Part 4: David Andolfatto, How Big Is Bitcoin, and Is It Stable?

March 31, 2014 | St. Louis Mo.

Andolfatto then briefly explains some of the benefits and drawbacks to virtual currency. So, how big is the bitcoin realm? Currently, there are about $7 billion bitcoins in circulation worldwide, compared to about $1.2 trillion in U.S. dollars. About 40 transactions happen per minute, compared to about 200,000 Visa transactions per minute. However, the average bitcoin transaction size is about $2,000, compared to about $80 in the average Visa transaction. While it's relatively small now, there is potential for growth.

Andolfatto then discusses the trends concerning the price of bitcoin. Is bitcoin a bubble? He defines "bubble" as a liquidity premium; examined this way, bitcoin is a bubble. So is bitcoin a good investment? Perhaps, but the outlook depends on a host of factors, Andolfatto explains. Things such as how rapidly and extensively it penetrates the market, how government regulations might evolve over time and what competing products might emerge in the future.

Is bitcoin a "good money?" A good money, Andolfatto says, should maintain stable purchasing power over short periods of time. Price-level stability depends both on money supply and money demand. He then provides a look at purchasing power of currencies—including bitcoin, gold and the U.S. dollar. Next, he examines the idea of "nominal exchange rate indeterminacy"—how the market exchange rate between two intrinsically useless objects is determined—and examines the fundamental economic forces that dictate the exchange rate between competing currencies. What would happen in a world of multiple, unregulated, competing virtual currencies? Likely, he says, we'd see excess volatility.

Presentation (pdf)


David Andolfatto: OK, summary. What do we have here? A stroke of genius, I think, a monetary system governed by a computer algorithm. It offers a potential of low-cost banking available to anyone in the world with a cell phone. It has a digital cash supply free of political manipulation. Sounds fantastic. Some of the drawbacks, well, in bitcoin in particular as opposed to other protocols like Ripple for example, in bitcoin, the decentralized structure of the protocol implies a relatively slow processing speed, so you could wait something like 10 minutes to get your payment processed. I don't know how the technology might evolve to speed that up, but this process of communal recordkeeping, it's decentralized, so it takes time. If you could appoint somebody you could trust, you could do it right away. But you know how hard it is to get consensus in a committee. That's basically what we have here.

The other thing is that, while the protocol is often portrayed as something that does not require trust at any level, that's not quite true. What's true is that trust is located in some different parts. It's true there's no central bank that you have to trust. You don't have to trust the Bank of America, that's true, but you do have to trust other things. Do you trust the code, the source code, how it's written? Do you trust the programmers? Do you trust the miners? Do you trust Satoshi Nakamoto, who has a switch? Is he going to suddenly double the supply of bitcoins? I don't know.

How big is it? Currently about 7 billion in bitcoins are in circulation. That sounds like a lot, but if you compare it to U.S. dollars, there's about 1.2 trillion U.S. dollars in circulation, so bitcoin is still kind of small relative to U.S. dollars. There's about 40 transactions per minute. How does that compare with, say, Visa? Visa processes on average something like 200,000 transactions per minute. The average transaction size in bitcoin transactions is about $2,000. In Visa, it's about $80. So what we have here is relatively few transactions. They're relatively large transactions. So it's still small potatoes relative to what's out there, but of course, the exciting thing is the potential for growth. It's been growing rapidly.

Let me talk a bit about what everybody's talking about here is the price of bitcoin, right? For many years, it's been trading close to zero, since '09 I guess. Then we saw the price skyrocket. People were amazed at this price appreciation here. Then it crashed, then it kind of averaged about $100 for a while, and then it suddenly over the course of a very short period of time, it just skyrocketed, 10-fold increase or more. I guess it came tumbling down, was this the Mt. Gox episode? Is that what was happening? Some sort of issues with Mt. Gox, or was that earlier? I can't remember now. (audience says China) Oh, was that China? Then more recently, the IRS ruling. I'll touch upon these things. What's striking is the rapid price growth and the volatility since then.

Is bitcoin a bubble? Well, it kind of depends on what you mean by bubble. "Bubble" is one of those words that you have to use carefully. It kind of means different things to different people, so I'm going to define it in a particular way. I'm going to define a bubble as basically what is known in the literature as a liquidity premium. If we define bubble in that way, then the answer is yes. If you think about decomposing the market price of any security into two components: some measure of its intrinsic or fundamental value, and if you take a look at the difference between the market price, if it's trading above its intrinsic value, we could ascribe the difference to a liquidity premium. That is to say, most assets are valued not only for their intrinsic use but how easily they can be liquidated, how easily they can be passed along in future transactions. So by this definition, yeah. I mean, bitcoin has a positive market price. It's intrinsic value is zero, and therefore, it's entire market value must be a bubble. The only reason people value bitcoin is because they view it as a liquid instrument. They believe that someone else will accept it in exchange down the future road. Most assets, like I said though, have this property, at least a bit of a liquidity premium, even gold. Even though gold might have some positive intrinsic value, if it was to circulate quite widely, the market value of gold would likely exceed its fundamental value, and that would reflect its value in facilitating exchanges.

Is bitcoin a good investment? Wouldn't you like to know that? I think I'll skip this slide. (laughter) Warning: We have very good economic theory that tells us that asset price changes are difficult to forecast. A lot of people have lost a lot of money not listening to this theory.

How do you forecast these things? I don't know. It kind of depends on your outlook for any new product, right? How rapidly and extensively will it penetrate the market? Geez, I don't know. I've got some ideas. How might government regulations evolve over time? Great, now you want me to predict our government? Now only our government, but also the Chinese and the Russians. How are you going to predict this stuff? It's crazy. How easy is it to replicate the product? What did I just say? Bitcoin is an open source software. It's out there for all of us. It's free. What's to stop somebody from creating bitcoin 2 and bitcoin 3 or bitcoin 4? It's just out there. Presumably, bitcoin has some first mover advantage, but a lot of companies have had first mover advantage and have lost them over time. Also importantly, what sort of competing products might emerge now and in the future? It's very hard to predict. So, good investment? I don't know, so be careful, and it might have some part in a diversified portfolio of investments. Just don't go crazy. Don't go putting all your eggs in one basket.

I have to say a little bit about bitcoin and the failure of Mt. Gox. What was Mt. Gox? Maybe you saw that on the news. A lot of people did. Mt. Gox, as far as I understand and somebody can correct me during the Q&A if I'm wrong, it was basically a... think about when you go to the airport and you see these foreign exchange kiosks. Just put a Mt. Gox label on it and that's what it is, except these exchanges live all over the world. So they're places where you can trade your bitcoin for different currency: dollars, yen, euros, things like that. Except with an important difference: I guess these exchange centers also offered wallet services, which is to say they permitted you to hold accounts there that they would look after, except that these accounts are not insured. You have to trust the intermediary to manage your wallet services. My understanding is that what happened was that these wallets were basically stolen. It was just a good old fashioned bank heist. As far as I know, the bitcoin protocol was not the issue here. Some people were blaming bitcoin for this, but that's kind of like blaming the Federal Reserve for printing paper notes that are stolen by that little local bank across the street. It was just a good old fashioned bank heist. So be careful where you put your money in general, whether it's bitcoin or whatever.

I asked the question, "Is bitcoin a good investment?" Well, I don't know, but I feel a little more confident in asking this question, answering this question: "Is bitcoin a good money?" It kind of depends on what you mean by what constitutes a good money. Among other things, I think a good money should maintain a stable purchasing power over short periods of time. Price level stability depends on both money supply and money demand. Advocates of bitcoin, and for that matter advocates of the gold standard, want a rigid supply of money. And it's clear what's motivating that. It's legitimate. What they want is a supply of money that's free from political manipulation. But there's costs to that policy. The cost is that you're neglecting the demand volatility. You've got a fixed supply, and you've got a demand for money that could potentially behave very, very violently. And indeed, money demand we know can fluctuate violently in the short run. I mean, all you have to do is go and take a look at the bitcoin price chart. The supply of bitcoin is not changing when you saw those price fluctuations. All that was the demand for the stuff was gyrating wildly.

That also happens in time of financial crisis, like the one that we recently experienced. What did we see during the last financial crisis? We saw a flight to quality instruments like the U.S. dollar and U.S. Treasuries. These were deflationary episodes. Demand for money and Treasuries went up. Interest rates and yields plummeted. We had a moderate deflation during that period. To combat this type of demand volatility, wouldn't it be nice, at least in principle, if we could trust the stewards of this money supply, like the Fed, if we could permit them to supply additional cash when the demand was very high to kind of stabilize the purchasing power of the object? Wouldn't it be nice if we could do that? You can't do that with bitcoin, I guess unless you program it. You can't do that with gold. These are things in relatively fixed supply in the short run.

I've got a plot here of the purchasing power of currencies since 1990. I've got four currencies here. I've normalized the purchasing power to 100 in 1990, and I've plotted the yen, the euro, the U.S. dollar and the Zimbabwean dollar. Take a look at this bottom chart here. This is the purchasing power of the Zimbabwean dollar, and as you can see the purchasing power just plummeted. It basically went down to zero. That was the famous Zimbabwean hyperinflation under Robert Mugabe.

At the opposite extreme, we have Japan. We see the purchasing power of the yen since 1990 has remained more or less stable. And indeed, since about 2000, the purchasing power of the yen has basically been rising modestly, so this has been even a moderate deflation in Japan, not very much, but it's basically flat. Then in between, we see the experience of the euro in green and the U.S. dollar in blue. What we see here is the manifestation of roughly a 2 percent inflation target. The Fed and the ECB say "We're basically targeting 2 percent depreciation in the purchasing power of our currency. We have adopted that. That's how we define price stability."

And so you don't necessarily have to be an advocate of whether this line is better than this line. The striking thing about those lines, in my view, is that they're relatively stable. They don't exhibit wild fluctuations. So, you know, sure, there's a 2 percent inflation in the United States, but it's kind of forecastible. It's kind of something you can predict, you can bet on, something that the Fed is trying to manage, something to help you manage when you write contracts and stuff like that to coordinate kind of a 2 percent depreciation in the purchasing power of the currency. Whether it should be a 1 percent inflation target or zero, that's something we can debate.

Now, let's look at a shorter sample period. How does the purchasing power of the U.S. dollar hold up on the short run relative to, let's say, bitcoin? Here we see I've normalized the purchasing power of the U.S. dollar and bitcoin to 100 in November of 2013, and you see the purchasing power of the U.S. dollar over that short period of time hardly changed at all. There's hardly any inflation. Take a look at the volatility in the purchasing power of bitcoin. Can you imagine? You go to work, you earn your bitcoin, and the next day you want to go and buy some bread, and the purchasing power of your bitcoin just plummets by 50 percent. That would be kind of annoying. Or the other side: Suppose you've got your bitcoin, and you go and you spend it and you buy a piece of bread and the next day the price of the bitcoin doubles. It's like, "That's annoying." You don't want that in a monetary instrument.

Just for good measure, I thought I'd plot gold here for the gold bugs in the audience. I've normalized the purchasing power of gold to 100 from two years ago, January of 2012, and you see the purchasing power of gold doesn't fluctuate as much as bitcoin, but it is volatile. The purchasing power of the U.S. dollar, you can see a moderate depreciation. You see how it's going down, it's going down a little bit, but take a look at gold. It pops up. It goes down. Then, it's higher, and over the last year and a bit, it's basically lost 30 percent of its value.

What the heck does this mean? Nominal exchange rate indeterminacy? I think it's going to be something that people will be talking about, and you are the first to hear about it. So let's see if this pans out. That's my first prediction of the evening. The question is: What determines the market exchange rate between two intrinsically useless objects? Take these poker chips for example. Take the blue one and the red one. Can you imagine? You go to a casino. These poker chips are circulating in the casino, and the casino owner says, "Hey, laissez faire, man. Let the market decide. Let the participants determine the exchange rate of the chips. See what happens." What happens? What economic theory would you bring to bear that would fundamentally pin down the exchange rate of a blue chip and a red chip. Theory says there's nothing. The exchange rate can fluctuate for purely psychological reasons. There's nothing fundamental. Economics is very bad at explaining how prices are determined between two useless objects. We're very good at explaining what determines the relative price of oranges and apples. These are intrinsically useful goods. But two intrinsically useless objects? There's nothing in economic theory that really pins down the relative price.

Consider two more intrinsically useless objects. (The $1 bill and the $5 bill) They're identical in every respect, forget the numbers for the moment. One has a picture of Washington. One has a picture of Lincoln. Imagine these intrinsically useless notes are circulating in the community, and suppose you believe in laissez faire. Tell me: What sort of theory do you have that tells me what will determine the exchange rate between Lincoln and Washington. I mean, nothing really. In reality, the exchange rate is 5 to 1. There's a fixed exchange rate system that's basically stipulated and enforced by the Fed. People seem to be OK with these types of fixed exchange rate systems. When the casino sets the exchange rate between different poker chips, that seems to be fine. When we have a common currency area, and the Fed sets the exchange rate between these notes, people seem to be fine.

Now, I want you to imagine a world with multiple, unregulated, intrinsically worthless virtual currencies out there. Here, I've got an example: a bitcoin note and a lightcoin note. What are the fundamental economic forces that determine the exchange rate between these competing currencies? The evidence is that exchange rates of fiat currencies are excessively volatile. And as I just alluded to, the problem is that there's no fundamental economic force that pins down the relative price of two intrinsically worthless objects. And so this explains why fixed exchange rate regimes and common currency areas are so popular.

What would happen in a world of multiple, unregulated, competing digital currencies? I think the outcome would be what we've seen in history with traditional fiat currencies. We'd see excess exchange rate volatility. I mean, you'd be a merchant, and you'd have to have about 100 different wallets. You'd have to diversify, hedge your currency risk by maintaining 100 different wallets of all these different currencies. There might be some way to manage it better. I'm not saying this is good or bad. I'm not passing any value judgment. I'm just saying this is an issue that I haven't seen talked about very much, and I think it deserves to be talked about, what is likely to happen.