By Robert Murphy – LibertyChat.com –

As a completely decentralized mechanism of payment—which relies on numerous copies of a publicly distributed ledger rather than a central institution to keep records—Bitcoin both shows the power of markets to create valuable “network goods” and also limits the ability of the State to crack down on it. In addition, by its very design the number of bitcoins is mathematically limited, making it safer from debasement than even commodity monies like gold and silver. For these reasons, one might have expected every libertarian to support Bitcoin with open arms.

However, in practice this has not occurred. There are many libertarians who argue that Bitcoin can’t ever become a genuine money, precisely because of its unorthodox origin. Specifically, the critics rely on the monetary theories of the Austrian School when raising this objection against Bitcoin. In my talk at the Texas Bitcoin Conference in Austin a few months ago I walked through the framework to show the apparent problem. In the present post, I’ll use a recent article by Frank Shostak to discuss the same controversy.

First let’s quote from Shostak to let him make his case against Bitcoin in his own words:

Some experts maintain that Bitcoin will displace the existent fiat money and will usher in a new era of free banking, which will finally put to rest the menace of inflation.

Unfortunately, this is a pipe dream. Electronic money will not replace fiat paper money. The belief that it can stems from a failure to understand the nature and function of money and how it emerges on the market.

To see where this view goes wrong, let’s first see how money comes about. Money emerges out of barter conditions that permit more complex forms of trade and economic calculation. …

In short, money is the thing for which all other goods and services are traded. Furthermore, money must emerge as a commodity. An object cannot be used as money unless it already possesses an exchange value based on some other use. The object must have a pre-existing price for it to be accepted as money.

Why? Demand for a good arises from its perceived benefit. For instance people demand food because of the nourishment it offers. With regard to money, people demand it not for direct use in consumption, but in order to exchange it for other goods and services. Money is not useful in itself, but because it has an exchange value, it is exchangeable in terms of other goods and services.

The benefit money offers is its purchasing power, i.e. its price in terms of goods and services. Consequently for something to be accepted as money, it must have a pre-existing purchasing power: a price. This price could have only emerged if it had an exchange value established in barter.

Once a thing becomes accepted as the medium of exchange, it will continue to be accepted even if its non-monetary usefulness disappears. The reason for this acceptance is that people now possess previous information about its purchasing power. This in turn enables them to form the demand for money.

…

Observe that a bitcoin is not a thing; it is a unit of a non-material virtual currency. A bitcoin has no material shape; hence from this perspective the notion that it could somehow replace fiat money is not defendable.

Shostak and I agree on the standard Austrian explanation of the purchasing power of money, and how it emerges spontaneously from a condition of barter. We also agree that historically, the monetary good first served as a “regular” commodity that had market value because of the non-monetary services it provided (either in production or consumption).

So does this prove that Bitcoin can never become a generally accepted medium of exchange, i.e. a genuine money?

No, Shostak has not demonstrated this. As he himself admits, people today accept dollars, euros, and other fiat currency in exchange because they have knowledge of its pre-existing purchasing power. In other words, people have a frame of reference for valuing fiat money today because they saw what the fiat money could buy yesterday.

The same holds for Bitcoin. People right now do have an objective anchor point for setting their expectations of what bitcoins will fetch in the market place tomorrow—they can look up the price (quoted in bitcoins) of goods yesterday (or more accurately, 2 minutes ago).

Now it’s true that Shostak and others may argue that the dollar can only get away with this bootstrapping method because of the historical link to the precious metals, but that’s simply not true. How many people who use dollars today, know exactly what the dollar price of an ounce of gold was in 1971 right before Nixon closed the gold window? Moreover, how is such knowledge in any way relevant for making decisions right now about the demand to hold dollars?

The reason Mises needed to supplement his theoretical explanation of the purchasing power of money with his historical “regression theorem” was simply to protect the explanation from charges of infinite regress. In other words, since Mises was explaining today’s purchasing power of money (ultimately) by reference to its purchasing power yesterday, Mises needed to come up with a way to stop the explanation at some finite point in the past. He did this by saying at some point, the monies gold and silver (or other commodity monies) were mere commodities in a system of barter. Economists already knew how to explain relative prices in a barter world, so Mises could stop, having completely explained the purchasing power of money in a logically coherent way.

We can give a similar explanation for Bitcoin. We can trace back its purchasing power until the point at which Bitcoin was invented. Certain people really did sell pizzas and other goods against bitcoins in the first transactions. Why did they do so? I don’t know; ask them. But the point is, they did do so. That gave everybody an objective frame of reference for the market value of bitcoins, which then snowballed to the present day.

In closing, let me be clear that I am not necessarily predicting that Bitcoin will one day be used by billions of people as a primary money. Rather, I am merely arguing that the argument against Bitcoin citing Misesian monetary theory—such as Shostak recently used—doesn’t work.

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