Bitcoin has been called many things, both positive and negative: from a legitimate new currency alternative to just another old Ponzi scheme; from an innovative and efficient transfer payment system to a criminal enterprise money-laundering operation.
But one thing it has never been called is a fantastic teaching tool in “monetary economics”. So let me do that here. Even though I still consider it to be a doomed experiment in the evolution of currency, Bitcoin at the very least proves its usefulness as a grand illustration teaching us some of the most fundamental concepts behind money.
What specifically does “monetary economics” refer to?
In order to keep the learned economists reading, let me supply a definition they would be more trusting of, as explained by personal financial coach and consultant Dave Smant.
“Monetary economics, as defined in McCallum’s (1989) textbook, ‘is concerned with the effects of monetary institutions and policy actions on economic variables [such as] commodity prices, wages, interest rates, and quantities of employment, consumption, and production’,” Smant begins. “The subject covers the origin, functions and value of money, a large part of macroeconomics with an emphasis on monetary policy, central banking and financial institutions, and financial markets.”
For the rest of us 99%, here’s the Wikipedia definition:
“Monetary economics is a branch of economics that provides a framework for analyzing money in its functions as a medium of exchange, store of value, and unit of account. It considers how money, for example fiat currency, can gain acceptance purely because of its convenience as a public good.”
Bitcoin helps us understand “the effects of monetary institutions” (aka central banks, like the U.S. Federal Reserve), and their “policy actions” (changing the interest rate, buying bonds, printing money, etc.) on the value of the money we carry in our wallets.
In a nutshell, Bitcoin can help us understand the effects that the Federal Reserve’s bond buying programs and lowering of interest rates have had on the U.S. dollar. Let’s divide these into two simple concepts: circulation and debasement.
Circulation Lubricates the Economy
Without even knowing it, Bitcoin users have come to understand the importance of monetary circulation. As recently as just two years ago, so few stores and shops accepted Bitcoin as a method of payment, which greatly limited Bitcoin’s usefulness as a currency.
Yet as the number of shops and websites accepting Bitcoin has continued to grow, commerce and trade transacted in Bitcoin have increased exponentially.
The movement of money through an economy is critical to the health of that economy. Money is like the motor oil in a car’s engine; remove it and every moving part seizes-up.
This is what happened during the financial crisis of 2008-09. When tens of thousands of home owners could not afford the higher interest payments on their homes, they were foreclosed upon. Banks not only lost money but were short of cash; they didn’t have enough money to lend. Businesses couldn’t borrow to finance their operations, and many scaled-back or shut-down all together, resulting in lay-offs and the eventual loss of 8.5 million jobs in the span of one year. All because money was too difficult to get a hold of.
Rather than lending money to companies, banks were storing what little money they had left in bonds, which drove their prices up and their yields down. This was the worst thing they could do. It’s like Bitcoin users simply leaving their Bitcoins parked in their e-wallets. It effectively took money out of circulation.
We can see now why the U.S. Federal Reserve implemented a series of bond buying programs. As the Fed purchased billions of dollars’ worth of bonds each and every month, bond prices rose even further, dropping their yields even lower. The Fed’s intent was to squeeze the banks and other investors out of bonds, forcing them to sell bonds which were only yielding 1.5-2.5% or so, and invest that money in the stock and housing markets where they could generate higher returns for themselves – in addition to stimulating the economy.
Ultimately, then, the Fed’s goal was to squeeze all that cash which was parked in bonds and have it circulate through the economy where it could benefit companies, merchants and consumers, and create jobs in the process.
I bet Bitcoin users never knew they had so much in common with the U.S. Federal Reserve and its bond buying programs. Both they and the Fed have been stimulating the economy by increasing the circulation of their respective currencies, keeping the gears of commerce humming smoothly.
Debasement Thins Out the Oil
A second major lesson Bitcoin users have been learning about monetary economics is the effect on prices whenever the currency’s value changes. Universities offer courses on how currency changes affect an economy, and here the average Bitcoin user has already learned this lesson for free just by using Bitcoin to buy their daily cup of coffee.
Bitcoin users: What have you noticed about prices at your local coffee shop as the value of Bitcoin has been steadily dropping over the past few months? Undoubtedly you have noticed something very annoying about prices – they’ve been going up. Every time the value of BTC drops, your next cup of coffee costs a few more BTC decimal points.
This is perhaps the most important rule of monetary economics: when a currency falls, prices rise. In fact, this is the very concept behind the monetary policies of not just the U.S. Federal Reserve but of almost every other central bank in the world.
For several years now since the financial crisis of 2008-09, nations around the globe have been in a “currency war”, where each one is trying its darnedest to slash the value of its money. The idea of weakening one’s own currency often baffles people, since it seems so counter-productive. Why would anyone intentionally reduce their own wealth by debasing their currency?
But the truth of the matter is that they are not reducing their wealth; they are in fact increasing it. Remember what Bitcoin has shown us over these past few months? When a currency falls, prices rise. As a currency weakens, you need to spend more of it to buy things.
While this is no fun for the consumer, it is great fun for the merchant. Every day that BTC falls, the coffee shop collects more BTC for every cup of coffee it sells. If the shop holds them until BTC rises again, it will be able to cash-out with a sizable bonus. While a depreciating currency hurts the buyer of goods and services (the Bitcoin spender), it helps the seller of goods and services (the merchant).
In similar fashion, a depreciating currency hurts and helps nations as well. It hurts nations when they buy goods and services (importing), but it helps them tremendously when they sell goods and services (exporting). As an example, the Bank of Canada recently cut its benchmark interest rate to 0.75% last week, resulting in a drop in value of the Canadian dollar by around 2 cents versus the U.S. dollar, or 2.2%. This means that Canadian exporters will be collecting 2.2% more for everything they sell abroad, just like BTC merchants are now collecting more Bitcoins from their sales.
The U.S. Federal Reserve had also slashed its interest rate to as low as 0.25% back in 2009 in an effort to devalue its currency. But not simply to collect a little extra from its exports. It’s intent was a little more complex.
Remember that property values all cross America were dropping fast, losing as much as 30-50% of their values in some areas. Since a falling currency causes prices to rise, the quickest and easiest way for the Fed to re-inflate the economy and personal wealth was to cause the USD to fall by lowering its interest rate, cheapening its worth.
This is why the Fed has been reluctant to raise interest rates yet, since prices have not inflated enough for the Fed’s liking, with the current annual inflation rate of 1.3% remaining well below the Fed’s 2% target.
The recent strength of the USD isn’t helping the Fed reach its re-inflation goal either. As the dollar strengthens, prices fall, especially in commodities such as oil, gold, and others. The Fed fears price deflation, since it erodes personal and corporate wealth. It wants to see prices rise, which required currency debasement – just as Bitcoin has been teaching us.
A Newfound Respect for Bitcoin?
While I still personally believe Bitcoin has a much too shaky foundation beneath it to fulfill one of the most fundamental roles of a currency – namely, being a stable store of value – I am prepared to admit that it is fulfilling another fundamental role of money – namely, its benefit to commerce and trade through its “acceptance purely because of its convenience as a public good”, as Wikipedia put it.
As its circulation increases, it will do its own part in greasing the gears of local and web-based economies. And if its price remains volatile, it will benefit BTC spenders when it rises while benefitting BTC merchants when its falls – each side locking-in profit on the reversals.
Yet even if its impact on a business or the overall economy is small, its impact as a teaching tool is indispensible. For in Bitcoin we have a laboratory experiment taking place before our very eyes, which gives us a fantastic opportunity to see on a simpler scale a reflection of the grander reality that exists in the larger monetary system.
At the very least, Bitcoin serves as a source of practical education on monetary economics which its users have been learning without even realizing it. Who would have thought Bitcoin could teach so much, all for the price of just a cup of coffee per day?