The recent bitcoin chain split got me thinking again about bitcoin-as-money, specifically as a unit of account. If bitcoin were to serve as a major pricing unit for commerce on the internet, we'd have to get used to some very strange macroeconomic effects every time a chain split occurred. In this post I investigate what this would look like.
While true believers claim that bitcoin's destiny is to replace the U.S. dollar, bitcoin has a long way to go. For one, it hasn't yet become a generally-accepted medium of exchange. People who own it are too afraid to spend it lest they miss out on the next boom in its price, and would-be recipients are too shy to accept it given its incredible volatility. So usage of bitcoin has been confined to a very narrow range of transactions.
But let's say that down the road bitcoin does become a generally-accepted medium of exchange. The next stage to becoming a full fledged currency like the U.S. dollar involves becoming a unit of account—and here things get down right odd.
A unit of account is the sign, or unit, used to express prices. When merchants set prices in a given unit of account, they tend to keep these prices sticky for a while. A few of the world's major units of account include the $, £, €, and ¥. These units of account are conventional ones because there is an underlying physical or digital token that represents them. The $, for instance, is twinned with a set of paper banknotes issued by the Federal Reserve, while ¥ is defined by the Bank of Japan's paper media. Unconventional units of account do not have underlying tokens, but I'll get to these later.
So let's go ahead and imagine that bitcoin had succeeded in becoming the unit of account on the internet. The most commonly heard complaint of bitcoin-as-unit of account—a bitcoin standard so to say—is that it would be inflexible, more so than even the gold standard. It would certainly be more volatile, since the supply of bitcoin—unlike gold—can't be increased in response to prices. And those are fair criticisms. But there's a less-talked about drawback of a bitcoin standard: when a chain split occurs, all sorts of confusing things begin to happen that wouldn't occur in a conventional monetary system.
For those not following the cryptocurrency market, a chain split is when a new cryptocurrency is created by piggy-backing off an existing cryptocurrency's record of transactions, or blockchain, thus creating two blockchains. Luckily for us, a bitcoin chain split occurred earlier this month and provides us with some grist for our analytical mill. On August 1, 2017 anyone who owned some bitcoins suddenly found that not only did they own the same quantity of bitcoins as they did on July 31, but they had been gifted an equal number of "bonus" tokens called Bitcoin Cash, henceforth BCH. Both cryptocurrencies share the same transaction history up till July 31, but all subsequent blocks of transaction added since then have been unique to each chain.
This doesn't seem to be a one-off event. Having just passed through a split this August it is likely that Bitcoin will undergo another one in November. The history of Bitcoin is starting to resemble that of Christianity; a series of contentious schisms leading to new offshoots, more schisms, and more offshoots:
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Here's the problem with chain splits. Say that you are a retailer who sells Toyotas using bitcoin, or BTC, as your unit of account. You set your price at 10 BTC. And then a chain split occurs. Now everyone who comes into your shop holds not only x BTC but also x units of Bitcoin Cash. How will your set your prices post-split?
The most interesting thing here is that an old bitcoin is not the same thing as a new bitcoin. Old bitcoins contained the entire value of Bitcoin Cash in them. After all, the August 1st chain split was telegraphed many months ahead—so everyone who held a few bitcoins knew well in advance that they would be getting a bonus of Bitcoin Cash. Because a pre-split price for the soon-to-be tokens of $300ish had been established in a futures market, people even knew the approximate value of that bonus. This anticipated value would have been "baked into" the current price of bitcoins, as Jian Li explain here. Then, once the split had occurred and Bitcoin Cash had officially diverged from the parent Bitcoin chain, the price of bitcoins would have fallen since they no longer contained an implicit right to get new Bitcoin Cash tokens.
Thus, BTCa = BTCb + BCH, or old bitcoins equals the combined value of new bitcoins and Bitcoin Cash.*
As a Toyota salesperson, you'd want to preserve your margins throughout the entire splitting process. In the post-split world, if you continue to accept 10 BTC per Toyota you'll actually be making less than before. After all, if one BTC is worth ten BCH in the market, then a post-split bitcoin—which is no longer impregnated with a unit of BCH—is worth just nine-tenths of a pre-split bitcoin. In real terms, your income is 10% less than what is was pre-split.
You have two options for maintaining your relative position. Option A is to continue to price in current BTC, but jack up your sticker price by 10% to 11 BTC. Customers will now owe you more bitcoins per Toyota, but this only counterbalances the fact that the bitcoins you're getting no longer have valuable BCH baked into them.
This would make for quite an odd monetary system relative to the one we have now. If everyone does the same thing that you do—mark up their sticker prices the moment a split occurs—the economy-wide consumer price level will experience a one-time shot of inflation. Given that bitcoin schisms will probably occur every few years or so, the long-term price level would be characterized by a series of sudden price bursts, the size depending on how valuable the new token is. When splits are extremely contentious, and the new token is worth just a shade less than the existing bitcoin token, the price level will have to double overnight. That's quite an adjustment!
We don't get these sorts of inflationary spasms in modern monetary systems because there is no precise analogy to a chain split. When August 1st rolled around, Bitcoin supporters could not invoke a set of laws to prevent Bitcoin Cash from being created on top of the legacy blockchain. In fiat land, however, a set of actors cannot simply "fork" the Canadian dollar or the Chinese yuan and get off scot-free. The authorities will invoke anti-counterfeiting laws, which come with very heavy jail sentences.**
The closest we get to chain splits in the real world are when the monetary authorities decide to undergo note redenominations. Central bankers in economies experiencing high inflation will sometimes call in—say—all $1,000,000 banknotes and replace them with $10 banknotes. And to compensate for this lopping-off of zeroes, merchants will chop price by 99.999% overnight. But redenominations are very rare, especially in developed countries. Up until it dollarized in 2008, even Zimbabwe only experienced three of them. Under a bitcoin standard, they'd be regular events.
Option B for preserving your relative position is to keep a sticker price of 10 per Toyota, but to update your shop's policy to indicate that your unit of account is BTCa, or old bitcoin, not new bitcoin. Old bitcoin is just an abstract concept, an idea. After all, with the split having been completed, bitcoins with BCH "baked in" do not actually exist anymore. But an implicit old bitcoin price can still be inferred from market exchange rates. When a customer wants to buy a Toyota, they will have to look up the exchange rate between BTCa and new bitcoin (i.e BTCb), and then offer to pay the correct amount of BTCb.
To buy a Toyota that is priced at 10 BTCa, your customer will have to transfer you 10 new bitcoins plus the market value of ten BCH tokens (i.e. 1 bitcoin), for a total price of 11 bitcoins. This effectively synthesizes the amount you would have received pre-split. As the market price of Bitcoin Cash ebbs and flows, your BTCa sticker price stays constant—but your customer will have to pay you either more or less BTCb to settle the deal.
The idea of adopting a unit of account that has no underlying physical or digital token might sound odd, but it isn't without precedent. As I pointed out earlier in this post, our world is characterized by both conventional units of account like the yen or euro and unconventional units of account. Take the Haitian dollar, which is used by Haitians to communicate prices. There is no underlying Haitian dollar monetary instrument. Once a Haitian merchant and her customer have decided on the Haitian dollar price for something, they settle the exchange using an entirely different instrument, the Haitian gourde. The gourde is an actual monetary instrument issued by the nation's central bank that comes in the form of banknotes and coins.***
So in Haiti, the nation's unit of account—the Haitian dollar—and its medium of exchange—the gourde—have effectively been separated from each other. (In my recent post on Dictionary Money, I spotlighted some other examples of this phenomenon.) An even better example of separation between medium and unit is medieval ghost money. According to John Munro (link below), a ghost money was a "once highly favoured coin of the past that no longer circulated." Because these ghost monies had an unchanging amount of gold in them, people preferred to set prices in them rather than new, and lighter, coins, even though the ghost coins had long since ceased to exist.
I love the medieval concept of ghost money: using a long dead coin—say Louis IX's gros tournois—as a unit of account https://t.co/TmCTE7OdBs pic.twitter.com/LUNntsw0l3— JP Koning (@jp_koning) August 22, 2017
Unlike option A, which would be characterized by a series of inflationary blips each time a split occurred, option B provides a relatively flat price level over time. After all, the old bitcoin price of goods and services stays constant through each split. However, as the series of chain splits grows, the calculation for determining the amount of new bitcoins inherent in an old bitcoin would get lengthier. In the example above, I showed how to calculate how many bitcoins to use after just one chain split. But after ten or eleven splits, that calculation gets downright cumbersome.
Whether option A or B is adopted, or some mish-mash of the two, a bitcoin standard would be an awkward thing, the economy being thrown into an uproar every time a chain schism occurs as millions of economic actors madly reformat their sticker prices in order to preserve the real value of payments. If bitcoin is to take its place as money, it is likely that it will have to cede the vital unit of account function to good old non-splittable U.S. dollars, yen, and other central bank fiat units. The Bitcoin community is just too sectarian to be trusted with the task of ensuring that the ruler we all use for measuring prices stays more or less steady.
P.S.: I've focusing on sticker prices here, I haven't even touched on contracts denominated in bitcoin units of account. For instance, if I pay 10 BTC per month in rent for my apartment, what do I owe after a split? Ten old bitcoins? Ten new bitcoins? Or would I have to transfer 10 new bitcoin along with 10 units of Bitcoin Cash? Who determines this? What about salaries? The problem of contracts isn't merely theoretical, it actually popped up in the recent split as some confusion emerged on how to deal with to bitcoin-denominated debts used to fund short sales. Matt Levine investigated this here.
*There is also the complicating fact that the price of bitcoin didn't seem to fall by the price of Bitcoin Cash, thus contradicting the formula. As Matt Levine recounts:
In a spinoff, you'd expect the original company's value to drop by roughly the value of the spun-off company, which after all it doesn't own any more. 5 BCH spun off from BTC on Tuesday afternoon, and briefly traded over $700 on Wednesday (though it later fell significantly). But BTC hasn't really lost any value since the spinoff, still trading at about $2,700. So just before the spinoff, if you had a bitcoin, you had a bitcoin worth about $2,700. Now, you have a BTC worth about $2,700, and also a BCH worth as much as $700. It's weird free money, if you owned bitcoins yesterday.**Say counterfeiters do manage to create a large amount of fakes. Even then this "fiat split" would have no effect on the value of genuine notes. Central bank are obligated to uphold the purchasing power of their note issue. They will filter out fakes be refusing to repurchase them with assets, the purchasing power of counterfeits quickly falling to zero, or at least to a large discount. When central banks are fooled by counterfeits they will use up their stock of assets as they erroneously repurchase fakes. But even then they will never lose the ability to uphold the value of banknotes as long as the government backs them up with transfers of tax revenues. Fiat chain splits only begin to have the same sort of effects as bitcoin chain splits when 1) counterfeiting goes unpunished; 2) the central bank can't tell the difference between which notes are genuine and which are fakes; and 3) it lacks the firepower and government support necessary to buy back paper money in sufficient quantity. Only at this point will counterfeiters succeed in driving the economy's price level higher.
This, by the way, is what the Somali shilling looks like... a fiat currency constantly undergoing chain splits.
*** I get my information on Haiti from this excellent paper by Frederico Neiburg.
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