Saturday 7 December 2013

"I, Broken Economist": An Analysis of Gary North's economics of Bitcoin

Conceited arrogance

There is one thing that becomes apparent when reading Gary North's articles. He knows a lot. But there is also another thing that becomes apparent sometimes, in particular in his latest article on Bitcoin. He thinks he knows more than he actually knows. I can't address his article in full detail now as I'm at the Latin American Bitcoin Conference, but I thought I'd mention some core issues with his article.

Heterogeneity of a monetary system

He writes that money enables economic calculation, and thus division of labour. He writes that Bitcoin couldn't exist if money did not already exist. He writes that you cannot buy everything with Bitcoin (yet). He writes that without goods being priced in Bitcoin, it can't be money.

I agree with all of this (or let's just assume I do). I also claim that it's irrelevant. Because North does not have a general theory of liquidity, and a general theory of transaction costs. Which is very sad, because Menger was very eloquent on explaining both of these categories and made profound discoveries. People who claim that their arguments are based on Menger, yet do not have either a theory of liquidity or a theory of transaction costs do not really understand Menger.

North only has a partial theory of liquidity (a theory of stable prices) and a partial theory of transaction costs (division of labour). But Menger was very elaborate on explaining why both liquidity and transaction costs are heterogenous and cannot be summed up to a particular activity. The implied error of the homogeneity of a monetary system is visible when North writes:
"You cannot have a monetary system that does not apply across the board, yet still defend the concept of the division of labour through competitive pricing".
It is visible also in other partial implications of the alleged homogeneity, for example assuming that liquidity is a final means of payment. This already has been erroneously claimed by Smiling Dave. Final means of payment is merely one of the factors that influence liquidity. Liquidity is also not a unit of account. Unit of account and liquidity influence each other, but again are merely one of the factors.

In other words, North's critique of Bitcoin misses that there are components of liquidity and transaction costs other than those he mentions. The total mix of all these influences the choice of a medium of exchange. The weight of the result is not only different based on the evolutionary stage of Bitcoin, but also on the particular circumstances of a particular user. This is why some people in some situations will find Bitcoin more advantageous, and other people or even the same people in a different situation disadvantageous. It is also why it cannot be apriori concluded what the future of Bitcoin will be, we can only make educated guesses. The only thing we can do as praxeologists is to conclude that Bitcoin might expand in those areas where its advantages are assessed as subjectively the most important with respect to other media of exchange. It might never develop into "money", but it would be erroneous to conclude that that's the only relevant issue (the good old "money or nothing" fallacy).

Heterogeneity of social interaction

The problem that North thinks he knows more than he actually does is exacerbated by his misapplication of the system of property rights and social frameworks to Bitcoin (or the lack thereof). North does not understand that Bitcoin is a social framework. It is a more efficient social framework. Contractual relationships that are currently expensive or impossible (have high transaction costs) are now profitable and/or possible with Bitcoin. Payments are merely the first, easiest, type of a contract, on which Bitcoin demonstrates its advantages. Rather than being an "implicit denial" of contracts, Bitcoin provides a more efficient framework for them. I think that we can all agree that Bitcoin is not perfect. But there are no perfect goods. There is always the subjective assessment, imperfect information, and opportunity costs.

Bitcoin is at a very early stage, and the basis for the framework is still expecting human actors to fill it with their own activities. Contrary to North's claim that Bitcoin "put the cart before the horse", it's the opposite. Bitcoin first created a framework, and then this was incrementally use for payments.

This is also, paradoxically, why North is clueless. He understands how social institutions evolve in theory, yet he cannot connect empirical data (when it happens right under his nose) with the theory.


North complains that people who criticise his position of Bitcoin do not understand the Austrian school. Well, I know for sure that North does not understand certain aspects of it (in particular Menger's approach to liquidity and transaction costs), and on other aspects he can't connect the theory with empirical data. He's also lazy (because he did not read Austrian literature on Bitcoin and he did not gather empirical data on Bitcoin), and conceited (because he thinks his credentials give him immunity from errors).

As I wrote before, the future of Bitcoin does not depend on the understanding of economists. It depends on human action. I don't care about North's opinion. But as a researcher I see it as important that I address errors. Others than can read both, make up their own mind, and build on top of it. The Austrian school did not end with Menger, it began with him.

Wednesday 4 December 2013

Gary North is clueless about Bitcoin


In the last couple of days, Gary North has made posts about Bitcoin on his blog:

My major irritation is that North makes two fundamental mistakes that a researcher shouldn't do. He did not review existing Austrian literature on Bitcoin, and he did not collect empirical data. Instead, he repeated long refuted fallacies, and he made up his own fictional history of Bitcoin. This is why I have said in the past that the people associated with the Ludwig von Mises Institute have become lazy and stupid. There has been progress in the meantime, however. Mark Thornton, for example, has become a fan, and the LvMI actually started accepting both donations and payments for their webshop in Bitcoin. But then Gary North pops up.

To a small extent, I am familiar with North's work. I quote him in my master's thesis, and I read his chapter from the Theory of Money and Fiduciary Media (more on that later, when I quote North based on the notes I made when I read it).

Inability to classify Bitcoin

North repeatedly argued that Bitcoin is not used in market exchanges. This is empirically false. I buy goods with Bitcoin all the time. And I was told that even Walter Block (whom I argued earlier to be clueless about Bitcoin) sold his book for bitcoins once. I don't know why North makes claims to the contrary. However, this allows him to perform a methodological trick: because he denies that Bitcoin is used in exchanges, he can avoid having to classify it within the Misesian framework for classification of goods (into consumer goods, producer goods, and media of exchange).

Instead of classifying Bitcoin as a good then, North classifies it as a ponzi scheme.

Ponzi scheme

North provides his own definition of a Ponzi scheme and a reason why it causes problems. I submit my own definition, which is in my opinion more economically useful.

A ponzi scheme is a hierarchical system of fractionally backed claims. By putting an amount of money into the system, the participant gains a claim for a larger amount of money than he put in. In order for the settlement of claims to work at the beginning, the system is built hierarchically, so that earlier participants can get money from later participants. The reason why a system like this collapses is that as the amount of debt increases, so does the risk of triggering a settlement of claims. A full settlement at any particular time is impossible: the system is insolvent. Once there are too many triggered claims, this causes a cascading wave of defaults, and the claims thus become unclaimable and worthless. In a ponzi scheme, the trigger typically happens when not enough new people enter the system on time as the old claims mature, but this is merely a special case of trigger. All kinds of other triggers can hypothetically cause the cascade.

Bitcoin is not a system of claims. Bitcoin is a pseudo-commodity, not a claim. People who purchase Bitcoins do not have a claim on anybody, nor does anybody have a claim on them. There is no debt to settle, and no default that makes Bitcoin unclaimable. The mechanism that makes a ponzi scheme to collapse is absent with Bitcoin. Whatever reasons are there for Bitcoin to succeed or to fail, the analogy to ponzi schemes is invalid.

The necessity to classify Bitcoin as a claim, in the absence of the ability to classify it as a good, follows directly from the Misesian framework for classification of goods. The difference between a good and a claim is explained by Mises several times as relevant for determinant of their price: the price of claims is derived from the price of the underlying good. Sometimes, there are other factors influencing the price of a claim, but the price of the underlying good is a necessary component at least at the beginning.

The connection between the price of a good and a claim has been expanded upon by Malavika Nair, who also has a chapter in Theory of Money and Fiduciary Media, actually precisely about this topic. I exchanged some emails with professor Nair and this is what she wrote in respect to the classification of Bitcoin:
"I agree that Bitcoin is not a money substitute [i.e. not a claim, ed.], I think of it as closer to commodity money, just not a kind of commodity most people are used to. I know Selgin has come up with the term “synthetic money” but I’m not sure if that helps clear things up or confuses them. If anything, it’s a quasi-money or secondary money, which benefits greatly from its liquidity and the ease with which it can be sold for dollars".
In other words, Bitcoin is not a claim, but a good. It is priced for its own sake, not based on a price of another good it refers to. And since it is held in order to buy goods, it is a medium of exchange.

But even if we disregard the methodological nonsense and stick with North's own empirical description of the beginnings of Bitcoin:
"The money was siphoned off from the beginning. Somebody owned a good percentage of the original digits. Then, by telling his story, this individual created demand for all of the digits. The dollar-value of his share of the Bitcoins appreciates with the other digits."
even then the description is false. Almost all of Satoshi's Bitcoin are unspent, still where they were mined. As Bitcoin didn't even have a price for almost nine months, if Satoshi had attempted to sell his coins, he would have made a revenue of ... nothing. If he had tried to sell them when the price first formed on the market, he would have earned ...  932.68 USD. There's no typo, the value of all Bitcoin in existence at the time when the price emerged was less than a grand. If he waited until Mt. Gox started operating, he would have earned ... 171,517.5 USD (assuming he actually had all of the bitcoins himself). These sums are not even profit, only revenue, as they don't consider costs. Sounds like a real opportunity, doesn't it?

The theoretical explanation of the purchasing power of Bitcoin is missing, and the empirical one is contradicted by the empirical data. Now I'll proceed to explain why North cannot provide a valid theoretical explanation of Bitcoin.

Lack of a theory of liquidity

North refers to the chapter "The Regression Theorem As Conjectural History". Luckily, I made some notes when I read the book. North quotes Menger as writing:
"The theory of money necessarily presupposes a theory of the saleableness [nowadays we use the term liquidity, ed.] of goods. If we grasp this, we shall be able to understand how the almost unlimited saleableness of money is only a special case, - presenting only a difference of degree - of a generic phenomenon of economic life - namely, the difference in the saleableness of commodities in general."
This is precisely where and why North fails. He does not have a theory of liquidity. He has a theory of "stability of prices" instead. While Menger did claim that precious metals have a higher price stability than other goods, he argued that this is not a prerequisite for how the market participants treat it. In fact, with respect to the unit of account function, in Principles of Economics, Menger actually wrote this:
"The function of serving as a measure of price is therefore not necessarily an attribute of commodities that have attained money character. And if it is not a necessary consequence of the fact that a commodity has become money, it is still less a prerequisite or cause of a commodity becoming money." [emphasis added]
If the unit of account function is not a prerequisite for a commodity to become money, then it shouldn't matter how stable it is. Liquidity is not price stability. Liquidity is, in Menger's own words:
"A commodity is more or less saleable according as we are able, with more or less prospect of success, to dispose of it at prices corresponding to the general economic situation, at economic prices."
Apples have a relatively stable price. Yet apples are illiquid: they cannot be sold easily at the market price. Bitcoin does not have a stable price, yet Bitcoin is liquid. It's not as liquid as money, and it's probably not as liquid as gold. But it it is liquid and this satisfies the prerequisite for it acting as a medium of exchange. North's grasp of Menger's insights fails.

Speculation with Bitcoin

North argues that Bitcoin is used for speculation. The issue with this argument is that it does not contradict Bitcoin being used as a medium of exchange. The motivations of human actors in this respect are not mutually exclusive. If people hold a good in the expectation of dispensing with it in order to buy something else when they need that something else, it means they are using it as a medium of exchange. If they hold a good with the expectation of dispensing with it at a higher price when the time and place are opportune, they are speculating. But speculation is a normal part of life. A retailer buys, say, clothes wholesale, with the expectation of selling them at a higher price throughout the operating hours of his business, waiting for an opportunity. He speculates on the price of clothes. But that does not mean that clothes are a ponzi scheme or that there's something wrong about it. It does not refute the validity of other reasons for buying clothes.

People in countries with a high rate of inflation tend to increase the proportion of more foreign fiat monies in their liquidity portfolio. They simultaneously hold the foreign money because it is liquid (and can be used for its purchasing power), and because they expect the purchasing power to be higher than when holding their national, faster inflating, money. This proves that the motivations are not mutually exclusive.

The regression theorem

Regrettably, it turned out that a lot of Austrians do not comprehend the regression theorem. I suspect that this is because of the difference in the approaches of Mises and Menger. Mises spends the majority of his Theory of Money and Credit by analysing the mechanism by which prices form, and the factors influencing this. Based on this, he presents a threefold classification system of goods: consumer goods, producer goods and media of exchange. Mises himself did not invent this classification, he got it from an earlier economists but unfortunately I don't have my notes on this in a searchable form so I'll update this post with the proper reference later. Media of exchange, according to Mises, differ from other goods, because they are held for their purchasing power. He then goes on to explain how purchasing power (or "exchange value", another term he uses) emerges from use value through market exchange due to differences in marketability of goods (nowadays we use the term liquidity rather than marketability). He finishes with the conclusion that there is no other way for the exchange value to emerge than through a former use value and market exchange (catallactics), and theories that do not explain the exchange value of goods, "acatallactic monetary doctrines", cannot explain the exchange value of media of exchange.

While Mises viewed exchange value and use value as two components of the final price, Menger viewed the concept of liquidity as orthogonal to the concept of price. Their goals were different. Mises' approach is helpful for the analysis of the economic calculation, and for macroeconomics (business cycle, money supply and so on). Menger's approach on the other hand is helpful of understanding the microeconomic foundations of media of exchange.

Both Menger and Mises argued that the difference between money and a medium of exchange is quantitative rather than qualitative ("presenting only a difference of degree", in fact North himself has the same Menger's quote in his "The Regression Theorem As Conjectural History"). This is why we cannot make praxeological arguments about the origin of money that also do not apply to the origin of a medium of exchange. And this is why it's evident that some Austrians still don't understand the regression theorem.

The Mengerian approach to the origin of media of exchange is that media of exchange emerge out of liquid commodities. People recognise that some commodities are liquid (it is possible to"dispose of it at prices corresponding to the general economic situation, at economic prices"), and assisted by this knowledge, they start to hold them for this purpose (to dispose of them at economic prices). This is the moment when the function of a medium of exchange emerges. The Misesian approach is similar, but he uses the term "exchange value" to explain the liquidity premium of liquid goods (which is a more complex issue). This is why the Misesian approach is more helpful when examining prices, but less helpful when examining the motivations of market participants.

As Bitcoin is a medium of exchange (people hold it in order to purchase goods in the future), it must logically adhere to the regression theorem. It must have been a liquid good before it was used as a medium of exchange. And indeed, empirical analysis shows that this is correct. Before people used Bitcoin as a medium of exchange, it was possible to trade it against the US dollars on bitcoin exchanges, which featured visible order books. This made it easier to sell Bitcoin at economic prices. The fact that the exchanges were founded deliberately does not invalidate their economic function. Menger realised that specialised services that help with sales have a beneficiary effect on liquidity:
"The institution of an organized market for an article makes it possible for the producers, or other economizing individuals trading in it, to sell their commodities at any time at economic prices."
If we go even further chronologically, before Bitcoin exchanges existed, Bitcoin already had a price and was traded sporadically (i.e. was a good). The very early prices appear to have formed based on the variable production costs of Bitcoin at that time. And even further in the past, Bitcoin did not have a price, and while there were signs of using the blockchain, it probably didn't qualify as a good.

I document the process both in my thesis, and in an earlier blog post Professor Walter Block is clueless about Bitcoin. The origin of the function of a medium of exchange for Bitcoin is right out of the book. Menger's book, that is. Not North's book. North needs to deny the purchasing power of Bitcoin, because if he admitted it exists, he'd be left without the ability to explain it, having no catallactic theory of the origin of Bitcoin.

The network effect

North is equally clueless on the network effect (which was brought up by one of his critics). He goes even further:
"I can assure you that Carl Menger, the founder of Austrian school economics, did not use language like this: "money itself replaced non-money as a market network effect good." No Austrian school economist ever has. Austrian school economists do their best to communicate in something other than programmers' professional jargon."
North is wrong yet again. One economist familiar with the Austrian tradition, Mikael Stenukla, wrote a paper Carl Menger and the network theory of money. Many more Austrians are familiar with the network effect and understand that liquidity is a subset of the more generic concept of the network effect. The article was actually pointed out to me by Peter G. Klein, the executive director of the LvMI, who also did research the network effect.

Once you comprehend the network effect, you'll realise that the issue with respect to media of exchange is the empirical question of the critical mass of liquidity: the threshold below which a potential medium of exchange needs other utility in order for the system to be self-sustaining. Economists (including Austrians), who did not comprehend the concept of liquidity, implied that this threshold can only happen at a very high level of demand (or other auxiliary criteria, such as "price stability" proposed by North). But demand is not the same thing as liquidity. Bitcoin simply shows that liquidity can emerge at a lower level of demand than previously thought.

This is why it also cannot be concluded that Bitcoin cannot become money (the same non-sequitur that already was presented by Patrik Korda earlier this year). Of course it can. It just needs to outcompete other media of exchange. And this can't be determined apriori: it's an empirical issue. As I argued in my thesis, transaction costs play a major role in influencing the choice, and Bitcoin has lower transaction costs than anything that existed before that. Even though Austrians typically do not use the term "transaction costs" (I've heard Salerno use the term "transactions costs" once though), Menger used the term "economic sacrifices" and it was evident that it's the same phenomenon. It is also evident from Menger's writing that transaction costs are heterogeneous, with many influencing factors, and that:
"Economic development tends to reduce these economic sacrifices, with the result that even between the most distant lands more and more economic exchanges become possible which previously could not have taken place."
Bitcoin is just such an economic development as Menger mentions. It allows a more efficient conduct of market operations. This is why the claim of North that Bitcoin has no utility is absurd.

The utility of Bitcoin

North's denial of utility is filled with nonsense and lacks fundamental economic analysis. It has been repeated too often by others, but it's strange that reputable researchers like North come up with this too. In order to understand the utility of Bitcoin, I recommend the recent video by Stephan Molyneux. If you don't have the time to watch, I'll just provide some points which I consider important or interesting.

The True Value of Bitcoin by Stephan Molyneux:

Bitcoin can partially or fully replace the following services by more efficient ones:
  1. Proof of ownership (obsoletes notaries)
  2. Dispute resolution (obsoletes mediators)
  3. Record auditing (obsoletes accountants)
  4. Smart property (obsoletes the police)
  5. Decentralised stock exchange (obsoletes centralised stock exchanges)
  6. Highly efficient payments (obsoletes banks, debit cards, money transmitters)
  7. Full control over your money (obsoletes central banks and banking regulators)
  8. Conditional payments (obsoletes lawyers)
  9. No inflation
  10. No business cycle
And now, here's the kicker: points 1-5 does not require that Bitcoin is a medium of exchange (because they do not require Bitcoin to have purchasing power) and points 6-8 do not require that Bitcoin is money (because they do not require that Bitcoin is used as a unit of account). Only points 9 and 10 require that Bitcoin is a unit of account. If that ever happens, that's just the cherry on the top. Some, for example Michael Suede, even come to the conclusion that without the ability to steal money, states couldn't exist.

The claim that Bitcoin has no utility is ridiculous. North really should have done some research.


It looks like I still have a lot of work to do. I thought that the research that Austrians (and semi-Austrians) did with respect to Bitcoin (in particular John Paul Koning, Konrad S. Graf, Daniel Krawisz, and of course me) would be sufficient for the other Austrians to move on and continue contributing more new interesting things. Sadly, this didn't happen yet. There are still many Austrians that are lazy, ignorant, or sadly, outright fraudulent, as they fabricate a fictional history and present it as facts. This is in particular saddening as North is a historian.

I'm not an expert in North's writings. I did find his "Mises on Money" helpful and informative (I highlighted 35 passages into my research catalogue), while his "The Regression Theorem as Conjectural History" somewhat weak. I know he has something against George Selgin, but I don't care about that. However, his attempts to address Bicoin are just annoying. I attempted to address several core problems of his articles. I hope this helps people to understand Bitcoin, and Austrian economists to finally move on beyond long refuted nonsense, and produce something new and helpful.