Understanding Krugman on Bitcoin

In his column 'Bitcoin is evil' Paul Krugman writes:

I have had and am continuing to have a dialogue with smart technologists who are very high on BitCoin [sic] — but when I try to get them to explain to me why BitCoin [sic] is a reliable store of value, they always seem to come back with explanations about how it’s a terrific medium of exchange. Even if I buy this (which I don’t, entirely), it doesn’t solve my problem. And I haven’t been able to get my correspondents to recognize that these are different questions.

Krugman is entirely correct in that

1) the medium of exchange function and the store of value function are two distinct issues,

2) even if we were to assume for the sake of the argument that bitcoin was a successful medium of exchange this in and of itself need not thereby also make bitcoin a reliable store of value, and hence

3) we would need an additional argument to demonstrate that bitcoin could also succeed as a store of value.

None of these points seems particularly controversial, which makes it all the more surprising that Krugman writes that none of the smart technologists and bitcoin enthusiasts he's been in dialogue with even seem to recognize or acknowledge them.

Never one to shy away from speculating about what psychological and/or moral defects may cause the people who disagree with him to behave in such an apparently irrational and/or dishonest manner, Krugman devotes much of the rest of his column to suggesting that it is really an evil libertarian agenda rather than intellectual understanding and conviction that is what drives many bitcoin enthusiasts.[1]

The problem, however, may lie with Krugman rather than with the bitcoin enthusiasts.

Why Does Krugman Think The Way He Does?
Krugman doesn't seem to realize that bitcoin enthusiasts may in fact agree with all of the points that he makes here but still insist that it is possible to provide an explanation for how bitcoin could also be a reliable store of value, and even that it is possible to do so by reference to bitcoin's qualities as a medium of exchange.

That is, while bitcoin enthusiasts may recognize and acknowledge Krugman's points that the medium of exchange function and the store of value function are distinct issues, and that bitcoin's appeal as a medium of exchange need not also make it a reliable store of value, their point is that it could.

Bitcoin may be valued exactly because of its (actual and/or potential) function as a medium of exchange. And to the extent that there is a reliable demand for bitcoins as a medium of exchange, bitcoins will de facto also be a reliable store of value. And in turn, an increase in the reliability as a store of value may further facilitate its growth as a medium of exchange.

Now of course there may be many reasons, good reasons even, why Krugman might think that this explanation would be a bad one, but what is puzzling here is his apparent failure to even recognize and/or acknowledge it in the first place. It is not a particularly complex or uncommon argument, for example.

When confronted with such an apparent lapse in a smart economist's cognitive performance it may be tempting to try to hoist Krugman on his own petard and engage in speculations about any psychological or moral failings on his part that might explain his failing: what fetishes or evil agendas of his own might have prevented his understanding?

Or worse, one might even be tempted to suggest that Krugman does in fact perceive and understand what his opponents are saying but for whatever reason just chooses not to engage them on that argument, and instead tries to make it seem as if it's his opponents who are missing the point.

Let's assume though that Krugman's is an honest intellectual mistake of non-pathological origins, and try to understand the intellectual framework that may underlie it.

To do this I first examine in some more detail how bitcoin enthusiasts think that bitcoin could succeed as both a medium of exchange and a reliable store of value, and then go on to explore the empirical and theoretical reasons that may explain why Krugman may simply have been unable or unlikely to recognize or grasp what the bitcoin enthusiasts were trying to explain to him, or to realize that this was in fact their answer to his challenge.

Bitcoin's Monetization
Bitcoin enthusiasts argue that the current period of volatility is an unavoidable, not necessarily fatal, and if all goes well only temporary phase in the process of the monetization of bitcoin, the process in which bitcoin becomes a widely used medium of exchange. In this process bitcoin goes from being

1) a mere oddity that is known to and valued by only a small number of computer scientists, cryptographers, libertarians, anarchists and others, to...

2) something that is demanded in large part not so much as an actual medium of exchange used to buy and sell goods and services with but demanded more as a speculative vehicle in the hope that it will become a widely used medium of exchange in the future (in which case its price will have increased dramatically) or at the very least that for whatever reason its price will continue to increase in the short term, to...

3) something that - as entrepreneurs and investors build the bitcoin infrastructure and ecosystem, increase bitcoin's liquidity, and integrate bitcoin into the regular economy while disrupting many industries through innovation - is accepted and used as a medium of exchange by more and more people and businesses, to...

4) a widely or even universally used medium of exchange.

In this final stage bitcoin's value will have stabilized because its being widely used means that a) the uncertainty about bitcoin's future will have significantly decreased, b) the market will have become much bigger which makes bitcoin's price less sensitive to large transactions, and c) its growth will have slowed down and leveled off (as there are fewer and fewer people and businesses left that haven't entered the bitcoin economy yet) which would also decrease the deflation rate.

In order to get from phase #1 to phase #4, however, you do need phases #2 and #3 in which the price of bitcoin drastically increases not so much due to an increase in its actual use as a medium of exchange, but primarily as a result of people betting on its future as a medium of exchange in the form of a) speculative buying of bitcoins for a profit, and b) investing in the bitcoin infrastructure.

It is only through those kinds of activities that the price will come closer to the level that it would be at if it were to be commonly used as a medium of exchange, and that it becomes possible and attractive for the average user to use bitcoins as a medium of exchange in the first place.

Value, Exchange and Speculation
We see then that in this process of bitcoin's monetization the two functions that Krugman talks about – reliable store of value & medium of exchange – develop interdependently: In the first phases bitcoins greatly increase in value as a result of people betting on its long term potential as a medium of exchange, as well as shorter term speculative trading. The gains in value are in large part the rewards for being willing to assume the enormous risk involved. The increase in its value will then persuade more and more people to buy bitcoins, and more and more entrepreneurs and investors to help build the bitcoin infrastructure and ecosystem [2] which in turn reduces the risks and uncertainty involved and makes bitcoins more and more useful as a medium of exchange, which finally helps to stabilize its value by replacing speculation with actual use.[3][4]

Obviously the above is is an absurdly simplified and simplistic description of what in reality will be a mindbogglingly complex process: The causal relations that will actually exist between...

- the demand for bitcoin as a medium of exchange,

- the demand for bitcoin as a store of value

- the demand for bitcoin as it is used in applications and services built on top of the Bitcoin protocol,

- changes in the price of bitcoin,

- the growth in its market,

- changes in the regulatory and institutional environment

- and countless other economic, social, technological, political and cultural elements

... will be interdependent, never simple and never unidirectional.

However, very, very, roughly speaking the above is the way in which bitcoin enthusiasts envision the process whereby bitcoin could succeed both as a medium of exchange and as a reliable store of value.

That is not to say, though, that this is what in fact will happen. The above scenario is entirely hypothetical, fraught with enormous risks and uncertainties, and entirely unprecedented in the history of the world. But if bitcoin succeeds, then it is likely through a process that very roughly resembles the one described above.

The fact that such a process of monetization is unprecedented as well as still highly unlikely to actually take place may be one reason why it might have been difficult for Krugman to discern that nonetheless this was what bitcoin enthusiasts had in mind.

What's more, in addition to these empirical barriers to understanding (caused by the unprecedented nature of the process as well as its unlikelihood) there may also have been theoretical barriers, in that the way Krugman thinks about the nature of money almost by default excludes a scenario of the kind that I sketched above. I explain this in the next two sections.

Storing Value
As said, Krugman is entirely correct in his insistence that the function of a medium of exchange is distinct from the function of a store of value: A given good may succeed at both functions (as gold used to, and dollars do now), be unsuccessful at both (e.g. a cheeseburger), or succeed as a store of value but fail as a medium of exchange (e.g. diamonds).

The fourth possibility however, namely that a good is successful as a medium of exchange but unsuccessful as a store of value, shows that the fact that they are distinct functions does not mean that they are wholly independent of each other: It is hard to come up with an example of a successful medium of exchange that is not also a more or less reliable store of value. And most of the relevant economics literature argues that this is because a good cannot be a successful medium of exchange if it is not also a reliable store of value. As James Toobin puts it in his entry on money for the Palgrave Dictionary of Economics: “A society's money is necessarily a store of value. Otherwise it could not be an acceptable means of payment.”

Why would this be so? Consider three ways in which a good may be an unreliable store of value: its value may plummet, it may greatly increase, or it may fluctuate wildly. Each of these scenarios is said to have negative implications for its use as a medium of exchange.

In the first case, in which the value of a good plummets, this is obvious: after all, why would anybody accept a good as payment if she cannot reasonably expect that the good will continue to be demanded by people and so retain its value so that she can sell it in the future for goods or services that she would like to buy?

If instead the value of a good is increasing rather than decreasing, it is said that people may be inclined to start to consider the good in question more as a speculative investment than as an everyday medium of exchange and they may not want to offer it as payment for other goods or services in the first place and rather hold on to it in the hope that it will further increase in value.[3]

And if there is no clear expectation either way and the value of the good instead fluctuates wildly, it becomes hard to know how much of it one should ask or offer in exchange for another good. If you can use 1 bitcoin to buy a cup of coffee on Monday and that same bitcoin buys you a three course meal on Wednesday but only a box of matches on Friday it is entirely unclear how many bitcoins you should ask for the goods and services you would like to sell.

In none of these cases, then, does the good function as a stable store of value, and in each case this is said to significantly impair its role as a medium of exchange.

Now although it is interesting to explore whether, how or why this argument that a good cannot be a successful medium of exchange if it is not also a reliable store of value is in fact correct [5], doing so is not directly relevant for the purposes of this article because most of the bitcoin enthusiasts will accept the argument that a good cannot be a successful medium of exchange if it is not also a reliable store of value.

In fact, they may even agree that in its short history bitcoin has suffered from all three types of problems mentioned above and that this may have also so far to some extent hampered its actual use as a medium of exchange. As said though, they would argue that these problems are only temporary, that it is possible for bitcoin to outgrow these problems.

The problem is that in Krugman's theoretical framework such a scenario simply doesn't seem to make sense.

Bitcoin As A Non-Starter
Above I noted that it is commonly and reasonably assumed that a successful medium of exchange also needs to be a reliable store of value. It may be that on the basis of this belief Krugman concluded that therefore there has to be something prior to the good's use as a medium of exchange that would turn it into a stable store of value, and/or external to it that would ensure its success as a medium of exchange (and, as a result, as a store of value). If this is a valid inference then clearly bitcoin has a problem, as a brief examination of Krugman's argument shows.

Krugman compares bitcoin on the one hand to gold and dollars on the other. Gold had a prior non-monetary use that ensured that there was a demand for it which helped to make it into a stable store of value, which in turn (together with some of its other features) made people willing to accept it in the market as a medium of exchange.

And dollars are successful as a medium of exchange in large part because of the United States government's requirement that taxes be paid in dollars and the Federal Reserve's ability and willingness to start buying back dollars if its value goes down too much. So gold became successful as a medium of exchange thanks to its prior (and enduring) success as a stable store of value which in turn was dependent on its non-monetary uses, and the dollar became a stable store of value because there is an external institution - the US government - that more or less guarantees its success as a medium of exchange.

But in the case of bitcoin, so the argument goes, there is neither a prior non-monetary use nor an external institution that backs it. And this makes bitcoin quite literally a non-starter: Because it is not a stable store of value people will not want to use it as a medium of exchange, and because there is no guaranteed or stable demand for it as a medium of exchange it does not become a stable store of value, and it needs to be at least one of these if it is to have a chance at succeeding as the other as well.

The problem for Krugman, however, is that the inference is in fact not valid. That is, even if it is true that for a good to be a successful medium of exchange it also needs to be a reliable store of value, it simply does not follow that therefore a good has to first be a reliable store of value as a result of its non-monetary uses for it to then be able to succeed as a medium of exchange, and/or that a good first has to be backed by an external institution that ensures that there is a stable demand for it as a medium of exchange for it so that on that basis it can become a stable store of value.

The possibility envisioned by bitcoin enthusiasts, namely that a good could start from nothing, from a situation in which it is worthless both as a medium of exchange and as a store of value, but then, on the market and without a prior non-monetary use or governmental backing, gradually acquire both of these functionalities, in a process in which progress in one functionality can cause progress in the other so that they develop in an interdependent and mutually reinforcing manner, is simply not excluded by the claim that a successful medium of exchange also needs to be a reliable store of value.

The latter claim only describes the end point, the stage in which the good is finally successful in both functions, but it leaves entirely open what process may have led to that final stage. And as such it doesn't imply a requirement that throughout that process the good must have already been fully successful as either a reliable store of value or a widely used medium of exchange, on the basis of which it could then acquire the other functionality.

Summing Up
The theoretical framework that may have been behind Krugman's thinking on bitcoin rests on a fundamental error, an invalid inference. But it is this framework that essentially excludes the possibility of the kind of monetization scenario that is described by the bitcoin enthusiasts, and that thereby may have made it difficult for Krugman to even grasp what the bitcoin enthusiasts were trying to tell him.

The fact that this scenario is unprecedented in world history may be another reason why Krugman didn't grasp it, and also a reason why the fundamental error in Krugman's (and many other people's) intellectual framework has survived for as long as it has: Up until now there have simply not been events in world history that unfolded in ways that directly contradicted the framework, and so there may have been less reason to critically examine said framework.

Bitcoin may become the first such event. Then again, it may not. And in general, there may very well be good reasons for thinking that this kind of monetization process is unlikely to ever take place, for thinking that bitcoin cannot and/or will not succeed. Not just because governments will prevent it but also because there may simply be flaws in the logic of the scenario, flaws that can be demonstrated by using economic theory.

This kind of critical analysis of the scenario of bitcoin's monetization does, however, require that the analyst in question recognizes and understands the scenario in the first place, and that he is not using a fundamentally flawed framework for his analysis. In turn, bitcoin enthusiasts would do well to then take their critics seriously and not to dismiss their arguments out of hand in the belief that the criticism can simply be explained away by assuming that it is merely the result of a lack of understanding and/or bad intentions.[6]


Notes
[1] Note though that Krugman does not explicitly say that this is also what motivates the specific bitcoin enthusiasts that he has been in dialogue with.

[2] Bitcoin's price increase may also hinder rather than encourage investments in the bitcoin infrastructure. See my earlier article Why Start or Invest in Bitcoin Companies? Why Not Free Ride Instead?

[3] Some of course argue that deflation need not hinder a good's role as a medium of exchange, but an explanation as to why mild deflation may not actually be a bad thing does not necessarily also show that the same can be said about the kind of extreme deflation that has been characteristic of bitcoin in the past year.

[4]  It should be noted that in an important sense there is no categorical difference between demanding bitcoins because you think you may want to use them to buy something a day from now and demanding bitcoins because you think they will be worth ten times as much a year from now: We typically call the latter a form of speculation while we think the former is just using a good as a medium of exchange.

In fact though in both cases there is an essentially speculative element and in both cases bitcoins are ultimately used as a medium of exchange. And for that to be possible, in both cases bitcoins would have to be a reliable store of value for the period during which they are held. The difference lies in the length of the period that value needs to be stored, and in the expected additional increase in the value during that period.

[5]  Some have argued that the risk that is the result of price fluctuations need not be that problematic for merchants or consumers because these can use specialized companies to instantly convert bitcoins into dollars and the other way around when needed. That way they would only be exposed to fluctuation risks for the time it takes to transact, which need not be longer than a few seconds or minutes or hours. So in this scenario these specialized companies take on the risk associated with price fluctuations.

One problem with this scenario may be that because these companies will have to charge a fee for this service so as to compensate for the risk that they are assuming by holding bitcoins. And the higher that risk is, the higher this fee will be, and hence the higher the transaction costs for merchants and consumers. There may be a point at which these costs will become greater than the advantages merchants and consumers get from transacting in bitcoins in the first place.

[6] Trying to actually understand rather than just dismiss and pathologize one's critics, trying to figure out what it is that they are actually thinking, and what intellectual reasons they may have for thinking it, can be a useful first step towards having more productive discussions as well as more pleasant relations with them.

In this spirit let me also immediately add that although I have made considerable effort to research and understand the views of both Krugman and bitcoin enthusiasts, there may very well be flaws in my understanding, characterization and/or analysis of their views, and I very much welcome critical feedback.