Bitcoin is an amoeba, central banks are blowfish

When my mother asked me yesterday if I was still buying the bit points, I took it as a sign that it was time for another bitcoin post.

One of the most popular reasons for owning bit points—sorry, bitcoin—is that the supply of coin is fixed whereas the supply of central bank money can be increased ad infinitum. Like an amoeba colony nearing population saturation, the bitcoin supply is growing at a decreasing rate as it approaches the magic 21 million number, the ceiling specified by designer Satoshi Nakamoto. Bitcoin advocates believe that this controlled supply effectively grounds the price of bitcoin while leaving the value of central bank money to flap in the wind.

But this ignores the mirror image of this argument. Yes, a central bank can rapidly increase the supply of notes and reserves. But blowfish-like, a central bank can just as quickly suck this supply back in—indeed, a central bank can go to the extreme of extinguishing every last liability it has ever issued. Bitcoin, on the other hand, can never be destroyed by its issuer—it has no issuer. The implications of this for the values of bitcoin and central bank money are important. I'm going to use someone else's model to show why.

Mencius Moldbug has a recent post called How Bitcoin Dies. If I'm not mistaken, he's making reference to Adam Ferguson's book When Money Dies (pdf), an account of the Weimar inflation. In any case, I agree with much of what Moldbug (his real name?) writes. Bitcoin's value is highly tenuous, and it wouldn't take much of a shock to send it to 0. I'm going to borrow Moldbug's model of a bitcoin economy and use it to explain a central-bank economy. This will help us to see the core difference between the stabilities of these two exchange media.

Moldbug starts out by imagining that there are 2 types of bitcoin users. First, there are "speculators" who hold bitcoin over time, hoping to earn a return. The second type of user, the "exchangers," only hold bitcoin for brief moments to engage in daily transactions, selling all coins to speculators at the market close. Only speculators, therefore, hold bitcoin overnight, presumably selling it back to exchangers the next morning.

If we abstract a bit from this, what Moldbug is really talking about is the two famous "functions" of money, that of serving as a store-of-value and a medium-of-exchange.

Now if speculators all flee the market at once, then desperate exchangers have no one to sell to come evening time. Bitcoin's overnight price falls to 0. Since bitcoin no longer has any purchasing power, the next day exchangers will find their bitcoin useless as an exchange media. Bitcoin becomes just bits. What might lead to this result? Moldbug hypothesizes that a government closure of the various bitcoin exchanges would spook speculators, causing them to all exit and drive the price down to 0.

I want to show why the same thing can't happen to central bank money. During the day, banks in an economy need large quantities of central bank balances for clearing and payments purposes. A central bank provides these balances to banks in return for collateral. At the end of the day, what do the banks do with these unwanted balances? Well, let's say that they sell them onwards to speculators to hold overnight. Speculators accept the trade because they think they can make a return. The next day the banks repurchase these balances in order to use them for their daily payments. This is very much like the stable bitcoin economy described above.

What happens when the speculators suddenly exit the market? Banks now have no one to sell their clearing balances to at the end of the day. As in our bitcoin case, won't the value of balances fall to 0? No. The issuing central bank will offer to buy all of the balances back.* With what? With the collateral that was originally used to buy them. Unwanted clearing balances will therefore be slurped right back up by the central bank. So long as the central bank holds adequate collateral, it will be able to suck every single clearing liability it has issued, contracting its balance sheet to 0.

This, in short, is why the bitcoin price is highly unstable whereas the price of central bank liabilities is highly stable. All that underpins the value of bitcoin is the presence of a few speculators in the market—whatever random event causes these speculators to depart will be the end of bitcoin. In the case of central bank money, the original issuer is committed to repurchase whatever is unwanted, even if speculators scramble to leave.

In real life, speculators typically don't hold central bank clearing balances overnight. Central banks usually repurchase all clearing balances back at the end of the day, returning the collateral to the banks so they can use it for the next market day. Central banks are like blowfish.** They blow themselves huge during the day in order to accommodate the needs of banks for clearing balances, then suck themselves tight at night when they aren't needed. Bitcoin is like a slowly growing amoeba. It can't contract itself when it needs to.
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PS: What about gold? If speculators all leave the gold market, demand will still be anchored overnight by those who desire gold for ornamentation, dental, and manufacturing purposes. Thus, when the market reopens next day, exchangers will find their gold still has a positive value, although probably far less than the night before.

Disclaimer: I am long bitcoin. Why? I'm curious about bitcoin and the best way to learn is by doing. Secondly, I'm speculating that before it hits $0, it could hit $50. There are a lot of people out there who don't yet realize that they'll be buying over the next months. Keynes's beauty contest and all.

*Central banks are required to ensure that the value of clearing balances stay moored to basket of consumer goods, or a CPI target. They typically do this by setting the overnight bank rate. If no one wants to contract to hold reserves overnight, the interest rate will collapse. The central bank will have to conduct open market sales - basically repurchasing clearing balances with collateral - in order to reduce the supply of clearing balances until the overnight interest rate has returned to its prior level. In any case, that's why a central bank needs to "suck" the money supply back in.

** I'm borrowing the imagery from Alex Tabarrok's 2008 post, although he uses a bullfrog.