Ever since Bitcoin started to capture the public imagination, I have downplayed the idea that it could ever represent a serious challenge to the US dollar. I disagree with the goldbugs who believe that simply fixing the supply of money is the best monetary policy, that inflation is theft, etc. Rather, I have argued that Bitcoin is a good medium of exchange despite being a bad unit of account and a risky store of value. These three functions of money tend to go together for reasons that Ludwig von Mises outlined over a century ago in The Theory of Money and Credit. But more recent research from the 1980s and 90s has explored the possibility of the separation of these three functions. A contemporary example of separation is that Treasurys are used to settle transactions in the shadow banking system, even though the transactions are denominated in dollars—the medium of exchange is different than the unit of account. Bitcoin could be just another example of the continuing separation of the functions of money as technology progresses.

I still think that this is correct—we are observing modest separation of the functions of money. Bitcoin doesn’t need to be a unit of account in order to be useful. On it’s own, Bitcoin makes a terrible unit of account.

But.

This is speculative, but there is a scenario in which Bitcoin could create a real challenge for state-backed currencies. This scenario is not impossible.

As I wrote last week at The Umlaut, Bitcoin is not just money, it is a decentralized platform for generalized, programmable contracting, a transport layer for finance. It can be used to create all kinds of financial contracts, including, with the help of a trusted computer called an oracle, contracts contingent upon events in the real world. Suppose that an oracle existed that reliably provided information about the USD/BTC exchange rate. It would become possible to create a long-term contract, executed through Bitcoin, denominated in dollars. If the cost of querying the oracle were negligible (as we might expect it to be), then the cost of this trade would be the forgone interest on the funds used to meet the “margin requirements” built into the contract.

Now assume a second oracle that reports nominal GDP. By combining the two oracles, it becomes possible to write a contract, executed over Bitcoin, that is denominated in shares of NGDP. In fact, we could simply standardize this transaction and create a new currency unit, built on top of Bitcoin, that is equal to a trillionth of NGDP. We could call it a Sumner. Instead of getting a mortgage for $300,000 for a house, you could promise to pay 19,000 Sumners. That way, if the economy went south, you would owe less in real terms, and repayment would not become harder. If the economy boomed, you would owe more in real terms, and repayment would not become easier. Similarly, workers who had wage contracts denominated in Sumners would experience a real pay cut when the economy shrank, decreasing their employers’ incentive to fire them, and an automatic raise as the economy grew again. Sumners would have built-in monetary policy.

So by combining information from two oracles into a simple, standardized, tradable futures contract executed over Bitcoin, we create a cryptocurrency overlay that is superior to dollars, at least according to the market monetarists (see Scott Sumner’s 1989 paper and his recent Mercatus paper). As I said above, this is speculative; as far as I can tell, there are no oracles or Bitcoin-executed futures contracts yet. And there are at least two further (possibly surmountable) problems.

First, it remains to be seen what the long-term cost of hedging will be. The margin requirements built into a Sumner depend on how volatile Bitcoin is with respect to NGDP. It’s possible that over the long run, the volatility of Bitcoin will settle down a fair bit, even if it is never as stable as the dollar. If Bitcoin is some day only 3-5 times more volatile than the dollar, that should be enough to support the creation of Sumners. For now, Bitcoin’s price swings are still incredibly wide.

Second, there remains the puzzle of why we don’t see NGDP futures in the dollar economy. As far as I can tell, there are no regulatory barriers to creating them and using them to denominate transactions. Yet in spite of their supposed superiority to dollars, no one uses NGDP futures to trade, and indeed, there aren’t even NGDP futures markets. If it’s a question of there not being enough permissionless innovation in the financial system, then maybe market monetarists should embrace cryptocurrencies as a way to try out their ideas.