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.

2 Comments

  1. Wesley Freeburg

    This comment is cross-posted from an article on the Alt-M website to which the author herein commented – leading me here! (https://www.alt-m.org/2017/10/26/blockchain-gold/)
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    I completely agree. What you may have overlooked is the fact that the world’s primary reserve currency (the “dollar”) since in or about 1968 (when the gold “cover” was removed from the dollar – or if you prefer, in 1971, when Nixon/US defaulted to the world on dollar-gold redeemability) – the “dollar” (now an undefined legal fiction) also lacks a unit of account specification. That currency which is used to measure value in more transactions worldwide than any other, is missing a definition! While I agree with you that gold fulfilled that function (as Unit-of-Account used to be defined as 1 Dollar = approx 11 1/3 grains of fine gold) far better than that which we have now – which is NO DEFINITION, using gold as a Unit-of-Account is also deeply flawed. You correctly point to the International System of Units (SI) when discussing measurement. If you consider the methodology carefully, you will come to note that measurement is merely a specification (an agreement) of a quantity. The quantity (the “unit”) must be of the same nature as that being measured. For example, length is measured with a quantity of length (called the “meter”). This is defined by the distance travelled by light in a given amount of time. Time is measured with a quantity of time (called the “second”). The second is defined by the duration of a given number (periods of radiation) of lightwaves to pass. And so on. By 2018, all of the base units of measure will be based upon natural measurable, phenomenon (“natural units”).

    The mistake you’re making in your otherwise insightful comments, is to use a commodity (a thing) to measure a non-thing. As you yourself argue, a unit of measurement cannot work if it is affected by such things as suppy and demand (or worse still – the whims of the banking cartel). Gold is such a thing. The best illustration of this is to examine the gold-silver ratio over recorded time. While I’ve seen convincing evidence for the existence of a parity (1:1) ratio at some points in history, it’s well documented that the Silver:Gold ratio has swung from 8:1 in biblical days to 82:1 recently. While gold fulfills other functions of money admirably as a store of value, and a medium of exchange, it has failed as a unit-of-account. Bitcoin fails both as a unit-of-account AND as a store of value.

    I have proposed an addition be made to the International Standards of Measurement to specify what I have named the “Quanta” as the standard of value. Value is an abstraction. Only an abstraction can be used to measure an abstraction. Don’t confuse the term “abstraction” with something loosey-goosey, though. Mathematics are abstractions – used to measure things in real life. Given that all life on the planet depends upon the stock and flow of energy to function, I have defined the Quanta as one-tenth of the reduced Planck Energy Constant. In physics, Planck units are a unified system of natural units. Putting aside the math, I’ve defined the Quanta, specifically, therefore, as 39 megajoules of energy (about the amount of energy needed to power eleven 100-watt light bulbs for one hour). No, the Quanta is NOT electricity, or oil, or gasoline or food. The Quanta is merely a measurement – a specific quantity of value. Using Quanta to express price, and to compare the value of currencies, facilitates the definition of a Unit-of-Account (“money-of-account”) that is UNCHANGING throughout the world – unaffected by supply or demand, or the whims of humankind and his misguided laws.

    Said differently, ALL humans consume about 2500 calories a day. It takes 9.8 joules to lift one kilogram one meter against gravity at all (sea-level) places on the planet. It takes exactly 4.186 joules to raise the temperature of 1 gram of water one degree Celsius at all (sea-level) places on the planet. It takes exactly the same number of watts per second to light a 100 watt light-bulb at all places on the planet. Value is in the eye of the beholder. Value cannot be measured directly. But value may be expressed as a universal measurement – and I’m proposing the Quanta as that unit. Quanta are not “things” (commodities) that one may hold in one’s hand. Like a meter, or a second, it is a unit of value that is unchanging. You may one day have an ounce of gold for sale – and the price, expressed in Quanta (let’s say 1,500 Quanta) would be understood worldwide. To transact, the medium of exchange need only be agreed – “how do you wish to pay?”. You might accept “dollars” or BTC or oil. But all these media of exchange lack a universal system of value measurement – they all are UNDEFINED. All the world’s currencies (which “prices” are always expressed in terms of another constantly fluctuating currency – or commodity) are in a constant flux. The business calculus cannot be efficiently or accurately made without a money-of-account that is separated from the media of exchange. Once you’ve learned to separate the two and settle on the correct Unit of Account (the Quanta), you will be well on your way to a better solution!
    https://twitter.com/i/moments/879149801962696705
    @wesfree

    Reply
  2. 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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