Finance and Economics

Articles about Finance and Economics

Bitcoin Solves the Wrong Problem

Bitcoin has been in the news lately for its amazing run-up over the past year and recent crash. For those who have been living under a rock (or anyone reading this years in the future when Bitcoin has disappeared), Bitcoin is a "virtual currency" created through some clever cryptoanalytic techniques to ensure a limited supply of currency and unique ownership of the bitcoins.

I'm not an expert in these things, but by all accounts Bitcoin does what it claims to do. The total supply of bitcoins is limited and predictable, and ownership of bitcoins is provable and transferrable. Some people are promoting Bitcoin as a replacement for money, and claiming that it can be treated like virtual gold.

But it isn't, and I predict Bitcoin will never achieve anything close to mainstream success as actual money. The fundamental weakness with Bitcoin is that the underlying Bitcoin technology solves the wrong problem. The system uses the model of a physical commodity (like gold) as money, and therefore is engineered to guarantee a very specific and predictable supply of bitcoins.

In the real world, though, one of the most important characteristics of money is that it has a stable and predictable value. It's vitally important that a dollar today is worth very close to what a dollar was worth yesterday, and that we are confident it will be worth pretty much the same tomorrow. But the demand for money can vary widely, depending on whether people want to hold on to their money (like in 2007-2008 when the banks were collapsing) or spend and invest like crazy (like in the dot-com bubble). So the supply of money has to change to match the demand and keep the value stable.

Our financial system has a system for creating and destroying money: through fractional reserve banking, banks create money by making loans, and can destroy money by calling loans in (or simply not making new loans as the old ones are paid off). The system isn't perfect, which is why we have the Federal Reserve and why different currencies change value relative to each other. But on the whole, it's pretty good most of the time.

Bitcoin, though, has no such mechanism built in. With a predetermined bitcoin supply, the value of a bitcoin is guaranteed to fluctuate like crazy as demand changes (and this is, in fact, what has been happening), and that's useless for money. In order to give some flexibility to the bitcoin supply, you have re-introduce fractional reserve banking. That requires an oversight body like the Fed to make sure the banks do the right thing in both boom and bust. In the end, you've basically just re-created the banking system of 1928, which failed in part because the gold standard was not flexible enough to deal with the challenges of the Great Depression.

I do like the idea of having a peer-to-peer currency, where the system creates the right incentives to have a frictionless money with no requirement for central oversight. But the core problem to solve isn't fixing the supply of money, it's democratizing the process of matching money supply to money demand so that the value is stable. I don't have any idea how to do that, but I do know that Bitcoin is entirely the wrong approach.

Cornering the Market in Money

Cornering the market is a (generally illegal) form of market manipulation where someone buys or controls enough of something--a stock, commodity, etc.--so as to effectively control the market price for that item. It can be very profitable, since the person who has cornered a market can force buyers (at least those buyers who have no alternative) to pay essentially any price.

For example, you might corner the market in frozen concentrated orange juice by going out and buying up all the OJ you can find, then entering into contracts with the OJ plants to buy their production. At some point, someone wanting to buy frozen concentrated orange juice would be forced to come to you, and pay whatever price you ask.

In practice, there may actually be more OJ futures available to buy in the market than actual OJ production, since a significant fraction of the market is not actual buyers or sellers of the physical commodity but speculators who trade futures contracts expecting to close their positions without ever touching any actual juice (except perhaps at breakfast). So when those futures contracts start to mature, the speculators discover that they are obligated to deliver actual frozen concentrated orange juice (which is unavailable) or buy back their contracts at some absurd price. You have, in effect, created an artificial shortage of OJ to your own benefit.

Cornering a market is very expensive, since you have to have enough capital to lock up most of the supply. It can also be very risky, since if you try and fail to corner a market, you can wind up paying too much for a huge amount of something you don't actually need. Nevertheless, every so often someone tries to corner a market; and occasionally someone succeeds.

The most profitable, and most difficult, market to corner would be the market for money itself. Money is in some respects a commodity like any other: it can be bought and sold, you can create derivatives, and you can write contracts which obligate the delivery of a certain amount of money under certain conditions. If you could corner the market for money, you would drive up the value of money (otherwise known as "deflation") by creating an artificial shortage (aka "liquidity crisis"). The people you traded with would be unable to deliver the money they were obligated to under their contracts, so you would be able to demand whatever other hard assets they might have instead.

Cornering the market in money would be hard, but maybe not impossible. The best way would be to buy up a whole lot of some financial contract which is normally relatively inexpensive, but under the right (very rare) circumstances obligates the seller to give you a hundred or a thousand times the capital you invested. Ideally, the seller would view the contract as safe (so the price would be low), but could be triggered by some crisis.

A Credit Default Swap (CDS) fits the bill pretty well: pre-2008, you could buy a contract for a few tens of thousands of dollars per year which would obligate the seller to give you $10 million upon the failure of some big investment bank or blue-chip corporation.

So you buy CDSs on a bunch of big low-risk corporations at 2006 prices (which is to say, dirt cheap). Since the CDS isn't directly tied to an actual bond issued by the company, you can actually buy more CDSs than the company has outstanding debt. Then, recognizing that there's a cascading effect, you also buy CDSs on all the companies who sold you the first set of CDSs--since if Lehman Brothers has to pay out on all those swaps, they'll have a good chance of defaulting as well. Since the CDS market is almost completely opaque, nobody will know how many contracts you've bought up or what the aggregate value is.

At 2006 prices, you could have invested a few billion to buy CDSs which would pay (in aggregate) a trillion dollars or more if the companies started failing. Lots of investors have a few billion to throw around. Almost nobody--other than the U.S. Treasury which prints its own money--has a trillion.

The corner happens when one of the companies you bought CDSs on starts getting into a little trouble. Every company has rough spots, so this is bound to happen sooner or later.  That will make the market value of the CDSs you own go up, and lets you demand more collateral from the companies you bought the CDSs from.

That, in turn, requires those companies to come up with cash quickly, and hurts their financial stability--which drives up the value of the CDSs on those companies, and lets you demand more collateral from a different set of counterparties.

If it all plays out right, in fairly short order every company which sold you CDSs is selling every asset they can get their hands on in order to meet their contractual obligations to you. Cash becomes the most valuable commodity because nobody can find enough of it. It's financial armageddon, but you win big.

The only flaw--and it's a big one--is that the government can create new cash any time they want.  Normally they don't like to do this, because it can lead to inflation.  But if the government discovers what's going on early enough, they can print more money, give it to the foolish companies who wrote those CDSs (like AIG) to make good on their promises, and break the cycle of collapse by making money less scarce.  This excess cash can (at least in theory) be taken out of the system at a later date once things have stabilized, in order to prevent hyperinflation. you bet on the Federal Reserve being on top of things and pumping the cash to the right place at the right time? Or do you bet that nobody will figure out what's going on until it's too late?

So, How 'Bout That Economy?

I've been optimistic that we're near the bottom of the economic downturn since the beginning of 2008.  I'm starting to understand that I don't have a clue when this will end (but neither does anyone else).  To give myself some credit, however, I was also early in calling the start of the recession (back in February 2008, I wrote that I thought a recession started between November 2007 and January 2008, which was dead on and months before the Conventional Wisdom said we were in one).

In retrospect, what I wrote a year ago ("....the recession began sometime between November and January....we're probably close to the bottom right now....") seems hopelessly optimistic.

All of this is a way of saying, don't believe my opinions about the economy, I don't have a clue.

But I do have some observations:

  1. This is already the worst economic downturn since the early 80's, and there's a good chance it will be the worst since the Great Depression.  But we're nowhere near as bad as the Great Depression and I see no reason to assume it will get that bad.
  2. As bad as the recession of the early 80's was (and it was the only one on par to what we're going through now), it also ended surprisingly fast.  At least surprising for the people in the middle of it.
  3. The Great Depression capped a whole series of Depressions in the 1800's and early 1900's, some of which were almost as bad as the Great one.  The economy really is different (more stable) now, as compared to the Gilded Age.
  4. Therefore....we will come out of this recession, and maybe sooner than the Conventional Wisdom thinks.  Right now the Conventional Wisdom is that the recession won't end until the end of 2009, and some are pushing it into 2010 or further.  The CW will always see the end of the recession 6-12 months in the future, even when the recovery is already beginning.

Fred Wilson wrote yesterday that he sees a fundamental shift in the economy going on: the big old "blue chip" companies are often the ones who got themselves overleveraged and in trouble, and the younger, smaller companies are taking over.  I think there's a lot of insight there: over the past 20 years many mature companies (GE, GM, etc.) turned themselves into "growth" companies by developing financing arms, which essentially goosed their growth with leverage.  The real growth companies (ones whose core businesses were growing) saw no need.  The new "blue chip" companies are ones like Google, Microsoft and Cisco, with dominant market positions and cash-rich balance sheets.

In my own business, I've observed that the world is definitely not coming to an end, and in fact innovative companies are taking market share (a statement which--fortunately--describes our biggest client).  There is still consumer demand, especially if you have a product or service which people like at a good price.  There is still room to compete, especially on value and no-gotcha services.

So while I'm still optimistic that we may be nearing the bottom of the recession (and I'm going to stay optimistic no matter how long it takes!), in practical terms I'm keeping my head down and focusing on business.  If enough people do the same, this recession will be over, and sooner than we all think.