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I'm going to make the following claim. The price of bitcoin is inherently volatile. Even if bitcoin gets bigger, its core level of volatility is never going to fall. Bitcoin's hyperactive price movements prevent it from becoming a popular medium of exchange. Merchants are too afraid to accept bitcoins. If they do, they could experience large losses. Consumers who hold bitcoins are loath to spend them. Many of these hodlers are trying to change their financial lives by getting exposure to the very same roller-coaster ride that merchants are trying to avoid. If they use their bitcoin to buy stuff, they risk losing out on the opportunity for life-changing returns. Why is bitcoin's high volatility intrinsic to its nature? Bitcoin is a rare example of a pure Keynesian beauty contest . Players in a beauty contest gamble on what John Maynard Keynes described as what "average opinion expects the average opinion to be." No matter how big the game gets, the best collective ...

Does a lowering of a central bank's interest rates create inflation or deflation? Dubbed the ' Sign Wars ' by Nick Rowe, this has been a recurring debate in the economics blogosphere since at least as far back as 2010. The conventional view of interest rate policy is that if a central bank keeps its interest rate too low, the inflation rate will steadily spiral higher. Imagine a cylinder resting on a flat plane. Tilt the plane in one direction —a motif to explain a change in interest rates—and the cylinder, or the price level, will perpetually roll in the opposite direction, at least until the plane's tilt (i.e. the interest rate) has been shifted enough in a compensatory way to halt the cylinder's roll. Without a counter-balancing shift, we get hyperinflation in one direction, or hyperdeflation in the other. The heretical view, dubbed the Neo-Fisherian view by Noah Smith (and having nothing to do with Irving Fisher), is that in response to a tilt in the plane, the...

Tomorrow marks the twenty-sixth anniversary of the 1987 stock market crash. On October 19, 1987 the Dow Jones Industrial Average fell 22.6%, the largest one-day decline in stock market history. The best explanation for the decline, and the least well-known one, was put forth by economist Robert Shiller. This post gives a quick rundown of Shiller's work on understanding crash phenomena, in particular the famous 1987 event. Eugene Fama, who along with Shiller and Lars Hansen shared the Nobel Prize this week, had very different reaction to the event than Shiller. In an essay penned not long after the crash, Fama, a true believer in the efficient market hypothesis, did his best to square the event with theory. The crash, wrote Fama, has the look of an adjustment to a change in fundamental values. In this view, the market moved with breathtaking quickness to its new equilibrium, and its performance during this period of hyperactive trading is to be applauded. [Perspectives on October 1...

Market monetarists have a reductio ad absurdum that they like to throw in the face of anyone who doubts the ability of central banks to create inflation. It goes like this; "So, buddy, you deny that central bank purchases can have an affect on the price level? What if a central bank were to buy up every asset in the world? Wouldn't that create inflation?" Since it would be absurd to disagree with their point, the buying up everything gambit usually carries the day. In this post I'll bite. I'm going to show how a money issuer can buy up all of an economy's assets without having much of an effect on the price level. Let's return to my Google parable from last week. You don't have to read it, but you should. If you don't have the time, here's a brief summary. In an alternate world, Google stock has become the world's most popular exchange media and all prices are expressed in terms of Google shares. Google conducts monetary policy by changin...

I see that the mainstream bloggers are starting to flog the bitcoin story, which means I'll be moving on to greener blogging pastures for the time being. I've had some great discussions in my last few posts with my commenters. As always, this blog is meant to be learning tool, both for me to absorb things from others and hopefully vice versa. In this post I'm going to discuss the idea of a plunge protection team made up of avid bitcoin collectors that could potentially anchors bitcoin's price and provide a degree of automatic stabilization. In all my bitcoin posts I've been emphasizing that bitcoin lacks a fundamental, or intrinsic, value. Regular commenter Peter Surda disagrees, pointing out that despite their intangibility, virtual goods should not be seen as inferior to so-called real assets. I completely agree with him. 0s and 1s can be valuable. When I bandy around the term fundamental value , I'm not talking about physicality or solidity. What I'm...

I'm starting to sell my position in bitcoin. I'll probably keep about 10% of my overall position but the rest will be repatriated back to the conventional fiat banking system. Anyone who's been reading my bitcoin posts knows that I consider the fundamental value of bitcoin to be around zero. Consider what a bitcoin is. When you buy a bitcoin, you're basically securing a spot in a ledger. Bitcoin isn't actually a coin—it's just a key, a ticket, or an identifier, that indicates where in the ledger you sit. When people trade bitcoins among each other, what they're doing is swapping themselves into or out of that ledger. Space is limited. The amount of bitcoin in existence amounts to about 11 million, so there are only 11 million spots available. Now there's nothing wrong with paying good money to secure a spot in a ledger. We've all done it before. When you buy an airline ticket you're basically buying room in an airline's ledger. The airline c...

In my other life, I analyze the stock market. I always find it interesting when the stock market reveals its often hidden monetary nature. The common assumption is that monetary analysis should be confined to a narrow range of coins, dollar bills, central bank reserves, and bank deposits. But this ignores the fact that all valuable things in an economy have a degree of liquidity, including stocks. A stock's price can be decomposed into a "fundamental" component and a liquidity component. Fundamental value arises from a stockholder's right to receive any distribution of the assets of a corporation. The liquidity component is the premium on top of fundamental value that arises from the owner's ability to easily sell that stock. Knowing that a stock can be easily sold provides the owner with a degree of comfort that would otherwise be lacking if the stock was less saleable, or not saleable at all. This "comforting service" is built into the stock's pric...

Last week I wrote a post that attempted to dehomogenize Scott Sumner from Krugman. I left a similar but more precise comment on Bob Murphy's blog. Sumner seemed to endorse it. But there's something that doesn't make sense. Open market operations can really only have an effect if markets are not efficient. Yet Sumner is a great believer in efficient markets (as commenter Max notes on RM's blog). See Scott here and here . How can Sumner reconcile those two positions? First, some definitions. I'll define efficiency as the idea that financial assets trade in the market at the discounted value of their future cash flows. Any deviation from this value will be fleeting as investors arbitrage it away. Another word for discounted value is fundamental value . Here's the logic for why open-market operations need an inefficient market to work.* Say reserves are currently plentiful and yield 0%. Twenty-year 2% bonds are trading in the market at their fundamental value ...

Daniel Kuehn and Robert Murphy wonder why Scott Sumner takes Paul Krugman to task on liquidity traps when they each seem to be saying the same thing - monetary expansion will get you out of a trap. The phrase "monetary expansion" can mean many things. I think Krugman and Sumner have categorically different opinions concerning one specific sense of the phrase   – quantitative easing's ability to have independent effects in a liquidity trap, . When it comes to thinking about monetary policy, Krugman, Delong, Eggertson, Woodford, and other New Keynesians begin with a frictionless model populated by rational agents. No individual has the power to set prices and everyone can attain any quantity of assets at a given price. There is no limit on borrowing. With these assumptions and interest rates at zero, quantitative easing is powerless. That's because all asset prices are uniquely determined by the present value of their future cash flows. A central bank that threate...

Gavyn Davies's post Will central banks cancel government debt? dovetails nicely with the recent fundamental value of fiat money debate. [For commentary on this debate, see Nick Rowe , Paul Krugman , David Glasner , Stephen Williamson here , here , and here , David Andolfatto , Brad DeLong , and Noah Smith ] Let recap the debate first before turning to Gavyn's post. Noah Smith pointed out that since fiat money is fundamentally worth nothing (its future value = 0), then all financial assets are worth zero. Financial assets, after all, are mere promises to receive fiat money. Now back up a second. As I pointed out here , modern central bank money is not fundamentally worthless. Were it to fall to a small discount to its fundamental value, Warren Buffet would buy every bit of money up. Central bank money has a fundamental value because even if it can no longer be passed off to shopkeepers, there are assets in the central bank's kitty. Modern central bank money provides a cond...

Noah Smith has an interesting post in which he asks: "Is money fundamentally worth nothing more than the paper it's printed on?" He goes into some soul searching on the definition of "fundamental." His concern with definitions is helpful. The recent debt super-debate was largely blown out proportion due to definitional differences, in my opinion . If anyone is worthy of describing the word fundamental , it's the sage of Omaha. In deciding whether to purchase a stock or not, Warren Buffett conceptualizes the problem by imagining that he'll never be able to sell it again. He's stuck with it forever. If you abstract from an asset's ability to be exchanged onwards, what you're left with is pure fundamental value. This applies to commodities and consumer goods as well as it does to financial assets. The definition of fundamental having been dealt with, we're left with a thorny problem. The word money is still undefined. As Neil Wallace poin...