Bit­coin's fu­ture is tied to en­sur­ing low volatil­ity

The Pak Banker - - OPINION - Noah Smith

TWO big things have hap­pened in the cryp­tocur­rency world re­cently. The first is that there are now two com­pet­ing ver­sions of bit­coin: bit­coin core and bit­coin clas­sic. There is quite a lot of ar­gu­ment about which will be­come more pop­u­lar. The se­cond de­vel­op­ment is that the price of bit­coin - now known as bit­coin core - rose a lot in late 2015. This has raised the ex­pec­ta­tions of many cryp­tocur­rency buffs that bit­coin will re­place the fiat money printed by cen­tral banks.

But when I read th­ese de­bates, I see a lot of mis­un­der­stand­ing. Whether peo­ple are talk­ing about which ver­sion of bit­coin will pre­vail, or whether cryp­tocur­rency in gen­eral will re­place fiat cur­rency, they keep mak­ing the same er­ror. That er­ror is the as­sump­tion that long-term value is what makes a cur­rency good. The truth is it's al­most the op­po­site. Most peo­ple I meet - in­clud­ing tech peo­ple, many of whom are big bit­coin fans - haven't had much con­tact with mon­e­tary eco­nom­ics. Many of them tend to as­sume that in or­der for a cur­rency to be valu­able, it has to be backed by some valu­able com­mod­ity - gold, for ex­am­ple. With­out back­ing, the folk the­ory goes, money is in­trin­si­cally worth­less - just pieces of pa­per.

In this view, money is com­pa­ra­ble to a stock cer­tifi­cate - a place holder that marks own­er­ship of some­thing in­trin­si­cally valu­able. It im­plic­itly equates the word "money" with value. But un­like gold or stocks or hous­ing or other real as­sets, money's pri­mary value de­pends not on in­trin­sic value but on some­thing else - liq­uid­ity. "Liq­uid­ity" is a loose term. In gen­eral, it means your abil­ity to quickly and eas­ily trade some­thing for other things. Houses are not very liq­uid, since it can take months to sell one. Stocks are more liq­uid. But money should be the most liq­uid thing of all; you should be able to use it to pay for any­thing, at any time. If you can't, you should switch to a new, more liq­uid form of money, and stick your old, less liq­uid money in a vault some­where.

This means that money with no real as­set back­ing it can be per­fectly good. All you need is for other peo­ple to ac­cept it for close to the same value that you got it for. As long as peo­ple can be counted on to take your money, the money is good. No gold re­quired. In the Great De­pres­sion, al­ter­na­tive the­o­ries of money were put to the test. Be­fore that episode, the US and Euro­pean economies ad­hered to a gold stan­dard - na­tional cur­ren­cies could be ex­changed for gold. As growth col­lapsed, some coun­tries ex­per­i­mented with go­ing off the gold stan­dard, hop­ing that this might end the de­fla­tion that was thought to be hurt­ing growth.

None of the coun­tries that aban­doned the gold stan­dard suf­fered hyper­in­fla­tion, nor did their cur­ren­cies col­lapse. In­stead, as Ben Ber­nanke and Harold James noted in a 1990 pa­per, the coun­tries that aban­doned the gold stan­dard soon be­gan to re­cover. Scep­tics will note that al­though liq­uid­ity is the pri­mary source of money's value, it isn't the only source. You also need money to hold its value over short pe­ri­ods of time.

There's a lag be­tween when you

get money and when you spend it. You'd like the value of what you ex­changed for the money to be very close to the value of the things you spend the money on a lit­tle while later.

So if you want money to be a good short­term store of value, you need it to have low volatil­ity. That's the main rea­son high in­fla­tion is bad, ac­tu­ally. It also tends to be very volatile, mak­ing money's value more un­cer­tain in the short term, which gets in the way of money do­ing its job. That's why cen­tral banks try very hard to main­tain their in­fla­tion-fight­ing cred­i­bil­ity. If peo­ple be­lieve that the cen­tral bank might de­cide to de­value the cur­rency at any time, then they will have an in­cen­tive to aban­don the cur­rency for al­ter­na­tive forms of pay­ment, like bit­coin, gold or a for­eign cur­rency.

Fears of cen­tral bank ir­re­spon­si­bil­ity could thus be­come self-ful­fill­ing prophe­cies.

The cur­ren­cies of rich coun­tries such as the US and Ja­pan are re­mark­ably sta­ble in value. Both in­fla­tion and the volatil­ity of in­fla­tion have rarely changed dra­mat­i­cally month to month, es­pe­cially af­ter the mid1990s. Peo­ple ex­pect this state of affairs to con­tinue - they think the dol­lar isn't risky in the short term. And that is why the US dol­lar re­mains a good form of money. Now, in the fi­nan­cial world, we ex­pect low risk to come at a price: poor long-term re­turns. And in fact, the value of the US dol­lar de­creases over time, at a very slow con­sis­tent rate.

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