Why Bitcoin can’t be a currency

[Steve]

I am glad to see this thread.  In light of the market action in silver, this is very timely.  I don't agree with the blog post that bitcoin would completely collapse when an irrational exuberance imploded...bitcoins would find a level of support, but perhaps not before merchants decided to completely abandon it as a pricing mechanism.  But what this highlights is the inherent volatility of commodities...and bitcoin is very much like a commodity.  Commodities are volatile not because of their limited supply, but because of the irrational behavior of humans.  I could go on about why this is the case, but I think the best way to understand how commodities and irrational behavior can lead to extreme volatility is to study examples...considering the recent collapse in the silver market (and, yes, I know market manipulation is in play there), I think the history of the Hunt brothers and silver provides good insight into such irrational behavior.

I think this is why many studied (but honest) economists have reservations about using commodities as a basis for a currency.  If you have a benevolent central bank, if someone were to try and corner the market for a currency, the central bank can simply buy up assets (with newly printed currency) to maintain the price stability of the currency...when that someone later realizes the folly they're engaged in and begins to divest dollars, the central bank can sell assets and soak up the excess currency to again maintain price stability.  But of course, this requires a central authority.  The challenge is how to achieve similar stability without a central authority.

So, if you accept the fact that commodities and human nature tend to lead to wild volatility, and you understand that wild volatility is an impediment to the adoption of something as a pricing mechanism (note: I don't necessarily think bitcoin needs to provide a pricing mechanism to have value and relevance), then the question is: what can be done to mitigate such irrational behavior that leads to extremely volatility (with the goal being to create something that actually is useful for pricing)?

One idea I had was rather simple: come up with a mathematical model that shows people the value of their bitcoins in terms of bitcoins, but adjusting for the percentage of bitcoins they hold.  Someone holding 100 bitcoins probably does have ~$350 worth of savings.  But someone holding 100,000 bitcoins has nowhere near the purchasing power that the current exchange rate would imply (not in any sufficiently short timeline).  I'm sure a lot of people here understand that fact, but clearly (see Hunt brothers) this fact might be lost on some less educated people with more dollars than sense.  If you had a mathematical model that gave people a more accurate sense of real purchasing power, then they would very readily see the diminishing returns you get from hoarding ever larger sums of bitcoins.  This might mitigate the risk that some wealthy, but irrationally exuberant, individual would enter the market and try to dominate bitcoin holdings (causing a rapid rise in value followed by an inevitable collapse).

The second idea I had was that you simply give up any notion of using bitcoins for pricing.  Instead, use some inflation index to price things and just settle in bitcoins (or any other currency).  Something like http://www.pricestats.com/ might be useful for this purpose.  Loans and other contracts could also utilize some inflation index for its terms rather that any currency.  Under this scenario, the market will have harsh lesson to teach anyone trying to corner the market in bitcoins, but merchants will be unaffected by the volatility.

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[grondilu]

What about you just let people decide if they want to continue pricing their products in bitcoins or not ?


If the price of bitcoin is volatile in dollar, why should this mean that bitcoin's value is volatile, and not dollar ?



And even if bitcoin is volatile, there is nothing preventing a merchand to keep pricing in bitcoin anyway, thus improving bitcoin's stability.

For instance, I have been paying some hosting service 0.5 BTC a month.  So far, the guy has never requested any change of price, despite a BTC/USD pair having been multiplied more than four times.  And I don't mind continuing paying 0.5 BTC.   The reason is just that to me the value of one bitcoin hasn't changed much, as my bitcoin stock hasn't changed much either.

Don't forget about the subjective value of a commodity.  Market is not the absolute truth.   Some economic agents may be irrationnal, but not all of them are.

[markm]

Quote: "If the price of bitcoin is volatile in dollar, why should this mean that bitcoin's value is volatile, and not dollar ?"

One reason is probably a desire to regard the value of Bitcoins as having increased.

But the fact that Amazon and eBay and Sears and Zellers and Superstor and Sainsbury's and Marks & Sparks etc have not changed their prices to reflesct the declining value (in bitcoins) of the dollar is probably the main reason for most people.

It Walmart changed their USD prices to reflect how little the USD is now worth compared to a Bitcoin would they make a dent in this kind of perception of simply make themselves uncompetetive compared to neighbouring merchants who still think USD is good?

I wonder how a bitcoin type currency might do if it were initially distributed by merchants prepared to back it with goods at certain prices instead of by arbitrary miners? For example if Canadian Tire started a Canadian Tire blockchain for its Canadian Tire money, waiting until all coins, or at least a large proportion of them, are in circulation bfore opening up the network to every tom dick and hairy that wants to process blocks for it?

Attempts are already in progress at such experiments but not by anyone as large as Canadian Tire yet...

-MarkM-

[hazek]

People forget, money has a price just like any other commodity and that price is called interest rates.

And it's through the interest rates that Bitcoin will deal with fluctuations in demand. The higher the demand the higher the price of money will be the more lucrative it will be for people to lend. More lending will mean more money will be available.

Why is this so hard to understand?

[allinvain]

Is this in and of itself such a huge flaw?

I suppose it depends on the magnitude of the associated price swings.  The Bitcoin economy is currently very small.  An article in a popular magazine can dramatically increase demand in a short period of time.  However, if the Bitcoin economy were 10 or 100 times larger than it is now, exchange rates wouldn't vary as rapidly.  For example, Silver prices dropped 19% in 3 days.  That was the biggest drop in 28 years.  In Bitcoin-land, we see swings like that every week

I suppose a healthy options/futures market could substantially reduce negative effects also.  If a vendor can buy a 30-day put option, he can price his goods in Bitcoins without worrying what the markets do.

I agree. What the bitcoin economy needs is a) to grow as rapidly as possible b) to outpace demand for bitcoins as purely speculative i nvestments c) sophisticated financial tools (ie optios, futures, etc)

[allinvain]

I think this is why many studied (but honest) economists have reservations about using commodities as a basis for a currency.  If you have a benevolent central bank, if someone were to try and corner the market for a currency, the central bank can simply buy up assets (with newly printed currency) to maintain the price stability of the currency...when that someone later realizes the folly they're engaged in and begins to divest dollars, the central bank can sell assets and soak up the excess currency to again maintain price stability.  But of course, this requires a central authority.  The challenge is how to achieve similar stability without a central authority.

That really makes me wonder if it were possible to code a "bitcoin central bank" within the bitcoin protocol itself. This logic would respond to price data already freely visible in the block chain and make corresponding adjustments to the bitcoin total supply. I dunno if this is really a good idea in the end but it's interesting to think of it none the less.

[allinvain]

What about you just let people decide if they want to continue pricing their products in bitcoins or not ?


If the price of bitcoin is volatile in dollar, why should this mean that bitcoin's value is volatile, and not dollar ?



And even if bitcoin is volatile, there is nothing preventing a merchand to keep pricing in bitcoin anyway, thus improving bitcoin's stability.

For instance, I have been paying some hosting service 0.5 BTC a month.  So far, the guy has never requested any change of price, despite a BTC/USD pair having been multiplied more than four times.  And I don't mind continuing paying 0.5 BTC.   The reason is just that to me the value of one bitcoin hasn't changed much, as my bitcoin stock hasn't changed much either.

Don't forget about the subjective value of a commodity.  Market is not the absolute truth.   Some economic agents may be irrationnal, but not all of them are.

Well the reason the guy hasn't asked for a price change it because the value of bitcoins have been going up and thus he now getting 3x more than before (relative to the USD of course). So in a sense you're now paying $1.75 for hosting. Unfortunately for the moment (cause of the bitcoin economy being relatively small) people still automatically compare bitcoin prices to USD prices or do the conversion in their head. It's as if bitcoins are pegged to the USD!

[allinvain]

People forget, money has a price just like any other commodity and that price is called interest rates.

And it's through the interest rates that Bitcoin will deal with fluctuations in demand. The higher the demand the higher the price of money will be the more lucrative it will be for people to lend. More lending will mean more money will be available.

Why is this so hard to understand?

True, but at the moment there is no money market for bitcoins hence no interest rates. Is anyone out there lending bitcoins? I doubt it.

[hazek]

Yes, no one is lending, yet. Bitcoin is still super young and we don't yet have all the needed mechanism in place in order to facilitate proper lending. But that's something I'm 100% confident will eventually happen if Bitcoin can maintain it's appeal.

[allinvain]

Yes, no one is lending, yet. Bitcoin is still super young and we don't yet have all the needed mechanism in place in order to facilitate proper lending. But that's something I'm 100% confident will eventually happen if Bitcoin can maintain it's appeal.

Yep, I agree with you. I'm looking forward to seeing a peer to peer lending site.

[grondilu]

Yes, no one is lending, yet. Bitcoin is still super young and we don't yet have all the needed mechanism in place in order to facilitate proper lending. But that's something I'm 100% confident will eventually happen if Bitcoin can maintain it's appeal.

Yep, I agree with you. I'm looking forward to seeing a peer to peer lending site.

There is Ripple already.

[FreeMoney]

I think this is why many studied (but honest) economists have reservations about using commodities as a basis for a currency.  If you have a benevolent central bank, if someone were to try and corner the market for a currency, the central bank can simply buy up assets (with newly printed currency) to maintain the price stability of the currency...when that someone later realizes the folly they're engaged in and begins to divest dollars, the central bank can sell assets and soak up the excess currency to again maintain price stability.  But of course, this requires a central authority.  The challenge is how to achieve similar stability without a central authority.

That really makes me wonder if it were possible to code a "bitcoin central bank" within the bitcoin protocol itself. This logic would respond to price data already freely visible in the block chain and make corresponding adjustments to the bitcoin total supply. I dunno if this is really a good idea in the end but it's interesting to think of it none the less.

What are you talking about? There is no price data in the block chain.

[allinvain]

I think this is why many studied (but honest) economists have reservations about using commodities as a basis for a currency.  If you have a benevolent central bank, if someone were to try and corner the market for a currency, the central bank can simply buy up assets (with newly printed currency) to maintain the price stability of the currency...when that someone later realizes the folly they're engaged in and begins to divest dollars, the central bank can sell assets and soak up the excess currency to again maintain price stability.  But of course, this requires a central authority.  The challenge is how to achieve similar stability without a central authority.

That really makes me wonder if it were possible to code a "bitcoin central bank" within the bitcoin protocol itself. This logic would respond to price data already freely visible in the block chain and make corresponding adjustments to the bitcoin total supply. I dunno if this is really a good idea in the end but it's interesting to think of it none the less.

What are you talking about? There is no price data in the block chain.

Sorry I should've made myself a bit more clear. I did not mean price data as in what bitcoins are valued at but price data in the sense of information about how monetary velocity, the size of transactions, etc - data that can be used to gauge what the currency is doing.

[allinvain]

Yes, no one is lending, yet. Bitcoin is still super young and we don't yet have all the needed mechanism in place in order to facilitate proper lending. But that's something I'm 100% confident will eventually happen if Bitcoin can maintain it's appeal.

Yep, I agree with you. I'm looking forward to seeing a peer to peer lending site.

There is Ripple already.

I meant a site where people can lend and borrow bitcoins - the bitcoin equivalent of the "Prosper" site.

[grondilu]

Yes, no one is lending, yet. Bitcoin is still super young and we don't yet have all the needed mechanism in place in order to facilitate proper lending. But that's something I'm 100% confident will eventually happen if Bitcoin can maintain it's appeal.

Yep, I agree with you. I'm looking forward to seeing a peer to peer lending site.

There is Ripple already.

I meant a site where people can lend and borrow bitcoins - the bitcoin equivalent of the "Prosper" site.

Well, you can do it on this very forum, don't you know?

[hazek]

Well, you can do it on this very forum, don't you know?

Oops, yeah wasn't aware of that! Well then, problem solved!

[allinvain]

Yes, no one is lending, yet. Bitcoin is still super young and we don't yet have all the needed mechanism in place in order to facilitate proper lending. But that's something I'm 100% confident will eventually happen if Bitcoin can maintain it's appeal.

Yep, I agree with you. I'm looking forward to seeing a peer to peer lending site.

There is Ripple already.

I meant a site where people can lend and borrow bitcoins - the bitcoin equivalent of the "Prosper" site.

Well, you can do it on this very forum, don't you know?

Yeah I saw that thread a while back. Once again I was referring to a dedicated site for such activity, not some thread

[FreeMoney]

I think this is why many studied (but honest) economists have reservations about using commodities as a basis for a currency.  If you have a benevolent central bank, if someone were to try and corner the market for a currency, the central bank can simply buy up assets (with newly printed currency) to maintain the price stability of the currency...when that someone later realizes the folly they're engaged in and begins to divest dollars, the central bank can sell assets and soak up the excess currency to again maintain price stability.  But of course, this requires a central authority.  The challenge is how to achieve similar stability without a central authority.

That really makes me wonder if it were possible to code a "bitcoin central bank" within the bitcoin protocol itself. This logic would respond to price data already freely visible in the block chain and make corresponding adjustments to the bitcoin total supply. I dunno if this is really a good idea in the end but it's interesting to think of it none the less.

What are you talking about? There is no price data in the block chain.

Sorry I should've made myself a bit more clear. I did not mean price data as in what bitcoins are valued at but price data in the sense of information about how monetary velocity, the size of transactions, etc - data that can be used to gauge what the currency is doing.

It's not good to use that info for serious things like that. I can add major tx on the cheap. And even outside of tricks, how do you tell 'legit' economic activity from move my savings to a new wallet?

[allinvain]

I think this is why many studied (but honest) economists have reservations about using commodities as a basis for a currency.  If you have a benevolent central bank, if someone were to try and corner the market for a currency, the central bank can simply buy up assets (with newly printed currency) to maintain the price stability of the currency...when that someone later realizes the folly they're engaged in and begins to divest dollars, the central bank can sell assets and soak up the excess currency to again maintain price stability.  But of course, this requires a central authority.  The challenge is how to achieve similar stability without a central authority.

That really makes me wonder if it were possible to code a "bitcoin central bank" within the bitcoin protocol itself. This logic would respond to price data already freely visible in the block chain and make corresponding adjustments to the bitcoin total supply. I dunno if this is really a good idea in the end but it's interesting to think of it none the less.

What are you talking about? There is no price data in the block chain.

Sorry I should've made myself a bit more clear. I did not mean price data as in what bitcoins are valued at but price data in the sense of information about how monetary velocity, the size of transactions, etc - data that can be used to gauge what the currency is doing.

It's not good to use that info for serious things like that. I can add major tx on the cheap. And even outside of tricks, how do you tell 'legit' economic activity from move my savings to a new wallet?

That's a very good point you bring up. As far as I know there is no real way to differentiate. The Federal Reserve is in the same position of imperfect knowledge so I don't see how anyone could design a system that would have perfect knowledge of the transactions within a monetary system. I would venture to say that it is impossible.

I for one am not in favor of this "virtual central bank" idea. However I am curious to hear some ideas about how you'd go about "achieving stability without a central authority"

[hazek]

I for one am not in favor of this "virtual central bank" idea. However I am curious to hear some ideas about how you'd go about "achieving stability without a central authority"

Oh gawd, how the fk do you think? How does any price stabilize? People bid and eventually the market discovers the appropriate price.. You don't see the price of milk jumping up and down by a huge margin even though there is no milk central bank, you don't see the price of houses jumping up or down by a huge margin even though there is no house central bank nor do you see the price jump up or down by a huge margin for any other established good or service and none of them have a central bank besides fiat money. Sure the market place constantly reevaluates the price and changes it if necessary  but that's how it's suppose to be.

Once the market for Bitcoins gets deep enough there will be no problem in always knowing the approx exchange rates even for the future with futures contracts.