Bitcoin Series 26: the Polemitis Impossible Trinity*

Lunch, unfortunately, is never free.   Dumplings, Shanghai, March 2013, paid for in yuan.

Lunch, unfortunately, is never free.   Dumplings, Shanghai, March 2013, paid for in yuan.

* Credit for the tongue-in-cheek name to Ruben Damiao.  

I am sure that this has been stated much more formally and correctly by many economists - consider this a layman's version to keep from missing where your lunch is being charged to you.  And if there is a formal statement of this, please let me know.

The Polemitis Impossible Trinity posits that a designer of a new currency can, at best, embed two of the following three desirable characteristics in a currency:

1. No Foreign Exchange Risk:  In other words, the new currency is not volatile vs. the existing presentational currency / national unit of account.

2. No Counterparty Risk: There is no need to trust a counterparty for redemption of the currency.  In other words, there is no chance that the issuer will become insolvent and default in general or choose to (or be forced to) default to a specific party due to sanctions, political pressure and so on.

3. No Money Supply Risk: There is no risk that the money issuer will increase the money supply beyond a pre-defined amount.

Some Examples:

A.  Most sovereign ('fiat') currencies are designed to embed characteristics 1 and 2.   The USD dollar is an excellent unit of account in the United States and has no volatility vs. the dollar.  (in fact, the FX question is silly for sovereign currency, but we have to have it in here for other examples).  

The Fed can choose to never default in USD terms - this is precisely why it is a good 'lender of last resort' for example and the most trustworthy USD counterparty.  On the other hand, the supply of dollars is not fixed and can be expanded - in fact this is what creates the lack of counterparty risk (in USD terms).

A FedCoin or nationally backed cryptocurrency would have the same characteristics.   It would trade 1:1 with the USD, it would be redeemable for USD but it would be vulnerable to increases in money supply

B.  Centralized private currencies (pre bitcoin) fared horrifically on this metric which is why they usually ended very badly.  

They had FX risk and, in many cases, both money supply and counterparty risk.   In other words, at best, they scored 1/3 (depending on if you believed the issuer would prioritize money supply over default risk), but one can easily imagine a private centralized currency issuer scoring a 0/3.

C.  Bitcoin prioritizes #2 and #3.   You can hold bitcoins with no counterparty risk and the money supply is fixed / predictable.   What you lose is #1 - Bitcoin's value will fluctuate against any given national currency and unit of account.

D.  Old-fashioned commodity money like gold is closest to Bitcoin in this regard.  If you hold physical gold, you can eliminate counterparty risk and money supply is fairly predictable / fixed.   There is, however, foreign exchange risk as the price of gold will vary vs. your national unit of account.

The point of this exercise is not to judge which one currency is better or if counterparty or money supply or exchange rate risk is high or low in any given circumstance.   In fact, it is highly plausible that certain trade-offs make a lot of sense for certain situations -- most economists would argue that trading off #3 for #2 is an excellent choice in a sovereign currency.

The point is to avoid falling for the 'free lunch' trap.

In terms of Bitcoin, the trap goes like this:  "Bitcoin is great, but I dislike this volatility.   We look forward to NewBitcoin that has all the neat features of Bitcoin but no FX volatility."

That may be a wonderful idea, but if you have eliminated the FX risk, you have just introduced somewhere into the system counterparty or money supply risk.   Look carefully and you will find it!   That still might be a good choice, but it is no longer Bitcoin.   It is something else you have designed along the Impossible Trinity.

P.S.  Spare a thought for the Eurozone.   Scoring 2/3 on this metric should be easy for a leading global economy, but the Eurozone is at best a 1.5/3.   The debacle of the last few years has shown that  #2 (counterparty risk) exists in European sovereigns, based on the mood in Germany that week, along with the always money supply risk in any political currency.

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Posted on March 31, 2014 .