Creighto:

I have no need for the benefits provided by Bitcoin at the moment, and so regardless of the size of the "first adopter" wealth, I have no reason to take this kind of action myself.  My argument is essentially that I like the benefits offered by Bitcoin, but I think there are economic flaws that will limit adoption.  I would like those economic flaws to be resolved at some point because I think it could change the world for the better. 

Forever-D: 

Regarding the potential for a decline in the impact of the wealth transfer.  The higher the exchange rate USD/BTC, the greater the wealth transfer.  I mean aggregate transfer, not flow, although flow would also increase so long as adoption was growing.  Could you show me mathematically how this declines sharply over time and trends to zero?  I am not saying that you are necessarily wrong, but that does not make sense to me.  As per the gold example, if total assets in the US doubled, and M2 doubled as well, then you would need more gold, or higher-priced gold, in order to back the currency.  With double the M2 and the same finite supply of gold, I would expect the wealth transfer to actually be MORE severe, rather than less severe, because gold would have represented a smaller portion of total original assets.   

Is the small amount of deflation enough to put off new users?. Given the value accrues to people holding the existing currency, and the currency can be avoided, and the benefits of the currency can be replicated, I think this, and the wealth transfer, will be a sufficient put-off.  This could be limited if the effective money supply could grow because of fractional reserve lending, but with deflation this seems unlikely to me. 

On the wealth of early adopters.  The wealth transfer is a permanent problem under Bitcoin, especially if deflation continues.  The total amount of loss to deflation, and therefore everyone who adopted before the next person, continues to grow. 

Maybe one of those super rich early adopters will invest in some awesome new technology?  Sure, that's possible.  But the wealth they have was not CREATED by their investment in Bitcoin, but was rather just a wealth transfer.  The productive output of the real economy stayed the same.  So you are merely shifting wealth between people, not creating wealth, unless you argue that the service itself, being extremely valuable, is what they are being paid for.  But I am arguing against that because it is replicable.  I am not making the assumption that wealth is static, but I am assuming that Bitcoin itself is not affecting wealth.

On what people will prefer.  If InflaCoin worked as I suggested, whereby the total amount grew with the size of the economy, then people would prefer InflaCoin to Bitcoin.  Why?  People prefer to spend and earn in a relatively stable currency.  Customers would not prefer to buy in Bitcoins, because they would not want to make purchases; they would rather hold onto their coins.  People also will prefer to save in a stable currency.  Earnings from deflation must come at the expense of someone (as a saver), as must earnings from inflation (as a borrower).  Saving in a stable currency where you earn return for actually lending your savings to people, rather than just holding onto it yourself, is preferable.  I do not want to have to speculate on changes in currency value when I just want to buy and sell things.  Yes, I have to speculate on the change in relative value between goods or services (such as the value of my labour versus the value of a cheeseburger), but I do not want to have to speculate on currency changes on top of that. 

Generally I am not a huge fan of the paradox of thrift concept, because most of the time an increase in savings by one group represents an increase in loanable funds to another group.  So long as the market is efficient and there is loan demand, this should not cause a problem.  Where no one wants to borrow because there is a significant minimum rate because of deflation, however, I think the paradox of thrift has greater validity.  Where people are just going to hold the "cash" themselves, this becomes an issue. 

On how the cost of entering the Bitcoin economy is determined by the exchange rate

In order to answer this, let's think instead of what it would cost now to adopt the gold standard.  Adopting the gold standard would have a cost: There would be a requirement to back a certain amount of the money supply with gold.  This would mean that the price of gold, of course, would go up, because government would have to buy gold in order to back the currency.  There are about 5.3Bn ounces of mined gold (http://en.wikipedia.org/wiki/Gold).  US M2 is currently about USD9Tn (http://en.wikipedia.org/wiki/File:Components_of_US_Money_supply.svg).

Let's say the clearing price to cover the US money supply is going to be $6k per ounce (just random numbers here).  So if the US did not have any gold to begin with, they need to buy 1.5Bn ounces of gold.  The economic output of the economy stays the same.  Everything else stays the same, including the total assets and output of the economy, but $9Trn went to purchase gold (and the government taxed the people to get there).  A massive wealth transfer just occurred from everyone else in the economy to those who originally owned that gold.  Current US assets are ~$188Trn (http://rutledgecapital.com/2009/05/24/total-assets-of-the-us-economy-188-trillion-134xgdp/).  At a USD price of $1,500, those 1.5Bn ounces of gold represented 1.2% of economic assets.  Suddenly, instead of having 1.2% of economic assets, the original holders of that gold have 4.8% of economic assets in USD terms.  Total economic output remained the same, and yet there was a massive wealth transfer from one group to another because of the return to the gold standard. 

Okay, so what was the point of that lesson?  The point of that lesson is that one cost of adopting a currency (in the case above adopting a gold standard) is the wealth transfer that goes to the existing holders upon adoption.  Why?  Because total productive assets in the economy stayed the same and their share of those assets went up as a result of adoption. 

Now, if I'm forced to adopt the gold standard because my country goes out and purchases all that gold on my behalf, transferring all that wealth to other citizens, I cannot do much about that.  But if you ASKED me to voluntarily give up a few percent of my assets to other citizens merely because they held onto some shiny metal that wasn't going to produce anything and I did not actually want, there is no way I would do so. 

We can think about Bitcoins in the same way.  The cost of adoption for everyone is the amount of wealth that is transferred upon adoption, in terms of real productive assets, to those who participated in Bitcoin early.  If I am not going to be coerced into paying that, then I must do so voluntarily.  So I must believe that the value of doing so exceeds this cost.  There is supposedly someone who has 340k Bitcoins or so.  And yet the actual output of the economy stays the same.  His spending power must have come from somewhere (someone). 

So the costs of buying BTC are:

a.  Conversion costs;

b.  Risk of losing your purchasing power; and

c.  The wealth transfer embedded in the conversion to another currency.

Those must be weighed against the benefits, which I noted before.  The issue is, there is a way to get those benefits WITHOUT using BTC itself, because the only barrier to entry is the first mover advantage (acceptance of the currency).  So if the third cost becomes too high, someone can just abandon the system and create a competing system with similar properties.  And if that system provides all the same benefits WITHOUT the massive wealth transfer to early adopters, then people will use that instead. 

How would an inflationary currency outcompete a deflationary one?

To a certain extent, you answered the question yourself. 

First, if you want to HOLD cash, you would rather HOLD it in a deflationary currency.  But what if you want to spend it?  I don't want to SPEND my deflationary cash... I can buy more goods in the future if I just hold onto that cash now!  If everyone has the incentive to hoard, that leads to deflation and a decline in spending.  This limits economic growth; we know this from the real world.  Too much hoarding; not enough purchasing.  What will it do to Bitcoins?  Well, the real value of Bitcoins is not in the coin itself (it's just data), but rather in the fact that you can use them to buy real goods and services.  And if you don't want to use them because you would rather hoard them, then there isn't much value to them, is there?  Seems like a conundrum, but then you add competition to the mix.  Someone else comes out and offers the same concept of a digital currency that is untraceable, that cannot be seized, that crosses borders, but there is no deflation!  People spend their coins freely.  They don't have to worry about losing out because they are not long the currency.  And so everyone who wants to use an untraceable, seizure-proof, transnational currency switches to that one.  And no one wants your Bitcoins anymore.  And suddenly Bitcoin inflation is infinite, because there is no market for them.

Second, this new currency avoids the massive wealth transfer to early adopters (let's just say they have a solution for it; I don't know what the solution is).  So there is no cost of adoption of the currency?  And people will spend it freely?  And I don't have to worry about speculating when holding it because prices are relatively stable?  Count me in!

Third, it's tough to make loans in a deflationary currency, and as a result the money supply cannot grow through the fractional reserve process (it can theoretically, but I am saying in practice it will not).  Why is it tough to make loans?  Because you will only make loans that are risky enough to still require someone to pay you for lending.  If the currency is appreciating relative to goods (there is deflation) of 20% per year, then someone has to be a risk of greater than 20% in order for me to charge them interest.  Otherwise I'd rather just get my currency appreciation (deflation) earnings. 


Price stability, excluding changes in productivity, is a valid goal.  I don't think that price stability affects population growth or total world output.  Price stability, when excluding changes in productivity, is a monetary policy and currency issue. 

To the extent general price stability cannot be achieved when there are no severe shocks to a system then there is a currency problem.  If the relative price of goods to one another is consistent, but the price in terms of the currency is not, then there is a currency problem. 

It Bitcoin accepts that it must be limited in economic size in order to achieve price stability (which is fundamentally true), then Bitcoin will not survive.

Hopefully everyone accepts the fundamental basis for why the Bitcoin economy would have to remain limited in size in order to have broad price stability.  For this once again we go back to a limited money supply only allowing for price stability to the extent the quantity of goods traded remains the same.  Without growth in the money supply, growth in the economy will lead to deflation.  Deflation discourages new entrants into the market.  So with the money supply fixed, price stability can only be achieved with a fixed GDP.

Why does that mean Bitcoin will not survive?  Because there is a strong need for what Bitcoin provides, which is anonymity, near-costless transfers, the ability to transcend borders, freedom from forfeiture, etc.  With the cost of entering the Bitcoin economy high because of the limited money supply, people will figure out how to take the idea and create an alternative that does not have these issues.  If that occurs, then people will tend to use this new system rather than Bitcoins, and at some point the market penetration of Bitcoins will be such that their value will decline, and you will see inflation, rather than deflation, in Bitcoins until they are worthless. 

Either the Bitcoin money supply needs to be able to grow with the Bitcoin economy, such that there can be price stability with growing GDP, or Bitcoin will be supplanted by a similar technology that deals with this issue and as a result Bitcoins will become worthless. 

When I refer to price stability, I do not mean that all prices should remain stable.  I mean that, in general, prices should not fluctuate without a change in the underlying supply and demand of the item. 

No one (that I know of) targets price stability in regards to individual items.  It is price stability in regards to a broad basket of goods that is a reasonable target.  Without changes in productivity, that is a reasonable expectation.  In a closed economy, without international trade, it would be reasonable to expect the price of goods to remain relatively consistent on a broad basis.  Of course that could not be said for each individual good.  Without the price signals of the market, there would be no supply and demand signalling process.  But should the broad price index swing wildly in one direction or another without changes in productive capacity?  No.  If it does, that means there is likely a currency problem, not a general economic problem. 

Obviously my original explanation was insufficient, given it was interpreted as suggesting that an economy with centralized price controls and fixed pricing of individual goods is optimal.  The truth is far from that; however, to the extent the broad price index moves wildly without changes in productive capacity, that signals that there is a change in the value of the CURRENCY ITSELF that is occurring, rather than changes in the actual value of goods.  A stable currency, relative to the total productivity of the economy, is a reasonable target. 

I thought a bit about the issues that I noted in my last post.  Kept me from sleeping, actually. 

Essentially, you want to keep the monetary base expanding in order to try to maintain price stability.  The best way to do this is to expand the monetary base at a rate that is equivalent to the increase in the value of transactions.  We know that Nominal GDP is equal to the Monetary Base * Velocity of Money, and that therefore if we increase the Monetary Base (holding velocity constant), then we increase Nominal GDP; whether or not prices stay the same with that change is dependent on whether or not Real GDP also went up.  So if we want pricing to remain consistent, then if we can hold Velocity of Money constant we just need to increase the Monetary Base in line with any increases in Real GDP.  That means for Bitcoin that you need a way to determine the total value of the the market at any one time and increase the limit on Bitcoins as that market value grows. 

What's the best way to do that?  I'm not sure, but that's fundamentally what you would want to do. 

Okay, so if our monetary base is expanding, who gets the value of that expansion?  If we say it just always accrues to the guys with the fastest computers, then that means all capital created goes to reward people who just buy faster computers.  While there is a value in the incentive you are creating to have more computing power on the network, and therefore greater security, you create two problems: 

1.  All cash passes through the hands of people who mine the coins.  If you want to create a currency that everyone the world over can actually use, is it really fair that 100% of all of the original monetary base must at some point be owned by people who just have computing power sitting there doing calculations that only serve a limited purpose?  Not really. 

2.  If those people save, rather than spend, their cash, then the creation did not help anyone anyways.  And if they are not spending it, then you have a problem with how cash is entering the market.  You can end up with a deflation problem anyways. 

There is, however, a simple solution to both of these problems if the network has achieved scale.  Instead of distributing the new cash that needs to be created only to data miners, distribute it first as transaction cost rebates.  Instead of rewarding people for sitting and using their computing power, you are now rewarding people who are using their coins in transactions.  People who are providers of liquidity in the market get a rebate on their transaction costs for their efforts (with the rebate always less than the transaction cost itself).  This limits your monetary base growth to the value of your transaction costs, which may not be sufficient to maintain price stability, but it's better than having all of the value merely go to computing power.

Fundamentally, in my opinion, the problems I noted need to be solved for this to become a real currency with global usage.  It will not do so if it is a currency set up for deflation where massive value accrues to the first movers, because there is insufficient incentive for people to participate in your network rather than set up a new one once the value accrued to first movers is too high. 

I'll give you an alternative answer as to what happened:  4chan.

Bitcoins got mentioned on 4chan, specifically on /b/, and on some threads with a lot of viewers. 

Inflation is theft from existing holders of a currency, or a tax on them.  It's a gift to those who are borrowers, so long as it is unexpected (they have fixed obligations that they need to repay in the future and so inflation helps them out).  

Deflation is theft from those who are "short" the currency (those who need to purchase the currency in the future in order to satisfy future obligations), or a tax on them.  

Either way, price instability is taking from one group or another.  Sure, as a saver it is great to have a currency that will appreciate in the future (prices will decline), but the problem with that is that people don't want to spend a currency that is depreciating.  They want to hold onto it.  And people don't want to participate in a currency where a bunch of first movers have a massive advantage because of their original position.  That limits the total size of the economy in the future, which also limits the amount of potential appreciation in the currency (because the price of the currency is essentially Price/Quantity = Money Supply * Velocity of Money).  

Either way I see a fundamental problem in the currency in that initial holders get unfairly rewarded and there is always deflation in the system to the extent the quantity of goods being traded grows.  I understand people making the point that the initial holders are not unfairly rewarded in that they did something, but the fact is that people can always replicate the same system with a new chain at any time.  If there is too much value accrued to early adopters no one will want to use the current chain.  

There is a fundamental need for a currency like this.  I see two major issues, however:

a.  Lack of expansion of the monetary base means there is price instability in the system in the form that penalizes new entrants.  Therefore, this discourages new entrants.  New entrants can avoid the system (there is no coercive force behind it); and

b.  The value upon expansion of the monetary base accrues based on computing power, where that computing power is not necessarily needed to actually perform legitimate work but is rather there in order to set some kind of threshold (a level of "pain" in order to determine who gets the new money).  If that computing power was actually required in order to process the transactions, rather than to solve problems at an ever-higher level of difficulty, then I could see this sticking.  But that is not the case.  

Rezin777:  In regards to being able to use the savings, unk made the point that if no one else wants to accept the currency in which you saved then they are not savings at all.  Bitcoin does not solve that problem.  I believe that one of the primary reasons Bitcoin will be constrained, and as a result supplanted in the future, is that there is a hard constraint on the number of coins in existence, which accrues massive value to the original holders or originators of the currency if the currency does in fact grow in terms of total GDP.  As a result, to the extent you are saving by putting your capital into Bitcoins, you are taking a very real risk of an alternative currency and a resulting lack of demand for Bitcoins.

Perhaps there is some value in Bitcoins because there is demand from people who want a currency with an absolute constraint, but I believe this will ultimately limit the acceptance of the currency and create significant incentives for alternatives.

The only way you will have price stability in this currency, and as a result a currency that will gain widespread acceptance, is if you have the amount of currency fluctuate with the size of the economy which the currency represents.  If I can be confident that socks that cost 1 Bitcoin now will cost 1 Bitcoin, or 1.02 Bitcoins, next year, then I will much happier to hold that currency.  Otherwise the level of speculation inherent in holding the currency will limit widespread use. 

Whether it is Bitcoin or someone else, the fundamental concept that you can have a currency that is untraceable is here to stay and is going to change the world.  Given you can replicate the technology with a new chain at any time, however, a chain that allows for price stability will be the one that is ultimately accepted. 

Unk is essentially correct that Bitcoin does not change anything with regards to many of the points brought up by dacoinminister.

For small stocks, it is tough enough to find liquidity for a basic buy/sell in the market, let alone some option trade.  To the extent you could just post a bid/ask on ANY trade anywhere, this might help, but I am not sure why this is related to Bitcoin itself.

The bigger point, and this is where I agree with daconminister, is anonymity.  If you can make bets on stocks without anyone knowing that it was you who actually made the bet, then you can make trades based on inside information without an issue.  This is the key.

And dacoinminister is right that to the extent there is a price differential between the two markets then an arbitrageur will step in and correct the mispricing.  This, and all of the other "black market" uses of Bitcoin, is why there is real VALUE in Bitcoin.

There is a reason, however, that Bitcoins will never reach the value that dacoinminister is talking about.  And that's because huge value accrues to early adopters.  Not only does huge value accrue to early adopters, it will CONTINUE to accrue to early adopters through deflation, because there is a limit on the number of Bitcoins that will ever be issued.  Competing with Bitcoin, however, is free.  You can create a new, comparable system, at any time, without cost (just adoption costs).  So if there is BILLIONS of dollars in value held by the originators of Bitcoins, then someone else has billions of dollars in incentives to create a new system... and to create a system where value does not consistently accrue to original holders through inflation.

The solution to this will be someone else creating a system where new coins are created as the economy grows, thereby maintaining price stability and eliminating deflation pushing value onto the original currency holders.