Tag Archives: Inflation

The Truth About Tax Cuts

cashme

This kid is gonna be POTUS one day.

Let me ask you a question: for what do you think your taxes pay? Is it better roads, good schools, social services, like firemen and police?

Maybe, probably at the state and local level. But, at the national level, your tax dollars really don’t pay for anything.

Let me repeat that: your tax dollars really don’t pay for anything.

In the U.S., our government can literally print as much money as it wants. It can completely eliminate its liabilities more or less at will. So why collect taxes?

The truth is that, at least when it comes to taxation on a national scale, our tax dollars don’t “pay our bills.” Our government can literally print as much money as it needs to cover any entitlements, military spending, or pretty much any other bonafide social safety net expense or ridiculous boondoggle it decides to fund. Imagine if you had your own printing press that could perfectly reproduce Federal Reserve notes. And it was completely legal. Would you ever be short of cash? No? Well, that’s pretty much the way our fiat currency system works.

Politicians play on the fact that, as a controlled commodity, it’s difficult for most people to accumulate money in significant amounts. So they talk about “deficits,” ”debt,” ”spending,” etc., referencing metaphorically what most people live very much literally. The government never has to worry about running out of money. Think of it as having a bank account with infinite dollars.

When it comes to money, the government is concerned about something else entirely: debasement. It’s more worried about printing so much money that it becomes worthless. A debased currency makes everything tremendously more expensive (except debt, which would actually decrease in value).

So there are mechanisms within the fiat currency system to prevent an excessive accumulation of money. In other words, our monetary system contains mechanisms for destroying money. Fractional reserve banking is one such method.

The other is taxation.

The purpose of taxation is to remove the “extra” dollars from the economy. However, as it functions, this system is profoundly flawed.

If the purpose of taxation is to remove excess money from the system, consider what happens when taxes are “cut.” When the government cuts taxes, it has decided to remove less excess money from the economy. Why would it do that? Because, at least theoretically, the additional money could be used to spur innovation and productivity, which we call “economic growth.” That economic growth translates as societal wealth, in the form of better goods and services. Economic growth is what propels us all into progressively higher standards of living, at least materially.

However, what happens if that additional money does not create economic growth? What happens if major new innovations are not created and productivity doesn’t actually increase? What happens when the options for monetizing new products and services simply don’t materialize? Think of the “unicorns” of Silicon Valley… what would happen if Uber flamed out? What would happen if the public ends up rejecting augmented reality (AR) or virtual reality (VR)? What happens if self-driving cars end up being a dead end?

The key for tax cuts is that, if they don’t spur growth, they exacerbate the problem of currency debasement. Rather than allow the government to get those dollars back, the wealthy prefer to hold on to them by whatever means, legal or illegal. Our laws and force apparatus give those dollars real worth even though they are inherently worthless. As a matter of status, the rich want to keep those extras dollars to buy the bigger house, the bigger boat, the bigger jet, etc. More houses, more boats, more cars. At a certain level of wealth, it’s all ego tripping.

Which brings me to this point: have you ever noticed how tax cuts go almost exclusively to the wealthy? Why don’t they go mostly to those lower on the chain? The simple answer would be because that would defeat the purpose. People further down the chain will simply spend the money into the economy. “What’s wrong with that?”, you may ask. “Aren’t the rich going to get the money anyway?”

Yeah, but there’s a problem with that… it’s called “price inflation.” When merchants and businesses know that there is more available money in the economy, they tend to raise prices. Since taxes can’t be cut enough for most of those lower down the economic chain to make a material difference in their incomes, the effects of “tax cuts for everyone else” will likely simply translate to higher prices. So the money will indeed “trickle up” (actually flow up), but then everyone will be stuck with higher price levels for goods and services. Oddly enough, funneling the money directly to the rich prevents that outcome.

The real question is “Does it work?” My best answer is that it has to, at some level. At least materially, our standard of living continues to increase. There are a few large bets on the horizon technologically that could have a major positive impact on living standards, such as AR, artificial intelligence (AI) and machine learning (ML) , and autonomous vehicles. Will tax cuts help those big bets pay off? It’s possible.

But, in the wake of that, a potentially dangerous condition is also developing: the increased displacement of human labor in the value chain. Labor is the method by which most people acquire the means to participate in the economy; simply put, it’s how they earn money. However, globalization and increased technological automation is leading to an increased deprecation of Labor value. At the more developed end of the spectrum, employment is either shrinking or progressively moving to lower wage work. All signs are that this trend is accelerating. So far, Capitalism has not found a way to address what it perceives as a short-term transition that could easily become a long-term crisis. Tension is already rippling through the most advanced economies in the form of increased populism. The world is changing and Capitalism so far has shown little capacity to manage that change effectively.

If you look at taxation from the perspective of its intended purpose, then you can understand how disingenuous the arguments of the wealthy are against higher taxation. The rich want those further down the chain to shoulder more of the tax burden. The reality is that such a proposition will almost certainly have a profound effect on economic growth. As the middle class evaporates, those lower on the chain can barely afford to make their way in the modern economy as it is. If the purpose is to get the “excess” dollars out of our economy by getting it from those who can least afford to give it, I don’t see how that is going to have a positive outcome. The reality is that we tax the rich because they have the excess dollars. Their argument is that they are the ones who fund innovation and enterprise. But it’s just as likely that they will devote their money to financialization; in other words, they’ll use safe financial instruments simply to make more money rather than making riskier bets that may spur much greater growth. Even worse, a lot of that money will be used simply for indulgence, avarice, and status-seeking. As displays of opulence and decadence become more visible in our more socially connected world, the potential for backlash increases substantially, the outcomes potentially catastrophic. Remember the French Revolution?

The truth is that our economic system is fundamentally unbalanced and likely to become more so. Money is being kept out of the hands of the very people who need it most and given in wheelbarrows to the very people who need it least. The worst part is that this is probably our economy’s optimal condition; it is unlikely that the system can be made more equal, or even more equitable, without running the risk of high price inflation at least, and, potentially, economic collapse. As it stands right now, the only way the system continues to function is if it continues to become more and more unequal.

I don’t see how that ends well.

The Deflation Phenomenon

deflation

In my last post, The Riddle of Scarce Abundance: A Redux, I made the claim that technology has a naturally inflationary bias, rather than a deflationary one. I want to explore that thought in more detail.

Let’s consider the idea of technology lowering the costs of goods which is, by definition, price deflationary. If I purchase a smartphone that replaces any number of individual products, it stands to reason that helps me keep more money in my pocket. This will most likely have an inflationary effect, related to the concept of “more money chasing fewer goods.” It’s apparent that technology has allowed the price of many goods to drop. In an environment where more money is available, then it stands to reason that prices will increase in other areas for producers or rentiers to capture more of it.

But if deflation is “less money chasing more goods,” inflation’s opposite, then what would it look like to have an environment of “more money chasing more goods”? That’s pretty much where we are right now so let’s examine it:

If I have $100 and purchase five items with that total amount, each item will have an average cost of $20. However, if a technology-driven drop in prices allows me to purchase the same five items plus five more for the same $100, then the average cost per item is $10. You could posit that technology has caused price deflation.

So technology drops the prices and a greater global market increases demand; instead of selling a $100 item to a thousand people, you can now sell a $10 item to a million people.

From this point, you are looking at two possible scenarios:

  1. Expanding global markets indicate that price increases should happen at some point somewhere at the top of the global supply chain because demand has increased in aggregate, which should cause commensurate price inflation;
  2. Competition has greatly increased at the top of the global supply chain so that prices for raw materials, commodities, and other essential resources continue to drop with demand, forcing price deflation.

Considering the tanking of commodity prices, my guess is that competition at the apex of the global supply chain has increased substantially. In other words, there are far more companies providing raw materials, commodities, and resources at the apex of the global supply chain. This likely happened when countries chased growth by significantly lowering the costs of borrowing money in the wake of the global recession.

To clarify, our current deflationary situation could be the result of too much competition at the top of the global supply chain. It’s also possible that major technological advances at the top of the global supply chain have greatly lowered the marginal costs of making essential resources available, though I think this is less widespread than people think. However, it is unlikely that efficiencies created by technology farther down the global supply chain are producing a glut of resources because far greater global demand should be offsetting that condition.

So, if I’m correct, it stands to reason that increasing the cost of borrowing will force consolidations that will lower competition and increase prices at the apex of the global supply chain which will trickle down, increasing price inflation.

But this creates its own problems, particularly the prospect of runaway price inflation. On top of that, raising interest rates hasn’t actually worked; every central bank which has attempted it has been forced to reverse course because of increasing disinflation/deflation.

So what’s happening? My guess is that central banks can’t raise rates high enough to quickly kill competition at the top to force consolidations. Come to think of it, let me rephrase that: central banks are scared to create runaway price inflation by increasing interest rates too high, too quickly. Another problem is growth; higher interest rates will negatively impact the anemic growth most countries are already experiencing.

So, if I had to guess, it seems like the central banks are worried about accelerating inflation too quickly, which will slow down economic growth by harming consumers, and allowing continuing disinflation/deflation, which will also slow down growth by harming debtors. Central banks are stuck between a rock and a hard place, with recession looming no matter what course is taken.

The world seems to have decided that it’s going to bank on (pun intended) the Federal Reserve of the U.S. to solve the problem. As banks move to negative interest rates to put more money into the real economy to battle disinflation, the Federal Reserve is slowly stepping up its interest rates in the hopes of making borrowing more expensive without letting the inflation beast out of the dungeon. It looks like its going to be a delicate dance.

If my speculation is correct, then the problem is that money became too cheap and abundant in the wake of the Great Recession. Companies that would normally go out of business in such a competitive atmosphere can prop themselves up indefinitely because of easy cash, either through lending or through markets. The problem is that even with the spigot turned off, the level of money in the system makes runaway inflation a serious threat.

Which brings me back to cryptocurrency, particularly having a good one. With it in place, people would have a completely liquid safe haven against inflation. However, I think I understand why some people may think Bitcoin is suited to this particular financial atmosphere; its artificial scarcity allows it to better retain value in such deflationary conditions, something that would be more difficult for an expansionary cryptocurrency. In the event of serious inflation or hyperinflation, any cryptocurrency, provided it had widespread acceptance, would, in theory, provide a safe haven. I’m not sure Bitcoin is at a level of acceptance and maturity that it can provide an effective buffer in the event of a major financial shock though. No doubt some are willing to bet that it can.

So where does that put me with my original hypothesis as presented in my post, An Alternative Theory of Deflation? I’m still pretty certain that the demand for interest is a significant deflationary force, though I’m not sure how much. I’m also still certain that the extraction and holding of profit is also significantly deflationary, particularly when it is parked in banks and not reinvested. The move by banks to negative interest rates seems to support this. At the very least, these factors are contributing to an environment in which technology and competition is driving down prices while the money supply in the real economy dries up.

So, is technology actually “deflationary”? In a properly functioning economy, it shouldn’t be, at least not ultimately. The increase in dollars it produces as well as the increase in demand should be offset by an increase in the prices of related essential resources, such as commodities. With the exception of oil and natural gas (and probably a few others), I doubt that technology has improved the marginal costs of extracting or processing essential resources significantly enough to create the apparent “overabundance” that we are now experiencing. I’m more inclined to think that easy credit has facilitated unwise expansion and increased competition at the apex of the global supply chain. The common wisdom is that China, with its surging economic growth, motivated this expansion, which makes sense, and the global glut is a result of its cooling economy. In any case, reigning it in without creating massive inflation is going to be a challenge.

How would all of this be handled in the world of The Currency Paradox? Simple. Neither inflation nor deflation would have to exist. The true price of every physical item can be known based simply on the aggregate amount of time it took to create it. Easy modifications can be implemented for certain situations; for instance, ears of corn can be priced by the amount of time they took to grow and be harvested divided by the number of ears harvested. Almost all items, even virtual ones, can be priced in relation to time/effort.

But that’s a post for another day.

The Riddle of Scarce Abundance: A Redux

oracle of Delphi

In my post, Currency and the Riddle of Scarce Abundance, I offered what I thought were the ideal traits of a cryptocurrency that had the ability to replace fiat currencies.

Since then, Bitcoin, the current cryptocurrency poster child, has once again embarked on a roller coaster ride of volatility, prompted mainly by the defection of a prominent developer in the Bitcoin community, Mike Hearn. In his post, The resolution of the Bitcoin experiment, Hearn refers to Bitcoin as a “failed experiment.” Many conflated Hearn’s statement to mean that Bitcoin was “dead” and gleefully pointed to the exchange rate and transaction volume to paint him as a bitter opportunist who also had the ignominious condition of being dead wrong.

Here’s the thing though… Hearn never claimed that Bitcoin was “dead” he only claimed that it had failed. In that respect, I think there is a lot of evidence that he may be correct. Despite the claims that Bitcoin transactions are increasing, there is almost no evidence that its use for common financial transactions is increasing. As for its exchange rate, there are many incentives to trade in Bitcoin, few of which are relevant from a currency standpoint. The truth is that Bitcoin, in its best case, only shows utility as a speculative vehicle and, in its worst, shows signs of being heavily manipulated.

The simple reality is that, if a cryptocurrency intends to replace central bank-issued fiat currency, people, first and foremost, have to have an incentive to use it for common financial transactions. As I’ve stated before, no one truly has an incentive to use Bitcoin every day. Why? It’s too volatile and doesn’t really do anything significantly better than the current currency paradigm.

My thinking is that Bitcoin suffers from an abundance, or lack thereof, problem. Its scarcity is used as a means to trap value but it works against the currency being used every day. I’m willing to admit that this may strictly be a matter of psychology. But the truth is, Bitcoin feels scarce. Its deflationary bias exacerbates that feeling. Not only is it not practical as an every day currency, it feels like it’s not practical as an every day currency. People intuitively understand that Bitcoin doesn’t work because there isn’t enough of it to go around (yeah, I know, “divisibility,” blah, blah, blah).

In my opinion, the best use case for a cryptocurrency in today’s world is as a reserve currency. People may choose to buy U.S. dollars for that purpose but I think there would be something uniquely encouraging for many people if there was a popular currency that was not controlled by any nation that could also be used seamlessly across borders. But I think it also has to feel like a currency as well. There has to be both an actuality and an intuitive sense that the currency is stable yet flexible, that it can grow effectively with demand without destroying its ability to store value. Call it “faith.”

What I came to understand is that a currency can expand as long as it remains in lockstep with demand. There has to be effective mechanisms to destroy money as well as create it in an economy. I think many of the problems faced in our current economic system stem from a fundamental disequilibrium in the creation and destruction processes of money. The imbalance is caused by the demand for interest on debt-based money which creates a net-negative sum bias. The result is that, as debt is serviced and profit is protected, an artificial scarcity of money is being produced in the every day economy which is encouraging a deflationary environment.

As an aside, many people believe that technology is a major factor driving deflation. This is an interesting theory. My first response is that this leads to a very strange syllogism:

  • Software allows more to be done with fewer resources;
  • As a result of software “eating the world” and efficiencies of scale, fewer resources are being consumed;
  • The result is deflation as there are more resources available in relation to demand.

Here’s where this gets tricky for me: how does this reconcile with an expanding money supply? At the personal level, if I have a smartphone that can substitute for a myriad of devices, it stands to reason that I should have more money in my pocket. Now scale that out to hundreds of millions of people. If deflation is less money chasing more goods but tech is helping people keep more money in their pockets, then how is technology causing deflation? Indeed, technology should be having an inflationary effect, at least monetarily, relative to the expanding money supply. The expansion of markets globally easily translates into greater use of resources in aggregate. It should not be possible for technology to have a deflationary effect. Quite the opposite actually.

Indeed, there is a massively deflationary element counteracting the naturally inflationary bias of technology. There is mounting evidence that rents, particularly in housing, are contributing to that effect. So, even in an environment in which technology should be putting more money in people’s pockets, the demand for that money in the form of rents is systematically eroding people’s personal wealth. So even with more income and personal wealth, many people are actually poorer as the result of the increased demands on it. This seems to validate Thomas Piketty‘s research on economic inequality. The economist Branko Milanović has coined the term “wealth-poverty” to explain this phenomenon.

The money supply is expanding at an amazing clip, more natural resources are being consumed now than at any time in history, yet disinflation/deflation is a problem in all but the most corrupt countries. This is a strange contradiction, one that has many central bankers puzzled. Disinflation and deflation suggest that the expansion of the money supply can’t keep up with even the tepid amount of growth that we are now experiencing.

So how does all of that relate to cryptocurrency? Well, one of the advantages of a cryptocurrency is that it can provide insulation from the current economic forces. A stable cryptocurrency can provide a completely liquid safe haven and act as an effective counterbalance to central banking monetary mishaps. Think of it as a safety net for the global currency system.

So getting cryptocurrency right is very important, so much so that I think even central banks would be able to get behind a good one. It could be used as an escape hatch should the worst happen.

But, as I’ve shown before, Bitcoin is already rigged in favor of its early adopters. Increased demand would only ensure that each subsequent purchaser of it gets less and less while the fortunes of those who accumulated early and cheaply would go through the roof.

The answer is the creation of a cryptocurrency that allows true supply/demand equilibrium. Everything necessary to create it now exists. As in many things, it is not a lack of capability but a lack of will that is preventing it.

Currency and the Riddle of Scarce Abundance

sphinx

In 2008, a person (or persons) named Satoshi Nakamoto, posted a paper that may prove to be one of the greatest technological developments in history. Nakamoto introduced the world to Bitcoin, an attempt to circumvent central-bank controlled fiat currency using a digital currency created, validated, and protected through cryptographic means. Since then, Bitcoin has grown to a market cap of over 4 billion dollars as of this writing. However, it’s value has dropped significantly from its peak of roughly $1200 per coin in 2013 to about $320 per coin today.

In my opinion (and most metrics bear out), Bitcoin is not very effective as a currency, particularly because of its fixed limit at 21 million total units. This artificial scarcity has two main outcomes:

  1. the positive is that Bitcoin is able to retain value better than most fiat currencies;
  2. the negative is that economic inequality is baked into Bitcoin; high demand for a fixed limit crypto-currency advantages those who are able to accumulate it in large quantity, particularly early on when it is least expensive.

Over time, I’ve come to appreciate both the elegance and flaws of Nakamoto’s Bitcoin. To illustrate, here are some excerpts from a few recent email exchanges I’ve had regarding the development of a new crypto-currency:

Excerpt 1

“So, here’s where the conundrum kicks in… how do you ensure supply/demand equilibrium while incentivizing miners to mine? Is it possible to gain the deflationary benefits of a fixed limit currency with the expansive capabilities of a non-fixed limit?

The way Bitcoin handles this is through divisibility. The problem with this is that it creates an inflationary effect… as long as its scarcity increases its value in exchanged currency, the same amount of exchanged currency purchases smaller and smaller amounts of Bitcoin while simultaneously massively inflating the Bitcoin worth of those who have accumulated a lot of them.

I conceptualized the chron to address this problem. The way supply/demand equilibrium is met is simply that people create their own money through time/effort. In essence, people simply print the money they want/need through their own productive effort.

As I stated, the validation process likely cannot be duplicated in a digital decentralized sense. The chron was designed for governments to adopt.

So that leaves these criteria:

Fixed limit – for high exchange rate

Non-fixed limit – for supply/demand equilibrium

In two articles, The Post Where I Fix Bitcoin and Fixing Bitcoin Part II: Pricing with Bitcoin Units, I attempted to solve the distortions in Bitcoin by creating a scheme that automatically divides the current pool of Bitcoin into lower fractional units when demand increases by implementing a fixed exchange rate.

This process confirmed that Bitcoin divisibility, without the benefit of exchange with other currencies, is, by nature, an inflationary process. Utilizing a fixed exchange rate was also inflationary. Bitcoin is only deflationary when in relation to another resource or currency with which it is exchanged that is itself increasing. In theory, that could be any natural resource but it is currently fiat currency.

Satoshi Nakamoto figured out that divisibility allowed a currency to be both scarce and expandable but there is simply no free lunch.”

Excerpt 2

“… a digital currency is worthless because its natural marginal costs are near zero. Again, Satoshi Nakamoto did an interesting job of addressing this issue with the proof of work system, which facilitates the creation of a digital file at substantial marginal cost. In other words, Nakamoto found a way to make generating a digital file very expensive. He made the creation of Bitcoin worthwhile by attaching it to a problem, the Two General’s Problem. By finding a way to eliminate third party trust using algorithms, he found a way to legitimize using copious amounts of energy to increase the marginal costs of creating a digital file.”

In my personal research, I’ve come to understand that the ideal currency is, by nature, paradoxical: it must be scarce enough to retain value and abundant enough to sufficiently meet demand for its use. In other words, the ideal currency must strive to achieve the supply/demand equilibrium that allows it to retain relevant value yet be common enough to use for daily transactions. I explain this more thoroughly in the following excerpt:

“Satoshi Nakamoto figured out that divisibility allowed a currency to be both scarce and expandable but there is simply no free lunch.

So the key is to try to create a free lunch: a currency that doesn’t lose value to inflation yet is abundant enough to freely spend.

What it boils down to is a currency must be both:

Scare and abundant

Indefinite and finite (as a store of value, you should be able to hold it forever yet, to prevent an overabundance, it should also be consumable)

In my personal explorations, I have only identified two things that naturally fit these criteria:

The first is time, hence the chron. It is the one essential that everyone shares that is both limitless and limited (through lifespan), has unquestionable intrinsic value, is a perfect store of value (through the concept of “history”) yet is “consumed” over a lifespan;

The second is ethyl alchohol. It is the one physical commodity that has very high practical utility in an emergency circumstance and high desirability in general. In theory, an indefinite amount can be made but there is always only a finite supply. It can pretty much be stored forever but there is a strong motivation to consume it as fuel, medically, or for enjoyment.

The challenge is in attempting to meet those criteria with a digital currency, which is the only practical means of creating a universal currency today. However, by its very nature, a digital currency is worthless because its natural marginal costs are near zero…

A question was asked whether lending should be part of a new economic paradigm. Here’s the thing: lending is what allows fiat currency to be both relatively scarce yet abundant. Our money is constantly in the state of being both created and destroyed through lending. This is what has made fiat currency so resilient conceptually… it is able to exist in a paradoxical state. However, in order to make it work, it requires monopolization of force. That is the only way the money itself has any value, the people with the guns say it does.”

Indeed, the ideal currency must be both scarce and abundant, finite and indefinite. I’ve decided to call this problem “The Riddle of Scarce Abundance.”

Bitcoin handles the “scarce abundance” problem with divisibility. However, as previously stated, severe economic inequality is the natural result.

If I was going to design a crypto-currency, the first thing I would do is enable it to produce unlimited coins. This would guarantee that everyone who wanted them could get them in quantity. Their abundance would encourage their use for everyday transactions. However, particularly for a currency produced digitally, this is naturally hyper-inflationary. Though “proof-of-work” and fixed limitation discourages reckless currency production, they don’t eliminate the problem. So how do you ensure the ideal supply/demand equilibrium of a currency such that it is both abundant enough yet retains its value over the long-term?

The answer is that the currency must be in a constant state of both creation and destruction. In other words, there needs to be a mechanism in a crypto-currency that eliminates the currency as well as creates it. Done properly, an ideal rate of coin destruction acts as a counterbalance to unlimited coin creation, allowing a currency to be both abundant and scarce. The key is to balance both processes to reach the currency’s ideal supply/demand equilibrium of maximum retention of value with enough abundance to encourage general purpose use.

However, if coin destruction is done improperly, the coin’s ability to store value will be destroyed. One of the advantages of the fiat currency system is that banks act specifically as mechanisms for both creating and destroying money. When a bank loan is paid off, the bank uses the received money simply to cancel the liability it created, rendering the credit/debit transaction to zero. However, in the world of crypto-currencies, all coins are held personally. So any mechanism to destroy coins has to respect the fact that all coins in a crypto-currency represent someone’s personally-held value. No one wants to hold coins that could “self-destruct” for fear of having their personally-held value destroyed.

The answer that I came up with is “taxation.” What I determined is that a percentage-based “transaction tax” could be implemented directly into a crypto-currency scheme so that, every time it was used for a transaction, coins were destroyed. The process would act as a “consumption” mechanism; as long as the coins were held, they would retain value, and, when they were used, they would be consumed in such a fashion as to not affect their ability to store value.

As is the case with most good ideas, I figured someone had already figured this out, so I decided to research the more popular altcoins to see if such a “taxation” process was already in use. Surely enough, I discovered a coin that had implemented the idea: Peercoin. However, the fashion in which it is implemented is fairly crude and not adaptive. If I’m not mistaken, its “taxation” process is also regressive by nature.

The alteration I would implement would be a variable transaction tax, one that increases or decreases relative to the amount being transacted. To be more specific, the lower the number of coins transacted, the lower the transaction tax and vice versa. Though not a perfect way to achieve a progressive tax style outcome, the reasoning is that richer people will generally transact in larger coin amounts.

This strategy goes a long way to ensuring supply/demand equilibrium but another flaw that should be addressed as it relates to Peercoin is its fixed rate of inflation, which is set at 1%. Implementing a method for increasing coin production when demand increases is essential or price distortions will likely result. Tying the rate of coin production to transactional velocity may be the solution. Changes in the transactional velocity rate should strongly correlate to demand for the currency; adjusting the rate of coin production as transactional velocity accelerates or decelerates should, in theory, allow for a highly balanced supply of the currency relative to demand.

So this is my idea for a better crypto-currency… one that is both abundant and scarce. The alterations I’m suggesting should allow it to achieve true supply/demand equilibrium thus achieving maximum stability. Many people think that scarcity is a desirable quality in a currency but what is more essential for its ability to store value is its stability.

As I’ve stated before, I don’t hate Bitcoin, I just don’t like it. I think I understand why Satoshi Nakamoto designed it in the way that he(?) did and the scarcity of the currency definitely works to his advantage as his coins are worth significantly more now than when they were initially mined. However, if he got that far in the process, I doubt he couldn’t have gone just a few steps further. He was SO close to creating the ideal replacement for fiat currency.

The good news is that he leaves a lot of work on which to build. The dream of a stable crypto-currency truly superior to fiat currency that can be made available to almost everyone everywhere is within reach. While I do not think such a crypto-currency would be superior by any means to the innovation presented in The Currency Paradox, I think it would be a great intermediate step. Ending currency wars would go a long way toward reducing economic inequality and increasing economic equitability.

Fixing Bitcoin Part II: Pricing with Bitcoin Units

will-work-for-bitcoin-560x325If I had to sum up Bitcoin, I’d have to say that it is a remarkably great thing tied inextricably to a remarkably bad thing. My criticisms of Bitcoin as a currency are pretty extensive at this point, so I won’t rehash them.

However, I personally think the blockchain could be completely game changing, which is why I attempted to “fix” the Bitcoin currency problem.

I wasn’t sure that what I proposed would work so I decided to see if it was possible to create a method for pricing based on my concept. Using the variables I created, it is indeed not only possible but easy to use Bitcoin strictly as mostly whole units. Indeed, what I’m about to show is that it is pretty simple to make Bitcoin just as easy to use as fiat money.

What I’m proposing allows Bitcoin to be used mostly in whole units irrespective of what it is trading for. This system easily moves from Bitcoin to fiat currency and vice versa. Let’s start with the variables:

  1. Price of item in fiat currency;
  2. Maximum Exchange Rate (= 10 units of correlated fiat currency);
  3. # of expansions of the Fractional Rate. This correlates to demand and is equal to the number of times Bitcoin exceeds the Maximum Exchange Rate. For instance, a Fractional Rate of .000000000000001 means that demand for Bitcoin has caused its exchange rate to “turn over” 15 times. This number is easily determined simply by counting the number of places to the right of the decimal point. In the above example, the # of expansions of the Fractional Rate would be 15.
  4. Price of item in bitcoin units.

The formula for converting fiat pricing to Bitcoin pricing would be as follows:

((price in fiat currency) / (maximum exchange rate = 10)) * (# of unit expansions) = (price in bitcoin units)

Let’s say you want to sell an $899 PC in Bitcoin units. Using today’s current Bitcoin exchange rate in $USD, here’s how it would look:

($899 / 10) * ($221.20/10 = 22) = 1977.80 BTC units

Note: “221.20” is Bitcoin’s exchange rate in $USD as of this very instant; to approximate the Fractional Rate, this number is simply divided by my proposed Maximum Exchange Rate of 10 units of a correlated fiat currency. In this example, this would be equivalent to $10USD.

Conversely, the formula for converting Bitcoin pricing to fiat pricing would be as follows::

((price in bitcoin units) / (# of unit expansions)) * (maximum exchange rate = 10) = (price of in fiat currency)

Using the previous dollar figure of $899, let’s convert Bitcoin units into fiat currency:

(1977.80 / ($221.20/10 = 22)) * 10 = $899

Lets say the fractional rate is 71 instead of 22. Using the same $899 price from the previous example, here are the conversions:

($899 / 10) * 71 = 6382.90 BTC units

or

(6382.90 / 71) * 10 = $899

In this fashion, it is possible to price items in units of Bitcoin relative to fiat currency or the reverse.

This system also reveals some interesting facts about Bitcoin:

  1. It is completely possible to make Bitcoin as easy to use as fiat currency;
  2. As previously stated in my post “Bitcoin and Divisibility,” the demand factor for Bitcoin has an inherently inflationary effect. Simply by increasing the Fractional Rate (which reflects a demand increase), the number of BTC units needed to purchase the same $899 increased proportionally;
  3. Bitcoin and fiat currency are indelibly linked. Without fiat currency as a correlative, pricing in Bitcoin is just as arbitrary as it is using fiat currency.

I will admit that I was wrong about another aspect regarding Bitcoin… it does have tremendous potential as a store of value. The thing I underestimated is how much information has a correlating dollar value, such as deeds to homes or cars and other contracts associated to assets or paid services. While I do not think these things have much value in a pure survival aspect, they obviously have a great deal of value for running a modern society. In other words, I don’t think Bitcoin has the intrinsic value of food, water, medicine, plumbing, electricity or a host of other essential life components. However, its ability to greatly simplify, store, and secure huge swaths of information with corresponding value is profound. Such a development could tremendously simplify many legal and financial processes.

I’m still greatly opposed to Bitcoin as it exists right now and would rather see it fail, regardless of its potential benefits, then have it manifest as another tool for inequality. Should Bitcoin the currency ever be fixed, then I would gladly support it as a technology and platform. But I can’t, in good conscience, support it until then.

The Tone-Deafness of the Bitcoin Community

hands-over-earsI can’t say I was surprised by the recent Bitcoin crash. Indeed, I was expecting it. I’ve written extensively about what I view as its challenges and have even attempted to correct one of its most significant. As it stands, Bitcoin isn’t much of a solution for any problem related to currency.

What has amazed me the most about the reaction to the recent crash has been the tone deafness of the Bitcoin community. The mentality has been what I’d call “defiant denial.” The whole notion is that Bitcoin token value doesn’t really matter, the network will go on. This is pretty much a technicality; yes, the Bitcoin network will continue as long as the marginal costs to produce them is less than their exchange value. The difficulty in producing Bitcoin adjusts based on the number of active miners in the system; difficulty increases when there are more miners and decreases when there are fewer. My assumption is that these fluctuations in difficulty allow the marginal costs of Bitcoin to almost always be low enough for there to be an incentive for them to be produced. However, the trade-off is that, as the total computational power of the network decreases as economic considerations force some miners to stop participating, the network weakens and becomes more susceptible to a “51%” attack.

When Bitcoin crashed, Silicon Valley venture capitalist Marc Andreesen trotted out his New York Times op-ed titled “Why Bitcoin Matters” to rally the troops. I had intended to do a complete deconstruction of it but I thought “Why bother?”. I figured there wasn’t much I could say that a total bottoming out of Bitcoin wouldn’t state more eloquently. Needless to say, Bitcoin sank to under $180 and has since stabilized in the $200 range, down roughly $150 per coin in less than a month. I think that will get much worse over time.

What’s apparent is that the Bitcoin community isn’t looking at it realistically and doesn’t seem to truly understand why no one could really give a rat’s ass about it. There seems to be this arrogant sense of inevitability about it; technologists and Bitcoiners seem to think that it is only a matter of time before the rest of the world opens its eyes to the wonders of Bitcoin. Maybe that is the case, but chances are much better that they are sadly mistaken.

Rather than a complete dissection of Andreesen’s position, I’m only going to address three essential areas. By the end, it should be sufficiently apparent why Bitcoin is not only far from an inevitability, it is currently well on its way to complete failure.

First point: if you’ve read anything about why Bitcoin is supposedly so great, you’ve read about something called the “Byzantine General’s Problem” but more accurately referred to as the “Two General’s Problem.” I won’t go into any more detail about it because:

Neither consumers nor merchants give a damn about it.

The first, and most essential, error Bitcoin fans make is in thinking the Two General’s Problem means anything to anyone other than a software engineer/cryptographer. Third party trust (TPT) is not something to which most people are particularly hostile. To the contrary, TPT is something which generally makes people feel more secure when doing sensitive transactions over the Internet. The notion of an arbiter, even an imperfect one, gives people the sense that, should a problem occur, there is an objective third party capable of solving it.

Since almost no one cares about the Two Generals’ Problem, what actual problem is Bitcoin truly solving for anyone other than computer geeks? Merchants want to make money, consumers want to save it. Bitcoin provides a small way for merchants to keep more of the money they bring in, so a few have adopted it. There is no evidence that Bitcoin saves consumers money (and the volatility of it as a currency practically guarantees it doesn’t), so there is no compelling reason for them to use it… and they don’t. In either case, Bitcoin’s utility is either negligible or non-existent.

This brings me to my second point. In this respect, many Bitcoin supporters think remittances will be Bitcoin’s immediate “killer application.” But here’s the deal… there are only two outcomes possible in the best case scenario. The first is that the value of Bitcoin tokens will increase as transaction demand goes up. For the average person, this will become a problem (I’ll elaborate on this later). The other alternative is that, though low now, transaction fees will increase significantly very quickly. Why? Energy costs, which will increase directly in proportion with transaction demand. The “proof of work” system utilized by Bitcoin is extremely energy intensive as every node keeps a perfect record of every transaction. To cover these additional costs, either the value of the tokens or the transaction fees must increase to compensate. If transaction fees increase, then any price advantage derived from utilizing the Bitcoin network for remittances will dwindle as demand increases.

Which brings me to my last point: let’s say that Bitcoin token values increase and transaction fees remain stable (and low)… what are the economic dynamics of Bitcoin as a currency? For instance, let’s say you purchase .1 of a Bitcoin for $5 and then the value increases such that you can purchase .01 worth of Bitcoin for the same $5. Bitcoin fans marvel at the potentially high deflationary power of Bitcoin but what they won’t tell you is that this is only relative to its relationship with fiat currency. In absolute terms, the purchasing power of every subsequent Bitcoin acquirer decreases as demand increases in a very inflationary way. Pay attention to the fact that your $5 purchases less of Bitcoin’s total purchasing power when demand increased in the example. In other words, as demand increases, the average person’s percentage of Bitcoin in absolute terms will decrease as more people want it. Bitcoin fans will tell you this isn’t a problem because, relative to fiat currency, you can only control whatever amount of Bitcoin you can afford to acquire regardless.

However, what they won’t explain to you is that the increase in demand will cause the values of those who control significant amounts of Bitcoin to explode. Early adopters who have accumulated Bitcoin in large amounts will just be able to sit back and watch their fortunes go through the roof as increased demand shoots Bitcoin values relative to fiat currency into the stratosphere. The result is a form of economic inequality between early adopters (most of whom are already fairly wealthy) and those who acquire Bitcoin later that would make current economic inequality look positively egalitarian. To put this in perspective, as of Feb. 2014, almost 94% of Bitcoin wealth was controlled by about 7% of the addresses. Contrary to what the media would have you believe, this is not a populist movement.

It is on this basic premise that I oppose the concept of Bitcoin as a currency. It fuses the worst aspects of fiat currency and commodity currency into an amalgam which practically guarantees a state of economic inequality that would be orders of magnitude worse than the current fiat currency paradigm. This is not hyperbole, simple mathematics bear this out.

As a technology, Bitcoin is truly amazing. While the average person may care less about the Two Generals’ Problem, solving this issue has long been the Holy Grail for many computer scientists. However, as a currency, problems related to Bitcoin will increase in direct proportion to its utility. It will solve none of the problems of today’s fiat currency paradigm and will increase some in ways that will prove far more destructive.

In the near future, the blockchain may well revolutionize computing. But, in the end, I expect Bitcoin the currency, at least is it operates now, to wind up in the dustbin of history.

The Post Where I Fix Bitcoin

bitcoinIt’s no secret that I think Bitcoin has issues that limit its viability as a currency. However, criticism is easy, finding solutions is hard. So I want to take a shot at solving some of the issues that I think will prevent Bitcoin from gaining mainstream adoption.

In actuality, I don’t intend to “fix” Bitcoin per se because I’m not particularly sure this solution can be implemented. However, I definitely think that, in an ideal scenario, it could make Bitcoin or another virtual currency far simpler to use and more attractive to adopt.

When evaluating Bitcoin, I’ve had a tendency to think in terms of units instead of fractions. Why? Because it’s much simpler. A single whole unit is a pretty easy concept to grasp. Indeed, adding two whole units together is pretty much where everyone starts in mathematics:

1 + 1 = 2

One of Bitcoin’s major flaws is that it moves away from this simple premise and introduces fractional units into basic accounting. Our current money system also has fractional units but they only go two places to the right of the decimal point. Fractional units for accounting in Bitcoin can go infinitely more places to the right. So I think it’s imperative that Bitcoiners get back to the concept of whole units. For the rest of this post, the following concept will be very important:

1 unit

Rather than drag this out, I’m going to keep it simple and just introduce my concept for simplifying Bitcoin. Here it is:

1 unit of Bitcoin = 10 units of the most highly valued fiat currency with which Bitcoin is exchanged

My concept is a hard cap on the value of every unit of Bitcoin. The way this would work is that, starting from the top most unit of Bitcoin, a bitcoin, each unit of Bitcoin can have a maximum value of 10 units of the most highly valued currency of the time or other baseline correlated currency. Using the US dollar as an example, it would look like this:

1 BTC = $10 MAX

What this means is that every bitcoin can only have a maximum exchange value of $10 USD. Now what happens when the exchange rate exceeds $10? Then Bitcoin drops down to the next fractional unit, expanding its potential unit base by 90%. It would look like this:

(1 BTC = $10 USD) = (1(.1) BTC)

1(.1) BTC = $10 USD MAX

In the above statement, Bitcoin’s potential unit base has been expanded by 90%. The “(.1)” of the statement is what I will refer to as the “fractional rate.” This number lets you know how much one unit of Bitcoin is worth relative to the full money supply. The best thing about the fractional rate is that it is completely unnecessary for persons or businesses to track, they only need to concern themselves with units. What happens when these new fractional units reach the $10 USD exchange rate?:

(1(.1) BTC = $10 USD) = (1(.01) BTC)

When those fractional units reach a $10 exchange rate then:

(1(.01) BTC = $10 USD) = (1(.001) BTC)

When those fractional units reach a $10 exchange rate then:

(1(.001) BTC = $10 USD) = (1(.0001) BTC)

… and so on.

The elegance of this solution is that the fractional rate can be tracked in software while people and businesses need only concern themselves with units. For the purpose of familiarity, Bitcoin unit prices could be set out to two decimal places just like it is done with US dollars or any number of decimal places with which a nation or culture is familiar.

This solution also combats two serious issues with Bitcoin today: hoarding and disproportionate control of money supply.

As I pointed out in “Bitcoin and Divisibility,” high demand on a fixed currency lowers the average amount of purchasing power each person holds. Early adopters who have purchased large amounts of Bitcoin benefit disproportionately as higher exchange rates and limited supply constrain the amount available for each subsequent holder. This concept largely mitigates the negatives of mass holding of Bitcoin as the number of available units increases by 90% every time any one unit of Bitcoin exchanges for 10 units of a correlated fiat currency. Not only does this allow proper expansion and contraction of Bitcoin unit supply (the process can simply go in reverse in times of low money demand) but the process, in theory, should not have an actual inflationary effect because the new units are potential units rather than actual; the units don’t count against the money supply until they are actually purchased. In this fashion, the supply of Bitcoin is always in sync with demand.

The most important aspect of this strategy is that it prevents anyone from controlling a disproportionate amount of Bitcoin because they are always measured in units and not ratios. For instance, if someone bought 100,000 units of Bitcoin at the fractional rate of .01 and the rate moves to .001, the biggest loss s/he could take is roughly $10 per unit (using the US dollars example); this applies regardless of how many times Bitcoin moves to the next fraction and only if the holder converts them back into fiat currency. This is an excellent loss limiter.

In other words, regarding units of Bitcoin, 1 always equals 1, the fractional rate is simply a measurement of Bitcoin’s current state of demand. For all intents and purposes, the price of Bitcoin can only fluctuate between 0 and 10 units of a correlated fiat currency so losses and gains are limited to this range. But, once again, this is only relevant when Bitcoin is exchanged for fiat currency; otherwise it always retains its absolute value in Bitcoin units.

By now you may be thinking “Couldn’t this screw miners?” Well, it kind of does… but it doesn’t have to. Simply multiplying the number of bitcoin mined by the number of times the unit supply has expanded and then multiplying that figure by the max exchange cap should create mining incentives similar to the current ones. The equation would be as follows:

(mined bitcoin * # of unit expansions) * 10 (max exchange cap)

For instance, if a miner creates 25 bitcoin and the fractional rate is .001, the number of unit expansions would be three (the easy way to determine this is simply to count the number of digits to the right of the decimal). With a max exchange cap of 10 exchanged currency units per 1 unit of Bitcoin (we’ll use $10 USD for the example), the equation would look like this:

(25 * 3) * $10 = $750

Using the current bitcoin reward of 25 units and its current exchange rate in USD ($314.62 aggregate as of this exact moment), we can compare compensation:

25 * $314.62 = $7865.50

(25 * ($314.62/10 = 31 shifts)) * $10 (max exchange rate) = $7750

[Note: the equation “$314.62/10” is the exchange rate divided by the max exchange cap. This estimates the fractional rate which would, in this example, be a decimal point followed by 30 zeros and a one or “.0000000000000000000000000000001.” This leaves a remainder of 4.62; using the fractional rate method, this would be the current exchange rate for a single unit of Bitcoin]

At double the current USD exchange rate:

25 * $629.24 = $15731

(25 * ($629.24/10 = 62 shifts)) * $10 (max exchange rate) = $15500

Using this method, there would be negligible difference in mining incentives.

To recap, my concept is setting a firm cap on each individual Bitcoin unit at 10 units of the most highly valued currency with which it is exchanged (or, at least, an agreed upon baseline currency). The number of times the cap was reached would be measured with what I refer to as the “fractional rate”; this rate would act solely as a measurement and point of reference regarding overall demand for Bitcoin. The advantages to this system are as follows:

  • Allows Bitcoin to be transacted mostly in whole units, simplifying accounting;
  • Allows more precise expansion or contraction of Bitcoin currency relative to demand;
  • Removes both inflationary and deflationary disadvantages of Bitcoin;
  • Sets absolute cap of losses to roughly 10x lowest possible investment (in whole units in related exchanged fiat currency; exchange rate range in fiat currency would be .01 to 9.99;
  • Sets an absolute profit/loss risk profile for potential investment;
  • Eliminates overall disadvantages of mass holding of Bitcoin while retaining an individual holder’s incentive for holding as an investment strategy. Holding, while no longer having the potential to be immensely profitable, becomes an excellent default strategy as loss of investment value is minimized;
  • Prevents disproportionate control of Bitcoin by early adopters/heavy accumulators, thereby eliminating the potential for structurally high inequality between early and late holders (in other words, minimal penalty for getting into Bitcoin late);
  • Mining incentives are mostly unchanged;
  • Most importantly, in my opinion, the value of Bitcoin tokens are always inexpensive enough to transfer or exchange. “Colored coins” and other programmable currency becomes far more practical.

As always, I acknowledge that this may not be the answer. But, if it is, then finding a way to apply it to Bitcoin should be the first order of business in my opinion. Using this concept, I think it is possible for Bitcoin to fulfill its potential as the currency for the Information Age. Though I doubt it will solve the inherent problems of Capitalism, I think it has the potential to make a positive difference overall.

Can it be applied to Bitcoin? I’m not sure. I leave that to the Bitcoin community to figure out. But, rather than a criticism, it’s an honest attempt at presenting a solution that could actually make a difference.

So here you go, Bitcoin community. My two cents. The ball’s in your court.