Bitcoin Economics – Credit expansion and the characteristics of money (Part 2)

Abstract: In this piece we look at why Bitcoin might have some unique combinations of characteristics, compared to traditional forms of money.  We examine the implications this could have on the ability of banks to engage in credit expansion.

 

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The main features of the different types of money

Despite the strong advantages of bank deposits mentioned in part 1 of this piece, namely the ability to use it electronically, physical notes and coins do have some significant benefits over electronic money.  The following table aims to summarize the main features of the different types of money, bank deposits, physical cash and Electronic Cash (Bitcoin).

 

Features of electronic bank deposits, physical notes & coins and electronic cash

Feature Bank deposit Physical cash Electronic Cash
Advantages of physical cash
Funds are fully protected in the event the bank becomes insolvent or inaccessible*
It is difficult for the authorities to confiscate funds
Funds can be effectively hidden from the authorities
Transactions cannot easily be blocked
Transfers can be highly anonymous
Transfers can be irrevocable
Transfers can occur instantly ? ?
Payments can occur 24×7 ?
Transaction fees are zero ?
Payments work during power outages or when communication networks are unavailable
Money can be used without purchasing or owning a device
Anyone can use the system, without seeking permission
Advantages of electronic systems
Payments can be made over the internet
Change does not need to be calculated
Payments can easily be recorded
Funds can easily be secured to prevent theft ?

Note: * Physical cash still has a potential problem with respect to the solvency, related to the policy of the central bank which issues the currency

 

Due to the strengths mentioned in the above table, physical cash will always have its niche use cases. However, on balance, banking deposits are superior to physical cash, for the majority of users.  The ability to use bank deposits electronically is particularly compelling, especially in the digital age.  As we explained in part one of this piece, it is this ability to use the money electronically that ensures there is always high demand for bank deposits, giving banks the ability to freely expand the level of credit.

 

The unique properties of Bitcoin

Bitcoin shares many of the advantages of physical cash over electronic bank deposits.  Although Bitcoin does not have the full set of advantages, as the table above demonstrates.  However the key unique feature of Bitcoin, is that it has both some of the advantages of physical cash and the ability to be used electronically.

Bitcoin aims to replicate some of the properties of physical cash, but in an electronic form, an “electronic cash system”.  Before Bitcoin, people had to make a binary choice, between physical cash or using a bank deposit.

Although technically physical cash is a kind of a bank deposit, a deposit at the central bank, physical cash still has unique bearer type properties which could not be replicated in an electronic form.  For the first time ever, in 2009, Bitcoin provided the ability to use a bearer type asset, electronically.  The simple table below illustrates this key unique feature of Bitcoin and blockchain based tokens.

 

The binary choice in legacy finance & the new option Bitcoin provides

Bearer type instrument Electronic type instrument
Physical Cash (Notes & Coins)
Electronic money (Bank Deposit)
Electronic Cash (Bitcoin)

 

Therefore Bitcoin can be thought of as a new hybrid form of money, with some of the advantages of physical cash, but also some of the advantages of bank deposits.

 

Bitcoin’s limitations

Although Bitcoin has inherited some of the strengths of both traditional electronic money systems and physical cash.  Typically Bitcoin does not have all the advantages of either electronic money or physical cash, however it is uniquely positioned to be able to have subset of the features of each.  This provides a new middle ground option.

For example, Bitcoin may never have the throughput of traditional electronic payment systems or the ability to use without electricity such as with physical cash.  Although as technology improves, Bitcoin may slowly develop more strengths and gradually improve its capabilities, to narrow the gap.

 

The implications of these characteristics on credit expansion

Understanding the dynamics of these characteristics, can be useful in evaluating the potential economic significance of Bitcoin, should the ecosystem grow. Bitcoin has at least six properties which provide some level of natural resilience against credit expansion, which traditional money does not have. This is because the advantages of keeping money on deposit at a bank are not always as pronounced in Bitcoin, compared to the alternatives.  However, Bitcoin is certainly not immune to the same credit expansionary forces which exist in traditional systems, indeed people can keep Bitcoin on deposit at financial institutions just like they can with physical cash.  Bitcoin may merely have greater resistance to the same credit expansionary forces.

At the core of our reasoning, is looking the advantages of bank deposits compared to physical cash, which are the characteristics that enable large banks to freely expand credit and evaluating to what extent they apply in Bitcoin.  As the table below shows, the advantages of keeping money on deposit at a bank are less significant in the Bitcoin world, therefore we think Bitcoin does have some unique resilience against the forces of credit expansion.

 

Physical cash vs bank deposits compared to Bitcoin vs Bitcoin deposits

Factor Physical cash compared to deposits Bitcoin compared to Bitcoin deposits
1. Security

Keeping money on deposits in financial institutions, increases security relative to keeping large physical cash balances at home, where the cash is vulnerable to theft or damage

Bitcoin can potentially allow a high level of security, without putting the funds on deposit at a bank

For example Bitcoin can be concealed or encrypted

2. Electronic transfers

Using the banking system, it is possible to send money effectively over the internet or by phone, across the world at low cost.

If physical cash is used, then a slow, inefficient, insecure physical transfer must take place

Bitcoin can allow users to efficiently transmit money over the internet, without using deposits at financial institutions
3. Convenience

Using a banking system to manage your money, can result in a convenient set of tools. For example the ability to use money using your mobile phone or use your computer.

Precise amounts can be sent so there is no issue with receiving change

Bitcoin can allow users to make payments on a mobile phone or without manually calculating change amounts.  Deposits at financial institutions are not required
4. Ability to redeem deposits In the traditional banking system, withdrawing physical cash from a financial institution is a long administrative process which takes time.  Banks therefore do not need to worry about keeping large quantities of physical cash in reserves Bitcoin can allow users to withdraw money from deposit taking institutions quickly, which may encourage banks to ensure they have adequate Bitcoin in reserve at all times
5. Auditability

Banks offer the ability to track and monitor all transactions, which can help prevent fraud and improve accountability.

Physical cash cannot offer this

Bitcoin’s blockchain or other electronic databases can allow users to effectively audit and monitor transactions, without using third party financial intermediaries
6. “Hybrid banking”

In traditional banking models there are only two fundamental choices:

1. Physical cash which provides full user control of the money

2. Money on deposit at a financial institution

This is a binary choice with no middle ground options, forcing consumers to make a difficult choice with no compromise option available

Bitcoin allows a wider spectrum of deposit and security models, resulting in a more complex credit expansionary dynamic.

For example:

1. 2 of 2 multi-signature wallet, where the bank holds one key and the user holds another key; or

2. 1 of 2 multi-signature wallet, where the bank holds one key and the user holds another key

 

The economic consequences of less credit expansion

The consequences of the lower level of credit expansion this analysis implies, does not really say much about whether this potentially new economic model will be more beneficial to society, nor does it say much about whether Bitcoin will be successful or not. The former is something that has been heavily debated by economists for decades and the latter is a separate topic, in our view.  Although, despite decades of economic debate, perhaps Bitcoin is sufficiently different to the money which came before it, such that the debate is required again, with new very different information.  For example inflation  or deflation, caused by cycles of credit expansion, may have very different consequences in a Bitcoin based financial system, than on one based on bank deposits and debt.  A key problem with deflation in a debt based money system, is that it increases the real value of debt, resulting in a downwards economic spiral.  For non debt based money systems like Bitcoin, it is less clear what the implications of deflation are.

Although Bitcoin may not necessarily result in a superior economic model, we think this analysis may suggest that Bitcoin may have some properties that make the economic model somewhat unique or perhaps interesting, compared to the possible models that came before it.  Therefore it does look like an area worth examining.

To many, the ultimate objective of Bitcoin is to become sufficiently dominant, such that there is a significant decrease in credit expansionary forces, which can neutralize the credit cycle and therefore the business cycle.  Although, this should be considered as an extremely ambitious objective, which we consider as extremely unlikely.  And even in the remarkable circumstance that Bitcoin grows to this scale, other  unforeseen economic problems, particular to Bitcoin, may emerge.