Sunday, January 1, 2012

Hyperinflation in Bitcoinland

There are Gold Bugs and there are Bitcoin Bugs. They all oppose fiat money (hate the Fed and other monetary authorities) and follow some sort of free banking view loosely based on Austrian views. The supply of bitcoins is strictly exogenous controlled by a complex system that cannot be trampled by greedy central bankers and politicians. Wired said in an article last year that:
"Bitcoin required no faith in the politicians or financiers who had wrecked the economy—just in Nakamoto’s elegant algorithms. Not only did bitcoin’s public ledger seem to protect against fraud, but the predetermined release of the digital currency kept the bitcoin money supply growing at a predictable rate, immune to printing-press-happy central bankers and Weimar Republic-style hyperinflation."
A very monetarist view of inflation, as you can see. The problem is that central banks print too much money, and by the way, in the US hyperinflation is around the corner.

The funny thing is that they had hyperinflation in Bitcoinland (a land of people that use this stuff) last year and they didn't understand it. The graph below shows the exchange rate between bitcoins and dollars from inception to the end of last year more or less. As it can be seen (not very well I'm afraid), prices fell from almost US$30 per bitcoin to around US$3 in two months.
Now think about it. If you bought a "I'm Satoshi Nakamoto" T-shirt (the guy that invented bitcoins, and yes they do sell them) say for US$ 30 in mid-June last year it would cost you approximately B$ 1 (B$ is not a bad symbol for them!). By late October, when the exchange rate depreciated brutally, you would have to pay for the same US$ 30 T-shirt around B$ 10. 10 times more. 1000% inflation in two months looks like hyper to me, even though the supply of bitcoins did not increase nearly as much, since it is controlled by a complex computational algorithm.

This should teach these people that hyperinflation is more complicated than just central banks printing money (see this paper). Still Ron Paul may have some support in Iowa, because of popular misperception about the role of money supply and the causes of inflation. Happy New Year!

PS: In my view Nakamoto is the intelligent version of Madoff. He got away with the dollars and dumped the bitcoins.


  1. Apparently Krugman blogged about this last year too. Here is the link

  2. Matias,

    Wasn't free banking tried; wasn't it a disaster?

  3. just on your last note: most or all early created bitcoins are still to be spent. just look them up! so, how do you come to this conclusion?

  4. Just got the last note, phatsphere. Note that it doesn't matter for inflation whether you spend or not the bitcoins. Inflation can be cost push not demand pull. That is prices may go up because the price of say oil goes up, even if people do not have or spend more money (read the paper in the linked in the post). In the case of Bitcoinland, that does not produce anything and imports everything, so to speak, since it is not a real country, the cost that matters is that of imported things in dollars. Hence, the relevant cost that went up is the exchange rate (by the way the same was true in all hyperinflations including Weimar's). It's not a conclusion of mine, it is a fact that you had hyper in Bitcoinland. Prices did went from B$1 to BS10 (as in the example).

  5. CMD my reading is that it is the case indeed. Sheila Dow, who has worked a bit on the issue, concludes in one of her papers that "the Scottish experience suggests that free competition in banking leads to concentration and to leading banks taking on central banking functions." The link here The main point against free banking, and bitcoin experiments, is that it leads to excessive volatility. In fact, the bitcoin has experienced a hyper-delfation followed by the hyper-inflation. Mind you, that's why Nakamoto (who ever he is) created it. He created them, and probably bought bitcoins as low as US$0.30 cents, and then sold them at the peak at almost 30, and then vanished. Not a Geek, the word for that is another, but I can't post it.

  6. This "Bitcoin Bug" (I'm the lead core Bitcoin developer) believes that a completely predictable supply of new bitcoins should eventually lead to a stable price level.

    I say eventually because the demand for bitcoins fluctuates wildly as people change their minds from "Bitcoin is going to Change the World!" to "Bitcoin will never be anything other than a novelty for geeks."

    Maybe I'm wrong-- maybe we do need wise central bankers with firm and steady hands on the monetary tiller to react to exogenous shocks and tweak the money supply to keep prices stable. That's essentially the Keynes/Hayek debate. One could create a system based on Bitcoin's technology with a central committee of some sort setting the monetary policy instead of having a fixed-in-advance schedule for the supply.

    That might trigger another interesting debate: can a completely transparent system like Bitcoin (where everybody knows exactly what the money supply is at any given moment) maintain a stable price level, or is some level of secrecy needed so central bankers can work their magic and not be foiled by a short-term-thinking/possibly-irrational market?

  7. Hi Gavin. Thanks for your comment. The fact, is that so far (and historical experience) suggest that these arrangements tend to be unstable. The reason is that you need a secure asset free of default risk in order to manage a currency. Nope no need for wise central bankers. Just a Treasury that can print the token on demand. For example, the bitcoin price collapsed after people were afraid of being swindled. If the Treasury guaranteed bitcoins at par value nobody would run for dollars (the secure asset in this case). Money has a fiscal basis. On chartal money I highly recommed you read the following paper by Charles Goodhart here

  8. The assumption that Nakamoto pulled off a pyramid scheme is not supported by empirical data (which, being public, can be verified by anyone). If anything, the data shows the opposite of a pyramid scheme: it's the late addopters, rather than early ones, that use Bitcoin for one purpose or another (including trading it for fiat). Nakamoto's Bitcoins are largely where they have been from the beginning, persumably on his or her computer. He's hoarding them or maybe even lost them.
    There are many hypothesis why the price of Bitcoin collapsed. My opinion is that there was a bubble created by the media and it would have collapsed sooner or later anyway. Since it hit the low of slightly below 2USD/BTC mid-November, it's been climbing again and it's over 5USD/BTC now. The Keynesian concepts of inflation/deflation are irrelevant with respect to Bitcoin, because they assume the absence of currency competition (also as an Austrian I think they are wrong anyway).
    Since the size of Bitcoin economy is small, the price will probably wildly fluctuate for the foreseeable future.
    Bitcoin works because it decreases transction costs compared to the alternatives (fiat or gold). This is a necessary condition for it to replace other money. The other necessary condition is that this decrease othweighs the network effect of the alternatives. The latter one is more difficult to estimate and is probably too complex to predict accurately.
    This and many other things I analyse in my upcomping paper "Economics of Bitcoin". I have been researching Bitcoin for about 7 months, emailed with many professional economists, read many books and research papers, analysed the available data and even conducted a survey of economic preferences/behaviour of Bitcoin users. I have also spoken to many people from the Bitcoin community.

  9. As a corollary, it is interesting to note that there never really was a Keynes/Hayek debate. Hayek got made a fool of. In Hayek's system (and from what I can tell, Austrian models in general), any action, whether it was private saving or "forced saving" i.e. a central bank setting interest rates, would cause accelerating inflation. I don't have a link, but I'm sure Matias has a link to Sraffa's responses to Hayek...they are awesome.

  10. Peter,

    Whether or not the media "created" a bubble is irrelevant, just as is the use of "Keynesian inflation/deflation". I don't think Matias used the CPI-U to analyze this; it's a simple matter of arithmetic.

    Moreover, bitcoin is a fiat currency. It isn't backed by anything; not gold or wheat or cattle or even a company's earnings. Further, a currency's success is based off of its safety, or better said, it's monopolistic status.

    Imagine if each state had it's own currency, the transaction costs would be enormous trying to do business across state lines (due to varying exchange rates). Austrians would love this type of competition, but if the "market forces" were allowed to work like this, there would be massive fluctuations in value (because each currency is "small"), to such an extent where one currency or a few would have to become dominant to allow for investment plans to be made beyond short periods. I think we could even go further and make the claim that competitive currencies would end up being similar to the stock market,serving no other purpose than to game prices. (Kind of what you imply about what happened at bitcoin)

    Then again, in my opinion, investment takes place not because of factor price adjustments etc, but because of the demand for products; but that's a different post.

  11. Yep, Sraffa's reply to Hayek is great. But better than that is that in the counter reply by Hayek, when he says that Sraffa did not understand Keynes' Treatise on Money, Keynes being the editor of the Economic Journal adds a footnote saying that to the best of his knowledge Sraffa did understand it correctly.

    Interesting Peter if he didn't sell them. How do you know that? By the way, your point that inflation/delfation makes no sense is not accurate. You do have changes in prices in any currency even in bitcoins. The money maybe virtual but reality still counts. So if you want to use bitcoins to buy a pizza (as in the supposed first transaction with bitcoins) the exchange rate matters. And that's why bitcoins will be fringe like the Ithaca Hours and other pseudo currencies.

  12. By the way CMD is right. Even if prices in dollars (CPI was fixed) the T-Shirt costs US$30 both times (no inlflation) the depreciation inplies that in B$ you did have (a fact that is by definition correct) 1000%. Things you bought with B$ (or tried to buy) were that much more expensive in B$ with the same price in US$.

  13. Can you explain to a non-economist what you mean by "you need a secure asset free of default risk" ?

    Secure in what sense? Bitcoins are quite secure in the computer science/mathematical sense; you can think of them as digital tokens that are scarce and cannot be counterfeited (but can be stolen). My primary focus for the last few months has been technical work to enable solutions that will make bitcoin "wallets" more secure against theft for ordinary people.

    And default by who? Since there is no central issuer, the only default risk for bitcoins I can see is the risk that everybody will suddenly decide that they don't want to accept them for trade (which IS a risk at this early stage; there is a reason the homepage says that bitcoin is an experiment). Am I misunderstanding what you mean by "default risk" ?

  14. By that vary same logic Bank of America stock was a ponzi as it went from $40 in Aug 2008 to $1 in Nov 2008.

    Although you would be more accurate at calling BOA a ponzi it's still not a scam because there is no hidden information that would cause people to not invest. (LOL, can't believe I said that about a bank that told investors one thing and said another to the fed in Dec 2008)

    But that is the perception, the bank is honest.

    With bitcoins everything is open for view, the source code, it's algorithm, and who has what. It's value is 100% up to the public and the public is fickle and chases what's hot and dumps what's not.

    I have a gold and silver channel on Youtube and when I mentioned bitcoins I was ostracized and the typical comment was "SCAM!". Thus ignorance of the power of bitcoins exist on both hard and soft money supporters.

  15. Hi Gavin. I mean if you buy a Treasury Bond that is worth x dollars, since the government has the monopoly power to print dollars, there is no risk of you not getting the dollars. So Treasury Bonds are risk free. The government cannot default on an asset that it prints. That's why in the middle of the Lehman Brothers collapse people (and not just in the US, but around the world) bought US Treasury Bonds. If you cannot print and default is possible, like Greece that owes euro denominated bonds and it cannot print euros you have default risk. The consequences of printing it are not as you may think inflation. It may be only under certain conditions. If the economy is at full employment and people actually spend the extra money. For more on the issue read this older post here

  16. Hi Davincij15, nope it's not the same as BOFA, since that is just stock and bitcoins are currency. You cannot buy a pizza with BOFA, so the fluctuation in the price of its stock does not affect prices. However if the value of bitcoins in dollars changes, the price of goods in bitcoins do change. Mind you I find the use of the term Ponzi with respect to bitcoins incorrect. It does have a function, like Cornell Hours, but it cannot fulfill all the functions of a currency, because of the absence an institution that provides a risk free asset (see my response to Gavin above).

  17. Matias, don't experiments like bitcoin fail because they are implicitly pegged to a government currency? For legitimacy at all, bitcoins need to convert into dollars, otherwise they are no different than pieces of monopoly money.

    It seems like bitcoins are kind of like what some emerging countries do when they peg to the dollar.

  18. Bitcoin is not a fiat currency. Only states' coercion can create fiat currency. Bitcoin is a commodity currency. Its value is derived from the decrease of transaction costs, i.e. it's backed by a service rather than a good, in a similar way than, say, email. Email has typically lower transaction costs than paper letters, so the former gradually displaces the latter from the market. This distinguishes Bitcoin from other systems, such as a new fiat currency. Because the Bitcoin units are defined without referring to other currencies, it makes no sense to compare Bitcoin to credit systems like Ithaca Hours or LETS (which are exchanged against fiat at predetermined rates).

    Unlike the dominant forms used nowadays (bank deposits, via debit cards / cheques / EFT), Bitcoin is not based on debt, so the arguments about default make no sense. In fact, apart from physical specie such as gold, all the money in existence is based on debt. If anything, that makes Bitcoin more resistant to defaults than the alternatives.

    Bitcoin is not pegged to any other currency. That's nonsense. Their price fluctuates freely, and unlike with fiat, there is noone that has a privileged position for controlling the exchange rate by changing the production rate or performing open market operations.

    Austrians define inflation/deflation as a change in the money supply, not via CPI. The inflation rate of Bitcoin is predefined and degressive, only subject to statistically insignificant fluctuations. If I remember right, last time I calculated it, the actual rate of Bitcoin production was only about 1% off (i.e. about 1% more Bitcoins have been produced within 3 years than the theoretical prediction).

    The "argument" about competing national currencies makes no sense. That's what we have now, and that's what most Austrians view as anachronistic. Money is subject to the network effect, and absent government coercion, there would probably only be a small number of dominant ones. It does not necessarily need to be one as goldbugs argue, since there are fundamental differences between, say, Bitcoin and gold. Gold, and most fiat currencies, cannot be put into other forms that have lower transaction costs than the physical specie without issuing debt instruments. This brings about the evolution of a media of exchange based on debt. Bitcoin can exist in any form, so there's no need for banking to manage other forms of money and is reduced to lending and borrowing (and forex).

    (continue in next post as the blog system thinks it's too long)

  19. (continuation)

    Bitcoin, while being a great medium of exchange, is nowadays typically not used as a unit of account. Merchants typically internally use dollars (or euros etc), and quote the Bitcoin price based on the current exchange rate. The modules for online shops do this automatically, and the service providers offer an immediate sale of Bitcoins against fiat, which mitigates the risk following from the fluctuating price. So again, the argument about inflation and prices makes no sense. On a free market, the function of a unit of account comes chronologically after medium of exchange. There is no necessity that Bitcoin ever evolves into a unit of account. It's designed in a way it can (because it's fungible and has a predetermined supply), but it's just a possible consequence of its growth.

    Government fiat is not risk-free. When the state defaults, the fiat becomes useless. I'm not even talking about debt-based money, which just evaporates if there is trouble. A Bitcoin will always be a Bitcoin, and will continue to exist as long as it provides lower transaction costs than the alternatives.

    Bitcoin breaks implicit assumptions of (most) economists. Challenge your assumptions. There are papers by non-Austrians that analyse how a virtual currency can come to being, how it affects the economy or central bank policy, and how currencies and payment systems compete.

  20. Just one 99-year-old anecdote to demonstrate how ignorant can people be of possibilities:

    “Lee DeForest has said in many newspapers and over his signature that it would be possible to transmit the human voice across the Atlantic before many years. Based on these absurd and deliberately misleading statements, the misguided public … has been persuaded to purchase stock in his company …” — a U.S. District Attorney, prosecuting American inventor Lee DeForest for selling stock fraudulently through the mail for his Radio Telephone Company in 1913.

  21. Hi Peter. Bitcoin is not pegged but it does have an exchange rate to the dollar, and the depreciation means that you had hyper in bitcoins. Again, you still have to buy things that have a price tag in dollars. Anything you bought in June 2010 was a 1000% more expensive in bitcoins (not dollars). That's a fact. Not a theoretical proposition.

  22. Yes CMD, that's why some developing countries end up having hypers. THey need to import stuff they don't produce, flight to safety leads to depreciations, and domestic prices go up. They at least do have a domestic currency guaranteed by the state, what they don't have is the international reserve currency.

  23. Matias, your argument still only makes sense for people who use Bitcoin as a unit of account. I personally do not know anyone who does that, and the survey I did did not reveal this to be very likely (I did not ask this question specifically, but over 90% of respondents do not fulfil the criteria for this).

    If you only want to use Bitcoin as a medium of exchange, you do not need to hold it longer than the minimum amount of time to do the transaction, which from practical point of view is a couple of hours at most. If you hedge (e.g. with Bitcoinica), you can eliminate the exchange risk entirely. So, you do not need to use it as a store of value if you don't want either. Many people do, or at least they speculate. But these two user categories (speculators and payment users) are not identical.

    Absent the usage as a unit of account (and a store of value), your argument makes as much sense as saying that the fluctuation of the stock price of Western Union or Paypal affect the users of their services. It doesn't.

  24. Just to clarify, I'm not saying the price didn't fall between July and November 2011. That would be obviously idiotic. I'm just objecting to calling this "inflation", since noone is using Bitcoin as a unit of account. So even if the price changed, it does not have the macroeconomic effects that economists associated with CPI increases, regardless whether their theories are right or wrong.

    Until the scope of the Bitcoin economy grows, I expect the price to fluctuate similarly to how it has been so far. Potential users that are bothered by this can avoid holding Bitcoins for longer periods. The speculators will be happy to trade with them.

  25. Peter, why would you convert dollars into bitcoins, then hedge, then buy a product? Why not just buy the product in dollars(saving time and transaction costs)...This is economically stupid.

    The only way for it to become viable is if large numbers of people hold it as a unit of account,it's a glorified futures contract, not a currency.

  26. CMD, you neglect the transaction costs. Bitcoin payments have low/no fees, and since they are based on open standards and decentralised foundation, there are also very low barriers to entry for service providers and no national restrictions. The service providers, apart from forex operators, are even optional. So compared to, say, the encumbent banking system, you have fewer middlemen and more competition.

    Of course, once you're content to use Bitcoins as a store of value, you can get rid of the forex completely and reduce your costs even more.

    The introductory video on is very helpful.

  27. Hi Peter. The point you keep avoiding is that the whole purpose of bitcoin is to have a currency that is free from political meddling because that would cause inflation. The rule for the growth of bitcoin supply is eerily similar to Milton Friedman's 1960s rule of constant growth of money supply. And yet you had 1000% inflation in 2 months.

  28. Please retract your statement about Satoshi spending his coins, implying that Bitcoin is a ponzi scheme. It is simply not true. It makes you look foolish.

    You can verify this publicly, by reviewing all of the Bitcoins generated up to block 30,000 or so ( The vast majority have not been spent.

    Yes, there was a speculative bubble, due to media exposure, rapid growth and the fact that many (new entrants) did not understand that hyperinflation is built into the algorithm, at least for now.

    Many of us actually anticipated this, and it has not been as much of an issue as you imply. Bitcoin is still up something like 1500% year-over-year.

  29. Hi Benjamin. Retract? Do I detect a certain authoritarian vein? Here is the thing, unless you have some way of knowing for sure that Satoshi did not buy bitcoins when prices were low and sold high (which I asked Peter, but despite his long comments he didn't reply) he may very well have swindled bitcoin holders. He vanished according to Wired, by the way, on the end of April 2010 when prices soared. Also, read the thread. I said above: "Mind you I find the use of the term Ponzi with respect to bitcoins incorrect." The fact, is that a Ponzi is an unsustainable pyramid. Bitcoins are not that. Satoshi might have cornered the market (buy cheap and drive prices up before you dump them). Finally, bitcoins, according to you guys are an alternative to currencies, and better because they would be independent of the problems associated with currencies that are affected by political decisions (like the Fed printing money to bail out Wall Street). The anger about the bailouts might be right, but your economics is way off. The evidence suggests that inflation above 40% a year leads to a collapse of output (classic paper by Bruno and Easterly 1998). So if Bitcoinland was an actual country its economy would have collapsed.

  30. Well obviously we shouldn't expect journalistic integrity on a blog. But it seems you are some kind of economics professor. "Authoritarian" or not, I have a feeling you would have been better off simply taking my advice and retracting what was obviously a false assertion.

    Buying low and selling high is now "swindling"? "Cornering the market" for something he invented? Surely even your students can see the error in these assertions.

    You are obviously grasping, and don't seem to understand even the most basic aspects of Bitcoin. Satoshi mined the first 1.5 million coins himself before even releasing the software. He would have zero need to buy Bitcoins from anyone. And we know these coins haven't been spent because this is recorded in the blockchain.

    Regardless, in your contrived scenario, from whom do you think he might have "bought" Bitcoins in order to "swindle" them?

    Furthermore, yearly Bitcoin inflation is less than 40%. In "Bitcoinland" this is a fairly simple calculation. And empirical evidence shows that the real Bitcoin economy has not collapsed, but continued to grow throughout the bubble and correction.

    If anything, all this proves is that Bitcoin is still a relatively small economy and subject to price fluctuation when faced with a massive influx of new participants. Comparing it to a country at this stage is ridiculously premature. The real Bitcoin economy would probably not even be capable of supporting a single person. The fact that it survived 1000% inflation over two months, and continues to grow in the face of 20%+ yearly inflation, is a testament to it's resiliency as compared to fiat currencies manipulated by increasingly irrelevant academic economists.

  31. There is no lack of integrity, and what you suggested is foolishness before, besides demanding a retraction. Yes, if you create something to profit out of the naivite of people like you, it is a swindle. Turns out you do not know whether he bought them cheap and sold them at the peak before vanishing. Of course he didn't need to buy them, duh. You don;t understand that he could have created it, and then when a market existed (and it did) he could buy it as low as 30 cents and sell it as high as 30 bucks. If you were able to understand the post you would see that it is about how it bitcoins are an impractical means of payments, with a terrible track as a reserve. On the PD I suggested that I thought that Satoshi was just in it for the money. Nothing wrong with that opinion, which by the way is also reported in the Wired article. You have to learn a bit (intentional pun) of economics. Maybe you're angry because you lost money with bitcoins.


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