The Infinite Promise, and Inevitable Demise, of Bitcoin

A reliable barometer of widespread speculation in any financial asset is the New York taxicab test. If the driver, upon seeing his fare in pressed suit and silk tie, inquires about the investment prospects of a certain security, one can be assured that said security has reached cult status. Although we at The Neanderthal are not inclined towards silk ties, we nevertheless have engaged in similar conversations during the housing and dot-com apexes, 10 and 20 years ago respectively.

Bitcoin today seems to have reached the same level of public interest. And the price of it, sticking with our barometric metaphor for another second, has certainly reached stratospheric levels.

Is Bitcoin going to take over the world? Or…     Is it a scam? At the very least a bubble?     We think these are important and understandably controversial questions.

 

COUNTING SHEEP

For trade to evolve beyond barter, which is an inherently impaired transactional mechanism, a common currency is required. For centuries, different societies have experimented with different forms of currency, from livestock, to trade beads, to sea shells, to tobacco leaves, to nuggets of gold and silver. Some of these currencies have had some intrinsic value, such as livestock and tobacco, and, to a lesser extent, gold and silver. But more often, as societies have evolved complex political and governmental structures, fiat currencies have come to prevail.

Fiat currencies have several advantages over intrinsically-valuable currencies. Firstly, fiat currencies are more practical, it’s simply much easier to settle one’s bar tab with banknotes than with bleating cattle. Secondly, fiat currencies are more easily standardized, and they are precisely divisible into smaller units. Thirdly, and most importantly, because fiat currencies can be created at will by central banks, they allow for proactive policy responses to business cycles. This feature is what has given fiat currencies their dominant position in the modern financial system.

However, this very pliancy of fiat currencies is also their Achilles’ Heel. Central banks, through the right of seigniorage vested in them, can increase the money supply when the economy enters a contractionary phase. When implemented correctly, such measures can certainly counteract recessionary forces. However central banks can make errors of judgement and thus misapply monetary policy, thereby exacerbating recessions or stoking excess inflation in expansionary phases. The other major problem with the fiat power of central banks is that central banks are prone to political capture. Politicians have a vested interest in printing money and creating inflation, because it facilities fiscal spending, and this tendency inevitably leads to boom & bust economic cycles. As the erstwhile Dean of monetary economics, Milton Friedman, has stated: “Governments want to spend money and sooner or later, governments are going to want to spend money without taxing it and the only way to do that is to print money – to create inflation. Inflation is a form of taxation. How long will governments be able to resist the temptation?”

To remedy this possibility of the abuse of fiat power, Friedman has argued for the abolition of the US Federal Reserve System, and its replacement with a mechanical framework that manages the supply of money based on formula. To quote from an interview given in 2006: “I’ve always been in favor of abolishing the Federal Reserve and substituting a machine program that would keep the quantity of money going up at a steady rate.”  Friedman further elaborated, “If you really carried out the logic concerning the quantity of money, you deprive the Federal Reserve of anything to do. Suppose the Federal Reserve said it was going to increase the quantity of money by 4 percent a year, year after year, week after week, month after month. That would be a purely mechanical project. You could program a computer to do that.”

While Friedman’s views on the Federal Reserve are not uncontroversial, we now actually have something akin to Friedman’s computer. For the very first time we have the possibility of a practical intangible currency, which is not dependent on a central bank or any other central authority, and the supply of which increases at a predetermined rate over time. This currency is Bitcoin.

 

THE DIVINE CURRENCY

In its theoretical underpinnings, Blockchain is a work of genius. Blockchain, and the currency it enables, Bitcoin, are very much a product of the modern age. Without computers and advanced cryptographic math, Blockchain would simply not be possible. By distributing the recordkeeping of financial transactions, and enforcing trust in those records through cryptographic techniques, Bitcoin has for the first time enabled a practical & intangible currency that does not draw its legitimacy from monarchical or governmental dictum. Bitcoin is of the people and for the people, which is more than what most governments can claim to be nowadays.

Secondly, as with any currency, the more people that use it, the more useful it gets. And Bitcoin is certainly well on its way to capturing the zeitgeist on a global level.

Lastly, Bitcoin, at least in its most popular variant, has a predetermined supply. The total pool of Bitcoins is expected to asymptotically approach 21 million over time. This preempts it from Friedman’s fear of an infinitely increasing paper money supply.

In this way, Bitcoin is very close to Friedman’s ideal monetary mechanism – all the convenience of paper money, without any of the central bank meddling, and growing at a preset rate.

But… As always, there is a catch. There is another monetary scheme to which Bitcoin can be compared – a comparison that does not augur well for Bitcoin’s future – namely, the Gold Standard.

 

FATAL FLAWS

Thus far we’ve argued that Bitcoin has many of the positive attributes of fiat currencies, namely practicality and standardization, but without the negatives, namely the risk of political tampering and runaway supply growth. However in many ways Bitcoin also resembles the ill-fated Gold Standard, which was one of the causes of the Great Depression, and which was subsequently discredited and abandoned in the 1930s.

Over the past centuries, governments around the world have used some version of the Gold Standard to imbue credibility and confidence in their fiat paper. In simple terms, the Gold Standard has meant the convertibility of paper money into some fixed amount of gold or silver bullion. Though governments had incessantly fiddled with this conversion ratio over time as would suit their purposes, and had in some cases even suspended convertibility, the Gold Standard was respected practice until the 1930s.

The Great Depression however exposed the crippling limits and contagion effects of this system. Because there is only a small and static pool of gold in the world (growing only very modestly in organic terms), there was not enough gold available in central banks to enable the kind of money supply growth needed to counteract economic contraction. Also because several countries globally shared the Gold Standard, economic contagion from one country spread quickly to the rest.

As one country after another departed the Gold Standard in the 1930s, it had become clear that fiat currencies, despite their risk for central bank error and abuse, were the superior monetary mechanism. Therefore despite Milton Friedman’s valid criticisms of them, centrally controlled fiat currencies endure and are here to stay. In a nutshell, the advantages of fiat currencies simply outweigh the disadvantages.

What is true of the Gold Standard is doubly true of Bitcoin. The Gold Standard at least allowed for some required increase in the money supply through the money multiplier effect, achieved when banks take in deposits with one hand and lend them out with the other. With Bitcoin, it is not yet clear whether fractional reserve banking can be implemented on top of a cryptocurrency system. Additionally, as a universal currency, Bitcoin allows no room for local exchange rate flexibility, and therefore under Bitcoin economic cycles will be transmitted automatically from one region to the next.

So it is, that despite its potential to improve upon fiat currencies in the ways that Milton Friedman had once envisioned, Bitcoin is destined to fail. Bitcoin, just like the Gold Standard before it, will ultimately be weighed down by its own inherent flaws.

But like the Gold Standard, Bitcoin will indeed have its moment in the sun – before it is forever relegated to the fringes of the modern financial system.

 

FATED FOR THE FRINGE

Beyond the fatal flaws that it shares with the Gold Standard, Bitcoin has some very specific problems of its own that might further exacerbate its decline.

Firstly, the Bitcoin system is fracturing, with new forks emerging rapidly. A currency is only useful if it is embraced by the bulk of economic participants. For Bitcoin, which derives its legitimacy from the will of the crowd, this is particularly true. With every new Bitcoin variant, the validity of the system is diminished.

Secondly, it is still not clear that the supply of Bitcoin will indeed be measured, as would happen if the number in circulation were to asymptotically approach 21 million. It is quite possible that the Bitcoin algorithm will be modified to allow for more rapid proliferation of the currency. A rapid and perpetual increase in supply would negate one of Bitcoin’s key benefits.

Thirdly, the creation of Bitcoin is actually quite computing intensive, and therefore requires a large and growing amount of electricity. It is likely that the Bitcoin ledger will become ever more complex as it grows, such that the processing of Bitcoin transactions will become prohibitively expensive.

Fourthly, ironically, even though it is a cryptographic currency, Bitcoin actually offers less privacy than paper money. Because every Bitcoin transaction has the IDs of the transacting parties associated with it, anyone who can decipher those IDs can decipher the true identity of the involved parties. This is not true of transactions with paper money, where for instance if we were to write a check to you dear reader, it would not be part of the public record.

Fifthly, even though the price of Bitcoin has risen sharply, price does not necessarily equal value. What we mean by this is that the trajectory of Bitcoin’s price is based on individual transactions as they occur, but liquidity in the Bitcoin market is still very thin. This is often the case with stocks listed on the ‘pink sheets’, where the market value of listed companies is often much greater than what can be cashed out in reality. Thus just because someone owns Bitcoin worth a million dollars does not mean that she can procure goods worth that much in the real world with that Bitcoin. Liquidity in the Bitcoin market will be the ultimate test of Bitcoin’s sustainability.

Lastly, even if Bitcoin continues it stratospheric climb, and especially if liquidity in the Bitcoin market increases, governments around the world will simply not give up their right to seigniorage. Governments and central banks will protect paper money at all costs. Therefore in order to halt the spread of Bitcoin, governments will simply regulate it, or perhaps tax it like any other asset where each sale is treated like a taxable event. Imagine filling out a tax form every time you buy a beer.

 

IN CONCLUSION

Therefore despite its promise, Bitcoin will never displace centrally controlled paper money. It will only exist in fringe circumstances, where fiat currencies are particularly undependable and where the rule of law is weak. Or perhaps it will be suitable for micro transactions that do not reach certain regulatory thresholds. But chances are, if you wish to buy a Big Mac or a Cadillac a decade from now, you will have to pay for it with cold hard cash, just like your parents did.

 

 

SOURCES

http://www.econlib.org/library/Columns/y2006/Friedmantranscript.html

 

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