Is Bitcoin a Good Money?

April 28, 2014


I asked the question, is Bitcoin a good investment? Well, I don't know. But I feel a little more confident in answering this question is, is Bitcoin a good money? Well, it 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 both on money supply and money demand. Advocates of Bitcoin-- and for that matter, advocates for a 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 of political manipulation. Sure, but there's cost to that policy. And the cost is that you're neglecting the demand volatility. You've got to fix 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. 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-- what that was just the demand for this stuff was gyrating wildly.

That also happens in times of financial crisis, crises 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. The 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 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. But you can't do that with gold. These are things that are 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's 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 there's even been a moderate deflation in Japan, not very much but it's basically flat.

And 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 a roughly a 2% inflation target. The Fed and the ECB say, we're basically targeting 2% 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 sure, there's a 2% inflation in the United States, but it's forecastable. It's something you can predict. You can bet on.

It's something that the Fed is trying to manage, something to help you manage when you write contracts and stuff like that to coordinate on a 2% depreciation in the purchasing power of the currency. Whether it should be a 1% 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? Well, 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.

I take a look at the volatility in the purchasing power of Bitcoin, now could you imagine, I don't know. You go to work, you earn your Bitcoin, and the next day you want to go buy some bread and the purchasing power of your Bitcoin just plummets by 50%? That would be annoying. Or the other side, suppose you 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 like doubles. He's like, Jesus. He's like, God, 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, it doesn't fluctuate as much as Bitcoin, but it is volatile. The purchasing power of the U.S. dollar, you can see. 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, and now it's higher. And then over the last year and a bit, it's basically lost 30% in its value. I don't know.

In the latest Dialogue with the Fed presentation, David Andolfatto asks: “Is bitcoin a ‘good money’?” According to Andolfatto, a good money should maintain stable purchasing power over short periods of time, with price-level stability depending both on money supply and money demand.

Advocates of bitcoin, he says, want a rigid supply—a supply that’s free of political manipulation. But, as Andolfatto points out, the cost of a rigid supply is an inability to respond to demand volatility. In the short run, money demand can fluctuate dramatically, which has happened with bitcoin. Andolfatto shows the short-run volatility of the purchasing power of bitcoin, as well as gold.

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