Do the problems bitcoin solves have economic relevance?

Dr. Paul Krugman tells us here that bitcoin is "a technically sweet solution to a problem that doesn't have much economic relevance".

Lets look in more detail at the problem that bitcoin solves so we can decide exactly how little economic relevance it really has.

First of all I should warn you that I have no personal experience in the topic of counterfeiting in any of its forms, which is the problem bitcoin claims to solve.  Therefore, it should strike you as somewhat surprising if my comments are useful on the topic.  You should realize that anybody with a few minutes to think could do at least as good a job piecing it together as I do here.  If not many have thought about it, that is perhaps noteworthy.

I'm going to divide the problem that bitcoin solves into three categories: M0 counterfeiting, M1 counterfeiting, and M1+ counterfeiting (the latter including all M2 and higher monetary base accounting).  We will note that it is really only the former problem that bitcoin truly solves, as the other two can still take place in a public coin economy, though the coins might provide potential solutions to these potential problems of higher level monetary fraud.  As to what the actual economic impact of counterfeiting is, you will be forced to draw your own conclusions.

To roughly outline all of these, I will produce for each of these three categories four fictional characters who perpetrate the counterfeiting, as Gedankenkriminelle.  Of course, these are merely imaginative scenarios.  Dear reader, in judging whether these problems might have economic relevance, you are asked to imagine your own scenarios if they could be more or less realistic.  Chances are, my examples will seem puerile and riddled with problems, as you probably know more about these industries than I do.  Throughout this exercise, try to see past these shortcomings to any possible economic relevance to the problem of counterfeiting, to see if you agree with Krugman's admittedly off-the-cuff assurance to the negative.

M0 Counterfeiting

M0 counterfeiting is generally viewed as unauthorized money printing.  The image you might have in mind is some teenage criminals with inkjet printers cobbling together banknotes from their basements.  In Edinborough Castle there are on display forgeries of banknotes made by prisoners in the castle.  They did very well in freehand from their cells using materials obtained under conditions of duress, making notes which apparently bought some of them rewards such as their own freedom.  These are the kinds of bills which you might accept at your lemonade business, which upon inspection under UV light your local bank will not accept.  If we stop here, it might still be true that we have not encountered a problem of real economic significance.  How many of us have really been handed fiat notes which we were unable to pawn off on anyone else due to manufacture errors?

Imagine that the teenagers in their basement do a better than average job for their demographic, and are able to create some notes that not only you accept at the lemonade stand, but which the bank teller winds up accepting when you bring them in for a deposit.  Now, has any economic harm been done?  To you, the lemonade stand owner, there is now no difference in the economic impact as from any other normal transaction.  You got paid just like usual.  In fact, someone who paid attention to Gross National Product would say that the economy has been improved in this scenario.  Again, Krugman could be right.

Or is there perhaps a problem here after all?  The teenagers, now flush with real cash (the bank's acceptance is what makes fiat real, at least for now in our narrative), are going to buy out the local video game store and the local price of lemonade has gone up.  There is a real economic relevance.  In fact, we see that where the money goes is also important, in addition to how much is floating around.

Before we get too far afield looking at macroeconomics, lets get back to M0 counterfeiting.  We have so far only looked a small subset thereof, the teenager in the basement.  Consider now two other of our fictional characters: the corrupt mint employee, and the disgruntled US army general in Koreastan.

The corrupt mint employee works for an authorized M0 creating mint (leaving the details of that up to you), but has not been well enough compensated for his duties.  He is able to instead run the machine overtime, issuing a few million extra units every month.  Perhaps he has been compromised by an organized crime syndicate, or runs one himself, or on behalf of his boss.  The details are not important.  What is important is that the bills will do just as well as those made by the overachieving teenagers: they pass the inspections made by the bank tellers.  After all, they are exactly like the others.  Thank God for this boost to the economy right?  This is hardly a problem is it 😉

The disgruntled army general in Koreastan is a similar story.  Being rich and powerful enough, he is able to get a hold of the proper machinery to do just as good a job as our corrupt mint employee, and create perhaps an even larger number of units.  He might even capture an actual mint in a raid and simply use those machines, or make a deal with the operators thereof directly.

These latter two characters face certain logistical problems of scale, in terms of how to unload the valuable goods they produce without causing problems that would force shutting down the operations.  Generally these problems are similar to those faced by e.g. the illegal drug industry, and are readily solved with the same tools of finance.

Any assessment of the economic relevance of these potential activities (recall, that is our goal here) will rely on two further questions.  The first addresses how many operations of this nature actually exist and what size they are, while the second addresses what they do with the money.  If you don't think anybody would do this kind of thing, you don't need to bother with the second question.  However it might be of interest to our later discussion so my apologies but please bear with me through the discussion.

So, where does the new money go?  Imagine for a second that our disgruntled general takes some of the profits from his operation and spends them in the local economy, giving families jobs, educating the masses, and working on developing a fusion power system.  How much economic harm has really been done here?  Well, none of course.  We have economic gain and prosperity.  You might argue that this is offset by an overall inflation in prices which affects every other M0 holder negatively.  Indeed.  However, is that small hardship of a point or so less buying power for other M0 users really as significant as the changes the General has managed?  It's a matter of perspective whether this kind of arrangement could ever be problematical, in an economically relevant way.

Now, consider in a more broad sense a 4th character, the standard legal operator of a M0 mint.  Government authorized money printing, however, in this case democratically decided in a problematic fashion.  A vote is taken, in which you disagree, but they win and so can print themselves a fresh trillion pesos or whatever.  This is hardly what we would look at as counterfeiting.  But what dear reader is really the difference between this troubled M0 mint and our disgruntled General, our corrupt employee, or even the teenage basement printer?  Accountability,  scale,  and what one actually does with the proceeds, presumably.  In any case we have an activity which seems to present its operator with remarkably higher returns than any other activity, a striking generator of economic imbalance.  In all cases, how the money is spent by the individuals involved may in fact be different than it would have been had the money required more time and effort to obtain.  In all cases the problem could have a relevance to.. well, that is for you to determine.

M0 counterfeiting really refers to the activity of all four of our fictional characters, and others, and as such this problem is "solved" by public coin in that a group of people using solely public coins as their exchange commodity cannot be affected by any such operations.  Just how much the world is affected by such operations, in volume and in selection of economic activity, is again up to you to conclude.

With advanced techniques of nuclear physics and unreasonable budgets, one can in fact create gold from other materials.  However creating public coin in secret appears to be something still more difficult to carry out.  After all, we all have a list of all valid coins.  We can check any coin against it and ensure that it's history is valid AND when a transaction has occurred (by waiting a requisite number of confirmations, to a desired probability).  M0 counterfeiting of a public coin is impossible, in the sense that it is impossible to show me an integer between 2 and 3.

M1 Counterfeiting

Those of you who have bothered at this point to go look up what M0 and M1 mean from some other sources have probably noticed that the total M1 money supply is larger than the M0 money supply.  Why is this?  Empirically speaking it must be easier for M1 units to be created than M0 units, for whatever reasons.

So, what are these reasons?  If we are concerned with the total of all accounts holding M0, that sum should be less than M0 right?  I mean, if there are no bank accounts then the total in accounts is 0, people put money in banks and the number goes up, and banks can only hold as much as - all the money, right?  Lol, yeah you weren't born yesterday were you.  Welcome to M1 counterfeiting.

Physically speaking, M1 counterfeiting appears ridiculously easy.  If you have ever operated a database (or e.g. run a spreadsheet), you know how easy it is to change the contents of an entry (or cell).  You bring the mouse up to the entry in question, then change the number to whatever you like.  Then: ctrl-S to save it.  Done!

In reality of course, there are barriers to this type of activity as producing anything economically relevant.  For one, if the teenagers in the basement make an account in a text file as follows:

Teenage Basement Savings Bank
Name: Reader of this Blog
Current Balance: 1,000,000.00 BTC

.. this will hardly be of any affect on the economy.  First off, you (or the teenagers) will be hard pressed to cash out even a single satoshi of this M1 asset.  A little thought and you will see here that creating M1 assets (well, in this case bitcoin M1) of economic import requires starting with some trust of users as a prerequisite, which requires building that trust.

So our first character, the teenager, cannot really participate in M1 counterfeiting, at least not without a bit of infrastructure in place.  One could theorize that the teenager circulates TBSB banknotes which allow people to trade in this M1 asset, and who knows - maybe some teenager will have some success with this arrangement.  They won't have much success with one of the holders of their notes who comes and demands M0, that is unless they are also maintaining a M0 supplier or their own M0 operation of some sort.  We leave this one as a dead end for your pursuit of the question of economic relevance like all the other branches of this tree for now.

Our next character is the corrupt employee.  In this instance, we can see how there is a real threat.  A bank employee with access to the database of accounts could in theory simply change any account balance to anything they like with very little effort.  Logs could be altered if necessary, to avoid evidence of the alteration.  Recall that -somebody- has root access on all computers.  How often does this happen?  Can any suitably inclined janitor at the bank's datacenter issue himself an account credited to a few thousand BTC?  Unlikely, as security *must* be in place, but the possibility could perhaps be thought of as a problem of economic relevance.  A higher up with the right passwords, and maybe a bit of support, sounds more feasible for the job.  Bear in mind this might be like stealing from the mob boss - a bad idea.  Markets appear to tell us that this kind of thing has been much less frequent than I would have expected.  Draw your own conclusions.

We should include here the army general as well, perhaps he has brought an armed division to a local bank and told them what balances need to appear on what accounts.  Perhaps the general has even started his own bank or cryptocurrency web wallet.

What we see here with both M0 and M1 counterfeiting is an obviously lucrative proposition, similar perhaps to purchasing sugar for 1 mBTC a gram and selling it a bit further north for 100 mBTC a gram.  Therefore we expect that people have reacted similarly to such endeavors, and have likely created a regulatory hierarchy of agents straight to the top to effectively monopolize the industry and keep out competitors, based largely on judicial and extrajudicial systems (again, using these terms as you wish to use them).  This is the expectation, however it is up to you to decide as to how impactful such operations are on the economy, or how problems can arise in their administration.

We should not forget the actions of our 4th player on this field.  What of the quasi-legitimate creation of M1?  Is creating money for a crappy loan, however through the appropriate regulatory and legal frameworks, so that e.g. a developer can have funds to build an ugly casino that blocks your view and destroys an archaeological site any better for the economy than our disgruntled general who creates funds and uses them to pay for research on a fusion generator?  Not necessarily.

To estimate the economic impact of M1 counterfeiting dear reader you will have to draw your own conclusions about the general utility of allowing anyone at all to authorize the easiest form of money creation (arbitrary amounts at zero cost), for example in financing wars, mining (bitcoin or otherwise), subsidized agriculture, the space program, public housing, environmental regulations, as well as to affect usury industries such as home mortgages, small business loans, car loans, and the like.

But wait, do public coins even help us with M1 counterfeiting?  At first glance it is just as easy to counterfeit bitcoin M1 as it is to counterfeit fiat M1.  Both, after all, are just account balances maintained by individuals.  However there is some difference due to both the verifiable nature of public coin and the ease of transport.  Those who might be pressured to use an M1 SWIFT transfer in a fiat transaction, or western union, can with bitcoin use a direct M0 transaction, and so we are not forced into M1 territory.  Similarly one can issue proof of funds with public coin, verifying solvency, which is not possible with fiat.  However, one should note that these things are just potential unproven tools for avoiding M1 counterfeiting, and won't solve the problem completely any more than SCUBA tanks ended all drowning.  (learning to swim is a better first solution).  Mt Gox customers were free to take their coin physical delivery for years.  Many did not, and so they wound up holding M1 counterfeit coins with "withdrawl indefinitely suspended".

M1+ counterfeiting

In this final category we delve even further into my own ignorance on the topic.  Please don't consult your local FED circular for their specific definitions of the integral series M0, M1, ...  because I am using them here in a "none cumulative" form.  M1+ will thus be any other financial instrument besides cash, and cash accounts.  Wow, that's pretty big isn't it?  Can we counterfeit any of these?  Well there are certainly examples worth considering, such as securities fraud, ponzi operation, real estate misrepresentation, and other things.  However in general it is worth pointing out that M1+ is really an M1 where the M0 has been replaced by a higher asset.  That is, if M1 represents accounts valued in fiat, than M1+ represents accounts valued in an M1 asset.  As such, we shouldn't have too much new to say on the topic.  It's the same kind of thing again.  But lets go through the motions anyway shall we?

Our teenagers might now produce a separate spreadsheet:

Teenage Basement Savings Bank
Account name: Blog Reader
Amount:  1000 units face value of TBSB bonds, paying 10 TBSB notes annually and repaying the bearer in full face value with TBSB notes upon maturity.

These kinds of instruments have legitimate use in many areas, and also as such could be fraudulently misrepresented in standard usage.  It is possible using coloured coins or other blockchain techniques to issue verifiable asset tokens, which could avoid the problem of counterfeit or oversold (that is, sold from fractional reserve) shares, tokens, bonds, etc.  However, one still relies on the trust of the issuer in redemption of such assets!

For example, our teenagers could issue their asset above as a specific chunk of bitcoin.  Users of the asset would now be able to verify the total number issued as well as the validity of any TBSB bond.  This doesn't mean however that they will indeed be repaid in full, nor that the asset in which repayment is said to occur will have any value.  They might do this rather so that passthrough operators and corrupt brokers cannot rip off others by fraudulently representing other paper as Teenage Basement Savings Bank bonds.

One could therefore simply use trustworthy issuers and managers when involving ones self in such higher finances.  If this seems like a strange idea to you dear reader, please do pause to consider what that means about the financial world you live in and what effect counterfeiting might have had in creating said world.

For completeness we should mention the corrupt employee, the disgruntled general, and the by-the-imperfect-book financier as well in terms of M1+ counterfeiting.  The disgruntled general might choose to sell "app1e stock" to unsuspecting folks for example, and pay off (or threaten) the relevant SEC guys or whomever else might give him problems.  He might even pay the holders of his fraudulent stock dividends, in efforts to keep new customers coming in.  The corrupt brokerage employee might sell some stock to folks in a similar manner, or merely credit some accounts as holding this or that stock or bond, which they could dump in exchange for other more liquid assets.  Corrupt clearing house employees have yet more opportunity for this kind of productive activity.  And finally we have the errors in the official channels of higher finance.  Good luck figuring that one out.

Public coin certainly doesn't address corruption nor the disgruntled in generality.  However it enables solutions that financial instrument issuers are free to use, should they find it reasonable to do so.

Even if you believe these problems are effectively solved with other arrangements, or alternatively that any and all perpetrators are acting in a net positive or even a "best we could do" manner, you are asked now if such problems have economic relevance.

Do you think counterfeiting is a problem of any economic relevance?

Addendum

Sorry, I meant to say Seigniorage.  Counterfeitting is really a crass term isn't it.  So then.  Does seigniorage have any economic relevance?