IntroductionThere are plenty of posts on this board and over the web concerning the future of Bitcoin as an actual medium of exchange instead of a speculative asset. People try to forecast when the world will adopt it as a payment method. Discussions often circle around external factors: the attitude of governments, banks, consumers etc.
I believe, however, that the problem is intrinsic. I also strongly believe that Bitcoin will never become a universal medium of exchange widely used for payments and we should call it not a cryptocurrency but rather a crypto-asset with investment/speculative/hedging functions or a crypto-gold, if you prefer. I came across similar opinions numerously and some of the following statements may seem familiar to the reader, but I need to put it all together and add some statements of my own to justify my solution to the problem.
Since we are focusing on economic matters here, let’s leave aside technical issues and discuss why Bitcoin’s economic model doesn’t allow it to perform the primary money function (namely being a medium of exchange). I see two main problematic concepts in Bitcoin’s design that impede the ability of the platform to perform the named function:
- Scarce supply
- Model of reward distribution
This post will be devoted to the scarcity of the supply, while the second matter will be the subject of part 2.
First of all, let’s try to envision how the economy would look like if we adopted Bitcoin as the only payment method.
Bitcoin-powered economyImagine that some enthusiast founded a new state called Cryptopia on an inhabitant island and made Bitcoin the only official state currency. People came to Cryptopia and started building the economy: producing goods, trading, forming financial markets etc.
Such conditions create strong incentives for the growth of the aggregate supply, but since the money supply grows very slowly, the price indices constantly drop. The population clearly sees the trend and, knowing that deflation is inevitable due to the hardcoded emission policy of Bitcoin, people prefer hoarding cash in expectation of buying non-essential goods later for a lower price (become hodlers).
Such behavior further impedes the development and the economy stagnates, being unable to develop, until it reaches an equilibrium at some point. When the prices stabilize, people stop hoarding and return their bitcoins into circulation. The increase in velocity provokes inflation, which stimulates economic growth. The economy starts growing until it faces an insufficient money supply and the deflationary trend recommences shrinking the economy to the basic level. This rollercoaster repeats indefinitely making life in Cryptopia a pure nightmare likely followed by high unemployment, uncertainty about the future and even higher material inequality than we have now.
The Bitcoin-powered economy simply cannot sustain stable growth, which is why it cannot serve as a substitution to fiat. We are not even taking into consideration debt deflation and a near-zero demand for bonds and other financial assets, as the economy will unlikely develop that far to form a fully-fledged financial market.
Bitcoin as a secondary currencyThere is no need, however, to make Bitcoin the main and only currency. It can easily co-exist with fiat, which it currently does, thus at first sight not producing any strong impact on the state on the economy. This case is much more complicated. There are different opinions on the matter, but I side with those who believe that an inherently scarce asset cannot perform functions of a medium of exchange instead of a mildly inflating asset.
The first problem of modelling a potential scenario is the absence of a theoretical framework. The economic science simply doesn’t research a model with two separate competing monetary systems, one of which is an independent and algorithmically controlled cryptocurrency. The entire money supply is classified into different aggregates depending on liquidity, but each aggregate still represents a form of the same unit. Although there is a notion of multiple-currency economies (practical implementations could be observed all around the world, e.g. Cambodia, Zimbabwe, Vietnam etc.), monetary policy in such countries is still conducted by Central Banks (CB) toward all circulating currencies (except the restrictions applied by the impossible trinity), which makes it inapplicable to our case as well.
We can take two different approaches:
a) Assume that a fiat currency and Bitcoin are different monetary systems simultaneously powering any given national economy. In this case, the total money supply is a sum of the fiat supply and the Bitcoin supply.
b) Assume that Bitcoin forms its own virtual borderless economic zone. In this case, when a good is sold for bitcoins, it contributes to the Bitcoin’s GDP, and if it is sold for fiat – to the national GDP.
Both models engender numerous difficulties, but with the help of the first model, it seems easier to describe the case at hand using the existing theoretical base. For simplicity, assume there is only one country and all bitcoins are accumulated in the hands of its residents (although Bitcoin is spread worldwide, which makes the problem of the money supply complicated).
Liquidity preferenceLet’s turn to the Keynesian liquidity preference theory. Although it was created to establish the correlation between the demand for money and the interest rate, it introduces some useful notions for our case.
According to the theory, the demand for money is a result of the following factors:
a) Transaction motive
b) Precautionary motive
c) Speculative motive
Motive
a correlates with the primary function of money – to be exchanged into goods and services, while motives
b &
c represent a different function – to store value.
The liquidity preference theory states that out of two assets people will prefer the more liquid one unless the other one provides a higher potential profit that outbalances the risks. With regard to a modern economy, this means that if other financial assets (bonds, securities etc.) are expected to provide a profit below some minimal margin and/or the value of money is expected to increase respectively, people will prefer hoarding cash driven by the speculative motive.
If this escalates, it forms a liquidity trap: people start perceiving money as the ultimate value storage not willing to exchange it into other assets. The speculative motive encourages saving over spending and functionally money and short-term bonds become near-substitutes. Conventional monetary policy becomes inefficient, since the interest rate is zero-bounded (although experiments with a negative rate are also known) and expansionary policy doesn’t help also: all newly injected money instantly transform into savings and do not contribute to the growth of the aggregate demand.
The trap escape scenario demands breaking expectations and encouraging spending: if the CB is able to convince business and consumers that the currency will devaluate and/or bonds’ prices will rise, hence bringing more risks into staying in cash, people may start spending their savings, thus restoring the healthy state of the economy.
Bitcoin vs fiatNow let’s try to apply these statements to our situation. Assume we live in an imaginary Bitcoin’s paradise: Bitcoin is recognized by everyone, every vendor accepts it as a payment method and the government creates no obstacles for using bitcoins on par with the national fiat currency. Although this situation is unlikely to occur, let’s intentionally put Bitcoin in the most favorable conditions that Bitcoin proponents dream of.
Given an equal liquidity and an apparently lesser risk of Bitcoin’s devaluation, the preference will be clearly on Bitcoin’s side. Being more preferable for motives
b &
c Bitcoin will face a higher demand, while the demand for the fiat currency will be driven only by motive
a. The growing disproportion in demand will drive both currencies to the opposite directions:
a) The fiat currency will be less favored by both consumers and business, and as everybody will try to get rid of it ASAP, thus escalating the velocity of circulation, it will fall into a liquidity glut. The purchasing power will constantly drop and at some point, when the inflation rate makes it extremely hard to maintain the required margin ratios, business will refuse to accept the fiat currency as payments or set restrictive prices, thus killing it completely. The fiat currency will inevitably lose to Bitcoin unless the government uses its coercive power to protect the former or severely contracts the supply to make the issuance model resemble that of Bitcoin.
b) Meanwhile, Bitcoin will stick in a liquidity trap. Suffering from the growing demand and given the inherently scarce supply it will be perceived as the ultimate value storage. Saving will prevail over spending; the aggregate demand in the economy will contract causing a recession.
I don’t see any scenario where fiat can stand against Bitcoin under the stated conditions and that is the problem. The good old Gresham’s Law completely fails: bad money do not drive out good money, because good money are now out of the government’s reach. When Bitcoin pushes fiat from the market, the government will be left with no opportunities to conduct monetary policy. Without fractional reserve, the real cost of credit in BTC will drastically rise due to the combined effects of the interest rate growth and debt deflation. All this will lead to a prolonged depression and likely launch a speculative inflation-deflation cycle as described above.
The irony is that the scarce supply makes Bitcoin simply too good to be a currency. We need a risky devaluating asset that we can easily part with, while beloved to any hodler’s heart Bitcoin just isn’t up to the task. We need something “spendable” but not “hoardable”.
Fractional reservePreviously, it was stated that without fractional reserve the availability of credit would likely decrease. This statement raises a question: why can’t we build a fractional reserve system on top of Bitcoin? Indeed, we can. I hope, however, that this will never happen, at least on the scale of the currently functioning fractional reserve banking.
The problem is that a Bitcoin-powered fractional reserve system will be extremely vulnerable to bank runs, which can become a time bomb beneath the entire economy.
Assume Alice deposits 10 BTC to her bank account, following which the bank lends 9 of the acquired BTC to Bob. Technically Alice now owns 0 BTC, the bank owns 1 BTC and Bob owns 9 BTC, as recorded in the blockchain. At the same time, the bank is liable to pay Alice 10 BTC on demand, while Bob is liable to pay the bank 9 BTC and some interest according to the schedule, which makes it a long-term liability. Such imbalance of debts’ maturity jeopardizes the system.
Fractional reserve banking relies on the assumption that only a fraction of deposits is demanded at a time. If Alice wishes to cash out, Carol and Dave arrive and deposit some BTC, 10 of which are given to Alice. From time to time, an insignificant lack of liquidity emerges, which can be countered by borrowing the required funds from other banks or the CB. In extreme cases, when a bank run is about to start and the entire banking system is threatened by a liquidity crunch, the CB can opt for massive expansionary measures (“print” money) that will provide the necessary liquidity and keep the system sustainable (as occurred in 2008).
None of these tricks will work with Bitcoin. Only if a single arbitrary bank faces a significant shortage of liquidity caused by reputational factors or another local cause, can it count on borrowing from other banks or the CB. If the entire economy is facing hardships, nobody will be willing to share and, having started in one bank, the liquidity crunch will rapidly spread and ruin the entire banking system. Even if the CB manages to accumulate some reserves in advance, they will still be limited and known and may turn out insufficient. We are not even considering the fact that someone can simply spread the idea of a Proof of Keys day.
Although a bank run is in many respects a psychological issue, it will be impossible to curb it in our case simply by promising to take all appropriate measures, since everybody is aware that no appropriate measures are actually available. Although we can see that the recent Fed’s announcement of unlimited quantitative easing helped to calm fears emerging from the COVID-19 pandemic without the actual need to apply any extraordinary measures, it wouldn’t work with a Bitcoin-powered economy.
If we set a low reserve requirement (for example, 10%, as currently adopted in the US), people will find out that up to almost 90% of their bitcoins actually doesn’t exist. It is not hard to imagine a devastating impact this situation will cause. A high reserve requirement (50% reserve allows to create only nearly twice more money) will soften the consequences, but not eradicate them completely. In any case, one “successful” global bank run will undermine the trust in the banking system irrevocably.
Protective motiveIn his liquidity preference theory, John Maynard Keynes introduced the speculative motive, which refined the model of the money supply, demand and interest rate relationship. The adoption of decentralized blockchain technology allows to introduce one more motive that can have an impact on the demand for money – the protective motive.
One of the distinguishing features of blockchains (herein I refer only to truly decentralized blockchains that do not allow history reversals, which doesn’t include systems like EOS) is the unique legal status of chain-based operations. As a state transition is executed in a decentralized manner and is immutable, blokchain transactions are beyond legal enforcement. For this reason, blockchains are considered to exist within a unique paradigm – code is law. This feature stipulates an additional political motive to prefer crypto-liquidity: to protect the wealth from a possible abuse of coercive power by governments.
The less the population trusts the regime, the more this motive influences the demand. It may play a negligible role in the economy controlled by a transparent democratic regime and gain a significant importance in autocratic states.
With regard to the issue at hand, the protective motive further restricts the opportunities of governments in the times of crises. If the government goes too far with interventions into the business processes, the protective motive can raise the liquidity preference by itself. It is hard to claim that this is undoubtedly bad, as it restrains governments from undue enforcement, but it will arguably make business cycles in a Bitcoin-powered economy even harsher.
ConclusionAs we can see, even if we neglect other problems of Bitcoin’s architecture, the scarcity of supply itself can be a reason that renders an appropriate economic development of a Bitcoin-powered economy nearly impossible. An asset that cannot grow in supply with a pace corresponding to the economic growth will provoke deflationary cycles, as it stimulates hoarding instead of spending. Moreover, certain properties of blockchain can further contribute to the rise in liquidity preference in comparison to fiat-based economies.
One can notice, though, that the model I describe seems unrealistic, for it considers Bitcoin equally liquid with a national fiat currency, while in the real world Bitcoin will unlikely be capable to spread on that scale. We may believe that governments will use their power to hinder the acceptance of Bitcoin as a medium of exchange, but I suppose that there is an intrinsic problem that restrains Bitcoin’s proliferation. That problem will be the subject of part 2.
