Last week, St. Louis Fed Vice President and Director of Research David Andolfatto released a presentation on Bitcoin, becoming one of the most prominent central bank officials to study the cryptocurrency.
We caught up with Andolfatto to ask him about why he put this deck together, where he thinks Bitcoin is going, and whether he personally has anything invested in it.
Business Insider: What was the genesis for this presentation?
David Andolfatto: Its genesis was a blog post I’d started, addressing arguments that gold bugs frequently put forth, that gold is superior money. Of course, Bitcoin was in the news — I read about the algorithm that fixes the supply of bitcoins at least at some limit. It struck me that despite their tremendous disparity in physical properties, they share the quality that they have a relatively fixed supply — which is why gold and bitcoin make lousy money.
I blogged some more on Bitcoin, and I brought to bear conventional theories of money and whether or not, just because it was virtual currency, whether it was good or bad.
Then Marcela Williams (the St. Louis Fed’s [assistant vice president of strategic communications] for the Bank) came and asked whether I’d be interested in presenting a talk on Bitcoin.
BI: How have your opinions on Bitcoin evolved since that first post?
DA: Early on, I thought, ‘This was kind of silly,’ and I kind of questioned the role of the miners, these miners who are mining bitcoin. And it led to the analogy of people mining for gold. I recall reading a blog post by Paul Krugman, who criticised Bitcoin. He was saying exactly what I was thinking: that this intensive effort to mine for gold …We don’t need more physical commodities. All that has to happen is the price level has to adjust. Economic theory says that kind of mining is inefficient.
I shared in that opinion, but I continued to read about it, and it struck me that that analogy was incorrect — that in fact what these miners were, was mislabeled. They were performing a communal service, a record-keeping service which is critical to any money system. Mining was a red herring, it’s just one way to reward record keepers for their service, and that protocol could function even with constant supply.
BI: What were the main things you wanted readers to come away with from your presentation?
DA: I was trying to describe how things function today. When you think about Bitcoin as a potential rival to the U.S. dollar, it might have some trouble competing, because despite the fact that a computer algorithm governs its supply, like nature determines the supply of gold, that benefit of a theoretically stabilised price level is not necessarily something you want when there’s demand volatility. So takeaway No. 1 is that Bitcoin suffers from the same defect as gold — the standard volatility was very much like gold.
One thing that people have not thought too much, in this new world of competing cryptocurrencies, is that we’ve got a lot of experience in history of multiple competing currencies, and there’s a nominal exchange-rate problem. Economic theory says there’s nothing fundamental to pin down the exchange rate between two intrinsically useless objects. If history is any guide, we’re going to see multiple currencies circulating with extreme exchange-rate volatility. So I asked, How do we think things are going to work out? Do we think merchants are going to accept several different virtual currencies? The relative prices remain stable? Really? What makes you think that? History shows these things are going to fluctuate like crazy.
So what does this mean? I just don’t see bitcoin replacing the U.S. dollar. The traditional way of controlling for [exchange rate] risk is to impose fixed exchange rates. The $US5 bill trades at a 5:1 ratio to the $US1 because we say so. But that goes counter to the whole spirit of these cryptocurrencies.
The U.S. dollar has already passed the market test. Some responded to me by saying, ‘Yeah because, it’s a monopoly.’ But there are several competing currencies out there in the world. The U.S. dollar is still the go-to currency, but there’s nothing domestically that prevents us from getting paid in pesos — Americans do have an opportunity to get paid in any currency they want.
But because the Fed has been manging the supply of dollars — which hasn’t always been perfect — these bugs have been patched, which the Bitcoin protocol is still working through. Inflation (of the dollar) has been low and stable for the past 30 years; most people are happy.
BI: You said Bitcoin could pose a threat to central banks. What did you mean?
DA: I do think its existence as a threat is very good: It will discipline the Fed and other central banks to continue to run responsible policies — if they don’t, people could switch to something else.
The idea of currency competition: Many countries impose currency controls. In Albania, you would suffer severe consequences if you were caught with U.S. dollars in your pocket. The purpose of currency controls is to stimulate demand for domestic currency, because the central bank and the central government want to exploit the people by inflating excessively, so the threat of currency competition — if a central bank, a government, knew people could stop using domestic currency and flock to an alternative, that would force the government to behave more responsibly.
In the past, because of paper notes, a ban on foreign currencies was much easier. But now everybody’s got a mobile phone, a PC — how do you enforce those currency controls? There’s no central authority — people are just trading these things using their telephones, so a government would have to take draconian measures to prevent that from happening.
So that’s not gonna happen in the U.S., but to the extent there are other technologies looming out there, that threat might discipline central banks.
Business Insider: How is Bitcoin viewed within the Fed community?
DA: We support each other in our research, but much of the Fed is concerned with the size of our balance sheet — our efforts are more focused on that. But I haven’t had any pushback. There are some people within the system keeping an eye out — Francois Velde in Chicago also had a note on it.
BI: What about Bitcoin’s underlying technology?
DA: I made a distinction between Bitcon and Ripple. Bitcoin lives on its idea as a currency provider, but there are other protocols that employ the same cryptology that cryptocurrencies employ to concentrate on the payment side. Bitcoin does two things: It creates and manages a money supply, and works as a payment processor.
Ripple is currency agnostic: It’s currently happy to let the U.S. Fed manage the U.S. dollar — with Ripple you’ll be able to send money across the globe with Federal Reserve-backed money.
I’m not entirely sure what units [mobile banking service] M-Pesa uses, but these people are quite sophisticated, so what’s to stop them from downloading Ripple or Bitcoin, and start using them? They seem very receptive to this kind of thing. Especially in Africa and the undeveloped world — that’s where you see excessive inflation.
I don’t see the same demand in the U.S., despite the criticisms of the Fed and the U.S. dollar.
Business Insider: Do you own any bitcoin? Should people be buying it?
DA: No. It’s highly speculative — I don’t think the average person wants to get in there. If you want to put $US10 in to experiment … but I would not want to put in my life savings. It’s usually volatile. You could get lucky, but you’d have to be careful. Let’s see how it evolves.
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