There has been a lot of attention on BitCoin of late, and a number of my correspondents have been digging into the topic.
I was looking for some good analogies through which to understand the idea and the dynamics of BitCoin and similar mathematically defined crypto-currencies. This is my first shot at constructing such an analogy.
In this model, I think of the economy (the exchange of goods and services) to be an intricate clockwork mechanism. Everything is connected to everything else. Energy flows through the gears, allowing the machinery to operate at some level of speed and efficiency to move things along.
Any economy, like any clockwork mechanism, has friction. Energy needs to be supplied to overcome the friction, and that energy eventually degrades to heat as the state of the clockwork mechanism evolves over time.
One can improve the efficiency of the machine by applying a high quality lubricant. With a good lubricant, there is less friction, and less energy is needed to drive the machine.
In an economy, money is the lubricant that allows the machinery of commerce to operate efficiently. That’s the function of money: to act as a lubricant for the gears of the economy.
Suppose an inventor devises a super-lubricant that outperforms all current lubrication technologies. What happens? In an ideal world, everyone upgrades to the new lubricant and it soon takes a lot less energy to keep the clockwork machine running smoothly.
What could possibly go wrong?
The problem is that manufacturing the new lubricant is not free. Just as it takes energy to overcome friction, it also takes time and energy to manufacture the super-lubricant. And so there ensues a “gold rush” to manufacture this wonderful new super-lubricant.
Eventually, those who got in the game early end up owning barrels and barrels of this valuable super-lubricant. The problem is, they are not using it to lubricate the mechanism. Rather they are hoarding it because its market value is rising. As a result there is a shortage of lubricant in the clockwork mechanism. The material economy is not yet benefiting from the new super-lubricant because very little of it is being released into the gears of the machine. Most of it is simply being hoarded in privately owned barrels whose value on paper is rising.
But if and when all that hoarded lubricant is released into the clockwork machinery of the real economy, two interesting things will happen. The real economy will operate more efficiently (and that’s a good thing) while the price (or value) of the (now increasingly abundant) super-lubricant will drop. When that happens, the late-comers to the gold rush game will find that they unwisely spent a lot of resources in vain to manufacture or purchase small amounts of the once scarce lubricant that has now become cheap and plentiful.
Does this analogy work? How can it be refined or improved?