Who Pays for Money?

Picking up where The Cost of Cash left off...

We discussed the notion that governments must pay to provide a money supply, a topic we continued with in Deficits Matter. A couple of things were left hanging. First, it seems that bitcoin might serve to effectively increase the money supply. That is interesting, if true. And if it is, the government doesn't have to pay for it. So who is paying for it?

Let's work through a couple scenarios and try to think about how all this is working. First scenario: you buy a bitcoin on an exchange. Someone else is holding the bitcoin and has offered to sell. You send them dollars, and they send you a bitcoin. What has changed? Nothing in the individual transaction. It's just a switcharoo and the slates come out clean. But, if a lot of people are buying, then the price of bitcoins will rise. Well, now that's interesting. The same Bitcoin is worth more dollars. What has changed? Still nothing. Dollars paid for Bitcoins cycle right back into the economy. That is to say, the Bitcoins aren't somehow backed by dollars that were invested. In Deficits Matter we defined three types of currency and showed how they are all backed by legal contracts. Bitcoin is a new form, let's call it auxiliary currency. It's auxiliary in the sense that it is not the same denomination as the primary currency, but it is still part of the money supply. And it is not backed by anything more concrete than belief. The price is only high because people believe it is high. That is literally it. There's physically nothing backing the price. No intrinsic value, no legal contract. So bitcoin is not just auxiliary, but it is also another category of currency as well, where nothing tangible gives it value. That's counter to, say, stocks, which are auxiliary currency, but by contract give part ownership in the company's capital and grant dividends, and sometimes convey voting power on the board. [Maybe stocks aren't the best example, as they also contain a high degree of belief valuation themselves.]

Second scenario: bitcoin mining. You mine a bitcoin and sell it. You've taken energy to run a computer algorithm that mines the bitcoins, then you get paid for the coin. Don't be mistaken in thinking that the energy spent mining is somehow invested into a Bitcoin. It is wasted. There are a number of schemes we could concoct that would deliver the desired release schedule with more energy efficiency. I suppose the Bitcoin designers chose CPU-intensive mining because it is easily distributable. Ultimately the mining destroys wealth, as resources must be consumed to power the operation. But that doesn't affect our analysis any. All currencies will have some overhead, even if Bitcoin's may be especially high. So you take your new Bitcoin and you release it into the world. What happens? Someone gives you dollars, and you give them Bitcoin. Congratulations, you've just expanded the money supply. And, if the economy has't changed, then you've caused inflation. The money supply has grown, while the denominated real wealth has stayed the same.

This brings us back to our question: who is paying for this extra money supply? My first guess was the people buying the Bitcoins. You can assume that Bitcoin will eventually go bust. When it does, all the people holding Bitcoins will lose their money. They must be the ones paying for it! But that's not the case. The people losing money when the price falls are offset by the people who made money when it climbed. It's a zero-sum game. There is no net outflow of cash that funded anything, save for transaction fees which are normal friction.

My second guess was that the cost was paid for collectively by poor allocation of resources. People are investing in Bitcoin when they might instead be investing in productive ventures. But the thing is buying Bitcoin isn't truly an investment. It is a currency exchange. You may do it speculatively, but that's not the same as investing. It's more akin to savings. If people are moving their money from investments to cryptocurrencies then their might be some distortions, but not so much if they are taking from their savings. The thing to keep in mind is that buying Bitcoin does not mean you are allocating wealth to Bitcoin. It's a currency exchange.

This brings me to my final guess as to who pays for the money supply added by Bitcoin: no one does. It kind of makes sense, since Bitcoin is a different class of currency that is not backed by anything tangible. It would have to be cheaper, at least. Bitcoin doesn't require a contract, and there's no expectation of interest. It is created by belief, and destroyed by disbelief. We don't yet have empirical data for cryptocurrency cycles since they're so new, but it's reasonable to expect that cryptocurrency valuations will rise and fall with the economy. When there's lots of money, people will buy Bitcoins in a gamble to get big returns. In downtimes they will sell because they need the cash, or fear their money will be destroyed by a disbelief implosion. What is interesting about that hypothesis is that the main goal for these recent economics posts is to gain a better understanding that can be applied to Energy-Backed Currency. This blog proposed the notion last year (and others had the idea before that) because energy production scales linearly with the size of the economy. If you could find a way to practically back currency with energy production, you could avoid both the deflationary and inflationary tendencies of the other currency types. Here, we suspect that Bitcoin valuations rise and fall naturally with the size of the economy too. That is fascinating! So cryptocurrencies naturally help grown and shrink the money supply in proportion with the size of the economy, and no one has to pay for it! But, is this truly any different than what happens in the stock market?

That's all for now. Please comment if you find logical errors in all this. Otherwise, we'll continue with this line of thought very soon.