Bitcoin and the Dodo-Bones Theory of Money

Monetary debates are usually seen as between Friedman-Keynes or Friedman-Hayek and so on.

JP Koning points to this fascinating debate between Joseph Shield Nicholson and Benjamin Anderson. Both were not so famous economists but their views on what is money remains as relevant as ever.

For instance, Nicholson spoke about dodo bones being money:

Bitcoin has become a test for the validity of many theories about money. Monetary theories that have proven capable of explaining Bitcoin have become more credible; those that haven’t have become less credible. Nicolás Cachanosky and Casey Pender, for instance, recently pointed out that Bitcoin and other cryptocurrencies can be explained as corresponding to Friedrich Hayek’s vision of a system of private currencies, originally outlined in The Denationalisation of Money. 

If Bitcoin is a test, it’s tempting to apply it to a fascinating early 20th-century monetary debate between Joseph Shield Nicholson and Benjamin Anderson concerning what sorts of things can become money. Neither economist ranks in the pantheon of great economists, but the set of ideas they were debating is important and timeless. Nicholson hypothesized that the most useless thing he could imagine — the bones of the dodo bird — could be introduced into circulation. The initial purchasing power of these dodo bones would be determined mechanically by reference to the quantity of bones and their “rapidity of circulation,” or what we know today as velocity. 

Anderson didn’t buy the idea that a useless thing could become money, and in The Value of Money he devoted a full chapter to criticizing Nicholson’s thought experiment. Nicholson had imagined 10 merchants each of whom owned one unit of an identical good, and 1 trader who desired to buy everything up with a purse full of money consisting of 100 dodo bones. When the market opened for business, the trader with the dodo bones would offer to purchase the 10 merchants’ goods at a price of 10 bones per good. 

Anderson leveled the charge of circularity against Nicholson. Why would anyone give up their valuable commodity for worthless dodo bones? Perhaps the trader might know other merchants that might take the bones off of him. But why would these other merchants do that? “It is, in effect, saying that the dodo-bones will circulate because they will circulate,” wrote Anderson, hardly a satisfying answer to the mystery of how a new money gets value.

Hmm.

Koning says how traditionally currencies were around Nicholson arguments as they are backed by something or the other. However bitcoin and other digital currencies are around Nicholson view:

History shows that Anderson’s theory is generally borne out. New coins have always been minted out of precious metals rather than an intrinsically worthless medium such as paper. According to George Selgin’s 1994 paper “On Ensuring the Acceptability of a New Fiat Money,” most new paper monies have been linked to established media of exchange at a fixed rate of exchange. When the euro was introduced, for instance, it was pegged to the 12 original national currencies. Even the world’s most notorious paper-money experiment, John Law’s Banque General, began with notes redeemable in gold coin. 

Selgin’s paper was written in 1994, long before the emergence of cryptocurrencies. The post-2008 blooming of thousands of cryptocurrencies — from Bitcoin to Dentacoin to Sexcoin — seems to finally favor Nicholson. Like Nicholson’s dodo bones, these digital tokens do not have any value apart from their ability to be exchanged, and they do not come into existence with a fixed exchange rate to a pre-existing commodity or currency. Cryptocurrencies are thus fatally handicapped by Anderson’s circularity problem, and this should —in theory at least — rule out their existence. Yet there they are, trading at a positive price. Crypto analysts like Chris Burniske are even using Nicholson-style logic, the equation of exchange, in an effort to arrive at a fair value for Bitcoin.

Hmmm..

In a way Bitcoin with all their volatility suffer from Anderson’s critique:

I’m wary of using Bitcoin as a test for monetary theory, whether this be Hayek’s theory, Anderson’s, or anyone else’s. Not only has Bitcoin been lifted off the ground, so have hundreds, perhaps thousands, of other cryptocurrencies over the last decade. The launching of these new monies seems suspiciously easy. While there is no precedent in monetary history for dodo-bones money, within the broader stream of financial history there is certainly precedent for a dodo-bones asset. Intrinsically useless IOUs such as chain letters and promises issued by Ponzi and pyramid schemers have been popping up for centuries. Cryptocurrencies may have more in common with these phenomena and less with monetary phenomena like dollars, banknotes, and coins. 

This is somewhat confirmed by the observation that cryptocurrencies do not show the same transaction patterns of traditional media of exchange. The most important of them, Bitcoin, is only accepted by a handful of large retailers. When cryptocurrencies do trade hands, participants seem to be motivated by speculation, not payments for goods and services. That they aren’t used much to buy stuff leads me to believe that Bitcoin and other cryptocurrencies have not yet qualified as a monetary phenomenon, and thus monetary economists are under no obligation to explain it. Anderson’s critique of Nicholson’s dodo-bones theory is probably safe, for now.

As I keep saying, even if these new currencies are not going to be favored, their springing up  helps us understand so many aspects of money…

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2 Responses to “Bitcoin and the Dodo-Bones Theory of Money”

  1. Bitcoin and The Dodo-Bones- Theory of Money – Forwardeconomics Says:

    […] via Bitcoin and the Dodo-Bones Theory of Money — Mostly Economics […]

  2. EugenR Says:

    Cryptocurrency is more than technology. All the currencies, including the all mighty dollar are based on faith and trust. So cryptocurrencies are nothing new in this field. The crazy high price of cryptocurrencies is because of two reasons, the first the trust in technology, second the dissolving trust in the existing currencies. Of course the dollar and Euro have some advantages, like backing if governments with military and police force. Also the capacity to force tax payment in official currencies. Then you have all the empty envelope, facade oriented banks, that still are successful to wake up trust (even if they are not trustworthy) among the masses. The governments still didn’t fight back against the cryptocurrencies, and this is surprising. But if to take in account, that the US president created so much contravercy in the world, they just don’t have time to put attention to the issue.

    To understand cryptocurrencies you have to understand the essence of money and how it is created. The real money is virtual as much as cryptocurrency. The value of Bitcoin is so high because of its scarcity as contrary to classical legal money, becoming abondant more and more since 2008. Technologicaly Bitcoin is not a good solution to make out of it a legal payment tool, because of it’s limited transaction capacity per time it can accomplish, and this is part of its essence. So it will never be an alternative to currency, but then this technological bottleneck will be solved, and then it or some other virtual currency will overtake the monetary system. The aboundance of dollars and partially Euro, that is only increasing, will make it’s value devaluated at the end of the day, so something alternative has to come, to replace it.

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