I have long been fascinated by both the progress made so far, and by and the promise of this new era of decentralized money that is only just beginning. Although I lack the technical expertise to fully understand the finer points of the code behind the different cryptocurrencies or to assess the nuances of the inner workings of Bitcoin, I do understand money, its history, its multifaceted functions, and the potential for abuse once a monetary monopoly arises. Therefore, I was inspired by the revolution that started with Bitcoin. The fact that its popularization put the idea in people’s minds that there can be better options than fiat currencies gave me hope that we might see the end of total state dominance over money in our lifetimes. It also convinced me that Bitcoin, as well as other decentralized currencies that might rise in popularity in the future, must not be seen as competitors to precious metals. They can easily provide better payment vehicles than national currencies, and provide a better medium of exchange. Gold will remain a superior store of value, as it has been for millennia, and in a tokenized form, its relationship with new digital currencies will likely prove to be a symbiotic one.
With these principles in mind, I like to read and to expand my knowledge on this topic, while I also seek out the guidance and insights of the people who have a much better understanding of the subject matter and all its different aspects. Their expertise has helped me attain a more well-rounded view, as they can illuminate and consolidate different points and arguments, either from a technical perspective, a financial or academic angle, or a philosophical one. This is why I was very happy to make the acquaintance of Konrad S. Graf, who kindly agreed to share some of his thoughts and insights on Bitcoin, on the topic of sound money and on the importance and impact of monetary decentralization.
Konrad S. Graf (@konradsgraf on Twitter) has published articles on bitcoin monetary theory and action-based legal philosophy and has delivered lectures and presentations on these topics at conferences in Europe and Australia. In 2015, he published “Are Bitcoins Ownable? Property Rights, IP Wrongs, and Legal Theory Implications”, a monograph on bitcoin and action-based property rights theory. His article, “Commodity, scarcity, and monetary value theory in light of Bitcoin,” appeared in The Journal of Prices & Markets. His monograph, “On the Origins of Bitcoin: Stages of Monetary Evolution”, was among the final three for a Blockchain Award for most insightful academic paper (the Bitcoin White Paper won).
Claudio Grass (CG): Among conservative investors, there has been a lot of skepticism and some hostility to the emergence of crypto- and digital currencies. Most of the superficial criticism has focused on the idea that they have no physical backing, but some arguments go further, for instance highlighting the extreme volatility in the new sectors, the numerous crypto heists and security breaches. Do you see these as the normal teething problems of any new industry or do you think these risks are “baked-in,” because of the nature of these new technologies, and thus they might persist?
Konrad S. Graf (KS): The security breaches one hears about in the news from time to time are of particular peripheral entities. Exchanges are the most common targets. I have argued that the uncertain and sometimes hostile regulatory environment has made the “teething problems” in these peripheral services industries much worse than they have needed to be. Whereas the anti-free-market mindset likes to blame “lack of regulation” for any problem and credit “regulation” for anything that works well, the presence of unhelpful regulation, or even the threat of it, also brings unintended and adverse consequences.
For example, the most natural adjacent industries such as banks, existing exchange markets, and financial services have tended to keep as far away as possible from cryptocurrencies, in part because they could not enter the field, even if they wanted to, due to regulatory obstacles, or even just expectations of potential regulator displeasure. This left the field wide open to amateurs, who either did not know about or did not care much about these concerns. The most infamous example was the MtGox exchange of earlier days. It eventually went bust due to incompetence, or rather, a competence level that had become insufficient to the rapidly rising weight of the task.
This has all changed quite a bit by now. Though weak and shady exchanges still exist, a few of the most reputable specialized crypto exchanges seem quite sound in their practices, at least based on the fact that they have a long track record of consistent security despite being obvious targets. In a notable new development in Germany, banks will be officially permitted, through licensed subsidiaries, to sell cryptocurrencies to their customers and offer custody services starting in January 2020. These banks face a crypto-specific learning curve, but best practices are by now already out there to be emulated. The Börse Stuttgart, Germany’s second-largest stock exchange, has already offered crypto trading to select clients for some time, but would now be able to open up this service to anyone in Germany.
Increasingly, more professional organizations can now step into these roles, something they could have done years ago, absent preemptive regulatory strangulation. Oftentimes, what people instinctively blame on lack of regulation, is instead the result of a regulatory climate that stands as an obstacle to higher-quality and more reputable players entering a nascent market sooner.
Some Bitcoin evangelists have emphasized the idea that you can “be your own bank” with Bitcoin, as you can manage your own keys and storage and payments directly. It is important that this is possible and that some people actually do it. However, one should also understand that many individuals and even some organizations will not feel qualified to manage their own bitcoin directly—and they will be right! Legitimate custody services are in demand for a number of good reasons and this is also the case with Bitcoin, in which, for example, errors are wholly irreversible.
The fact that a person or entity can manage their bitcoin directly without any custody service is important because it helps discipline custody services. In Bitcoin, there is a quite viable end-user opt-out path, not just from one particular custody service rather than another one, but from any such service whatsoever. With conventional systems, one has to either choose some bank to use or be excluded from large sections of the financial system. This makes it easier to maintain the licensed cartel system of conventional banking. In contrast, a person can fully participate in Bitcoin either by choosing a custody service, or by opting for the “do-it-yourself” approach, or a bit of both.
CG: The 2017 bubble and its subsequent implosion gave ample ammunition to Bitcoin’s detractors and to those who saw the currency as the epitome of fiat money. What would be the counter-argument to this view and, in your estimation, does Bitcoin constitute sound money?
KG: The most important step to properly assess this issue is to first separate what can be understood about Bitcoin from what can be said about the crowd behaviors and sentiments of both markets and competing commentators, especially in a climate of shifting regulatory uncertainty. The bitcoin price at any given time is quite a separate matter from the nature of the Bitcoin system itself, which simply continues to operate year after year as designed.
The concept of fiat money means money by decree and came to be used in contrast to commodity money. This raises the question of what “commodity money” means. I addressed this in some detail in my paper, “Commodity, scarcity, and monetary value theory in light of Bitcoin” (The Journal of Prices & Markets). Basically, though not currently functioning as a money – monetary asset seems a better descriptor – when we look carefully at what the concept commodity means in economic-theory terms, bitcoin qualifies as one on every count. Thus, if bitcoin did begin to function as “money,” it would be best viewed as a new variant of commodity money, that is, a digital commodity money.
Bitcoin was running for nearly a year in 2009 as a technical experiment before markets began to value its units at any price whatsoever, after which the units started to be priced in fractions of a cent. A market valuation emerged on top of a long-existing purely technical substrate. Satoshi Nakamoto did not declare in “fiat” style that bitcoin would have a monetary valuation, he just launched a technical system and explained how it might be used. A bit less than a year later, the data began to show the first emergence of proto-monetary valuation through free trading on the open market.
The essence of the idea of sound money is the reliable limitation of the rate of new unit production. “Soundness” is relative and such limitations can come in many forms. There are organizational structures, committees, and laws related to the production rates of fiat monies.
These result in various levels of soundness over time, relative to other such monies. Compared to this, a requirement that a money contain or be backed by a certain amount of precious metal seems like it would be a more reliable strategy to limit quantity inflation, because there are unavoidable costs of obtaining more such metal. Gold has come to display the strongest stock/flow ratio of any commodity, which helps explain its very long and ongoing role as a dominant monetary asset.
The stock/flow ratio model has been popularized in Bitcoin circles through Saifedean Ammous’s essential book, The Bitcoin Standard: A Decentralized Alternative to Central Banking (2018). Using this model brings more specificity and quantitative comparison potential to the otherwise more general idea of “limited production.” A large stock of gold is above ground and refined. One reason gold’s stock builds over very long time scales is that it does not decay. Relative to this above-ground stock only a small amount of new production or recycling is possible in a cost-effective way in any given year. Even if the gold price rises substantially, only relatively little additional gold can be won through increased mining investment. Returns diminish severely. On the stock/flow ratio, gold is clearly superior to any other physical commodity good for a monetary role.
Now here is where things get interesting. Bitcoin is designed to enforce a strict limit on new production of its digital units. This rate of new production declines about every four years until eventually reaching zero. That is “zero” as in no more new bitcoins, ever again. As a result, the bitcoin stock/flow ratio is set to surpass that of gold in 2022 and Ammous estimates it will be double that of gold in 2025 and then continue to pull ahead after that. This is not a matter of mere opinion, preference, or current market sentiment. It is baked into the nature of what Bitcoin is and how it works. There is also an intriguing recent indication that Bitcoin’s mainline long-term price trend has indeed been tracking its evolving stock/flow ratio over the years so far.
Integral to this design are methods and incentive balances through which it has been rendered extremely difficult, if not impossible, for any party to alter the production rate. Bitcoin is designed with an ingenious combination of several different types of cryptography with an open-source software model and a set of built-in incentives for miners to keep the whole thing running. On this see my Bitcoin: Magic, fraud, or “sufficiently advanced technology”?
CG: You mentioned that a system of backing with precious metals “seems like” it would be a better idea. Do you have some doubts about the backing idea?
KG: While the idea of “backing” sounds good, certainly compared to fiat money, it also implies an inherent separation of the monetary good itself from some issued substitute for it, such as an account entry or paper note. The very fact of this separation already introduces significant scope for corruption and behind-the-scenes shenanigans, what is called an “attack surface” in computer security.
And indeed, with gold- and silver-backed monetary systems, we have seen a long and varied international history of corruption. Official coins were replaced with lighter ones or more copper or silver was blended in with each redesign, the specie reserve ratio became tiny compared to the volume of substitutes, circulating units were simply “redefined” as exchangeable for less metal, and so on.
It was backing systems that did in fact give rise to fiat systems in historical sequence. Fiat money is often viewed as dramatically discontinuous from what came before, but it can also be viewed as just the next, more advanced stage in a long-running process of corrupting backing systems. There is also continuity in that even fiat issuers still maintain substantial quantities of gold in their vaults.
Bitcoin, in contrast, is the digital monetary good itself and can be sent directly anywhere without using any substitute, although substitutes can still be advantageous for certain applications. This helps avoid a large part of the risk inherent in any sort of backing system, including the “slippery slopes” that monetary history has vividly illustrated.
Even if bitcoin substitutes such as account entries, or even other cryptographic token substitutes, also came to be used—which I think they probably would for practical reasons of payment convenience, speed, cost, and privacy—Bitcoin still has another unique advantage. Any financial institution that claims to have a certain amount of bitcoin backing for its issued substitutes can be asked to prove it. Since a public block-chain is a transparent record, it is a relatively simple matter to “prove reserves,” now in a monetary context, by producing appropriate cryptographic evidence of control of specific addresses for anyone—or at minimum for auditors—to see in real-time.
The “real thing” that bitcoin is “backed by,” if one must use such terms, is the unique global network of computers running the Bitcoin software and in particular the specialized mining hardware working on the BTC chain. With this highly specific capital equipment, definite flows of electricity are consumed and turned into chain security, which includes protection of the monetary policy. Critically, this equipment and these energy flows are providing security for this chain and not competing ones.
In the upcoming second part of the interview, we tackle some of the common misconceptions about Bitcoin. Konrad also shares his outlook on Bitcoin’s potential in challenging currently dominant closed systems like SWIFT, as well as his expectations about the future of money itself. A key theme will be differentiating the qualities of a competitive money unit from those of a competitive payment service.