found it economical to price and settle transactions in a vehicle currency, usually the US dollar. The increasingly frequent deployment of sanctions enforced by restricting the use of the dollar has intensified the search for alternatives. See my more detailed discussion: “The Empire and the Dollar”  The search for alternatives to the dollar risks fragmenting the global market place as proposed by Russia’s Sergey Glazyev.  “A new global financial system”

The International Monetary Fund has already created such an alternative. An internationally established unit (anchor) is much less likely to be abused for national political purposes, but the IMF’s Special Drawing Right (SDR) suffers from some serious defects. However, these can be fixed. “Time for a New Global Currency”   Why the World needs a new Reserve Asset with a Hard Anchor

The SDR can be “fixed” in two stages. The first is to develop the private sector’s uses of the SDR unit of account (invoicing oil and other globally traded commodities in SDRs, borrowing and lending denominated in SDRs, SDR bonds and bills, and digital SDR deposits–eSDRs). See my more detailed discussion:  “Promoting Market SDRs”  As with national currencies, where hundreds of individual producers of the national currency are made interchangeable by being claims on the central bank, the market SDRs of many competitive producers would be interchangeable as the result of being redeemable for the official SDR of the IMF.

The second stage would require a reform of the IMF’s official SDR. Rather than allocating them from time to time to all IMF members, they should be issued according to currency board rules. In addition, the valuation of the official SDR should be changed from its current basket of five currencies to a small basket of homogeneous, globally traded commodities. The IMF’s existing rules for periodically adjusting the SDR’s valuation basket are transparent and appropriate and should continue to be used. In one sense, this would reestablish an improved international gold standard like system. It would be improved by replacing a single commodity anchor with a small portfolio of commodities and its supply would be improved by adopting the market driven rules of a currency board.  “Free Banking in a Digital Age”