Will Luther on Bitcoin, Vodka, and the Emergence of Money

Bitcoin and other cryptocurrencies are emerging as the new cutting edge of technology, and this may have major implications for the future of macroeconomic policy.

What is money and where does it come from? Will Luther, assistant professor of economics at Kenyon College, joins the show and explains the two competing theories on the origins of money. The first theory posits governments are needed to provide credibility for money as a medium of exchange. The second theory, the spontaneous order theory, argues market actors will arrive at an acceptable medium of exchange on their own. David and Will discuss historic examples of both public and private money, including the Somali shilling and the brief use of vodka as a form of currency in Russia in the 1990s. Will also explains how Bitcoin and other forms of cryptocurrency work and how cryptocurrency may affect future macroeconomic policy.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Will, welcome to the show.

Will Luther: Thank you very much for having me. It's a pleasure to be here.

Beckworth: You've written a lot, both theoretically and empirically, on how money emerges, what's required for money to emerge, and there's some interesting work that you've done. I want to share that with our listeners. I want to begin with the paper that you wrote with Alex Salter, recently published and it looks at two competing theories for why money emerges. One of the theories, as you articulate in your paper, is the state theory of money. The other is the spontaneous or the emergent theory of money. Can you describe these two competing views of what causes money to come about? Along the way, maybe define for us, what is money?

The Origins and Competing Views About Money

Luther: That's probably a good place to start. What is money? Economists typically define money as a commonly accepted medium of exchange. There are two aspects of that definition. The first is that it's a medium of exchange, so it's an item that you will accept in exchange, not because you want to consume it yourself, but because you believe that it will enable you to trade for some good or service that you would like to consume more quickly than the good you produce. That's what we mean by medium of exchange.

Luther: When we say a commonly accepted medium of exchange, we're talking about some item that you'll trade indirectly through, that most others are also trading indirectly through. Lots of items might function as a medium of exchange. You can think about if you go to a swap meet, you might be able to trade some shoes for a shirt, but most people aren't making transactions with shoes and shirts. They're using cash and so although shoes and shirts might function as a medium of exchange in some particular transaction, in most transactions we're going to be using a commonly accepted medium of exchange, like dollars. That's what we mean by money.

Luther: The big question is, what role does government play in determining the medium of exchange? At the risk of oversimplifying things a bit, we can sort all economists who have weighed in on this in the past into two categories. The first, as you mentioned, is the state theorists. We're thinking about folks like George Knapp and Abba Lerner. These are folks who think that governments are important, or perhaps necessary, for not just the emergence but also the continued acceptance of commonly accepted medium of exchange or money.

Luther: How does that work, the state theory of money? In general, state theorists are going to be talking about things like legal tender status or public receivability. That means declaring a particular money can be used to pay your taxes or when a government commits in advance to making all of its expenditures in a particular money.The state theorists, at the extreme end, they're going to say that a government can choose virtually anything to serve as money, so long as it grants it legal tender status or makes it publicly receivable ‑‑ that is, the taxes and expenditures.

Luther: On the other side, we have what we might think of as the spontaneous order theorists, where we have in mind folks like Carl Menger. The spontaneous order theorists are going to argue that money can emerge naturally out of a decentralized market process. Menger, in his famous account, "On the Origins of Money," he said, look, when folks are bartering with one another, they come to market, they're willing to trade the good they produce for the good that they consume, but they're also willing to accept some other good that's more salable ‑‑ that is, more people want ‑‑ because that will enable them to trade for the good that they ultimately want more rapidly.

Luther: You get this process that the economy converges on one or maybe a couple items that everyone is using as a medium of exchange. Broadly speaking we have these two camps. One says government's necessary for the emergence and continued acceptance of money. The other says, "No, no, you don't need government. Money can emerge naturally." As I like to tell my students, historical thinkers, their views are almost always more subtle than we give them credit for today. Admittedly oversimplified, but that's essentially the two opposing views.

Beckworth: Let's take those two ideas and apply them to, say, a group of people thrown on an island. So let's take the TV show, Lost. Let's say they never got off that island. They had descendants, communities emerged on that island. The spontaneous order would say, "Look, at some point these individuals would find some commodity, something that they could use to facilitate change." They would find it in their own interest to make life easier. To be able to trade with each other, they would have to come up with some kind of common item.

Luther: The beautiful thing about the spontaneous order approach is that it doesn't require that someone conceptualize thi,s or has some intentionality in advance at the system level. It's actually important to make the distinction where this theory is appropriate. For example, David Graver is an anthropologist who's cast doubt on the spontaneous order theory of Menger.

Luther: He'll say, "Well, before modern market economies, we didn't live in a world of barter, we lived in very small tribes where you produced for your family, and your family produced for you. You just gave each other everything." There wasn't any exchange in a commerce. We can dismiss Menger's account on those grounds. In fact, Menger recognized that there was this tribal society where people engaged in what modern economists would call gift exchange. We need to make a distinction between what we call the intimate order and the extended order.

Luther: Menger is talking about the extended order, trading with strangers. When you produce some goods, suppose you produce corn, and you come to market, and you want to buy some other good, like a barrel of beer. The problem in that situation is that you have corn and you want beer, but just finding someone who has beer isn't enough. You have to find someone who has beer and wants corn.

Luther: Menger says, "Look, when people were in that situation, you don't have to solve this double coincidence problem in one shot because you can trade your corn for some other good, maybe, wheat that you believe someone producing beer will be more willing to accept." Wheat, in that case, can function as a medium of exchange. You're on this island, like Lost. It's not that we would all get together and say, "What are we going to use as money?" One, if it's a very small item, we're in an intimate order, so we might not engage in monetary exchange at all.

Luther: Supposing that it's a big enough item, we've got to trade with those folks from the Dharma Initiative on the other side of the island. We don't interact with them. In that case, we would just be coming to the peripheral of our society with our production goods and trying to trade those production goods for goods we want to consume. In doing so, we would accept more saleable items, but the really cool thing about Menger's theory is that when you accept an item that's more saleable, you make that item even more saleable which means other people now have a bigger incentive to accept that money. When they accept it...

Beckworth: It's a network effect.

Luther: They make it more saleable. It's a bit of a snowball effect or a network effect. This money just emerges.

Beckworth: Let me go back to David Graver because he's been controversial in promoting his views. You brought up an interesting point that George Selgin has written about recently. You used an interesting way of framing it. I've often thought of it this way. I see money emerging in that framework similar to property rights. If you're in a small prehistoric village, community farming, there's trust, there's a moral code that causes you to behave properly. You know each other.

Beckworth: There's expectations, but as population grows, as small villages become large villages become cities, and you don't know people, the reliance on trust ‑ you can't go there. You have to rely on some other institution. Something else has to emerge that encourages good behavior, and so property rights. So, yes, many anthropologists will mention that prehistoric societies didn't have property rights, but they didn't need them. When you move to a metropolis of several million people, property rights are very important. I see money in the same manner. Am I understanding you correctly? When you get to that critical mass and there's enough people, you begin to not know each other. Money forms a very important role.

Luther: That's right. It's not an either‑or scenario. You can have overlapping institutions. The important thing to keep in mind is that money is an institution that facilitates exchange, but it's not the only institution. Today, I'm guessing that you don't pay your kids for their chores and then charge them for their Cheerios. You are in a long‑term relationship with the members of your family. Just because of the proximity and the types of relationships those are, you have access to some mechanisms. You can punish your kids if they don't do their chores. They can throw a temper tantrum if you don't give them the cereal that they want. You have some other mechanisms, trust and reciprocity, that will enable those relationships to be mutually beneficial.

Beckworth: The medium net exchange does not completely displace these other institutions that have always been there.

Luther: No. There's an intimate order and there's an extended order. For very small‑scale interactions with people you're trading with regularly, that's what I'm referring to as the intimate order...

Beckworth: The family.

Luther: Yeah. You don't need a commonly accepted medium of exchange, because you have access to other mechanisms to govern your behavior. When you're talking about trading with strangers, trading with people that you may not see as regularly, or maybe you're just engaged in more complicated transactions, now we're talking about the extended order. It's a bit naive to think that the institutions that work best in the intimate order are also the institutions that work best at the extended order. In effect, what we see is that in the extended order, if we don't have access to the same degree of trust and reciprocity, we rely on other institutions like money.

Beckworth: Going back to these two competing theories, the state order and the emergent, spontaneous order. As you just suggested, there's room for both. I think in your paper, you make the case that there's some truth in both theories. Can you articulate that understanding and give some examples from history?

Luther: For the listeners, if you want to organize your thoughts, you can think about a two‑by‑two quadrant here. The question is, "Is government necessary? Yes or no?" The other question is...we can think of two questions here. On the other axis, we can think of for the emergence of money and for the acceptance of money. We can also break this down further and say for the emergence and continued acceptance of commodity monies and for the emergence and continued acceptance of fiat monies.

Beckworth: Can you describe the difference between commodity and fiat money?

Luther: Sure. By commodity, we're talking about an item that someone somewhere wants to exchange because they want to consume that item, historical commodity monies like gold, sugar, or salt. Sure, these items might function as a medium of exchange, but they're also goods that people use.

Luther: We can contrast that with fiat monies. The word "Fiat" means by decree, which suggests some sovereign backing. When economists use the word "Fiat," what we mean is that it's intrinsically worthless, or to state it another way, no one accepts this item because they consume it. Their only reason for accepting it is because it has some monetary value. They believe they can trade it for some other good that they accept.

Beckworth: Let's go to history then, and look at some experiences where maybe both theories can shed some light on what actually happened. I want to go to a case that you have written about extensively. You have several papers on this. This is the Somalia shilling. Give us the backstory of how did this currency emerge, and what's really interesting about it given the civil war that took place there.

The History of the Somali Shilling

Luther: First, let me say that I was interested in this case of Somalia because I read a paper by George Selgin, whom you mentioned earlier. I believe it was in a 2004 economic journal article where he says, "Look, we have these models where it says fiat monies, that is intrinsically worthless items, can emerge as money without sovereign support."

Luther: If we look at the historical record, that doesn't seem to be the case. All of our unbacked fiat monies are government monies. That suggested an answer to one of these questions. Can fiat monies emerge naturally? Selgin said no. They have to have some sovereign support. I don't know if he still holds that view. We can talk about a case later that...

Beckworth: What you're saying is that the US government cannot just introduce a dollar. It had to have some backing initially before it could become accepted.

Luther: Yeah. Selgin would say...In an earlier paper, he actually argued that when you introduce a fiat money, you have to first fix its exchange rate with some previously circulating monies, some item that has a historical value. After it gains acceptance, you can take that backing away or you can remove that fixed exchange rate, however you want to phrase that. It can continue to circulate as a fiat money like our dollar does today. You would need some government to introduce that fiat money.

Luther: Back on our lost item, it wouldn't just emerge naturally in the same way that a commodity money would. If you think back to that Mengerian story, an item becomes money because it's first an item that people accept that's very salient. With intrinsically worthless items, no one accepts them initially, so they never get off the ground. That's why Selgin argued, at least in those earlier papers, that you needed some sovereign support to get those monies off the ground. That's the question of emergence. We'll move on to Somalia.

Luther: In 1991, the government of Somalia collapsed. Somalia had a currency, the Somali shilling. When the government collapsed, people continued to accept the Somali shilling. It becomes a more interesting case down the road, but if we think about that evidence, they still accept the Somali shilling today. If we just think about that evidence, that suggests that even if Selgin is right, we need some sovereign power to launch that fiat money. Once it's launched, we no longer need sovereign power for continued acceptance. After some period of continued acceptance, we have some other mechanism to maintain support for that intrinsically worthless item. We can see that we're somewhere in between these two theories.

Beckworth: What would you ascribe that to? Network effects? "Everyone else is still using the shilling, so I will continue to still use the shilling?" Is that the reason...

Luther: Historical acceptance provides pretty salient focal points. If you think about what money to use as a sort of coordination problem? It's a lot like, should we drive on the left side of the road or the right side of the road? The decision left or right isn't nearly as important as the fact that we all make the same decision. It's the same with money. No one wants to use the money that no one else is using. Once we're already using the money, absent some clear death knell for our existing currency, we're going just continue using them. We can we are in the middle of these two views now.

Beckworth: That's what happens after the government falls. The Somalia shilling is still used. Tell us about what happens later though with the counterfeiters?

Luther: Here's the thing. A few things happen when you don't have a government to manage your government‑sponsored money. One is that, the Federal Reserve in the United States they will take those out of circulation and replace them with new bills. Even when you get a one‑dollar bill that's not so worn and when it gets deposited in a bank if it's too worn they'll exchange it out for a crisp new one.

Luther: In Somalia that didn't happen. The first thing that happens is that the notes in circulation get very worn and they are described as smelly, because no one maintaining the circulation. Then we got some entrepreneurial individuals in Somalia, they said, "Wait a second, the 1,000 Somalia shillings note is currently trading for around $013 and we can contract with some foreign printing houses to copy these notes to create forgeries.

Luther: I won't say counterfeiting because the counterfeiting is an illegal reproduction and there is no government in Somalia, so it's not counterfeit. They contract with these foreign print houses to create forgeries of primarily the 1,000 Somalia shillings note, but also there were some copies of the 500 Somalia shillings note as well, because it was profitable to do so. You can print them for about $003 and they're worth about $013 and so you make a healthy little spread there and so they did. Of course anyone familiar with the quantity theory of money knows that as you produce more money, the value of that money falls.

Luther: They continued to import these forgeries until the exchange value of the 1,000 Somalia shillings note, the largest note in circulation was driven down to the cost of producing an additional Somalia shillings note. The exchange value was roughly $003. You might say that these private producers of Somalia shilling notes transformed an intrinsically worthless fiat money into a commodity money or a quasi‑commodity money because the new Somalia shilling, the forgeries of the Somalia shilling were eventually worth the cost of production. That is the cost of the ink and paper that those notes were comprised of.

Beckworth: That's a fascinating story. It illustrates the many principles in economics. Basic ones like, you produce up to the point where marginal benefit equals marginal cost. Producers will keep making those shilling note up until they get the value that cost them to produce it. Also it's fascinating in the sense that it shows how the commodity ‑‑ as you mentioned a commodity like money can emerge on its own. Now, it's more complicated than that, because there's this network effect. People have been using the shilling already, so they have this base to go off of.

Luther: Another thing I like about this story is that, it would also illustrate some constraints that emerge because money is socially defined. We accept what is money because of what other people except. What we're going to use this money. In his Fordham lectures, Milton Friedman considered a case of the private production of money and of intrinsically worthless fiat moneys and basically said, "No, you know, that doesn't work.

Luther: You'll get a hyperinflation because the issuers will just increase the denominations that are printed and there is no upper bound on how much of inflation you can get." Another way to think of it is there is no lower bound on the value of the money. You just erode it until it's worthless. That didn't happen in Somalia and the reason it didn't happen is because the largest denomination note that would be accepted was the largest domination note that had been accepted prior to the government's collapse.

Luther: It was very difficult to detect forgeries. There were really good forgeries. One way to spot a forgery is if suddenly someone tries to pass a note that didn't exist in the past, [laughs] you would not have any reason to believe that that's real, so you wouldn't accept it. Of course potential producers know this in advance, so they don't bother producing them. You get this upper bound on inflation or lower bound on the purchasing power of money where the largest nomination note equals the cost of producing them anew.

Beckworth: It seems when you thing through, what would happen in different scenarios? Like what if suddenly there's a big money demand shock? What if people for whatever reasons began to hoard money? They're nervous about the future and this means, rarely be the case over there. They probably have more supply‑side shocks. Let's just play along with this thought experiment. It's interesting to consider they probably ‑‑ that would increase the value of the currency?

Luther: That's right.

Beckworth: Then what would happen is these ‑‑ not counterfeiters ‑‑ these entrepreneurs as you said, they wouldn't have every incentive to go and make more notes, so money supply would go up. It would accommodate increase in money demand and it would be back to equilibrium or a steady‑state. If I'm not mistaken what you're suggesting is, this is a very stable monetary system. Am I right?

Luther: Yeah. I'm not suggesting that we replace current currency dollars with these really low value Somalia shillings note. They're certainly perfect, but in terms of maintaining the stability of the purchasing power, like all commodity monies, they have this built‑in, automatic mechanism, such that when demand for money increases and pushes the purchasing power of the money up. It pays to produce more of that money and in doing so, you increase the supply of that money and drive the purchasing power back down. You get this long‑run anchor on what the purchasing power of money is going to be and its going to depend on the cost of production.

Beckworth: I want to be clear. I'm not saying we should do here in the US. Given the alternative in Somalia, which might be a simple bank, which should be run by the same warring factions and the problems with institutions they have. It seems like to me this is a great outcome given what the alternatives are.

Beckworth: In fact we have a great counterexample of that. Going on south on the continent you go to Zimbabwe. Zimbabwe had hyperinflation. Let's talk about that episode briefly. It's really a interesting case and maybe you can help me understand how these two theories maybe apply here. Just to go back a bit. Zimbabwe has hyperinflation. What year did that start? Is it 2000...?

Luther: It's around 2008. Was that the peak year?

Beckworth: That was the year I think it ended. It reached its peak in 2008. 2007‑2008 is when it really takes off. The President Robert Mugabe is doing some policies that lead to this. The state's falling apart, they resort to the printing press and it gets so bad they eventually just say that they give up. Eventually the central bank, the government realize, they were just completely making things worse through this hyperinflation.

Beckworth: Steve Hanke at Cato has a great data on this experience. I encourage listeners to go take a look at his material. We'll have a link up for it, but what's fascinating is what happens afterwards. Once the government of Zimbabwe actually says we're done,. and you guys can use whatever you want to use. Almost overnight dollars appear. US dollars becoming medium of exchange along with to a lesser extent the South African rand and that serves as a medium of exchange for them. How would you apply your two theories to that story?

Luther: Yeah. I know you had John Taylor on your show, a couple weeks ago. John Taylor once said. "No self‑respecting monetary economist walks around without 100 trillion Zimbabwean dollar note in his pocket. Unfortunately, I don't have one of those, so you can infer from that what you will. It's very interesting, because in fact some people in Zimbabwe had already started using dollars or more rand and some places they were using gold as well. It is illegal to do so. That also shows, not just in Zimbabwe but in other cases of what you might call spontaneous dollarization.

Luther: It also shows that there are some limits on the extent of a sovereign power. Governments over some range might be able to determine the medium of exchange, but if the medium of exchange they are supporting is sufficiently bad, if it doesn't maintain a purchasing power much at all. If you're experiencing hyperinflation, then the folks in economy are using that money, at some point they're just going say, "Enough is enough. I will risk the punishment or imprisonment that the government is going to dole out if I'm caught using an alternative money because the money that they're requiring that I use is worthless." They gravitate to these alternatives.

Luther: We see some episodes of what we call spontaneous dollarization. That suggests that, even if we were to conclude that sovereign support is a necessary condition for the continued acceptance of a fiat money ‑‑ the case of Somalia suggest we shouldn't ‑‑ we can't conclude that it's a sufficient condition, because we have these episodes where things get really bad and people abandon the currency that has a sovereign support.

Beckworth: Another interesting example, I often share with my students is the case of Russia in 1998. They had a number of problems leading into that, but on top of all their own domestic problems, we have emerging‑market crisis money '97‑'98, it becomes contagious and spreads around the world. We find that Russia defaults on some of the short‑term government debt and this leads to a brief bout of hyperinflation. At least it's above the 50 percent benchmark [inaudible] out is the criteria to be hyperinflation and interestingly enough during this time a number of people resort to Vodka.

Beckworth: Vodka gets used as the medium of exchange and I saved it, I have a screenshot from CNN on their web page 1998. I saved this. Still have it. It shows these people hoarding these boxes of ‑‑ carrying these boxes of vodka. They're interviewing the people and the man says. "Look, I don't even drink vodka but I'm keeping it because this is what I need to do to get the things I want to survive."

Beckworth: Eventually, about the same time actually Russia at some point re‑denominates its ruble, which is another interesting part of the story. In '98 they introduced a new ruble to replace the old ruble. The new ruble comes at one new ruble for 1,000 old rubles. There's a lot of interesting and moving parts there, but I want to stress the emergence of, at least a temporary emergence of Vodka as a medium of exchange to underscore the point you've just said. There's some limits to the sovereign's ability to determine what is the medium of exchange.

Vodka as a Medium of Exchange

Luther: Yeah, you can think of Vodka as being particularly salable to use Menger's language. It's very easy to identify. With just a small sip you can taste the quality or the purity of the Vodka, especially if it hasn't been watered down. If it's something that a lot of people are already consuming then if you have some, there's a pretty good chance that you're going to be able to trade it for something that you want because whoever produces what you want probably takes Vodka. Either for themselves or because they know that other people accept Vodka.

Luther: Another interesting thing about this story that [inaudible 3i:33] is that, Russia they could re‑denominate their notes. They could devalue. You'll recall that in the Somalia case that wasn't an option. Governments if they're large, if there are a big force in the economy they can anchor everyone's expectations in their thinking that everyone's going to use these new notes. They can use their legal tender status and the taxing and spending power of government to create some demand for these new notes but in the absence of government that doesn't seem to be the case. It doesn't seem to be the case that private actors can devalue like this. In Somalia, for example...

Beckworth: That is fascinating.

Luther: they would limit it. They could only produce the largest denomination note because they had no reason to believe that anyone would accept a larger denomination and shows the different constraints we have here in the private and public orderings.

Beckworth: Along those lines, I believe its Hugh Rockoff, who's written about two currencies that coexisted in the US, right after the Civil War. Actually, there were three currencies during the Civil War. There was the Greenback in the US, which was fiat money and the US had been on the gold standard. They went off during the Civil War and the Greenback was the resulting currency.

Beckworth: Then there of course was the Confederate notes in the South. They became worthless near the end of the civil wars. Everyone expected them to lose, but interestingly in California there was the Yellowback. These emerged during the Civil War, once the US goes off the gold standard. The Yellowbacks are also dollars out west in California and they continue to be tied to gold, so their name Yellowback. There was actually a floating exchange rate between the Greenbacks and the Yellowbacks. It's not until 1879 when the US actually goes back on the gold standard with these two currencies, the differences disappear because everything is on gold.

Beckworth: During this period, greenbacks are on the East Coast and that's the more important currency. That's where most of the population is but in California the Yellowback and along the lines the story you told of Somalia, it maintains its value. This case is tied to gold but the temptation could've been there for the private sector to cheat as well but it didn't occur.

Luther: The temptation of cheat in the sense of devaluing or anything like that, you are talking about a backed money. It's very different than an un‑backed money.

Beckworth: True . We're going from a fiat to a commodity‑backed currency?

Luther: If contracts are enforced, then the banks issuing those notes have to be in a position or believed to be in a position to redeem those notes for the underlying gold. That puts a constraint on how much they can issue. That's a much quicker constraint than the constraints faced in Somalia. In some sense the underlying mechanisms, the gold in the gold standard, and the ink and paper in this peculiar Somalia standard, function much the same way.

Luther: As the demand for these gold‑backed notes increase when the purchasing power of gold goes up. That encourages miners to dig a little deeper. It encourages folks to meltdown their candelabras to coin them and that increases the supply of notes and gold coins in circulation. In doing so, it drives the purchasing power back down. Both of these systems, they're very different in terms of what the underlying commodity is, and how quick the constraint kicks in, but in terms of having an automatic mechanism that maintains the purchasing power of money over the long‑run, they're quite similar.

Beckworth: Let's move on to a more current development that speaks to these two competing theories and that's emergence of cryptocurrency and the best‑known example of that of course is Bitcoin. You've done a lot of work on that. Why don't you explain to our listeners what is cryptocurrency and what is Bitcoin and where do you see it going?

The History and Future of Cryptocurrency

Luther: Sure. Cryptocurrencies, and Bitcoin in particular ‑‑ Bitcoin is an unbacked digital money. Now at the heart of Bitcoin is what's called the Blockchain. Basically it's just public ledger and there's a protocol for updating that ledger. Now, in most of our current ledgers, pre‑Bitcoin, if you think about your bank, if I were to write you a check. Let's suppose we both bank at Chase. If I were to write you a check, Chase would debit my account and credit yours. Chase as a bank would be functioning as a clearinghouse for this transaction. On the other hand if we're different banks, say I 'm a Chase and you're Bank of America and I write you a check. Now that clearing, it takes place at a higher level.

Luther: Maybe chips the clearing house at our bank payment system or Fedwire will debit Chase and credit Bank of America and then our individual banks will make sure that we get paid. We need some clearing. The question is how does this clearing happen? How does one account get debited and another account get credited when a transaction is made to prevent the sender of money from sending that money, that same balance of money to someone else?

Luther: With Bitcoin they have a protocol where all of the computers running the protocol are basically in competition to be the first to process a batch of transactions or to clear the transaction. You have to solve a complicated cryptography problem to verify that the transactions are legitimate. Since that's computationally difficult, the probability that any one person confirms a batch of transactions is random.

Luther: We can expect to process our own transactions and as long as no single user or group of users acting in concert have a majority of the computing power of the system, the honest nodes, as it's often described, the folks who are running this protocol with good intentions will be able to process the most amount of transactions in the least amount of time. They will generate the ledger, that is the longest and that's the ledger that's recognized as legitimate under the Bitcoin protocol. We need the least distributed network for processing a transaction.

Beckworth: Let's go back and then just chew over on that a little bit. What you're saying is instead of there being a financial intermediary like a bank ‑‑ say you and I have a transaction, there's always a third‑party. Traditions been that the third‑party would clear our transaction, whether it's a debit card or I send you a check, there's got to some third‑party to make sure these transactions go through. What you're saying is, there's a public account and it's a ledger in the cloud, I guess online, that everyone can see and no one person's going to be the sole person...

Luther: Keeper of the ledger.

Beckworth: Keeper of the ledger, exactly. It keeps us honest and it also removes the need for a single, important third‑party clearinghouse. Is that right?

Luther: Yes. I wouldn't say that all payment mechanisms require a third‑party clearinghouse. Getting about cash, for example. That's a system. There's still clearing that takes place but it takes place in a decentralized way. When I and you cash, I feel that leaving my hands, you feel it leaving yours and actually holding onto that cash gives you the right to spend that balance.

Luther: When I relinquish that cash, when I give it to you, I'm not able to spend it anymore. That transaction is cleared between you and me in the handing off of cash. When we're talking about digital balances, we need some mechanism to clear the transaction. Historically, we provide on central clearinghouse mechanisms like banks to debit one person's account and credit another, in other words, to maintain a central ledger.

Beckworth: When you say digital, what about checks? You count that as digital as well?

Luther: Yeah, absolutely. With checks, as long as the check isn't circulating as a medium of exchange, which would be a bit cumbersome, as long as we're just making payments, we're talking about a ledger that needs to be updated. That ledger is maintained by the bank or maybe by a collection of banks, but someone needs to process that transaction. In the past we relied on a central mechanism for processing those transactions like a bank or a clearinghouse system, whereas with Bitcoin and the other cryptocurrencies in existence today, we update this Blockchain using a distributed protocol. You can think about decentralized clearing systems, centralized clearing systems, and distributed clearing systems. Cryptocurrencies would fall in that third category.

Beckworth: What else do we know about Bitcoin. I infer that it has a limited amount of money that can be created by it, but there also are alternative cryptocurrencies. Do you see it being a practical medium of exchange in the future?

Luther: There are a couple questions in there. The supply of Bitcoin is constrained to 21 million coins, but it's divisible as well. But there are no more than 500 alternative cryptocurrencies. They're not Bitcoin, they are alternatives to Bitcoin. They have a floating exchange rates with Bitcoin just like the dollar has a floating exchange rate with the euro. Those are distinct currencies.

Luther: Trying to answer that question, Bitcoin being meaningful payment mechanism in the future? It's a lot like trying to try to answer whether Google will be the dominant search engine in the late '90s? There are just a ton of search engines out and picking the winner was a real challenge. What I would say is that this Blockchain technology is a technology that enables us to maintain a ledger without a central entity, by relying on cryptography, and a protocol for recognizing what the legitimate ledger looks like. That technology is here to stay and that we will be making use of that technology in some way or another.

Luther: Maybe it will be banks running a Blockchain in the background, so that when you swipe your debit card effectively that's cleared over a distributed network or whether it's some cryptocurrency, Bitcoin or Litecoin or Feathercoin or Dogecoin or one or the other seemingly infinite number of cryptocurrencies that are out there, it's tough to say. To the extent that, that technology lowers transaction costs, it enables us to clear transactions more cheaply. I expect that it'll be adopted in some sense.

Beckworth: Like all money there's going to be this issue of network effects. Once one of these digital currencies, these cryptocurrencies takes off, it seems to me that the dust will settle and there'll be a few, maybe just one, I don't know. Do you see that as a potential path for cryptocurrency just a few emerging, given the importance of network effects?

Luther: Yeah. We can ask two questions. One if this Blockchain is so great. Why didn't everyone switch from dollars or Euros to Bitcoin? Even if accept that a cryptocurrency like Bitcoin is better than the money we're currently using, it doesn't necessarily follow that we should switch. We're very much concerned with whether everyone else is switching. There are some switching costs we need to consider. It's not just enough that the new alternative be better but has to be sufficiently better toward the cost of switching.

Luther: Even if it passes that threshold, we still have this network effects problem. I don't want to switch unless everyone else is going to switch. We might get stuck using some older slightly worse money because we're not confident that everyone else is going to switch. That force also works in favor of Bitcoin relative to these competing cryptocurrencies. These all coins are alternative cryptocurrencies. If you're going to switch, you probably want to switch to the currency that you're confident most others are going to switch to, and at the moment the only cryptocurrency that most people have heard of is Bitcoin, so it's quite natural for folks to switch to Bitcoin as opposed to some other cryptocurrency.

Luther: That doesn't seal the deal for Bitcoin, but all coins...they have an advantage, a second mover advantage as well. They can see you where Bitcoin is lacking and then make some adjustments there. It isn't a strong force in favor of the status quo and in favor of the first mover, if we are going to switch and so it's a faster rule we'd have to deal with.

Beckworth: Another hurdle that I understand these cryptocurrencies have, at least in the advanced economies is they're not really been used as a medium of exchange for the most part. That's only happening in the emerging part of the world. Am I right that overseas are being used as money more whereas here is its more speculative investment purposes?

Luther: Even to the extent that they are used as a medium of exchange here, they're really only used as a payment mechanism. You might want to make your payment in Bitcoin because it's a cheaper way to make a digital payment. If you compare, let's say, a credit card transaction, if you can make a Bitcoin transaction and it only cost you one percent of the transaction to make, say you're on the seller side, where if you accept that payment through Visa or MasterCard, you would be paying somewhere between say, the two and six percent and you might say, "You know what I'd rather if everyone paid me in Bitcoin."

Luther: You see that, but even there its folks exchanging from dollars to Bitcoin, making a transaction in Bitcoin and then even on the seller side that's almost immediately switched out from Bitcoin to dollars. The payment is taking place in Bitcoin, but both the buyer and the seller in that transaction are ultimately holding dollars or Euros or whatever the relatively stable currency is.

Beckworth: In the US you can't use Bitcoin to go buy some items at the retail level. Correct?

Luther: Sure overstock.com accepts Bitcoin. There are some intermediaries now like Zappo that offer a card that you can swipe at a traditional merchant terminal. If you have Bitcoin you can spend them anywhere. I'd like to compare it to ‑‑ if you're overseas with your American‑issued credit card, and you go to say a German coffee shop. You swipe your American credit card. You pay with dollars. Your bank exchanges those dollars for Euros and the seller receives euro. The seller doesn't know or care that you just bought a cup of coffee with dollars because they received euro. That's what they are concerned with.

Luther: You could functionally do the same thing with Bitcoin today. You could be paying with Bitcoin in lots of places but since an intermediary like Zappo is willing to exchange that Bitcoin for dollars on the fly at the current market exchange rate, the sellers are paid in dollars and so they accept Bitcoin even though they don't have to receive Bitcoin.

Beckworth: One thing I've learned of the cryptocurrency comments, that you are part of and I again want to run this by you is that the use of Bitcoin and other cryptocurrencies is more like money in the developing parts the world. Is that correct? Whereas in the US and now here in Asia it's for highly speculative uses. There is people who are holding Bitcoin to a large extent in those parts of the world, because they think it's like an open values, as of a way to facilitate exchange.

Luther: If you think about your money, you would like to hold as a financial asset...

Beckworth: Store of value rule.

Luther: Yeah, especially if it's an asset that you want to be very liquid, you can then convert it into something you want to consume relatively quickly without a significant loss of value, Bitcoin isn't an attractive solution on that margin, relative to say dollars or Euros. It has a...

Beckworth: Very volatile.

Luther: Yeah, Bitcoin is relatively volatile. My friend Eli Dourado runs a Bitcoin volatility index. He points out that the volatility of Bitcoin has come down. It's just a little more volatile at the moment than gold. The 30‑day volatility index is like 1.5 percent and if you compare that with gold it's around 1.2 percent, and major currencies average between 05 percent and 1 percent volatility. Bitcoin is still pretty volatile, relative to gold and to major currencies. If your marginal choice is dollars or Bitcoin, and you're thinking about holding an item as a financial asset, then dollars probably make more sense on that liquidity margin.

Luther: If you're in a country like Venezuela, or Argentina and you think that the purchasing power is not going to be stable at all, that you're going to lose a lot of value or its going to fluctuate a lot, then the drawbacks in terms of a store of value, art, it's not that much worse and might even be better than those struggling currencies, so you are more likely to hold it in those countries.

Beckworth: Where do you see this going in terms of macroeconomic policy? If we do have a world of cryptocurrency in the future, does this change what the Fed can do or how the Fed operates?

Luther: To extent that cryptocurrencies are an alternative to central bank‑issued money then I suspect it would create a constraint on central banks, but we see that constraint in places like Zimbabwe, if your currency gets so bad, people will swap to dollars even when you punish them for doing so. If we have access to a relatively stable cryptocurrency that's very convenient to make payments with, then yeah, I would expect that to limit what the monetary authority can do, because if the monetary authority maintains the purchasing power of that money in some way that people think isn't desirable they can just switch to an alternative. Cryptocurrencies could function as a constraint.

Luther: Some folks have suggested...David Andolfatto, he's argued that the Fed could introduce a cryptocurrency, Fed coin and it would have all of the payment mechanism benefits of cryptocurrencies but it would be not an alternative to Federal Reserve notes, but a substitute for Federal Reserve notes and so the Fed wouldn't lose access to monetary policy there.

Beckworth: Has that gotten much consideration by them?

Luther: Only by...

Beckworth: Only David.

Luther: Economists like you and me, I guess.

Beckworth: And all the listeners of the show.

Luther: Yes, all of your Monday morning fans. We think about things like this. The Fed released a white paper, a couple years ago now, where they considered what were called a digital value transfer vehicles. For our purposes, let's just say cryptocurrencies. That seems to be what they were talking about. They said that the technology wasn't sufficiently developed at the moment, but it does suggest that the monetary authority in the US is looking at alternatives that are on the horizon. They're thinking about their clearinghouse system and potential ways of updating that, even if they don't think that cryptocurrencies are sufficiently mature at the moment.

Beckworth: On that note we're going to end. Our guest today has been Will Luther. Will, thanks for being on the show.

Luther: My pleasure, David.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.