Skip to content

Inflation indexing and Bitcoin rhetoric


The other day, the New York Times provided us with an example of how fads and fashions can be used to draw attention to, and win acceptance for, an economic argument. In his article In Search of a Stable Electronic Currency Nobel laureate Robert Shiller proposed the introduction of an inflation-indexed unit of account similar to the Chilean unit of development or unidad de foment (UF) which is existing since the 1960s. The article is in large parts a summary of the ideas of an academic paper the author published in 1998. In short, its main argument says that recent progress in computer technology has considerably widened the possibilities of inflation indexing which would allow for a better pricing, contracting and risk management in an economy.

This is rather dry stuff. Surprisingly the NYT article gained wide attention and was greeted almost with euphory on Twitter and elsewhere. Joe Weisenthal (Business Insider), for example, wrote: “Yale Professor and Nobel Laureate Robert Shiller has a great piece in the New York Times today that shows why he’s one of the greatest economic thinkers of our time.”

His next sentence indicates what this buzz is about: “The piece is kind of about Bitcoin — which he continues to think is a straight-up bubble* — but actually about how technology and electronic money can revolutionize the financial system in a good way [my emphasis.].” In contrast to Bitcoin, one would like to add, of which Joe Weisenthal, as his readers know, is a vehement opponent.*[On another occasion, Joe Weisenthal was quoting Robert Shiller even saying that as a currency Bitcoin is “a return to the dark ages.”]

At first glance, the NYT text is a Bitcoin article – which may have attracted Joe Weisenthal and others in the first place. But upon closer examination it is not. The Bitcoin theme only serves as a teaser to the entirely unrelated topic of inflation indexing. Bitcoin, so the simple argument, is an electronic money and an electronic money is what it needs to realize Robert Shiller’s earlier idea of inflation indexing.

It is a long teaser. Robert Shiller wrote:

Bitcoin, an experiment with a radically new kind of electronic money, has exhibited many of the characteristics of a speculative bubble. That was clear long before the collapse of the Bitcoin exchange Mt. Gox last week.

Bitcoin’s future is very much in doubt. Yet whatever becomes of it, something good can arise from its innovations — even if the results are very different from its current form or its numerous competitors. What I have in mind isn’t another wave of price speculation. Instead, I believe that electronic forms of money could give us better pricing, contracting and risk management.

The Bitcoin phenomenon seems to fit the basic definition of a speculative bubble — that is, a special kind of fad, a mania for holding an asset in expectation of its appreciation. Further, a bubble is publicized and amplified by news of price increases, often justified by some kind of inspiring “new era” story that attracts more attention as the price rises. In this case, the narrative was that a computer whiz invented a new kind of money in the form of electronic currency units, as part of a decentralized computer-driven system for a world economy that extends beyond the reach of any single government.

The central problem with Bitcoin in its present form, though, is that it doesn’t really solve any sensible economic problem. Nor should it substitute for banks and the governmental institutions that regulate them. They are reasonably effective institutions, despite their flaws, and should not just be scrapped and replaced by a novel electronic system.

Unfortunately, the Bitcoin success story has been tied intrinsically with instability, with excitement and envy for those who have become rich through investing in it — rich for a while at least, because the value of the electronic currency has fluctuated wildly. The instability of Bitcoin’s value in dollars is a measure of failure, not success. It means that any commerce using Bitcoin or its competitors would be buffeted by enormous inflation and deflation.

But if we go back to the electronic-money drawing board, we may conclude that Bitcoin has been focused on the wrong classical functions of money, as a medium of exchange and a store of value. Bitcoin offers a way of “mining” electronic coins that can replace our dollar bills and bank accounts. Yet there is no fundamental need for this. Money, as we’ve known it for decades, works quite well in these respects. It would be much better to focus on another classical function: money as a unit of account — that is, as a basic standard of economic measurement. Scientists spend a lot of time thinking about ways to improve systems of measurement. Business people should, too.

This has already begun to happen.”

What follows is a description of the idea of inflation indexing. From here onward, Bitcoin is only mentioned again once, in the last paragraph which reads almost like an obituary:

“Bitcoin has been a bubble. But the legacy of the Bitcoin experience should be that we move toward a system of stable economic units of measurement — a system empowered by sophisticated mechanisms of electronic payment.”

This is the narrative. Here, the Bitcoin example is used to draw attention to the main theme (inflation indexing) and to promote this idea by contrasting it to the negative Bitcoin experience which just caught the headlines with the MtGox debacle.

But, as Robert Shiller himself wrote in his earlier paper, the UF is not money, since it is not a medium of exchange. Therefore, in my view, there is no justification for the lengthy description of the factual or alleged weaknesses of  Bitcoin in this context. The UF is a measure of daily price changes, based on monthly variation of the Chilean Consumer Price Index. The Chilean money is the peso. The UF serves to keep certain prices in the Chilean economy such as financial instruments or real estate constant in real terms. On 4 March 2014 the CPI-indexed unit of account (UF) published by the Banco Central de Chile was 23,515.17 pesos.

So far, all this has nothing to do with electronic money, let alone Bitcoin. The Chilean peso is not an electronic money. But if it were, so the argument, inflation indexing would be much easier to implement and more widely accepted.

In Chile, acceptance of the UF is limited. As Robert Shiller remarked in his 1998 paper, the UF is not used to quote everyday prices because, as he presumed, calculations between the indexed unit of account and the currency may seem “unnecessarily complicating for our lives.” This could change with the introduction of an electronic payment system. In the NYT article he wrote:

With electronic software in the background, we can improve on the Chilean idea and make it more useful.

In his 1998 paper, he had already used a similar argument:

Indeed, there will inevitably be a blurring of the distinction between the currency and the separate unit of account once credit card companies allow charges to be made directly in the units of account, and banks allow writing of checks in terms of the units of account”.

I don’t want to delve too much into the intricacies of inflation indexing. I’m belonging to the generation who, as Robert Shiller decribed in a NBER research paper, “don’t like” inflation. This is because I know that if prices are on the rise someone has to pay them. As a rule, if one side of a contract is keeping the price fixed in real terms, the other side has to bear the full burden of inflation – and the former has no incentive whatsoever to care about rising prices.

In the New York Times, Robert Shiller gave an example:

Consider rents. Increases may seem unfair to tenants, yet they may be needed to offset inflation. In Chile, a landlord can easily set the monthly rent for the tenant in U.F.s and then never have to change it, reducing the potential for errors, delays and misunderstandings. The name “U.F.” reframes people’s thinking so that keeping real economic values stable is natural and easy.

Who says that tenants must bear the burden of inflation, and must bear it alone? Why is this “natural and easy”? Shouldn’t in a market economy pricing be the result of an individual bargaining process which would give both sides an incentive to keep prices low as both can be hurt by the effects of inflation? In an indexed economy, interests differ. In the example, landlords have no incentive whatsoever to care about rising prices and, for instance, to support an anti-inflationary policy. As a result, the risk of inflation may be higher than under a market solution casting doubt on the efficacy of Robert Shiller’s idea to actually establish a stable currency.

In my view, allowing contracts to be linked to an inflation index is a political decision about how the burden of rising prices is distributed. There are always winners and losers of inflation. Indexing means that governments are determining those winners and losers, and the resulting redistribution of incomes with rising (or falling) prices, in advance.

Robert Shiller is an expert on fashions, fads and bubbles. He knows how to use a fashionable topic to transport a message which he has, as he wrote, propagated for almost 20 years. In the current case, Bitcoin came handy after MtGox, one of the biggest Bitcoin online exchanges, declared bankruptcy, with 744,408 bitcoins – worth about $350m – missing.

Stressing it once again: Electronic money and inflation indexing are two different things. While the one may be desirable – for example as a means to introduce negative interest rates as several authors proposed recently (and in this case, there are lessons from the Bitcoin experience, see Izabella Kaminska for an overview) – the other may not. The establishment of electronic money may facilitate inflation indexing. The decision about the introduction of the latter is a highly controversial political matter which should be made independent of technical aspects.

Referring to a remark by Joe Weisenthal I would like to add: You need not be a Bitcoin believer to doubt the efficacy and social desirability of inflation indexing.

From → Markets

Leave a Comment

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: