[wynand]

I read some criticisms of Bitcoin (including those from a previous HN post about Bitcoin) and one of the biggest criticisms from an economics perspective (if I understand correctly) is that the Bitcoin network is at the mercy of positive or negative feedback loops (hyper inflation or deflation).

All current currencies are controlled by central bodies that can dampen the effects of these feedback loops.

Does anyone with an economics background have an idea of how the Bitcoin network could be adapted to counteract these feedback loops? For example, perhaps the network should make the transfer of small amounts very liquid whilst the transfer of larger amounts becomes progressively more "viscous".

[eof]

How is it at risk of a feedback loop in a way that other currencies aren't?

It seems bitcoins defend specifically against hyper inflation by limiting the number of coins that will ever be produced.

[jerf]

Real-world currencies have backing. The ability of dollars to hyperinflate or hyperdeflate is bounded by the fact they can be used to pay debts to the United States Government that are denominated in dollars. Their value recursively emanates out from there, but that's the base case. That's also why the fall of the US government would be pretty much immediately followed by the fall of dollars, as has happened to other government-backed currencies. Stripped of its backing, currencies completely collapse in practice. The recursive base case is gone and if the currency briefly holds on it's a Wile E Coyote off the cliff moment, and in the modern connected world I can't imagine it would be more than a few minutes.

At some point, BitCoin faces some dip in currency confidence. Not because it's "BitCoin", but because all currency face periodic confidence crises. All the major world currencies have faced them in the past three years. But they didn't simply collapse because they have backing. I don't know what stops the first BitCoin currency crisis from completely collapsing the currency, because when BitCoin holders ask themselves, "Hey, what is this really good for?", I don't have an answer. I know what a dollar is good for: Not being put in jail by the United States Government due to unpaid debt. Ultimately, without trying to be too philosophical, dollars are backed with men with guns (and the privilege of them not being pointed at you).

Contrary to apparently popular belief, currencies aren't merely arbitrarily-agreed-upon numbers that we all trade with. Every currency I know has some actual backing. Even the fancy electronic ones we've seen spontaneously develop online, they all have some form of local economy-appropriate backing. It isn't always "gold" (literal or electronic), but so far the "men with guns" approach has proved successful in the real world. BitCoin is an apparently-good design for the arbitrary number approach, but until it solves the backing problem I won't be putting one dime into it. As much as I don't particularly enjoy having the US government as my currency backing I do not see how going to a backing-free currency is the solution.

The currency can still hyperinflate even if it is physically impossible to produce more by virtue of people raising all BitCoin prices as their confidence in the currency collapses. But instead of hyperinflation producing lots more BitCoins, then collapsing the economy, hyperinflation will simply directly collapse the economy as it takes ever increasing amounts of the BitCoins in the world to buy a service, until eventually even every BitCoin in the world isn't adequate. Hyperinflation is a symptom of lack of confidence in a currency, not a cause. (Of course observing hyperinflation can further decrease confidence, but the hyperinflation started in the first place because of lack of confidence.)

BitCoin advocates tend to get very angry when I point this out. I think it's because they have no answer to this. The site used to have a FAQ that addressed this, but it just sort of mumbled words and now it's gone because it was actually better just to ignore the problem. My challenge would be to anyone who claims that currencies are somehow backing-free is show me the successful currency of any kind that really is just an arbitrary number with no backing that has reached any sort of significant size, shall we say, a million dollars or so worth of an economy? (All the electronic currencies like Microsoft Points are well above that size, for instance.) And I'll show the backing. It isn't always a physical item, especially in the electronic world, but it's always something that serves as a locally-appropriate backing.

("So why's it worth so much now?" It's in a bubble generated by all this publicity. What happens the first time this bubble even threatens to pop? That's when you'll really find out who is right, me or them. Oh, and I'd predict an even larger burst of publicity and public braggadocio if it looks like that's going to happen; that will be the only way to forestall the inevitable another few days.)

[__xc]

This obsession with 'backing' demonstrates a gross failure to understand the subjective theory of value.

What backs gold??? Nothing other than the subjective valuations of individuals. The same is true of fiat currencies, except here individual subjective valuations concern matters such as 'not getting arrested' or 'not getting shot.'

Bitcoin is a technologic, cryptographically-rooted, informational commodity. It has unique, desirable properties inherent to its design and structure. Individuals subjectively value these properties. Their reasons and value scales differ, but the simple fact that people are already trading Bitcoins proves that it is subjectively valued.

You talk about 'confidence crises.' This is unique historically only to fiat currencies (and paper currencies built fractionally on commodities like gold). The subjective valuation of fiat currencies is derived from political considerations. As such, confidence in them is built on the ever-shifting sands of political perceptions.

When was the last confidence crisis in gold? There hasn't been one. People value gold for its physical properties defined by the laws of nature. Those properties do not change and individuals have continued to subjectively value them.

The same is true of Bitcoin. Its properties are rooted in our present understanding of cryptographic principles. As long as individuals continue to value properties such as anonymity, decentralization, finite supply, low transaction fees, ease of digital manipulation, ability to integrate smart contracts, etc... we have no reason to expect a 'confidence crisis.'

This will be true as long as the cryptographic logic buttressing the system remains sound – just like the laws of physics underlie the desired properties of gold. Breaking this cryptographic logic (akin to cheap transmutation of lead into gold) would require breakthrough advancements of our knowledge of cryptography and discoveries on hitherto unsolved mathematical problems. But even in this case, the open-source nature of Bitcoin allows it to evolve new cryptographic implementations that would avoid such problems.

[orblivion]

One thing I like about your post is that it gives me hope of understanding how, if Federal Reserve Notes are based on "nothing" since the 70s, our currency hasn't collapsed entirely yet? I love Ron Paul but he's got to explain this one to me before I buy into it wholesale.

You say that it's because the US government forces other people to accept it as payment for debt? I don't understand how that enforces any particular value. It enforces that it's accepted, but what's to stop someone from asking for 10 times more than they do?

Or do you mean that for a debt incurred at time A at a given interest rate, it's guaranteed to be a certain ("inflated", but predictably so) amount by time B? What about with Bitcoins? The owner of the debt could lose credibility if s/he decides to change the contract and say "Bitcoins are looking bad these days, you owe me gold now instead". But I guess guns work a lot better than reputation loss against a currency collapse. Hmm.

Or did I misunderstand your point altogether?

[nhaehnle]

I do believe you misunderstood the point. Let me try to clarify from my own understanding.

There are legal tender laws, but these are not the point. They are largely irrelevant.

The point is that the US government itself accepts dollars as payment for debt. This may not seem like a big deal, until you realize that governments are unique in their power to force a debt onto you via taxation. Just like their monopoly on physical power, they also have a monopoly on economic power - for a number of reasons, which are not really important here, but the concepts are indeed very similar.

So the government forces debt on people, which can only be paid using the dollars that the government issues. This creates demand for dollars and therefore value.

Side note: You can learn an important point lesson from this. In a fiat money system, taxation has nothing to do with financing government spending. Government (by which I mean the union of all governmental institutions, i.e. executive + legislative + Fed etc.) can spend whenever and whatever amount it likes. The point of taxation is to create a demand for currency, which entices the private sector to offer goods and services for sale in exchange for that currency, thus enabling government to execute its mandate.

Returning to Bitcoin, there is no entity that can force Bitcoin-denominated debts onto people, and therefore the only people using it are doing so either out of curiosity or out of ideological dislike of government-run monetary systems - or perhaps out of the desire to make money off people who are simultaneously fools and members of the former two categories.

[kiba]

BitCoin advocates tend to get very angry when I point this out. I think it's because they have no answer to this

Who got angry over this? I happily concede that bitcoin have no intrinsic value.

("So why's it worth so much now?" It's in a bubble generated by all this publicity. What happens the first time this bubble even threatens to pop? That's when you'll really find out who is right, me or them. Oh, and I'd predict an even larger burst of publicity and public braggadocio if it looks like that's going to happen; that will be the only way to forestall the inevitable another few days.)

When the price of bitcoin rose so fast, it is only natural that a correction followed.

At some point, BitCoin faces some dip in currency confidence. Not because it's "BitCoin", but because all currency face periodic confidence crises.

Let see if your hypothesis bare this out.

[jerf]

The part you should have highlighted at the end is where I predict collapse, not where I predict it'll have a confidence issue at some point. There's no way BitCoin will avoid some sort of issue at some point and just monotonically increase in value forever and ever, amen. If nothing else, after its inevitable and mathematical wild success (cough) BitCoin will one day attract the attention of the IRS who will decide they need to tax it. If you manage to get that far without a confidence crisis, that's an automatic one. You'll lose a chunk of people for whom the primary draw was that the IRS didn't care about it. Confidence crisis isn't the question, collapse is.

(And that's the gentle one. There's also "The US government has decided that BitCoins are primarily a money laundering operation" and it starts throwing people in jail for using them. I consider this a less likely outcome by far, but still on the table.)

When I say confidence crisis, I do mean that as a distinct thing from a collapse; as I said, all currencies face confidence crises.

[kiba]

The part you should have highlighted at the end is where I predict collapse,

Fair enough.

Since your argument is so good, I linked to it on the bitcoin forum. http://www.bitcoin.org/smf/index.php?topic=4832.msg70583#new

I don't know who the bitcoin advocates that hate hearing this is coming from but the bitcoin community had always debate possible attack vectors and ways to counter it, if indeed it was a problem. Indeed, the government's response is a constant worry and there had been various opinions as to how big of a problem it is and how to win.

Running away from problems does not help us or anybody. It's best to confront it head on.

[wladimir]

Indeed, nothing ever monotonically increases, or keeps growing forever. Didn't we already made that mistake with the housing crisis? There will be drops, eventually, maybe even big ones.

I think the biggest confidence crisis possible for bitcoin would be a security breach discovered in the software.

Other things, like the IRS interefering, will cause smaller panics. There will still be a lot of countries left where it can be used. Bitcoin is by no means a US-only operation.

The surprising thing for me for bitcoin is that it's actually being used to trade things, and is not just seen as an investment vehicle. This makes me think it can succeed.

[tabsa]

So your argument is basically that government comes to tax bitcoin, or make it a part of a legal currencies, bitcoin will suddenly drop it's value? You could argue the opposite just as successfully - bitcoin will increase it's value even more because it will become a de facto legal currency (adoption will increase massivelly).

And the "bitcoin = domestic terrorism" attack is quite hilarious (in it's futility) if you compare it to war on drugs. Demand won. You can't make war on something large part of populations want and win.

[jerf]

"So your argument is basically that government comes to tax bitcoin, or make it a part of a legal currencies, bitcoin will suddenly drop it's value? You could argue the opposite just as successfully..."

Only with a heaping helping of wishful thinking. In the real world, when a currency incurs previously-nonexistent liabilities (in the accounting sense) the reaction of people isn't going to be piling in even faster. It may not kill BitCoin but it isn't going to be a moment where the value rises.

"And the "bitcoin = domestic terrorism" attack is quite hilarious (in it's futility)"

For the record, I disagree with the argument that alternative currencies are solely for money laundering or terrorism (note you added the terrorism connection, I just mentioned money laundering). I'm simply saying the government may make it. If you're going to be paranoid and cynical, do it right. If the government perceives BitCoin as a threat to its power, it isn't just going to come out one day and say "We perceive BitCoin as a threat to our power and so we're going to just stomp it out." They're going to have some reason with vague plausibility for enough people to give them cover to do what they want. (In fact I think that there may not even necessarily be any one person who thinks to themselves BitCoin is a threat to the dominance of the US Government and we must come up with some pretext to stomp it out, these things can sort of emerge from the successfully-evolved system itself.)

I actually approve of alternate currencies and expect that they will exist in the future regardless of what governments say. I think the embryonic versions already exist and the technological trend is unstoppable. I just don't think BitCoin is it, as it is today. Someone pointed out to me that someone could take BitCoin and actually provide some sort of backing, and I think that would be a potent combo, though given the "men with guns" option isn't really available that seems to only leave physical assets, which is tricky to pull off at scale. (You would need to actually be ready to provide all the physical assets if there is a run on the currency, no excuses, no clever contractual "no we didn't really mean it", you actually have to have it. Perhaps ironically, if you can, you may never have to, but if you can't, you will certainly have to.) If there's some sort of third option, someone might be able to actually provide the recursive base case and put BitCoin on a firm footing.

[noagendamarket]

Id smuggle a mobile phone into my jail cell and trade bitcoins from a nice warm bed with 3 meals a day.

Making bitcoins illegal would make them worth more as drug dealers and pimps would value their qualities more.

tl;dr bittorrent.

Hows shutting down piracy working out for you ?

[eof]

The IRS taxing bit coin will have about the same effect as piracy being illegal.

It's too easy to use it anonymously and too hard to crack down on it for there to be any real effect.

[eof]

> The ability of dollars to hyperinflate or hyperdeflate is bounded by the fact they can be used to pay debts to the United States Government that are denominated in dollars.

This is not really 'backing'. Backing is when your currency can be traded for a specific amount of a specific thing. Your currency actually 'stands for' something else. Saying the US Dollar is 'backed' by the fact that you can pay debts to the US govt is isomporphic to bitcoins being 'backed' by the fact they are anonymous and you can trade them for DNS hosting.

And fwiw.. the bitcoin economy is roughly ~4.5 million USD right now.

[teyc]

This is pretty insightful, the part about hyperinflation vs confidence.

I'm not a BitCoin supporter, but I still think you are wrong on this count.

Confidence depends on perceptions. Nothing can command confidence consistently if the underlying economy is bad or broken. In the case of BitCoins, not being able to artificially increase the supply is a virtue. (ps I'm not a supporter because bankers always figure out a way around limited supply of a precious commodity).

[jospehcanto]

Can you point out the diff between that and the stock market? Isn't a stock in the stock market not really backed by anything other than people's speculation?

[RickHull]

Stock in a company is equity. You own a slice of the company. If the company pays dividends, you are entitled to a portion of its future earnings.

[jeromec]

Yes, that's essentially correct. And that's why stocks can plunge and lose practically all (or all) their value relatively quickly, as happened to General Motors and many banking stocks in 2008, for example.

Edit: To clarify, even when a company pays dividends which holding the stock entitles you to you are speculating the company will continue to pay, or be able to pay, which is why you continue to hold the stock. This is why stocks are risky -- they have no guaranteed value (or backing) and can crash theoretically at anytime.

[jon_dahl]

Not at all. A stock represents a share of a company's earnings, which has real fundamental value. There are bubbles and random swings, but at the end of the day, a stock is worth something like the present value of future dividends. (Even for a non-dividend-paying stock - the idea being that eventually the company will mature and start paying a dividend.)

[orblivion]

Similarly to jerf, I think if you point this out to someone "in the know", and dig deep enough, they won't get mad, but it'll turn out that it's "really complicated" and "you wouldn't understand unless you were heavily involved". It happened at least once, and I wouldn't be surprised if this was common.

[reedlaw]

A stock should be backed by all the assets of a company, shouldn't it?

[kiba]

A stock is backed by companies' performance, I think.

[wynand]

I don't know enough about economics to give a qualified answer but let me try. All currencies are vulnerable to feedback loops but governments can do things like change the interest rate to encourage/discourage spending. I don't understand how this would be possible with Bitcoin.

I overlooked the Bitcoin limit - price inflation will certainly be limited through this mechanism. But I wonder if this might not cause prices to drop at a constant rate (since Bitcoins are so divisible) - this would include labor costs (although how wage stickiness would hold up to this remains to be seen).

[maurycy]

Decreasing supply of a good with a constant or increasing demand, ensures its increasing value. The govt is able to control the supply of money.

[maurycy]

Read about money creation[1]. It is not a conspiracy that it relies, simplifying, on debt. One wants to bind somehow an amount of money with the output.

Right now, BitCoins ignore the output. Even if there is no limit, it links the amount of money with either the computational resources or number of miners. There is no way to fix it. The limit is an ironic bounty.

[1]. http://en.wikipedia.org/wiki/Money_creation

[DennisP]

I think the answer is that multiple competing currencies give stability. Hayek wrote a book about it. So Bitcoin by itself might not be stable, but Bitcoin in an economy that also has other private currencies might do just fine.