This post is a third reaction to Patrik Korda's article about Bitcoin. There have been three main topics in our debate:
- regression theorem
- competition under network effect
- money substitutes
With respect to the regression theorem, tomorrow, Korda is debating Konrad S. Graf at the weekly University of Texas Mises Circle. I assume as usually with the meetings, it will be done over Google+ Hangout and available on youtube after a couple of days. Graf's arguments are very similar to mine, so I don't think I have anything to add there. I'm just looking forwards to watching the debate.
The competition under the network effect I believe I addressed sufficiently. Korda does not see any mechanism for competition under the network effect (apart from barriers to entry), and appears to believe it's random, so the market shares of individual cryptocurrencies will randomly wildly fluctuate. I addressed the mechanics of competition under the network effect in previous two articles (first, second), and I think that Korda hasn't addressed my points sufficiently. So for the time being, I'll wait up his reaction on this topic.
The last discussed issue is whether Bitcoin is a money substitute (fiduciary medium, token money), or not. While I find it absurd, I decided to address the issue in yet another post. There are several reasons for it. First of all, I think that a proper scholar should address all arguments with a logically mounted defense, no matter how absurd they claim. So it's a matter of principle. The second issue is that I apparently have readers (how it happened is a mystery to me), and I have an obligation to explain the issue to them. So it's a social issue too. Last but not least, I tend to make very abstract arguments that expose implicit assumptions, and criticise my opponents for making these implicit assumptions and lacking imagination. But this problem is universal, I am not immune to making implicit assumptions either. In other words, it could be that I'm just arrogant and wrong, and miss a logical fallacy that I'm making myself. So it's a matter of pragmatism as well. I'm new to blogging so it's a learning process for me. I hadn't really put much thought about meta-blogging, I just thought that it's better to have a dedicated outlet for channeling my thoughts rather than having them distributed across dozens of sites of other people. But I now made the conscious decision that I'll stick to proper scholarly work, and I'll treat apparent absurdities seriously. I think I tend to do that often anyway (treat absurdities seriously, that is), so it's not really much effort, I just need to remain conscious about it.
Definition of money substitutes
With respect to money substitutes, Korda made several interesting arguments that I hadn't considered before, and in fact shows that some of the points Mises makes are incomplete. Foremost, he is the only Austrian I know of, apart from me, that does not think that money substitutes need to be claims. While I still think his classification of Bitcoin is wrong (and I intend to prove it conclusively in this post), I sense that he, similarly as me, has the ability to expose implicit assumptions. I think if he thinks about the issue more deeply, he'll recognise the problems in his arguments. Austrian school and Bitcoin can benefit greatly from his skills. And even if we never end up agreeing, I think that defending from attacks is what makes assumptions stronger.
The issue with Korda's argument becomes most apparent if we try to understand the purpose of Part 1, Chapter 3 of Mises' Theory of Money and Credit (and the picture in Appendix B). I already touched upon that in my previous posts, where I argued that the reason for the classification is economic analysis, but I missed something even more fundamental (which Korda missed too). The purpose of the whole book is to analyse the exchange ratio between goods, with the particular emphasis on media of exchange (of which money is an example). In other words, Mises attempts to analyse prices. Why is it then necessary to divide money into different classes? Because the mechanisms of determining the price of individual classes of money are different. If the mechanism was the same, for the purpose of the whole book, a classification would be irrelevant. Mises realised that prices of different classes of monies are established differently, and that is why he invented those classes. In other words, he invented the class of money substitutes because the price of money in the narrower sense is determined by a different mechanism than that of money substitutes.
It is exposed a bit if we look at Part 3, Chapter 15:
The fact that is peculiar to money alone is not that mature and secure claims to money are as highly valued in commerce as the sums of money to which they refer, but rather that such claims are complete substitutes for money, and, as such, are able to fulfill all the functions of money in those markets in which their essential characteristics of maturity and security are recognized. It is this circumstance that makes it possible to issue more of this sort of substitute than the issuer is always in a position to convert. And so the fiduciary medium comes into being in addition to the money certificate.Korda interprets this in such a way that Mises was trying to show that money substitutes compete with money in the narrower sense. But this is an incomplete interpretation. If we view it from the perspective of the pricing mechanism, we realise that Mises was also trying to explain that the price of money substitutes is not determined by the same mechanism than that of money in the narrower sense. The price of money substitutes is derived from the price of the price of money in the narrower sense. That is the essence of the quote.
Now, Mises, and the Austrians that follow him, have a more precise definition of money substitutes, they argue that they are "mature and secure claims to money [in the narrower sense, ed]". In my thesis, I argued that this is imprecise from both sides: first, not all mature and secure claims to money are money substitutes (it's unlikely if the claim does not decrease transaction costs), and second, causal relationships other than claims also may result in money substitutes (so-called "complementary currencies" for example). But I didn't analyse the question of price in that depth. I assumed that the price is the same (now, other Austrians do that too, as I thoroughly quoted from in my previous article, so don't blame me, I didn't start it).
Korda argues that the price of money substitute doesn't have to be the same as the money in the narrower sense. I countered that the price of the money substitute can be (in the extreme) lower, but it can't be higher. Korda argued that Mises himself showed examples of money substitutes that trade at a premium. I was kind of rushing my argument, so I didn't really think it through and I must admit he has a point. I didn't find a Mises quote to the same, but I found mises.org wiki article on the Bank of Amsterdam which confirms it.
This caused me to think more deeply about the issue of price. Austrians in general assume that money substitutes have the same price as money in the narrower sense. There are few exceptions. Rothbard, I believe in America's Great Depression, argued that some claims must only be considered from the point of view of money supply only at a discounted rate. JP Koning, on the other hand, argues all the time that different forms of money have different liquidity levels and also different prices. So, the argument that the price needs to be exactly the same certainly is flaky. Heck, if Korda is right in attributing the report of premium on bank notes to Mises, Mises contradicted himself. That's a problem, and it needs to be fixed. I am pretty strict about having consistent definitions.
So how do we fix it? We define money substitutes from the same point of view that caused Mises to create the classification: the mechanism of establishing of price. But how to do that to allow for fluctuating prices? We borrow the concept of derivation from mathematics. In other words, if a price of money in the narrower sense changes, ceteris paribus, the price of the money substitute will change proportionately (i.e. there's a linear dependence). This allows for the possibility of a price change for another reason. If there is a perception of risk in the claim, the substitute will trade at a discount. If the money substitute is perfectly riskless, then it may appreciate to reflect the saving of transaction costs. It can't get out of these boundaries, because that would create an arbitrage opportunity. The funny thing is that the arbitrage opportunity also arises when complementary currencies (which I also count under money substitutes) attempt to trade at a fluctuating exchange rate, an argument which I made some time ago in another debate. Now, my point isn't that other factors can't influence the price, but that the price of the underlying money in the narrower sense must. I don't think that there are factors other than perception of risk and transaction costs, but I'm not building my argument to rely on that. For the purposes of this post, I will call this derivative relationship "coupling". The price of a money substitute is coupled to the price of the underlying money in the narrower sense.
In order for me to conclude my definition, it helps to investigate what happens when the price decouples, i.e. that changes in the price of the underlying money in the narrower sense won't have a proportionate effect on the money substitute anymore. Assuming that the former money substitute survives, it evolves into the new monetary base. One possibility that Mises himself mentioned was credit money, which happened when the country went off a metallic standard and people were expecting this to be temporary. Another possibility, one that many of us know from personal experience, is fiat money. In my thesis, I demonstrate this on the example of the Euro: at the end of 1998, the exchange ratios of 14 (if I calculate correctly) currencies were fixed with respect to Euro, and thus the Euro became a money substitute. After the old currencies were decommissioned, the Euro became fiat money (a separate money in the narrower sense). Yet another possibility, arguably, is commodity money: Luther and Symes can be interpreted in a way that this is what happened with the old Somali Schilling: after the central bank and legal tender laws broke down, this increased the (now competitive) production of paper notes, until the production price of those notes was very close to the market price of these paper notes. Technically, the old Somali Schilling had been fiat money, not money substitute, but I argue in my thesis that all fiat money must begin as a money substitute, and according to Symes' historical analysis, originally, Somalia did have multiple competing commodity monies, and several monetary reforms after that, which introduced paper money substitutes.
Which subtype of money in the narrower sense will be the result of a decoupling depends on the circumstances. But the point is that the coupling is a necessary feature of the money substitute. Without it, it either collapses or changes its nature, i.e. its price will be determined by a different mechanism.
What determines the price of Bitcoin?
Now, let's look back at Bitcoin. Korda argues that Bitcoin is a money substitute of all of the fiat currencies it trades against. Let's take then the dollar for example. What happens to the price of Bitcoin if the price of dollar decreases by 1%? We don't know. It may change or it may not. We certainly can't be sure that it will decrease by 1%. We can't even be sure it will change in the same direction, it could perfectly well cause people to prefer Bitcoin to USD and increase its price. The issue becomes even more apparent if we investigate what happens if the USD decreases by 1%, and the EUR increases by 1%. The price of Bitcoin is not coupled to any other money, or any other good for that matter. So it's not a money substitute.
What's even more, it never was coupled to anything else in the first place. As I argue in my thesis, the first available records of market price of Bitcoin show that at the beginning, the market price was derived from the variable production costs of Bitcoin. It wasn't coupled to any other good, i.e. it wasn't only not a substitute of money, but not a substitute of anything. Once again, the term "substitute" in this context does not refer to the similarity, rather to the causal relationship, the "coupling".
I believe that, motivated by Korda's resolute defense, I managed to both explain and fix the gaps in Mises' arguments. I exposed the essence of Mises' arguments, and the essence of a money substitute. I also showed that Bitcoin does not have this essence, and never had.
If Korda (or anyone else for that matter) would like to counter my argument, I'll make it very easy to respond. The only thing he needs to do is to answer the question "How is the price of money substitutes determined?"