The Economics Of Bitcoin – Challenging Mises’ Regression Theorem

There has been a lot of outcry from the libertarian gold bug community over the Bitcoin monetary system, with some commentators even going so far as to produce feature length videos decrying the monetary system.  David Kramer writes on Lew

What was Bitcoin’s prior material use/value? Zero. It is just bits in a computer. And what’s with the “fixed” amount of Bitcoins? Who/what determined the “proper” amount of 21 million for Bitcoins to top out at? A computer program? (Next we’ll find out what the proper minimum wage should be.) Only the free market can voluntarily determine how much of a real medium of exchange is needed in the marketplace over time. While the idea of  attempting to get rid of the Bankster monopoly on creating money out of thin air is commendable, Bitcoin is also money created out of thin air. Bitcoin is just substituting one bogus medium of exchange for another.

UPDATE: I’ve been getting a lot of reader response trying to “explain” to me the economic virtues of Bitcoin. Some responders have even mistakenly used Austrian economics to rationalize their views. I would suggest that before you write to me about the Austrian economics view of a medium of exchange, you should read the two books by one of the two giants of Austrian economics, Murray Rothbard, on what a medium of exchange is.

Doug Casey also chimed in with the following commentary:

L: Do they have value in themselves?

Doug: There’s the rub; I don’t see that they do. Bitcoins are just an electronic abstraction. They can’t be used for anything else, nor are they made of something that can be used for anything else. They are like one of those knots in a string that disappear if you pull hard enough on the ends of the string. They are not backed by anything at all. Like government fiat currencies, they are a con game, functioning only as long as people have confidence in them, regardless of whether that confidence is well placed or not.

The arguments made by Casey, Kramer, and Nielsio are typical of the gold bug community, and I present them to you so that you may judge for yourself which set of logical arguments is superior.  Judging by the ratings of the Nielsio videos, I think the public agrees with my position that not only are Bitcoins a legitimate money, but they are in fact superior to gold as a medium of exchange.

There is a lot of disdain for Bitcoins by the Austrian gold bugs for a few reasons.  The primary reason is that, well,  they are all holding gold!  It stands to reason that they don’t like potential threats to their investment holdings.  Another primary reason, which all of the above authors allude to, is that Bitcoins challenge the Misesian Regression Theorem of Money, which states:

…because of Menger’s explanation of the origin of money. We can trace the purchasing power of money back through time, until we reach the point at which people first emerged from a state of barter. And at that point, the purchasing power of the money commodity can be explained in just the same way that the exchange value of any commodity is explained. People valued gold for its own sake before it became a money, and thus a satisfactory theory of the current market value of gold must trace back its development until the point when gold was not a medium of exchange.

I’m going to come right out and say it – Mises was wrong.

*the crowd wails* Boo!  Hiss!  Heretic!  

I’ll explain why I think the whole basis for this approach to the origin of money is wrong in a moment, but first I will present you with an argument that attempts to demonstrate why Bitcoins do not violate Mises’ Regression Theorem.  Therefore, even if you don’t agree with my theory, you can clearly see that powerful arguments exist within the Misesian framework which demonstrates why the gold bugs are wrong in their interpretation of the Regression Theorem.  In this absolutely brilliant analysis on the Bitcoin forums, XC writes:

The Money Regression and Emergence of Money from the Barter Economy
The entire purpose of the regression theorem was to help explain an apparent paradox of money: how does money have value as a medium of exchange if it is valued because it serves as a medium of exchange?  Menger and Mises helped break this apparent circularity by explaining the essential time component missing from the phrasing of the paradox.

As Rothbard explains in Man, Economy, and State (p 270),

“…a money price at the end of day X is determined by the marginal utilities of money and the good as they existed at the beginning of day X. But the marginal utility of money is based, as we have seen above, on a previously existing array of money prices. Money is demanded and considered useful because of its already existing money prices. Therefore, the price of a good on day X is determined by the marginal utility of the good on day X and the marginal utility of money on day X, which last in turn depends on the prices of goods on day X – 1. The economic analysis of money prices is therefore not circular. If prices today depend on the marginal utility of money today, the latter is dependent on money prices yesterday.” [all emphasis added]

Rothbard then goes on to explain that in order for money to emerge from a barter economy, it must have a preexisting commodity value.  This commodity value arises from barter demand for the potential money in direct consumption (i.e. ornamentation).  This value seeds future estimations of the value of the money as a medium of exchange.  The natural market emergence of money is thus fully explained.

The Monetary Economy
However, once an economy has been monetized and a memory of price ratios for goods and services has been established, a money may lose its direct commodity value and still be used as a money (medium of indirect exchange).  Rothbard explains (p 275):

“On the other hand, it does not follow from this analysis that if an extant money were to lose its direct uses, it could no longer be used as money. Thus, if gold, after being established as money, were suddenly to lose its value in ornaments or industrial uses, it would not necessarily lose its character as a money. Once a medium of exchange has been established as a money, money prices continue to be set. If on day X gold loses its direct uses, there will still be previously existing money prices that had been established on day X – 1, and these prices form the basis for the marginal utility of gold on day X. Similarly, the money prices thereby determined on day X form the basis for the marginal utility of money on day X + 1. From X on, gold could be demanded for its exchange value alone, and not at all for its direct use. Therefore, while it is absolutely necessary that a money originate as a commodity with direct uses, it is not absolutely necessary that the direct uses continue after the money has been established.”

This explains the history of fiat currencies.  They originally started off as simple names for weights of commodity money (silver) that developed out of the pre-monetary barter economy.  Despite later losing their ties to direct commodity value through state interference, paper currency retained status as money because of memory of previous money prices.  This factor is so strong that the relationship between gold and the USD, for example, is somewhat inverted.  Gold no longer circulates as a common medium of exchange.   Prices are set in USD, not in gold.  Most individuals wishing to trade in gold do so based on their knowledge of USD/gold price ratios.  (“Hey, let me buy that $100 couch from you in gold?”  “Ok, USD/gold is $1000/oz. Give me 1/10oz of gold.”)  Legal tender laws, state taxation, and the entire financial regulatory environment maintain this inertia of USD prices and make it challenging to return to gold money directly, despite the destructive inflationary nature of fiat currencies.

The Emergence of the Bitcoin Economy
The very first businesses in the Bitcoin economy were exchangers (NewLibertyStandard, BitcoinMarket, BitcoinExchange,….).  This is not an accident, but flows from the analysis above.  In order for Bitcoins to serve as a medium of exchange without commodity value for uses besides indirect exchange, there must be a translated knowledge of money prices.  Market exchangers fill this gap and give Bitcoin users access to this knowledge.  Bitcoins may therefore currently serve as a money intermediary for paypal dollars\pecunix\euros.  But why is there demand for Bitcoin over USD??  This is a subjective valuation arising from properties such as anonymity, decentralized system of clearance, cryptographic trust, predetermined and defined rate of growth, built in deflation, divisibility, low transaction fees, etc…. inherent to the Bitcoin system.

The essential point is that once exchange can occur between a money (USD) and Bitcoins, providers of goods have a means by which to value Bitcoins as a potential medium of exchange.  The money regression is satisfied, because taken back far enough we reach traditional commodity money: BITCOINS -> USD -> MONETIZED GOLD & SILVER [start monetary economy] -> [end barter economy] COMMODITY GOLD & SILVER.

Of course, if a major meltdown occurred and knowledge of all price ratios was wiped out, Bitcoin probably would NOT directly emerge as a money (assuming Bitcoins have limited value outside of exchange).  Fiat currencies with zero direct barter value certainly would not.  Commodities such as gold and silver that have widely recognized direct value in barter would likely emerge first.  The economy would then be monetized with price ratios in gold and silver.  Bitcoins then, being valued for intrinsic properties amenable to exchange, might then become prevalent in trade.  Initially, creators of value would continue to make their price value ratios in terms of the true money (gold oz/BTC ratio), but with time Bitcoin prices (BTC) can emerge (see as example).  We are in this initial phase now.

Therefore, so long as exchange of BTC and USD/Euros/etc… occurs, knowledge of existing price ratios can be utilized in the Bitcoin economy.  In time as Bitcoins become increasingly marketable, these fiat<->BTC price ratios will seed direct BTC price ratios.  The Bitcoin Economy thus emerges.  The Misean regression theorem is satisfied.

 Now, to challenge the assertions of Mises, Rothbard, and XC, I will start by presenting a question:

If there were no money or money prices in existence today, could Bitcoins arise as a currency without a pre-existing dollar price framework?  

According to XC’s interpretation, this should not be possible.  Nor should it be possible under Rothbard or Mises’ interpretation.  However, I don’t see a conflict with Menger’s theorem about money arising from the saleability of a good.  If you carefully consider Menger’s proposal, you’ll find that a good does not have to have a pre-existing use in order to arise as a money.  The good simply has to be saleable.  Consider that a good could have absolutely no use except to act as a money.

Menger attempts to demonstrate that money arises from the market selecting the most saleable good as the preferred medium to facilitate indirect exchange.

…astute traders will begin to engage in indirect exchange. For example, the owner of a telescope who desires fish does not need to wait until he finds a fisherman who wants to look at the stars. Instead, the owner of the telescope can sell it to any person who wants to stargaze, so long as the goods offered for it would be more likely to tempt fishermen than the telescope.

Over time, Menger argued, the most saleable goods were desired by more and more traders because of this advantage. But as more people accepted these goods in exchange, the more saleable they became. Eventually, certain goods outstripped all others in this respect, and became universally accepted in exchange by the sellers of all other goods. At this point, money had emerged on the market.

A direct quotation of Menger on this subject:

Under such circumstances it became the leading idea in the minds of the more intelligent bargainers,and then, as the situation came to be more generally understood, in the mind of every one, that the stock of goods destined to be exchanged for other goods must in the first instance be laid out in precious metals, or must be converted into them, or had already supplied his wants in that direction. But in and by this function, the precious metals are already constituted generally current media of exchange. In other words, they hereby function as commodities for which every one seeks to exchange his market-goods, not, as a rule, in order to consumption but entirely because of their special saleableness, in the intention of exchanging them subsequently for other goods directly profitable to him. No accident, nor the consequence of state compulsion, nor voluntary convention of traders effected this. It was the just apprehending of their individual self-interest which brought it to pass, that all the more economically advanced nations accepted the precious metals as money as soon as a sufficient supply of them had been collected and introduced into commerce. The advance from less to more costly money-stuffs depends upon analogous causes.

This development was materially helped forward by the ratio of exchange between the precious metals and other commodities undergoing smaller fluctuations, more or less, than that existing between most other goods, — a stability which is due to the peculiar circumstances attending the production, consumption, and exchange of the precious metals, and is thus connected with the so-called intrinsic grounds determining their exchange value. It constitutes yet another reason why each man, in the first instance (i.e. till he invests in goods directly useful to him), should lay in his available exchange-stock in precious metals, or convert metals, and the consequent facility with which they can serve as res fungibiles in relations of obligation, have led to forms of contract by which traffic has been rendered more easy; this too has materially promoted the saleableness of the precious metals, and thereby their adoption as money. Finally the precious metals, in consequence of the peculiarity of their colour, their ring, and partly also their specific gravity, are with some practice not difficult to recognise, and through their taking a durable stamp can be easily controlled as to quality and weight; this too has materially contributed to raise their saleableness and to forward the adoption and diffusion of them as money.

Menger doesn’t delve to deeply into why the metals should be so saleable, but he does touch on it by making various points about their fungibility, divisibility, scarcity, and recognizability.  And here in lies the heart of my argument.

As Menger points out, people can perceive the benefits that arise from having a money product to facilitate trade and to act as a store of wealth.  In Murphy’s article he makes the argument that “there’s the unlikelihood that someone could have invented the idea of money without ever experiencing it”  – and I say this the same as saying “there’s the unlikelihood that someone could have invented phones without ever experiencing phone service”.

The market has a need for a trade intermediary and a store of wealth.  This need can easily be preceived by anyone who has ever tried to barter a product.   Of course the people will recognize that a form of money is important from the time the very first trading community of humans arose.

Saying that people couldn’t figure out money was necessary without ever experiencing it is ridiculous in my book.  Archaeology suggests that people were using trade intermediaries as far back into human history as we can possibly see.  Money arose across continents between people who had no interactions with each other independently across all of human civilization.

So, once we have a perceived need in a free market for a trade facilitator and a store of wealth, what should we expect the market to do?  We can expect it to try and find a solution to this problem!  Mises attempts to argue that the market solved this problem because people valued gold for its own sake before it became a money, and it was this value they had for gold in ornamental use that allowed it to become a money.

This is patently wrong.  Consider that as soon as the market perceives a need for money, it wouldn’t matter if gold had a pre-existing value in ornamental use or not, because it would suddenly have value as a trade intermediary as soon as the need for a trade intermediary entered the public consciousness.

The very act of humanity perceiving a need for a trade intermediary would imbue gold with value as a trade intermediary because of the specific money properties that gold has.  Even if gold was brutally ugly to look at and made for poor jewelry, the money properties of gold would give it market value as a trade facilitator.

Consider this example using silicon microchips.  If I was to go back in time to ancient Egypt and carried with me a pocket full of extremely expensive microchips, do you think I could trade them for some wheat?  Of course the answer would be no, because absolutely no one could perceive any possible use for those chips.  They would be worthless baubles to the Egyptians.  It is only after the perceived use for them becomes apparent that they would suddenly have value.

When people first perceived that a form of money was a valuable thing to have, the next thought that would have gone through their heads is – what makes a good money? 

Should the money be cocoa beans?  wheat?  gold? – what properties should a good have that make it a quality money?  People used all of those things as a “money” at some point in history.  Consider that the process of selecting and determining the best money does not require that an item have a pre-existing use!  Because the need for a money exists, any item that can meet that need will be valued for its own sake as a money product.  It doesn’t matter if gold is ugly or entirely useless for any other purpose because those other purposes have nothing to do with fulfilling the need for a money.

The properties that make for a quality money are easily recognizable by markets.  The qualities that make for a good money are fungibility, scarcity, divisibility, and recognizability.  Because gold is one of the most fungible, divisible, scarce, and recognizable metals that exists within our physical universe, it came to be selected as the best money.

So now we must get back to how prices arise based on the market selected money product.

Consider my original question; if there were no money or money prices in existence today, could Bitcoins arise as a currency without a pre-existing dollar price framework?  I would argue that prices in Bitcoins could be readily established by the markets simply by introducing Bitcoins to this state of barter.

Given our technology today, people could easily establish a few facts that are entirely independent of prices:

1.  The number of Bitcoins in existence

2.  The amount of work necessary to produce a Bitcoin

3.  The rate Bitcoins come into existence

4.  The number of Bitcoins that will ever come into existence

5.  The money properties of Bitcoin (ie. its fungibility, divisibility, scarcity, and recognizability)

From which people can automatically make generalized assumptions about the value each specific coin would have.

Merchants would see the value of Bitcoins as a money and agree to accept them in exchange for goods and services because of the inherent properties they have.  The merchants would be speculating on the value of the coins at first until prices were established, but eventually if enough people recognize the inherent value of the coins, prices will be established for all products and services in terms of those coins.

Consider if I walk into a cafe and I inform the owner as to the existence of Bitcoins and their properties.  So he agrees to sell me a cup of coffee for a Bitcoin.  As soon as he makes that agreement, we now have pricing in terms of coffee established.  Why would the owner agree to such a trade?  Because he sees the inherent value of the coins as trade intermediaries.  He can evaluate the fungibility, scarcity, divisibility, and recognizability of the coins instantly and establish a value of each coin for himself without having to reference any pre-existing prices for any other products.  To the cafe owner, he sees the value of the Bitcoin as being more than the cup of coffee, so he is willing to trade the coffee for the coin.  It might be that he wants two coins or ten coins for a cup of coffee, but the number of coins the owner agrees to doesn’t matter in terms of negotiating a price.  All that matters is that the cafe owner sees potential value in the coins as a money.

In the same way a painting may have tremendous value to an art aficionado, while having almost no value to anyone else, the aficionado makes the determination about how much value the painting has based on his own internal value scale.  He sees value in the painting for its own inherent properties.  He doesn’t have to reference the prices of any pre-existing paintings to make a valuation of a particular painting for himself.

If enough people agree to accept Bitcoins for various goods and services simply because they see the inherent value of the coins as trade intermediaries, a pricing system in terms of the coins will rapidly establish itself.

To some, like the Bitcoin detractors I noted at the top of the page, the coins would have no value at all.  While to many others, the coins would have a tremendous value.  It doesn’t matter if some people reject them as having value in order for a pricing system to establish itself.  It only matters that some people see the value in them in order for a pricing system to establish itself.

From this point the market will weed out which goods act as the best trade intermediaries.  Those goods which are the most  fungible, divisible, appropriately scarce, and recognizable, will become the most broadly accepted forms of money.  Like all market competition, there may exist pricing across a market in several goods at once.  I don’t see any reason why people would not or could not price their items in terms of gold and Bitcoins simultaneously.

So to sum up my arguments:

Pre-existing use is not necessary for a good to become a money.  It is not necessary because the markets are able to recognize the value of a good in terms of its use as a money based on the good’s properties of  fungibility, divisibility, scarcity, and recognizability.  Once the market recognizes the value of a potential money product for its own sake, people will be willing to trade goods and services for it.

Prices in terms of the new money product can be established without having to reference pre-existing use values, in the same way prices for fine works of art can be established without anyone having to reference pre-existing values for other works of art.  The value calculations are internal to each individual who is willing to accept the currency based on the properties of the currency being offered for trade.

I can demonstrate that a free market money exists which has absolutely no other use other than to act as a money.

The market has deemed this good to have value in-and-of-itself.

The market has determined prices for this good without the good having to be valued in some other capacity, other than to be a money.

There will come a time in the future when textbooks reference the “Suede Monetary Utility Theorem” .

Probably after I’m dead, since that seems to be the way of things.

Read Prof. George Selgin’s response to this article here.

Related articles:

The Economics Of Bitcoin – Doug Casey Gets It Wrong

How To Use Bitcoin – The Most Important Creation In The History Of Man

Libertarian Goldbugs Hating On Bitcoin – Free Market Money

The Economics Of Bitcoin – Why Mainstream Economists Lie About Deflation

The Economics Of Bitcoin – How Bitcoins Act As Money

Against The Gold Standard

The Ridiculousness Of Demanding Government Return To A Gold Standard

The Economics Of Bitcoin – Resource Allocation And Interest Rate Distortion