A Central Bank Backed Perspective of a Bitcoin Standard

Here I provide a summary of the interesting and relevant points in regard to the possibility of a globally adopted Bitcoin standard. The author of the paper “A Bitcoin Standard: Lessons From The Gold Standard” lays down his understanding of what a Bitcoin standard means and then goes on to consider the implications. The paper is very significant as it very closely follows and explains the narration that John Nash left us in his works “Ideal Money”. The author explains how a Bitcoin standard would force all centrally banked currencies to have inter-relationally stable money and even more so than the gold standard because of the lowered arbitration costs. The conclusion is that a Bitcoin standard might not last long whether because governments force the citizenry off the standard or a new currency (government or private) arises that is seen as more favorable and useful than bitcoin.

The premise of Weber’s thought experiment to consider bitcoin like a neo-gold standard:

Suppose that the use of Bitcoin has grown to such an extent that it has replaced existing fiat currencies and has become the predominant medium of exchange or at least the backing for the predominant medium of exchange in a large group of countries. I will call a monetary system the Bitcoin standard, because such a monetary system will very likely be similar to the gold standard.

Contrary to the Bitcoin Maximalist view, a Bitcoin standard does still allow for the possibility that central banks or governments still control the issuance of a state’s money:

Just as three distinct media of exchange existed under the gold standard, three distinct media of exchange are assumed to exist under the Bitcoin standard: Bitcoin, fiduciary currencies issued by countries’ central banks, and fiduciary currencies (bank notes or deposits) issued by commercial banks.

But the monetary policy control and tools would be limited because of the market forces-although bitcoin isn’t costless, relative to gold it can be considered as such, and this quality increases the effectiveness of a gold-like standard:

The scope of monetary policy would be more limited under the Bitcoin standard than under the gold standard. The ability to issue fiduciary currency would give central banks limited ability to act as lenders of last resort. However, virtually costless arbitrage of Bitcoin across countries would prevent central banks from implementing interest rate policies to affect their domestic economies.

The author gives four conjectures that ultimately suggest the general trend for the otherwise differing nation’s would be secular deflation yet with the possibility of financial crises:

An empirical examination of countries’ experience with the gold standard leads to the following conjectures about how the Bitcoin standard might perform:

1. In the long run, there would be moderate deflation that would increase over time until reaching a rate of deflation equal to the negative of the rate of growth of world output around 2026.

2. Price levels of the various countries would be highly, but not perfectly, correlated, much as they were under the gold standard.

3. Exchange rates among the fiduciary currencies of various countries would be fixed at par, because the cost of Bitcoin arbitrage is essentially zero. 4.

4. There would still be financial crises, because they can occur under any fractional reserve financial system.

The conclusion is that such a standard would be difficult to achieve and possibly not very robust to political pressure:

The paper concludes by speculating that even if the Bitcoin standard were to come into existence, it would not last long, for two reasons: (1) The payments world is changing so rapidly that there will be a technological innovation that provides a potential medium of exchange with the same or greater benefits of Bitcoin or with lower costs. Such an innovation could come either from the private sector or from the government. (2) There would be pressure to return to a fiat money system so that a more activist monetary policy could be pursued.

The author touches on the important similarities and differences between Bitcoin and gold from a monetary standard point of view:

The most important similarity between the Bitcoin standard and the gold standard is that no central bank or monetary authority controls the supply, or more importantly, changes in the supply of the anchor of the monetary system.

That the supply of Bitcoin and gold are not controlled by any single issuer is favorable for the depoliticizing of the monetary anchor. Historically, gold had a relatively decentralized supply and cost to mine and geolocation of the ore bodies kept the supply predictable compared to other possible choices. Bitcoin is also very predictable in supply:

Changes in the supply of Bitcoin are set deterministically by the algorithm that governs how many new Bitcoins “miners” receive for verifying Bitcoin transactions and adding them to the blockchain. In the case of gold, changes in the world stock of gold were determined by gold discoveries and the invention of new techniques for extracting gold from gold-bearing ores. There is also a major difference. Increases in the stock of Bitcoin are deterministic and, therefore, predictable. The Bitcoin algorithm determines the rate at which new Bitcoins are created at each point in time until the limit of 21 million Bitcoins is reached in 2140.

But gold is not perfectly predictable as technology changes and new ore body discoveries can create supply shocks:

In contrast, increases in the quantity of the world gold stock over time were not predictable due to the unpredictability of gold discoveries and changes in world gold production. As I will show later, there were large year-to-year fluctuations in the rate of increase of the world gold stock

The author suggests there could be three mediums of exchange. Bitcoin being the first and the second:

…are fiduciary currencies issued by each country’s monetary authority. That is, central banks or government treasuries issue currencies that are not 100 percent backed by Bitcoin, but are redeemable in some specified amount of Bitcoin on demand.

Contrary to what many Bitcoin maximalists or gold bugs might believe, it is an extrapolation from the gold standard which compels the author to consider fiduciary currencies:

Given the usefulness of Bitcoin as a medium of exchange, it is possible that the Bitcoin standard could exist without each country’s monetary authority issuing a fiduciary currency. Nonetheless, I assume that monetary authorities choose to issue fiduciary currencies in order to have the ability to finance fiscal deficits through money creation. Further, I make this assumption to have the media of exchange under the Bitcoin standard be similar to those under the gold standard, because each country issued its own fiduciary currency under the gold standard.

A gold standard does not imply fully backed banknotes:

These central bank currencies are separate currencies that circulate alongside Bitcoin. They are tied to Bitcoin because they are redeemable in Bitcoin on demand. These central bank currencies are fiduciary because the central banks would not be required to fully back their issues with Bitcoin, just as under the gold standard central banks did not fully back their note issues with gold.

The private banking sector is able to function in the same way it traditionally has:

Under the Bitcoin standard, the private banking system continues to exist and engages in maturity transformation in the sense that banks do not hold assets with the same maturities as their liabilities. However, there is the question about whether banks issue callable liabilities; that is, whether banks issue bank notes or take callable deposits. I assume that they do so under the Bitcoin standard, and that, as was the case under the gold standard, these callable liabilities are not fully backed. These callable liabilities of banks are the third media of exchange I assume exist under the Bitcoin standard. Once again, I make this assumption so that the media of exchange under the Bitcoin standard and under the gold standard are similar.

Because of the efficient arbitrage the author puts forth a formulated explanation as to how and why a Bitcoin standard would tie the hands of central banks even more so than a gold standard:

Central banks had greater ability to carry out monetary policy under the gold standard than they would have under the Bitcoin standard.

The arbitrage cost of gold created sticking points in reaching exchange rate equilibriums and thus it is expected there would have been greater freedom on a gold standard than a Bitcoin standard for monetary authorities:

One might think that monetary authorities would not have this ability, because gold arbitrage would work to equate interest rates across countries. Gold would flow to the country where it would earn the highest rate of return and that would limit the differences in interest rates among countries on the gold standard. However, gold arbitrage could not eliminate differences entirely, because gold arbitrage was costly. The presence of costs to gold arbitrage gave monetary authorities some independence in setting interest rates in their country.

This is explained by this simple example between two countries as the cost of exporting the gold for investment purposes must be considered when deciding whether or not to save domestically or invest abroad thus reducing the pay-off of the arbitrage opportunity:

To see how this process worked, consider the case in which the monetary authority in Country A wanted to raise its bank rate, rA, to cool down the economy. An agent in Country B who has one ounce of gold faces the question of whether to invest the gold domestically or export it to Country A.8 If the agent invests domestically, the gold earns rB, the bank rate in Country B. If, instead, the agent exports the gold to Country A, the gold earns rA − k, where k is the per ounce time, shipping and insurance cost of sending gold from Country B to Country A. If rA − k > rB, gold will be shipped to Country A. The influx of gold will increase the reserves of the banking system in Country A and increase the money supply in Country A as banks increase their lending in response to the higher level of reserves. Thus, the monetary authority in Country A cannot set its bank rate too high. Otherwise, the resulting gold inflow will offset what they were attempting to achieve by raising the bank rate.

Nonetheless the arbitrage opportunity puts a limit on how far a central bank can reduce their “savings offer”:

Using analogous reasoning, the monetary authority in Country A faced a constraint on how much it could lower its bank rate to stimulate the economy. Consider an agent in Country A who has one ounce of gold. This agent faces the question of whether to invest the gold domestically or export it to Country B and invest it there. If the agent invests domestically, the gold earns rA. If the agent exports the gold to Country B and invests it there, the gold earns rB −k. Thus, if rA < rB −k, gold will be shipped out of Country A. The outflow of gold will decrease the reserves of the banking system in Country A and decrease the money supply in Country A as banks decrease their lending in response to the lower level of reserves. Thus, the monetary authority in Country A cannot set its bank rate too low. Otherwise, the resulting gold outflow will offset what they were attempting to achieve by lowering the bank rate.

The result of these two observations lead to the formalization of this equilibrium:

Combining these two arguments, the latitude that the monetary authority in Country A had with regard to setting its bank rate was:

And allows the author to conclude:

Thus, the cost of gold arbitrage in effect determined a policy corridor in which a central bank could set its bank rate different from other bank rates.

It it still arguable whether the cost of Bitcoin transactions are low enough and fast enough to suggest the arbitrage cost would be negligible, nonetheless, the author asserts that such a quality would imply that central banks would be forced to the same monetary policies:

Under a Bitcoin standard, however, it will not be possible for a country to conduct an interest rate policy to affect domestic economic conditions. As (1) shows, it was the cost of engaging in gold arbitrage that allowed a country to set a bank rate that differed from those in other countries under the gold standard. Such arbitrage costs do not exist for the Bitcoin standard; that is, k = 0. The costs of arbitrage between the fiduciary currencies of any two central banks are essentially zero. The time cost of obtaining Bitcoin for fiduciary currency or fiduciary currency for Bitcoin would be extremely small, and because the ledger containing transactions history is open and transactions are recorded regardless of location, no shipping or insurance costs are involved. Thus, the spot exchange rates for all fiduciary currencies would be one-to-one, and monetary authorities would be unable to set interest rates different from those in other countries.

Central banks could respond to banks as the lend of last resort provided there is an adopted fiduciary currency they control:

Should financial institutions have to meet withdrawal demands by depositors, they would draw on their reserve account with the monetary authority and obtain the paper or digital form of the central bank’s fiduciary currency. Because these fiduciary currencies are accepted as media of exchange, they would most likely satisfy depositors’ withdrawal demands.

Here is a key point. The ability to to lend as a last resort is limited under a Bitcoin standard (and effectively unlimited under the current orientation):

That central bank fiduciary currencies are redeemable on demand in gold or Bitcoin opens up the possibility of runs on central banks because of concerns about their ability to meet demand. The possibility of such runs means that a central bank can only issue its fiduciary currency up to a point. The ability of a monetary authority to act as lender of last resort under either the gold or Bitcoin standard is limited. This is in contrast with the almost unlimited ability of central banks to act as lenders of last resort under a fiat monetary standard.

Facing such a run on its fiduciary currency, a central bank is limited in what it can do because it cannot act as the lender of last resort to itself.

In approaching the conclusion the author puts forth 3 conjectures-basically that the value trend of all currencies would be deflationary and even more so than the gold standard:

Conjecture 1: In the long run, inflation would not be zero. Instead, there would be moderate deflation that would increase over time until reaching a rate of deflation equal to the negative of the rate of growth of world output around 2026.

Conjecture 2: There would not be periods of deflation followed by periods of inflation as was the case under the gold standard.

Conjecture 3: Price levels of the various countries would be highly, but not perfectly, correlated, much as they were under the gold standard.

It is an important point that on such a standard the money supplies would differ:

My reasoning is that under the Bitcoin standard, just as under the gold standard, the money supplies of different countries would not necessarily move together, although the more tightly a group of countries are linked in terms of trade and finance, the more closely their money supplies would be linked.

The author re-asserts that the implications of a costless arbitrage medium would cause the major currencies to value stabilize in relation to each other and Bitcoin:

A major reason that countries adopted the gold standard was to achieve stability of their exchange rates against those of other countries that also adopted the gold standard. The mechanism through which such stability was to be achieved was gold arbitrage. However, because there were costs associated with gold arbitrage, the exchange rates between the fiduciary currencies of different countries were not fixed but were restricted to a range around their par values known as the “gold points.”20 Because gold arbitrage was less costly the closer countries were in terms of geography and financial integration, the narrower should have been the range of fluctuations in exchange rates of their currencies.

Conjecture: Under the Bitcoin standard, the exchange rates among the fiduciary currencies of various countries would be fixed at par, because the cost of Bitcoin arbitrage is essentially zero.

The author makes the point that there would still be financial crises (or perhaps its an admission they have not found reason there wouldn’t be a financial crises). But it is not really a point against bitcoin since all such monetary standards we have used involved crises:

There would be financial crises under the Bitcoin standard. Financial crises have occurred in all financial systems, whether commodity-backed or fiat, in which financial institutions have demand liabilities that are not matched by assets with the same maturity. The Bitcoin standard would exhibit such maturity mismatches.

The author suggests such a standard would be longer lasting if it came into existence gradually:

In my opinion, whether the Bitcoin standard would last a substantial period of time depends on how the Bitcoin standard came into existence. The first case is that in which the Bitcoin standard would come into being gradually over time, which is the way the gold standard came into being. That is, the Bitcoin standard came into being because the number of merchants accepting Bitcoin gradually increased over time and because using Bitcoin became increasingly more convenient as the time to verify and complete transactions became even shorter to the point where no one used the old media of exchange.

The author conjectures that a Bitcoin standard would not last long as governments would break from the standard (this seems like it has already been defeated by the formulated insight):

My conjecture for this case is that the Bitcoin standard would not last long. There would be a major cyclical downturn or financial crisis that would lead to political pressure and demands for central banks to remove the “Bitcoin fetters” that prevent them from inflating to stimulate the economy or from providing large amounts of assistance to financial institutions in trouble. Central banks or governments would eventually yield to this pressure and break the ties between their currencies and Bitcoin, just as central banks and governments did when they went off the gold standard before and during the Great Depression.

He seems to flip flop on the possibility that Bitcoin would or would not pose significant influence on the value trend of a centrally banked currency:

In other words, the currencies of central banks or governments would become fiat currencies rather than fiduciary currencies.

In this case, I expect that Bitcoin would continue to play a role as a medium of exchange, since it had been the anchor of the monetary system. It would continue to have a role as a means of payment for exactly the same reasons that it has a role as a medium of exchange today. One reason is that it would eliminate the transactions costs of switching between central bank currencies when making transactions in different countries.

There is the observation that in such a scenario Bitcoin becomes a proper savings device:

Also, because there could now be fluctuations in the exchange rates between central bank currencies, Bitcoin would provide a means of hedging against these fluctuations.

It is quite game theoretic to consider the organizing properties of a “good” money:

The allure of reaping these benefits was one of the major reasons European countries gave up their individual currencies and adopted the euro.

The second possibility a Bitcoin standard, most Bitcoiners refer to as “hyperbitcoinization”, is where the centrally banked “fiat” falls completely out of favor. The premise seems to be a counter argument to the previous scenario in which central banks break value trend with bitcoin:

The second case is that in which countries had been on fiat monetary standards similar to the ones in existence today, but for some reason their fiat currencies are no longer valued, have gone out of existence and have been replaced by the Bitcoin standard. Further, there is no possibility of a return to a fiat standard. One of the major reasons that this could occur is that countries have been following bad monetary policies that have led to high rates of inflation.

The below paragraph is agreeable enough. The astute reader will realize the author is relying on works attributable to John Nash’s Equilibrium theory:

My conjecture for this case is that the Bitcoin standard still might not last long. One possibility is that the economy could switch from an equilibrium in which Bitcoin is valued to an equilibrium in which it is not. The possibility of multiple equilibria occurs with any monetary system based on an object, such as Bitcoin, that is intrinsically useless. In any such monetary system, there are two equilibria. In one equilibrium the money is valued; in the other it is not. Whether an intrinsically useless medium of exchange is valued depends upon whether agents expect it will be accepted in transactions in the future. If at any point people expect that Bitcoin will not be accepted in future transactions, it will lose its value at that time.

Another counterargument to the strength of a bitcoin standard. Note however the author admits “…I think the probability that it would happen is virtually zero:

In the case of Bitcoin, the switch to no longer valuing Bitcoin could occur for several reasons. One is fear of an attack on the blockchain by a group of dishonest miners. Such an attack would eliminate the decentralized nature of the blockchain ledger and give control of Bitcoin to a single entity. Such control would allow this entity to determine which transactions are permitted and give it the power to roll back transactions. Eyal and Sirer (2013) argue that, at a minimum, 2/3 of miners and more likely 3/4 of miners, have to be honest in order for such an attack to not be feasible.25 A second reason is extrinsic uncertainty (“sunspots”). Nonetheless, I think the probability that it would happen is virtually zero.

More agreeable game theoretical related observations:

For an intrinsically useless medium of exchange to be valueless, it must happen that no agent expects it to be accepted by any other agent either now or in the future. As long as there is some agent, say a government willing to accept the medium of exchange for taxes, that other agents believe will always accept the medium of exchange, then it will always have value.

The possibility a Bitcoin standard would be replaced, however, I think most knowledgeable computer scientists would admit that Bitcoin’s security will always remain unrivalved for reasons that I won’t unpack here:

A more likely possibility in this case is that the Bitcoin standard would be replaced by a different cryptocurrency-based standard. There are over 700 different cryptocurrencies in existence today. People could decide to switch to one of them that has better properties; for example, stable prices or very moderate inflation. However, as Eyal and Sirer (2013) point out, the possibility for an attack exists for any currency that has a decentralized ledger similar to Bitcoin’s blockchain.

However, as Eyal and Sirer (2013) point out, the possibility for an attack exists for any currency that has a decentralized ledger similar to Bitcoin’s blockchain.

The other possibility I think is also a counter-argument to a government’s ability to move off a Bitcoin standard:

Another possibility is there could be political pressure demanding that central banks or governments offer an intrinsically useful fiduciary currency to compete with Bitcoin. By an intrinsically useful fiduciary currency I mean a currency backed by some commodity or basket of commodities. If central banks or governments could credibly commit to redeem this currency on demand, and if they were willing to give up their own monetary units and adopt a uniform one, then this might be widely accepted as a medium of exchange and might drive out Bitcoin to a great extent. My reason for including the elimination of individual country monetary units is to make clearing simpler and to facilitate the use of the currency across country lines.

The author moves the possibility of a sort of digital-commodity backed Euro which, although a possible counter to Bitcoin, would ultimately be favorable compared to an relatively inflationary counterpart:

In other words, the Bitcoin standard might not be stable because a eurolike commodity-backed money could provide the benefits of the Bitcoin standard without its inherent stability issues.

In conclusion a Bitcoin standard would imply a more predictable price trend and draw productivity from resources that are otherwise held as hedges:

A Bitcoin standard would have two major benefits over current fiat money standards. One is that there would be greater price-level predictability due to the known, deterministic rate at which new Bitcoins are created. A second is that the resources currently devoted to hedging against fluctuations in exchange rates would be freed up to be used in more productive ways.

It is interesting for a central bank paper to suggest there would be increased gain for the output of the global economy but that adoption won’t happen because banks and governments won’t allow it:

Nonetheless, in my opinion it is unlikely that the Bitcoin standard will come into existence, because governments and central banks will take actions to prevent it. They will do so for two reasons. One is to protect the seigniorage revenues that they obtain from the ability to almost costlessly create money. The second is to retain the ability to implement interest policies to affect their domestic economies.

It is the growing observation of many economic philosophers that under such a standard governments and central banks would lose this control:

Governments would lose the ability to do either or both of these under the Bitcoin standard.

The conclusion, that even if a bitcoin standard came to exist it would not last long, runs in complete ignorance to the layer two lightning technology that has already rolled out:

Even if the Bitcoin standard were to come into existence, it is my opinion that it would not last long. The payments world is changing so rapidly that there will be a technological innovation that provides a potential medium of exchange with the same or greater benefits of Bitcoin or with lower costs. Such an innovation could come either from the private sector or from the government.