The most significant innovation in Bitcoin is not blockchain, nor the fact that it is a non-state-backed electronic currency. It is truly ground-breaking because it is the first ‘intelligent’ money. An ‘intelligent money’ is one which self-regulates.

Despite the important technological innovation in blockchain, Bitcoin’s ‘intelligence’ involves the application of a very simple rule: the quantity expands to 21 million and then it ‘grows’ at zero percent. I’m less interested in the merits of this rule, which are well-rehearsed, than the possibilities it suggests. The ‘intelligence’ of money could be extended in many interesting ways. From an economic standpoint, the obvious improvement in intelligence would be to design a currency which expands and contracts in line with demand for currency. Embedding this in the currency’s DNA would render central bank decision-making redundant – to everyone’s advantage. ‘Intelligence’ could also embed social goals – for example the currency could self-regulate the activities for which it is used, perhaps even rewarding or punishing activities contingent on their social impact. In extremis, I imagine we will have a currency which is fully intelligent, gathers data and evolves its own rules of distribution and growth. Tony Yates in an excellent analysis is pessimistic about the prospect for this sort of innovation, my sense is that it is inevitable – indeed it could be the basis of an edge for digital currency over existing state-backed money.

Those are some of the insights into the future of money which Bitcoin has revealed. What about Bitcoin itself? I think Bitcoin is a money. You can pay for things with it and it has a significantly large number of users. It is also a ‘currency’ in the sense that you can exchange it for other currencies in a market.

As a significant contemporary currency, Bitcoin is also unique because it is designed to have a finite supply. It is also unusual because it has been issued by the non-state sector and the revenue generated by the issuance has been dispersed across many individuals and entities under a decentralised system.

There are two immediate observations: it is an extraordinary phenomenon, and you can learn a huge amount about money from thinking about it.

What does it reveal about money? Money is not ‘backed’ by anything – not tax revenues, not gold, not ‘claims on goods’. Money’s value reside in a network externality, or more simply, an existing network of people who accept it as money.

Confusion arises because it is extremely difficult to establish a network of users. Typically, this requires either some form of backing or some kind of force – for example, the fiat power of a state. ‘Fiat‘ is a government order. But once the network is established, money no longer needs backing, or government decree. In fact, money does have an ‘intrinsic‘ value, just no value in alternative use.

Chartalism, the idea that money is only accepted because you are required to use it to pay taxes, conflates this critical distinction. One way to establish a network of users of a currency issued by a state is to require taxes be paid with the currency – but once the network is established, tax payment is the same as any other transaction. In a state, such as Hong Kong, where the government raises revenue mainly through land sales, and taxation is an afterthought, currency still has value.

The best piece of analysis I have seen of Bitcoin was written by Dan Davies. From memory, as I cannot find the original which was distributed by email, Dan provides a coherent explanation of how the network was established, and also a rigorous way to value Bitcoin.

Apologies for any misrepresentation, Dan, but I recall drawing the conclusion that Bitcoin could establish a network of users because it fulfilled a clear economic function: how to finance transactions which, by virtue of being illicit, existing money was at a disadvantage. Now this does not fully explain why Bitcoin succeeded in establishing a network – we need to understand why those in the illegal drugs trade decided to accept it. It’s geeky cleverness may have been its original edge – and despite its seedy origins, it may genuinely be the cleverest money ever. It’s original adopters may well have reasoned ‘this is so clever, I have to use it’. Or tell people about it.

Bitcoin reveals what we should already know about money, but is often confused – that money has no ‘backing’, and that it’s value simply resides in a critical mass of existing users.

Bitcoin also proves that “base money” is different to deposits – which Friedman and Tobin labelled as “quasi-money”. If banks started to lend bitcoin and take bitcoin deposits, we would have a bitcoin banking system with decentralised electronic base money. Those deposits would have very different properties to Bitcoin itself – not least of which is that banks could default on them.

Bitcoin illustrates very clearly why helicopter drops of money is the definition of monetary policy, and not fiscal policy. So far there has been a $200bn or so helicopter drop of bitcoin. Reserves do not have to be distributed through banks – that is a contingent institutional feature of our current monetary arrangements. And helicopter drops don’t have to be inflationary – so far there has been deflation in Bitcoin prices.

We can also learn about central bank accounting. Base money is clearly not a liability. No one pays interest on the ‘reserves’ of Bitcoin – which are dispersed beyond the banking sector. And not paying interest on reserves does not cause immediate Bitcoin hyperinflation!

Valuing Bitcoin

In most circumstances, how much money is issued matters. Bitcoin is designed to have a finite supply. Usually when we think of money we think of it in the context of a national or regional economy. We typically value currencies relative to domestic price levels. In consideration of exchange rate valuations we look at real exchange rates which adjust the nominal exchange rate for relative inflation trends across economies. Typically, we compare these ‘real’ exchange rates against history, and make adjustments for terms of trade etc. The Big Mac index is an attempt to do this in reverse – by comparing the exchange rate to the relative prices of an homogeneous product in different economies. Isabella Kaminska describes an innovative attempt to do something similar with Bitcoin.

What can we do with Bitcoin? Again, from recollection, Dan Davies substituted the illegal drugs market for the national economy and looked at the ratio of ‘base money’ Bitcoin to the gross nominal value of trade in illegal drugs.

The challenge with this very clever approach is that we don’t really know the scope of the Bitcoin economy, and we have no idea what ‘portfolio’ demand for such a unique currency will be. It may well be the case that even if illegal trade provided the initial network effect, the subsequent use of Bitcoin is independent. After all, we don’t use a ratio of base money to tax receipts, to proxy the demand for money in national economies. Arguments for and against Bitcoin’s portfolio properties can be made. Some will argue not having state backing is an advantage, others a disadvantage. I have no way of assessing our ability to control counterfeit Bitcoin – which must be one of its biggest risks.

The next biggest challenge to Bitcoin, as a money, relates to how it established itself as a network. Why would I ever want to use Bitcoin to buy and sell goods and services rather than an alternative currency? An obvious line of attack is to make transaction costs lower – but that is far harder than it seems, and near impossible given Bitcoin’s price volatility. Price volatility is a cost. This problem is revealed by its limited role as of unit of account. Many merchants may accept Bitcoin as payment – including high profile tech companies – but they price everything in dollars and convert immediately. At best, they may hold some inventory as speculative R&D.

I titled this blog ‘valuing’ Bitcoin. I have no idea what a fair value for it is – there is far too much uncertainty. Assets which generate cash flows are the easiest to value, or at least derive expected returns. That is why currencies are so difficult to assess. Sterling can trade at two dollars (which it did just over ten years ago), or at one dollar – without any material shift in relative prices. Bitcoin is a currency, and we have no well-defined Bitcoin-specific economy. It is as if international dollars started to trade independently – how would we value them?

What I would say is that Bitcoin is extremely important. It reveals an alternative future for money in general. As a specific money, it has unique properties. It’s persistence and relevance may surprise.


This from David Andolfato is superb, as is this from Tony Yates, and multiple writings from Izabella Kaminska.

Subsequently, Dan Davies published his highly perceptive original thoughts on the subject.

About The Author

Eric Lonergan is a macro fund manager, economist, and writer. His most recent book is Money (2nd ed) published by Routledge. He is also a supporter of Big Issue Invest (BII), the investment arm of The Big Issue, and is one of the initial limited partners in BII’s Social Enterprise Investment Fund LP. In a personal capacity, he makes direct investments in social enterprises. He also supports and advises The Empathy Museum.

11 Responses

  1. Nick Rowe

    I agree with a lot in this post. But I’m not sure how Bitcoin is the first “intelligent” money. Compare Bitcoin to (just one example) gold. When the price level falls, gold mining becomes more profitable, so the supply of gold increases faster, which slows (albeit to a small extent) the fall in the price level. Isn’t that “self-regulation”?

    • Eric Lonergan

      Hi Nick. Thanks for the comment. I am defining intelligent as “self-regulating”, built into the DNA of the money. I take your point about gold. One could make the same argument about currency boards, but your use of inverted commas highlights my point. The physical constraints on gold production is not really self-regulation. Typically any rule to control the money supply is determined by the issuer. Sea shells may be an exception, but again this is stretching the meaning of ‘self-regulation’. My central point is that Bitcoin opens up the possibility of an extraordinary and unique set of properties for self-regulation. We can imagine future variants with lots of intelligence – gathering data, regulating growth, even with rules about the distribution of helicopter drops, restricting eligible transactions, etc. ‘Intelligent money’ is a ground-breaking development. Bitcoin is a profound innovation – albeit somewhat low IQ!

      • Eric Lonergan

        To go one step further, we should expect to see a currency which learns, and starts to develop an evolving rule. The ultimate DNA will probably be ethical and universal.

  2. Eric Lonergan

    On reflection, “self-regulation” may be too narrow a definition of “intelligence”. Determining the rules of growth, distribution, and use may be more accurate. I guess there is a minimal requirement for “intelligence” but there is no upper limit … Either way, I don’t think ‘having a constraint’ is the same thing as having an intentionally designed, built in, rule for functioning.

    • Nick Rowe

      Eric: I think I sorta see what you might be getting at. It’s not clear (yet), but that’s OK. Maybe it’s clearer if we note that the growth in the stock of Bitcoin depends on the number of transactions using Bitcoin (I think that’s true). That’s a sort of *inbuilt* “intelligence” that is hard to imagine with gold or shells.

  3. Gary D Anderson

    I fail to understand, Eric, how money has no backing. Fed money must be backed by collateral, by law. Broad money is mostly in the form of collateralized loans.

    Only credit card money is not backed. I wrote about it at my name on this post. And of course, Helicopter Money is not backed, which I agree with you we need, in order to balance out the movement of backed money from main street to the uber rich.

    Bitcoin seems destined to be taken over by government. Otherwise, it is unconstitutional money.

    But as for the dollar, it may not be convertable into gold, but most of it is backed by collateral.

    • Eric Lonergan

      Thanks Gary – I think we mean different things by “backing”. I am obviously not saying that deposits are typically created by making loans, or that base money is typically increased by buying assets. The latter is of course a procedural feature, and base money’s value in now way depends upon it.

      My point is that a $10 bill has no value in alternative use. It only has value because a community accepts it as payment for goods and services. Whether somebody, somewhere has corresponding “collateral” affects this not a jot. Money’s value is in fact unique and instrinic – in the accurate sense of the word. A $10 bill has value in of itself.

  4. csissoko

    “From an economic standpoint, the obvious improvement in intelligence would be to design a currency which expands and contracts in line with demand for currency. Embedding this in the currency’s DNA would render central bank decision-making redundant – to everyone’s advantage.”

    I think your title captures the essential problem with bitcoin (and all moneys), but you fail to actually recognize it in the text — perhaps because money is very difficult to model and thus verbal models tend to omit essential details.

    Yes, we need “a currency which expands and contracts in line with demand for currency”, but that’s not the hardest part of designing money. Precisely because money is more about social norms/networks than backing — as you recognize — there’s an inherent price indeterminacy to every money. That is, there is a range of prices that are temporarily stable, or perhaps stabilizable, before the social norm starts to break down. This makes it easy for prices to drift towards instability.

    So what’s most important to any currency is how this price indeterminacy is managed and balanced with the need for expansion and contraction with demand. In modern societies central banks have been given the job of managing this price indeterminacy. It’s not clear that you won’t need something similar in a bitcoin money environment.

    • Eric Lonergan

      Thanks for the comment C Sissoko. I have some sympathy with this. My own sense is that with base money in normal times supply creates demand – it’s money after all. Not sure that there is some chronic price indeterminacy though, quite the opposite. Seems remarkably stable.


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