Understanding Bitcoin

A new article by JP Koning at the Moneyness blog revisits the idea that two monetary functions can be separated: medium of exchange (that which is used to actually buy things) and unit of account (what prices are quoted in and accounts generally kept in). He does this through a historical account of the monetary milieu of some medieval European cities. This has direct implications for viewing contemporary monetary developments half a millennium later.

In “Separating the functions of money—The case of medieval coinage” (13 September 2013), Koning suggests that a common unit of account (the pound/shilling/pence system) for pricing existed alongside a plethora of actual coins of various and sundry sizes, qualities, and metals. Each had to be repeatedly assessed and reevaluated due to wear, fraud, and outright devaluation in terms of the common unit of pricing. This had to be done so that such objects could actually be applied toward paying in specific transactions. Meanwhile, he claims that actual coins corresponding to this unit of account may well have been rare or might not have existed at all at certain times, at least relative to the mass of actually circulating crudely formed hunks of various metals (crude as retroactively judged by subsequent industrial coinage standards).

This is a thought-provoking discussion and I am sure there is more to be assessed and debated about the historical details. Nevertheless, the basic theoretical idea is that the unit used for pricing and what people actually hand over in trade to pay asked prices do not necessarily have to be the same. This implies that the problem of barter comprises at least two distinct issues: 1) no common unit of pricing for cost accounting, economic calculation, and comparison shopping and 2) no commonly accepted unit to be employed in concrete acts of payment. Koning thus seems to present a transitional hybrid case in which (1) is more developed while (2) is still a work in progress, or has broken down.

As it turns out, we are now witnessing a rapidly evolving case of just such a separation of functions. The difference is that, for now, it is the exact inverse of Koning’s medieval coins.
The opposite of medieval

Those who pay in Bitcoin today overwhelmingly pay prices that are listed in the local fiat currencies of the politically-defined jurisdictions they find themselves trading within. There are already a few exceptions, such as the Trezor high-security hardware wallet (priced at 1 bitcoin) and some mining shares, but such examples remain rare.

In current Bitcoin transactions, despite pricing still being largely denominated in euros, dollars, and the like, the actual “coin” being tendered differs from the unit of account and pricing. This separation of functions is much easier, quicker, and more accurate today than it was in, for example, Basel, Switzerland 600 years ago, due to the combination of real-time global networking and public exchange markets for both Bitcoin (see the new CoinDesk Bitcoin Price Index) and other forex pairs. This means accounting and thinking about relative exchange values can easily be done for present convenience using existing pricing constellations.

According to Koning’s account of the medieval cases he describes (taken at face value for our purposes here), the unit of account itself may even have been virtual, while the actual media of exchange handed over in transactions were the various and sundry physical coins people had managed to acquire in their previous work and trading. In diametric contrast, with Bitcoin today, we have a “virtual” coin with global circulation that is mathematically perfect in its uniformity and fungibility. These ideally homogenous global “coins” now circulate next to a hodgepodge of national-monopoly units of account/payment which have all sorts of shifting real values. Specifically, almost all such “shifting” of paper currency values is downward, just at differing rates of descent.
The potential for role reversal and later convergence

If and as Bitcoin grows and its price volatility stabilizes with expanding adoption, market participants could in time come to use it as a global unit of account against which the various and sundry unstable fiat currencies continue their extended monetary Danse Macabre. Bitcoin-denominated prices could be paid in Bitcoin, of course, or they could also be paid in a local fiat money, if both traders agree. Fiat would substitute for the relatively stable Bitcoin at the current day’s exchange rate in a way precisely opposite to their current respective roles.

Beyond this, in a long-term Bitcoin success scenario, medium of exchange and unit of account functions would most likely tend to move further toward convergence—price in Bitcoin, pay in Bitcoin. This would tend to greatly enhance convenience for all the buyers and sellers of the world (meaning everyone). That is the sort of thing that the American founding generations of the late eighteenth century would have called “the common good.”

In a more recent Europe, as Philipp Bagus explains in The Tragedy of the Euro (2010), the monetary authorities of more inflationary national currencies were repeatedly embarrassed by the relative strength of the less inflationary deutschmark. They therefore sought a coordinated means of inflating through the euro system, so that rates of monetary depreciation could be “harmonized.”

Likewise, in a future world with a successful Bitcoin, the inflationary paper monies of the world (that is, all of them) may eventually become rather self-conscious if compared to a global rising-value currency. This time, however, the inflationists may have a harder time sparing themselves distress than they did in pressuring German politicians to end the deutschmark against the general sentiment of the German people.

This is because the Bitcoin “cat” is not only out of the bag; it has spawned a global tribe of at least 200,000 currently active network nodes located in nearly every corner of the earth, any one of which contains a complete copy of the block chain.

Much more difficult than herding politicians, is herding cats.

http://konradsgraf.com/blog1/2013/9/14/bitcoin-as-medium-of-exchange-now-and-unit-of-account-later.html