Wrapping your head around Bitcoin can be a pretty monumental task. I’ve tried to simplify some of the technical aspects in the first four parts of this series. Often new Bitcoiners find themselves not only trying to learn some basic cryptography but also economics and monetary theory as well! Given the complexity of the subject and all the information (and disinformation) out there, it can be extremely difficult to find clarity. In this post I’m going to provide a brief introduction to macroeconomics as it relates to Bitcoin. Obviously, I can’t condense an entire textbook into a short blog post, so I’m going to make a lot of generalizations, but hopefully you’ll still come away with the main points.
Let me state up front that there isn’t anywhere close to a consensus among macro-economists as to what constitutes correct theory. Anyone who tries to convince you otherwise is being disingenuous. Most critics stress that widespread use of Bitcoin would certainly cause economic calamity. Maybe it will, maybe it wont, but it’s foolish to speak with such certainty when the economics is far from settled. I tend to believe that the critics are wrong, but I’ll at least give you a fair overview of both sides.
It’s The Aggregate Demand, Stupid
Some version of the following theory of economic recessions is held by a majority economists. It could be considered the “mainstream” theory to the extent there is such a thing.
Let’s start by asking what would happen if one day people just suddenly reduced their spending and increased their rate of savings? In this context we’re focusing on the saving of cash, not investment spending. Another way of putting it would but to say that the aggregate demand for goods and services suddenly falls (with a corresponding increase in people’s cash balances).
Classical economists would have responded by saying that prices and wages would just simply adjust downwards. Remember that wages and prices are determined by supply and demand. If aggregate demand were to fall (if cash savings were to increase) all prices in the economy would adjust downwards and the economy would establish a new equilibrium at a lower price level. We would experience a general deflation, but there would be no reason to expect this would have any negative impact on employment or production. In other words, a sudden increase in cash savings would not cause a recession.
Most mainstream economists tend to agree that if wages and prices adjusted downwards to a decrease in aggregate demand, then sure there wouldn’t be a recession. Their claim, however, is that there is a market failure at play. Specifically, wages and prices do not adjust downwards efficiently to changes in demand. There are several reasons for this:
- Workers tend to resist nominal wage cuts. Even though wages would be cut by the same rate as prices, workers tend mistake their nominal purchasing power for real purchasing power and develop the impression that a wage cut will make them worse off. As a result workers tend to become demoralized and unproductive when facing nominal wage cuts. Employers tend to avoid nominal wage cuts for fear of damaging morale. Firms could try to continue paying the existing workforce the same wage while cutting back the wages for new hires, but over time the new hires become demoralized by earning less than their coworkers and they poison the well and drag down the morale of everyone.
- Prices tend to be somewhat rigid due to “menu costs”. That is, it costs money for a firm to change it’s prices. Think of a restaurant that has to reprint its menu in order to change prices. Firms will be reluctant to change prices if change isn’t profitable after paying these costs.
So what happens if aggregate demand falls but wages and prices remain stuck at current levels? Well, typically when prices are above their market clearing levels you get surpluses. A surplus in the labor market is called unemployment. And when you have a surpluses of goods and services, businesses shut down production and you end up with idle factories or factories producing below capacity. In other words, production falls, unemployment rises and you end up in a recession.
So what can be done to rectify the situation? Pump up aggregate demand! The central bank can expand the money supply by printing money and using it to purchase financial assets (usually government bonds) from the banks. This will lower interest rates as the banks loan the newly created money into circulation. As the new money makes its way through the economy, the additional demand will re-employ the idle resources. Workers will be put back to work, factories will re-open, and the economy will start running on all cylinders again.
There is much disagreement among economists over how much money the central bank should print. Whether monetary policy should follow a set of rules or whether central banks should act at their discretion. They also disagree on the effectiveness of money printing in the face of a severe demand for money. This leads some economists to suggests the government should spend the money itself (fiscal stimulus). But in all cases the idea that wages and prices do not adjust efficiently to changes in demand is at the core of this theory.
Hopefully you can start to see why people who believe this theory are down on Bitcoin. The total supply of bitcoins is controlled by an algorithm not a central bank. What’s more is the supply of bitcoins is designed to increase at a decreasing rate, ultimately being capped at 21 million. If Bitcoin were widely used as money, and if there were a sudden decrease in aggregate demand, there would be no way to expand supply of bitcoins to pump up demand. For people who hold this view, any monetary system that constrains the supply of money is dangerous and will certainly cause recessions and depressions.
Reasons To Be Skeptical
So that’s a basic overview of “mainstream” macroeconomics. It’s simplistic and relatively straight forward and provides a mildly compelling explanation of recessions. But there are some reasons one might be skeptical of its explanatory power.
The Predictions Almost Never Match Reality
According to this theory, it should be relatively easy to, not only end recessions, but to prevent them from happening to begin with. Just put our best and brightest in charge of the money supply, have good forecasts, and print money liberally at the first sign of trouble. As economist Paul Krugman put it:
Recessionary tendencies can usually be effectively treated with cheap, over-the-counter medication: cut interest rates a couple of percentage points, provide plenty of liquidity, and call me in the morning.
Yet they do that and it almost never works as planned. In the United States, we’ve had a central bank with total monopolistic control over the money supply for over 100 years. Central bankers have had total authority to print as much money as they deem necessary without having to go through the political process. Still, over the last 100 years we’ve had 19 recessions/depressions including the two worst economic crises in world history. The following is a chart from a paper by economist Christina Romer (an Obama appointee and hardly an advocate of laissez-faire):
Factoring in the output loss from the Great Recession we find that the average output loss in pre-Fed recessions was 158.1 while the average output loss post-Fed has been 356.4. In other words, recessions have been worse with the Fed in charge, not better.
There are countless other examples. To bring it closer to the present, you might recall the chart below showing the projected unemployment rate with and without the Obama stimulus package. Ultimately unemployment ended up worse than they predicted if they had done nothing.
The explanations for the failed policies are usually that the economy was worse than they expected. Maybe so, but when this continues to happen over and over it’s reasonable to question whether you have the right model.
There Is No Explanation For Bubbles
Large scale, economy destroying bubbles clearly exist. There was a huge stock market bubble in the late 1920’s that ultimately burst and ushered in the Great Depression. There was the Dot-com bubble of the 1990s and, of course, the most recent housing bubble that took down our economy in 2008. Yet, there is nothing in mainstream theory, articulated above, that even defines what a bubble is, let alone how they form. In fact, many Keynesian economists are still under the impression that there was nothing wrong with the housing market in 2008. In their minds, the housing crash was just brought about by just a garden variety collapse in demand. If demand could have been propped up, the housing prices could have remained at the historic heights. Even casual observers should have a hard time believing that.
To the extent that bubbles are acknowledged, they are usually pinned on some form of irrational exuberance. While it’s likely that irrational exuberance can divorce asset prices from their true values, we typically find that the corrections tend to be rather hard and swift. Those who follow the Bitcoin price are certainly familiar with irrational exuberance, but the bubbles have lasted only days if not hours before the correction hit. It’s hard to explain multi-year, multi-trillion dollar, correction-less bubbles by appealing solely to irrationality.
Why The Sudden Collapse In Demand?
The mainstream theory doesn’t offer much in the way of a compelling explanation for this question. Here again from Krugman:
As is so often the case in economics (or for that matter in any intellectual endeavor), the explanation of how recessions can happen, though arrived at only after an epic intellectual journey, turns out to be extremely simple. A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time. [emphasis mine]
I’m emphasizing this quote because, contrary to the assertion, the reason for the collapse in demand actually matters a lot. It’s true that recessions are almost always coupled with a measurable decline demand, but is it necessarily the case the decline in demand caused the recession or could the causality be the other way around? Typically, these sudden drops in demand are explain by irrationality. Business is driven by “animal spirits”. The private sector suffers from irrational swings from optimism to pessimism, etc.
The problem again is irrationality doesn’t seem like a good explanation for this behavior. Savings tends to be a purposeful action undertaken to achieve a desired end. If it were the case that something else was responsible for crashing the economy, saving would actually be a rational response to the rising uncertainty. Cash is the most liquid asset available and a cash balance tends to be the best way to navigate uncertainty. It seems at least plausible that the causality may indeed run in reverse implying that there might be an alternative explanation for recessions.
No Concept Of Too Low Interest Rates
Mainstream macro has plenty to say about what happens when interest rates are too high. Yet, there is very little concern about the corollary ― too low of interest rates. Indeed the only negative consequence attributed to too low interest rates is usually mild inflation, which is typically treated as no big deal and can easily be dealt with by the central bank. It’s a fairly peculiar asymmetry. Economic devastation on the one hand, nothing on the other. Everywhere else in economics deviations from market prices produce negative results, yet here interest rates are assumed to be the exception.
The Hair Of The Dog
In this section I’m only going to cover the alternative theory to which I think most Bitcoiners probably subscribe.
The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with hardly a fraction in reserve. ― Satoshi Nakamoto
The above quote from the creator of Bitcoin, Satoshi Nakamoto, is essentially alluding to what is called the Austrian Business Cycle Theory (ABCT). Central to this theory is the idea that market interest rates play a critical role in coordinating savings with investment.
It’s a fact about the economic world that there are only so many resources (think concrete, steel, computers, etc.) available to be invested. Entrepreneurs have to collectively work with what’s available. Projects that consume too many resources cannot be completed and will have to be abandoned. According to ABCT, market interest rates are like traffic lights, regulating the flow credit so that only sustainable projects will be undertaken. If interest rates are low enough relative to the expected return on a given project, the investor is given a green light ― that is, the project is sustainable and it’s safe to invest. If the interest rate is too high relative to the expected return, the investor is given a red light ― stop, bad investment, do not invest. Investors are given a yellow light if the interest rate is borderline and understand to invest with caution.
Now what happens if traffic lights suddenly stop working? Typically drivers see the light is out and slow down or stop as they approach the intersection. But what if all traffic lights were suddenly set to green in all directions? We would expect a massive number of traffic accidents and pile ups. This is analogous to what happens when the central bank artificially lowers interest rates below the natural rates ― all investment traffic lights are set to green. Bad investment that are otherwise unsustainable are made to look like sustainable, good investments on paper. Remember nothing in the real economy has changed. There are no more resources available to invest. No more concrete, steel, computers, etc. Yet, the interest rates are giving the appearance that there are.
This problem is compounded by the fact that lower interest rates typically incentivize people to save and invest less and consume more. As the increased consumer demand pulls resources always from long term/capital intensive projects, there are even less resources available to be invested. With no other means to perform rational economic calculation except to rely on market prices, entrepreneurs will inevitably misallocate resources into unsustainable capital intensive projects. The resulting malinvestments and overconsumption are the typical characteristics of an economic bubble. Mainstream macroeconomists mistake this bubble as evidence that their “stimulus” is working. When the bubble bursts, they conclude that the only possible explanation is that people just irrationally started saving and that crashed the economy. The solution? More stimulus!
Let’s quickly walk through the above diagram. The top right diagram is the production possibilities frontier (PPF). The curve represents the maximum sustainable combination of consumption of and investment. Market participants typically chose a combination that satisfies their own personal preferences. The invested funds represent the supply curve in the loanable funds market (bottom right diagram). The intersection of the supply and demand curves determines the interest rates. Interest rates determine the shape of the Hayekian triangle (top left diagram). More capital intensive investments that are temporally remote from the consumer are represented on the left side of the triangle. Investments in close temporal proximity to the consumer are on the right side.
When the central bank prints money and buys bonds, this new money is essentially dumped into the loanable funds market, shifting the supply curve (S + ΔM) and pushing down interest rates. People respond to the lower rates by moving backwards along the PPF, investing less and consuming more. The supply of investable resources, shown in the bottom right diagram, shrinks. The increased consumer demand pulls resources towards the production of consumer goods, pushing up the right side of the Hayekian triangle. Investors borrow the printed money at artificially low interest rates, and invest in more long term, capital intensive projects extending the Hayekian triangle out to the left. The combination of these two forces (temporarily) pushes the economy beyond the PPF ― that is, beyond the maximum sustainable combination of resources. Hence a bubble ensues. The bubble cannot continue forever as there aren’t enough resources to finance both the increased consumption and investment and the economy eventually crashes.
If this theory is correct it would explain a number of holes in the mainstream theory.
- It provides a comprehensive explanation for bubbles that is sorely missing from mainstream macro.
- It explains why we’ve had 19 recessions/depressions since the creation of the Federal Reserve. In an attempt to stabilize the economy by pumping up demand, it is actually destabilizing it by distorting interest rates and misallocating resources.
- It explains why their predictions about how the economy will respond to stimulus are always off. If the problem is not a lack of demand, but rather resource misallocation, then printing money isn’t going to solve the problem and will likely make it worse.
- It explains the collapse in aggregate demand without appealing to irrationality. The bursting malivestments and resulting unemployment create uncertainty. People rationally respond to the rising uncertainty by saving money. Savings didn’t cause the economy to crash, the crashing economy caused the savings.
I should point out that ABCT doesn’t necessary imply that the mainstream theory of sticky wages and prices is wrong, but it does suggest it much less of a problem than they think. If recessions are understood as the predictable byproduct of central bank interventions, then it’s likely that (1) aggregate demand, absent a central bank, would tend to be fairly stable, and (2) wages and prices are likely more flexible than is commonly thought.
In this context, Bitcoin, rather than exacerbating our economic problems, would likely bring economic stability. Since the supply of bitcoins cannot be manipulated by a central bank, it precludes the possibility of interest rate manipulations that lead to resource misallocation. Also, while a discussion of income inequality deserves it’s own post, there is strong reason to believe that central bank money printing distorts the distribution of wealth, benefiting the Wall Street banks and large corporations at the expense of the average person. With Bitcoin, that wouldn’t be possible.
So to conclude, I want to reiterate that the above theories are just that ― theories of how the macro economy works. Given that we can’t conduct controlled macroeconomic experiments, there is always going to be some doubt about which one is correct. But given the recent economic turmoil, and the lack of consensus among economists, Bitcoin is likely to prove to be a very useful experiment.
I’ll leave you with a video of John Maynard Keynes and FA Hayek rapping about the theories I described above: