In the recent weeks we have been reading non-stop news about scams in the crypto world. Bitcoin has sunk below $20k. Mass-commentators are back on duty again. “Bitcoin is evil”.
Like all the meaningful, disruptive and innovative things in life, it's not all black and white. Let's get some things clear about Bitcoin.
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A monetary revolution
Bitcoin was created in 2009 on the heels of the financial crisis. It intended to be an electronic peer-to-peer cash system (Nakamoto, 2008) as well as a digital decentralised substitute to gold.
But unlike gold, Bitcoin is non-tangible and limited. There is no need to store it in a physical place, opening a new paradigm: every owner can be his own banker. Bitcoin is trustless and doesn't require a third party. Additionally, whereas gold can be mined on the Earth and potentially can exist in infinite quantities in the universe, Bitcoin is programmed to reach exactly 21 million units.
But why at all would we need a new currency? We already have our Dollars, Euros, Yuans, and a long long etcetera. We even “got rid” of the gold some decades ago!
Let’s take a brief look at the events of the last century.
In 1934, after the Great Depression, Roosevelt approved the Gold Reserve Act, which effectively meant the expropriation of part of the gold from American citizens. Immediately after it, the American government changed the statutory price of gold from $20.67 per troy ounce to $35. After WWII, many countries agreed to redeem its currency for U.S. dollars in Bretton Woods, but dollars kept being convertible to gold at a fixed exchange rate of $35 an ounce. But surprise surprise. In 1971, being the US government under pressure by inflation and trade deficit, Nixon gave his famous speech where he enacted a plan to end dollar convertibility to gold. AKA the US defaulted. The international monetary system turned into a fiat one.
From that moment on, and without the gold constraint, governments progressively increased their intervention in the monetary system by the hand of the central banks. The financial crisis of 2008 and the recent Covid pandemic have seen a shocking experiment with ultra expansionary policies never seen in history. For the better part of the 21st century, the world has had historically low interest rates.
Huge amounts of cheap money (a lot of supply, less demand) breaks the risk-reward relationship, creating bubbles and keeping alive projects and businesses that should disappear in a healthy market. It's basically like having a market hooked on drugs. You want more, but it's actually killing you little by little
This unprecedented access to inexpensive money has been the perfect breeding ground for the inflation we are currently suffering, unseen in over four decades.
Bitcoin is a monetary revolution. It intends to break the link between government and money (Ammous, 2018). To cease the continued manipulation of the system. Bitcoin covers and integrates a wide set of disciplines into a “simple” and elegant solution to solve many of the economic problems we have been suffering for centuries.
Not yet there
Bitcoin is yet far from being money. The 3 basic functions of sound money are:
Money is a store of value. Many assets comply with this function. Gold is a store of value, a diamond, a Rolex or even a Ferrari. Although it is an “efficient” store of value, what we today conceive as money is not a store of value in the long term and hence, it is not sound money. The Dollar has lost 97% of the purchase power in the last century.
Money is a unit of account. You can think of money as a yardstick-the device we use to measure value in economic transactions.
Money is a medium of exchange. This means that money is widely accepted as a method of payment.
As you can imagine, Bitcoin doesn’t comply with any of the 3 functions of sound money yet. It might be too early. Maybe it will never become a sound money and will only intend to be a store of value. Maybe. But the current fact is, it is neither of them.
Value of Bitcoin
“Bitcoin is purely digital and is backed by nothing. It doesn’t produce any cash-flow. Therefore, it has no intrinsic value.”
How many times have we listened to something like that? Is it true?
First, we must differentiate between real and financial assets. A real asset is an investment that has an intrinsic value due to its substance or the utility of its properties. On the other side, a financial asset gets its value from a contractual right, an ownership claim and the confidence attached to it.
Bitcoin is a non-tangible real asset. The fact that bitcoins are immaterial abstractions does not make their fundamental value zero. Bitcoins are valuable and their price are not zero because they are useful and scarce even if they are virtual (Polavieja, 2021). Even if an asset has 0 value for you, it might have value for others and hence, a market price. If not, ask citizens of countries hit by inflation for decades like Venezuela or Argentina how do they feel about an non-expropiable monetary asset. Ask all the Ukranians who had to flee from their houses after the Russian attack. Probably they will see some utility where others don’t.
With increasing global interest in Bitcoin in the last years, there have been some attempts to forecast the price of Bitcoin. One of the most famous ones is the Stock-to-flow model (S2F). The hypothesis in this study is that scarcity directly drives value (PlanB, 2019).
You can read more about it in the references. Although the model has predicted quite decently the price of Bitcoin in the last years, correlation doesn’t mean causality. An economic study on the hypothesis of the model makes evident that the model only looks at the supply of Bitcoins. Knowing only the supply doesn’t allow you to predict the price if there is no demand (Tapon, 2020). In other words, Bitcoin's tightening supply is only half the story.
As any real asset, Bitcoin is based on utility, confidence and adoption. If society starts to adopt bitcoin as a way to keep government hands away from their wealth, it might increase the chances to succeed. If not, it won’t. Similar processes happened many times in history, and it has always taken time.
As stated by (Rochard, 2020), people hold money to hedge against future uncertainty. This is why it is so crucial for a monetary system to optimize for minimizing its own uncertainty. There is a trade-off between exchange rate volatility and money supply certainty. Bitcoin maximizes the latter.
It is impossible to predict what the value of Bitcoin is or what it will be. Beware of charlatans predicting it.
How to detect someone has no clue about Bitcoin
Bitcoin is an asset whose utility is still in a development process. It is difficult to understand for a wide part of the population. And people tend to fear what they don’t understand. Therefore, it is imperative to lead an educational process to explain it in plain words.
Bitcoin has some problems or difficulties that must be overcome. But there are many stupid critics that have non-sense.
“Bitcoin is a Ponzi scheme”
A Ponzi scheme is based on the promise of profitability. You pay some money and you will receive in time your money + X additionally (funny to see these promised returns are always exceeding by far the expected returns of the best productive assets).
Therefore, a Ponzi scheme always needs the continuous inflow of new capital to pay the promised returns to the members sitting higher in the pyramid. Once the capital inflow stops (and it doesn’t need a lot of time due to the compounding effect), it bursts. The last round of newcomers, normally accounting for half of the total base, lose all their money.
Bitcoin is not a Ponzi scheme because it doesn't promise any profitability (even if many people have been attracted by it). Bitcoin is a network of a scarce asset with a set of rules which could be the basis of a sound money.
Don’t leave uninformed commentators comparing Bitcoin with other cryptocurrencies. Some might bring some value, many won’t, and some others are just scams.
“Bitcoin is used by drug dealers and money launderers; therefore it is bad.”
We have seen it everywhere. Spoiler alert: this is the worst argument ever. Will we try to forbid the dollar because criminals are using it? Then we should have done it decades ago. Furthermore, cash payments are extremely harder to track than Bitcoin transactions. Any transaction done in the Bitcoin blockchain is public and accessible. Users might have been anonymous in the past (nowadays is more difficult), but to track down illegal activities is easier in Bitcoin than with dollar cash payments (Metha et Al, 2019).
Fair critics
“Bitcoin is a speculative asset.”
Price development so far has been purely speculative. Precisely because Bitcoin produces nothing, you can not “invest” in bitcoin, you speculate with its price. Speculation is the process of buying something with the idea to sell it later at a higher price. But don’t fool yourself. The same happens with gold (apart from its industrial use, as store of value)
You might want to keep bitcoin to “support” this revolution or because you have hopes the revolution might succeed and you will be able to sell it at a higher price once the base of citizens finding it useful has increased. But you will never be investing.
“Governments won't simply allow non-state money to keep growing.”
Control over money is too central to a government's survival for them to allow this. Might be, but time is ticking. The most probable future is that bitcoin will become another monetary asset with certain qualities appreciated by less or more people.
But we could be living in a process of creative destruction. Bitcoin is an innovative asset with the potential to solve some of the failing current trends of our monetary system and debts, so this scenario is not completely negligible.
In fact, there are already countries who have adopted Bitcoin as a legal tender (El Salvador and some African countries). Obviously, not the most respectful ones with property rights. Furthermore, while allowing it as a legal tender is a good idea, imposing it, borrowing in Bitcoin and “investing” taxpayer money in it, is not. And this is what President Bukele has done in El Salvador.
“Bitcoin's mining process is extremely energy intensive, and therefore wasteful”
Bitcoin's energy spend is required to create the strong security assurances around bitcoin's transaction settlement. It is the main security to protect the network against attacks. It is its defense system and you need it to make it expensive for intruders even to try to do it. With time and innovation, we will find how to run it on renewable sources. Nowadays, there are already many Bitcoin farms in Iceland using hydro and geothermal power. But security never comes for free.
Inmutable
The Internet was “invented” in 1983. In the 2000s, the media and my grandmother still believed that the internet was mainly used to watch porn. We had the “Dot-com” bubble and consequently crash. But even with it, the Internet has been the biggest consumer revolution ever.
Prices drive narratives, but the Bitcoin chain has been doing the same since the first block mined 13 years ago. Actually, it has been doing exactly what it promised in its white paper.
We are in the early days of a monetary revolution. It is very difficult to know if it will succeed given the set of interests in conflict. But never underestimate the power of incentives. We need to recover our individual sovereignty, starting with one of the basis of any free society: the property of our own wealth and money.
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References
Ammous, S (2018). The Bitcoin Standard: The Decentralized Alternative to Central Banking. Wiley
Metha et Al. (2019). Bubble or Revolution: The Future of Bitcoin, Blockchains, and Cryptocurrencies. Paravane Ventures.
Nakamoto, S. (2008). Bitcoin: A Peer-to-Peer Electronic Cash System. https://bitcoin.org/bitcoin.pdf
PlanB. (2019) Modelling Bitcoin Value with Scarcity. https://medium.com/@100trillionUSD/modeling-bitcoins-value-with-scarcity-91fa0fc03e25
Polavieja, M. (2021). Bitcoin as a means of payment. https://manuelpolavieja.medium.com
Rochard, P. (2020) The Utility of Saving. https://pierre-rochard.medium.com/the-utility-of-saving-c56f7c170fc1
Tapon, F. (2020) 8 Flaws in Bitcoin's Stock-to-Flow Model Will Doom It. https://francistapon.com/Work/WanderLearn-Podcast/8-Flaws-in-Bitcoin-s-Stock-to-Flow-Model-Will-Doom-It
(Bubble or Revolution is a weak book from a monetary point of view. Interesting and easy to digest from the technology point of view. For a monetary approach, The Bitcoin Standard is deeper and better reasoned.)
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I will be happy to read different thoughts of the investment community about Bitcoin and its future. I am quite positive about the benefits it might bring. Do you see a down side?