A Non-Libertarian View of Bitcoin

In his work The Theory of Free Banking George Selgin describes how a banking system would evolve in a hypothetical land Ruritania. The inquiry is based on an assumption of an “unregulated society” such that there doesn’t initially exist a monopoly on the issuance of the money supply:

Another approach, which also helps in interpreting historical evidence, is to base assumptions on a logical (but also conjectural) story of the evolution of a “typical” free banking system, as it might occur in an imaginary, unregulated society called Ruritania.

At first glance the story of Ruritania and the banking system that unfolds from the natural order seemingly cannot be applied to our modern day economics as each nation (here the Euro can be viewed as a nation) has a central bank that would preclude the natural order described by Selgin.

However, it may be a matter of limited perspective only that gives the appearance that Selgin’s observations don’t apply to the real world global economy and it may be that the introduction of bitcoin, especially as the system reaches a certain level of maturity, will set the stage for the natural order Selgin describes.

Selgin expounds on four stages Ruritania would go through before reaching a special equilibrium. Regarding bitcoin’s role in fostering such grounds we are especially concerned with the fourth stage:

Our story involves four stages: First, the warehousing or bailment of idle commodity money; second, the transition of money custodians from bailees to investors of deposited funds (and the corresponding change in the function of banks from bailment to intermediation); third, the development of assignable and negotiable instruments of credit (inside money); and fourth, the development of arrangements for the routine exchange (clearing) of inside monies of rival banks.

With regard to the efficiency and value of clearing institutions Selgin explains:

Suppose Ruritania has three banks, A, B, and C. A has $20,000 of B’s notes, B has $20,000 of C’s notes, and C has $10,000 of A’s notes. 24 If they settle their obligations bilaterally, they need to have $20,000 to $40,000 of commodity-money reserves on hand among them, depending on the chronological sequence of their exchange. On the other hand, if they settle their balances multilaterally, they need only $10,000 of reserves among them: A’s net balance to B and C combined is +$10,000; B’s net balance to A and C combined is $0; and C’s net balance to A and B combined is -$10,000. Hence all three balances can be settled by a transfer of $10,000 from C to A. Apart from reducing reserve needs, multilateral clearing also allows savings in operating costs by allowing all debts to be settled in one place rather than in numerous, scattered places.

Thinking of bitcoin’s functionality, and its possible effects on the economy, on a global scale it is this role of high value clearing that bitcoin could be utilized for. This kind of role is not widely discussed or written about seemingly because many early bitcoin adopters attempted to explain bitcoin from a libertarian or anti-state view. Many central banks have also put out papers about bitcoin, mostly from a national view, however, we can find some that consider a more global consideration of the impact bitcoin might have on the future of our global financial system. One such paper written for the Bank of Canada A Bitcoin Standard: Lessons from the Gold Standard by Warren E. Weber explores the premise:

…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.

It is important to note that the “bitcoin standard” as described by Weber does not entail a type of money system where the government issued legal tender is fully backed by bitcoin (as some austrian economics minded thinkers and/or proponents of a return to a “true” gold standard would call for):

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.

In the scenario explored by Weber bitcoin effectively arises to play the high value clearing role that is achieved with commodity-money as described in the fourth stage of Ruritania. Bitcoin itself by legacy definition is not perfectly definable as a commodity money as it is difficult to argue it has any use-case that is not related to its function as a medium of exchange. However Selgin’s use of the term commodity-money in regard to Ruritania has a different nuance which, in conjunction with Selgin’s concept of Synthetic Commodity Money allows bitcoin to serve as the base money for a Ruritanian system:

I call this sort of money “synthetic” commodity money because it shares features with both commodity money and fiat money, as these are usually defined, without fitting the conventional definition of either; examples of such money are Bitcoin

I argue that the attributes of synthetic commodity money are such as might supply the basis for a monetary regime that does not require oversight by any monetary authority

Putting these points together, from an international or global orientated viewpoint, it seems that if bitcoin grows to a point of maturity where large value settlement moves from legacy banking institutions to bitcoin, the natural order as described by Selgin would come to fruition.

At first glance, especially to Austrian and Anti-state minded individuals, this may seem impossible since each nation (as well as the Euro as if a nation) already has a monopoly issuer of the money supply.

But globally viewed who can be said to be the sole monopoly issuer of the base currency that is “….capable of willfully manipulating the money supply…”?

The best that could be stated is that there are multiple monopoly issuers but of course this would imply there is no actual monopoly. It is on this observation that it seems Selgin’s order is indeed a significant consideration.

For such a world to come about and reach the great equilibrium of a ‘demand-elastic money supply’ as described by Selgin bitcoin’s market cap would have to reach a level of maturity where the largest value transactions could be settled without moving the exchange prices of bitcoin significantly. The cost and time to send bitcoin can make small value transactions infeasable for individuals and merchants, however, when thinking about settlement of millions, billions, or trillions of dollars worth of value the cost and time involved show bitcoin to be extremely efficient when compared the costs involved in maintaining an actual clearing institution such as the Bank of International Settlements.

For this bitcoin as a system can be thought of as a super clearing institution as described by Selgin which can fulfill the final settlement payment in Selgin’s previous settlement problem example:

Hence all three balances can be settled by a transfer of $10,000 from C to A.

Bitcoin would not perfectly remove the roles of all world settlement institutions but there is obvious and great value to be gained from this efficiency. The value of moving the settlement among nations to such a system can been further understood by Nick Szabo’s formalization of Adam Smith’s observations from his essay Transportation, divergence, and the industrial revolution:

Metcalfe’s Law states that a value of a network is proportional to the square of the number of its nodes. In an area where good soils, mines, and forests are randomly distributed, the number of nodes valuable to an industrial economy is proportional to the area encompassed. The number of such nodes that can be economically accessed is an inverse square of the cost per mile of transportation. Combine this with Metcalfe’s Law and we reach a dramatic but solid mathematical conclusion: the potential value of a land transportation network is the inverse fourth power of the cost of that transportation. A reduction in transportation costs in a trade network by a factor of two increases the potential value of that network by a factor of sixteen. While a power of exactly 4.0 will usually be too high, due to redundancies, this does show how the cost of transportation can have a radical nonlinear impact on the value of the trade networks it enables. This formalizes Adam Smith’s observations: the division of labor (and thus value of an economy) increases with the extent of the market, and the extent of the market is heavily influenced by transportation costs (as he extensively discussed in his Wealth of Nations).

The effects of cost savings in transfer through an economic network have a very significant impact on the efficiency or value of the network since they affect every transportation event. What is interesting is this suggests that early bitcoin speculators, whether they understood this or not, may have a reasonable argument for why bitcoin isn’t a ponzi in which each new investor needs a future victim in order to cash out. On a high value settlement scale at some point bitcoin’s market cap will be such that the fees to settle with it will provide a settlement system with obvious cost benefits over the existing legacy systems. Even with today’s market cap bitcoin likely serves cost competitive settlement for million dollar transactions (perhaps even smaller value transactions). For every transaction bitcoin can serve that the legacy system cannot or every transaction bitcoin can serve for cheaper than the legacy system there is good reason for bitcoin to have value. It would make sense then, in conjunction with speculators rightfully waiting for a good payoff, that bitcoin’s market valuation would continue to increase until the highest value transactors begin settling with it.

This addresses the apparent scability issue bitcoin is seen to have by many. Bitcoin can only process a finite amount of transactions per second on chain which is very disappointing to many enthusiasts who expect bitcoin to be a global money for the citizenry (usually also thought of by the same people as an anti-state or state-less option). To cope with this limitation a fee market is used such that those that pay the highest fee for their transactions to be accepted into a block have the highest chance of getting their transaction cleared.

Although many proponents of bitcoin, especially from the anti-state and even Austrian orientation, would be horrified the idea that bitcoin would be too expensive for the ordinary citizen, such a scenario where bitcoin is basically only held and utilized by large value settlers is part of the natural outcome of Ruritanian order:

In a mature free banking system, commodity money does not circulate, its place being taken entirely by inside money.

This means that not being able to serve every day citizens coffee value transactions does not preclude bitcoin from serving the important commodity-money role as described by Selgin-thus allowing for the conditions that foster a special equilibrium:

… the conditions for long-run equilibrium of a free banking industry can be stated. As the public holds only inside money, with commodity money used only in bank reserves to settle clearing balances, these conditions are as follow:

First, the demand for reserves and the available stock of commodity money must be equal. Second, the real supply of inside money must be equal to the real demand for it. Once the first (reserve-equilibrium) condition is met, the tendency is for any disequilibrium in the money supply to be corrected by adjustments in the nominal supply of inside money. An excess supply increases, and an excess demand reduces, the liquidity requirements (reserve demand) of the system. This is shown in chapters 5 and 6 below. On the other hand, if the reserve-equilibrium condition is not satisfied, the system is still immature. An excess supply of reserves then causes an expansion of the supply of inside money. If this leads to an excess supply of inside money, it will promote an increase in both reserve demand and prices, causing both the nominal demand for money and the demand for reserves to rise. There must be one price level at which both equilibrium conditions are met. When this price level is achieved, the system is in a long-run equilibrium.

The equilibrium when achieved implies an important relationship between the competing private banks of Ruritania:

This result has other important implications. It means that a solitary bank in a free banking system cannot pursue an independent loan-pricing policy. A “cheap-money” policy in particular would only cause it to lose reserves to rival banks.

This result coincides with Weber’s view on the implications of bitcoin being used as the preferred settlement medium among nations, as if nations themselves (or rather their central banks) interact on the global markets in a private Ruritanian setting (ie absent a central authority which can alter the base global money supply). As Weber observes the effects of a significantly reduced cost of transaction comparing a gold standard to a bitcoin standard he concludes:

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.

For this view, like in the description of Ruritania, we can ignore the role of citizens and their relationship with merchants and both group’s interactions with their domestic banks and focus on the relationship of existing central banks and the currencies they issue with respect to other central banks and their currencies. It is for all intents and purposes that national economies function like private Ruritanian banks in a way that serves to lay the grounds for the equilibrium Ruritania describes. Today, there is no world empire that decides the supply of the base money for our global financial system. Each nation chooses its own monetary policy which is exactly what a bank is necessarily afforded in order to have a free banking quality. Each (central) bank chooses whether or not to accept or hold the notes of each other central bank.

Bitcoin then can be seen as the extrapolation of what is a necessary implementation of that which would set the stage to the natural asymptotic convergence of all centrally banked money to perfectly demand elastic supplies but without cooperation or political coordination of any single central bank or nation.