The Problem with Bitcoin

The primary utility of any currency is as a unit of account.  Its other roles are a store of value and medium of exchange.  The unit of account is a monetary standard of measure.  It is a reference upon which the exchange of all goods and services can be measured.  It should be obvious that a standard of reference must be unchanging in value.  If the monetary standard of reference is constantly changing, then the exchange of goods and services becomes inefficient, chaotic, and costly.  It is no different than if the value of any of the seven base units that define the International System of Units were not held constant.  This is axiomatic in the mathematical and scientific world but is completely lost on economists and academia in the monetary world. 

A currency’s value is determined by its supply relative to its demand based upon a standard of reference.  There has never been an exception to this rule since the beginning of the use of any commodity or money for the exchange of goods and services.  It doesn’t matter if the currency is cowrie shells, tobacco, livestock, gold, silver, token coins, paper money, or digital coins, tokens, or cryptocurrency.  The supply of currency must be regulated according to a standard to meet demand.  Weimar Germany and Zimbabwe proved that the unlimited issue of the supply of paper currency without regard to demand results in a currency whose value ultimately equals the intrinsic value of the paper upon which it is printed.

The predominate result of the use of paper currency is the over issuance of supply relative to demand.  China developed the use of paper money and the printing press beginning with the Tang Dynasty (618-907).  By the Yuan Dynasty (1279-1367), paper money became the only legal tender.  Predictably, China experienced continuous cycles of paper currency issuance, devaluation, collapse, followed by new currency issuance.  

Monetary authorities regulate the value of paper currency through control of its supply.  Without an unchanging standard of reference upon which to match supply with demand, monetary authorities can manipulate the value of currency for perceived economic means other than monetary stability.  This always ends in devaluation because of the natural temptation that arises from the “imagined” ability to create wealth out of thin air.  Mankind’s attempt to end this cycle led to Great Britain’s creation of the gold standard.  Since gold’s value remains stable, and is therefore a standard of reference, any currency linked to a fixed weight of gold becomes equally stable in value.

Bitcoin and Cryptocurrency

Cryptocurrency offers a decentralized, democratic method of currency issuance beyond the control of government or central banks.  Its foundation is the blockchain.  The blockchain is a permanent, democratically validated public ledger.  The only way to manipulate the blockchain is to shut down the internet.

Bitcoin cryptocurrency suffers from the opposite effect of fiat paper currency.  Paper fiat currency is inherently inflationary while bitcoin is deflationary.  There is no particular reason that cryptocurrency must be deflationary.  It is a result of Satoshi Nakamoto’s designed mining algorithm for bitcoin which became the template for all digital cryptocurrencies, coins, and tokens.  While Satoshi was beyond brilliant in creating the blockchain as the basis for bitcoin, Satoshi had no understanding of currency as a unit of account.  By limiting bitcoin’s supply to 21 million units over a 131 year period, Satoshi designed bitcoin as a deflationary currency.  Satoshi mined the Genesis block on January 3, 2009.  Today, 79 percent of bitcoins have been mined.  The remaining 21 percent will be mined over the next 123 years until the total fixed supply of 21 million units is reached in October 2140.  Unless bitcoin changes its designed, deflationary mining algorithm, it will have a short life as a functional currency.  Because of its deflationary design, bitcoin is used more as a volatile investment bet than as a transactional currency.

Another way to look at bitcoin’s deflationary design is to examine what would have happened if gold’s total supply were mined a thousand years ago.  Today there are an estimated 187,000 tonnes of above ground gold and miners continue to discover new gold at an approximate 2 to 2 1/2 percent annual rate.  This rate has been consistent for centuries.  Combined with its unique monetary properties and annual production rate that negates technological advances and population growth, gold’s value remains stable.  This is why gold is the Numeraire, the monetary commodity par excellence.

Had the earth limited gold’s total supply a thousand years ago to say 500 tonnes, gold would today be a rare museum or collector’s relic instead of a monetary standard of reference.  Its utility as a medium of exchange would be negligible, only changing hands as a collector item.  Gold in fixed, limited supply could not act as a unit of account nor medium of exchange.   Gold standards would not have existed and another commodity would have become the monetary standard of reference.  Because bitcoin has limited its supply to a fixed amount that is already mostly realized, it will have a short shelf-life as a functional currency.  Other cryptocurrencies are following in bitcoin’s deflationary footsteps with their mining algorithms.    

The idea to value bitcoin by some market valuation is missing the true concept of bitcoin as currency.  Bitcoin will succeed or fail based upon its ability to achieve the three roles of currency, with the unit of account by far the most important.  Without a role as a unit of account, bitcoin only has value as a medium of exchange and store of value.  Even though bitcoin is infinitely divisible, the supply of bitcoin relative to its demand still determines its value.  Continued use of bitcoin will only increase demand against fixed supply and its value will rise accordingly.  Infinite divisibility does not change the fact that bitcoin under its designed mining algorithm is more valuable to hold for its constantly increasing value than for its use as transactional currency.    

As a monetary reference, gold is not defined by its market valuation.  It is defined by its properties that have made it the monetary standard over the history of mankind.  No other basic unit of measure changes in value with demand—they are standards—and the same is true in the monetary world.  If bitcoin cannot fulfill the required roles of currency, its long-term utility as a currency is nil.  Unlike gold and its physical presence that has value beyond it monetary properties, bitcoin would disappear into the ether from which it came.

Cryptocurrencies differ from gold in their mining habits.  With the majority of bitcoin already mined, each new halving of bitcoin available for mining requires increasing cost in computer power and electricity.  The mining of each incremental bitcoin, which become fewer and fewer over time, requires a greater value to justify the cost.  Bitcoin is designed to always increase in value which justifies the mining cost.  Yet, this in turn negates from its use as a functional currency.  At some point this will become an untenable situation.   

The opposite occurs with gold miners.  Gold’s value is stable and it annual production increases at a consistent rate.  If the price of gold rises, miners shift production to their least rich mines; if the price of gold then falls, they shift back to their richer mines.  It all works like a Swiss watch.

Gold’s supply is not infinite.  Mother earth limits it.  There will come a time when gold production can no longer maintain its historical annual rate.  There is no way to tell how far in the future this event will occur.  Technology may find new gold reserves and methods for mining gold that are now unimaginable in same way that new reserves and methods for producing oil are constantly found.   When the time comes, cryptocurrency is the natural evolution to replace gold as the monetary unit of account.  We have only scratched the surface of this potential.

1 Comment

  1. P. Rezende

    If bitcoin continues to yield too-high returns, and people just hold on to them instead of using them, it is plausible that vendors will begin to offer increasingly higher discounts if paid-for with bitcoin. They would take into account the crypto’s future returns in order to calculate these discounts, and it would be much more interesting for the customer to use (buy) bitcoins to make the purchase.

    I think your theories are flawed, let’s see how it plays out.

    Reply

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