Bitcoin and Divisibility

Broken-BitcoinI have to admit that I am fascinated with Bitcoin as a concept. It seems like it is one part brilliance to one part sham. It’s 19th century economics wrapped in a 21st century package.

There has been contention with my assessment that Bitcoin is “debased” currency. I thought I had made a pretty strong case, but I did make somewhat of an error when I stated that there would not be enough Bitcoin with which to manage an economy. I’m writing this post to further exercise my understanding of Bitcoin, yet still press my point regarding why I think it is fundamentally flawed as a currency.

I stated initially that there simply aren’t enough units of Bitcoin for it to serve as a currency. I was incorrect in this as it is theoretically possible to indeed manage an economy with only 21 million units of Bitcoin.

The thought exercise that helped me wrap my mind around this concept was imagining a world that existed strictly with Bitcoin as the currency. In this world, market pricing would determine the value of Bitcoin rather than exchange rate. One bitcoin could be worth 100 barrels of oil, or 100 kilowatt hours of electricity, or 100 pounds of coffee, etc. Let’s use the example of 1 BTC to 100 barrels of oil: if the supply for oil were to explode so that 1 BTC = 1000 barrels of oil, then a lower denomination of Bitcoin could be used to buy only 100 barrels of oil. In this instance, the original quantity of 100 barrels of oil would be valued at .1 BTC instead of 1 BTC. The point of Bitcoin seems to be the elasticity of value within a fixed sum. In theory, the money supply isn’t so much expanded or contracted as it is “shaped” by supply and demand.

In this fashion, all resources and all transactions are captured by the 21 million unit figure. The fixed limit of Bitcoin represents the entire economy.

What I considered is how this would play out if we suddenly colonized Mars. Now, those 21 million units not only represent the entire economy of Earth, but also the collective economy of both Earth and Mars. By definition, the value of each Bitcoin increases as they must encapsulate the value of much greater resources. As additional planets are colonized, Bitcoin would, by definition, increase in value as the resources of those additional planets are encompassed by the Bitcoin economy. Going back to the original example, an expansion of resources could swell the value of 1 BTC to 10,000 barrels of oil. 100 barrels of oil would then be worth .01 BTC. In this sense, Bitcoin would very much be deflationary.

The confusion was in thinking of Bitcoin in terms of units rather than ratios. The fixed nature of the Bitcoin money supply means that all pricing has a relative relationship to the TOTAL money supply, at least when pricing is done purely in BTC. The notion is that anyone pricing an item can move as many decimal places to the right as necessary to most accurately reflect its value, rather than for the purpose of creating new units for distribution as I was thinking.

To someone used to thinking in terms of absolute units, this is not an intuitive concept. There are also many questions regarding its feasibility in the real world …

The first thing you have to consider is that, in an economic system with a fixed money supply, pricing distortions are likely a natural outcome, By nature, all pricing is done relative to the pricing of everything else in a pure Bitcoin economy. Increased demand for certain items will naturally affect the market size in terms of money for other items. Think of it like squeezing the end of a long balloon; one end swells while the other end is flattened. The balloon doesn’t change in size but the distribution of air within it does, creating a distortion. This may not necessarily be a bad development, but, to my knowledge, this is something that has never been faced in an economic system. In the current fiat paradigm, every market has the amount of money it needs as a result of an expanding money supply.

Another thing to consider is how much Bitcoin is already controlled by various parties. Bitcoin’s creators, investors, early adopters already own quantities of it far out of proportion to its supply relative the population. This suggests that economic inequality would be an even greater problem in a pure Bitcoin economy should it ever fully supplant fiat currency. The deflationary effect would encourage hoarding and limit overall economic activity. Fortunes would grow simply as a result of the scarcity of the money, a dynamic that most benefits those who were early Bitcoin accumulators. On top of that, those same fortunes would be much easier to retain as they could not be disrupted by innovators or competitors with access to an expanding money supply. An increasing money supply also addresses market manipulations or distortions that benefit wealthy financial “insiders” at the expense of the general public by simply pumping more liquidity into the economy. In other words, the wealthy may capture more buckets of water, but everyone still has a chance to fill their buckets because the water keeps coming out of the tap. In a pure Bitcoin economy, there is only ever one big pool of water of which a relative handful control gallons and gallons while billions of others must share what remains, the relative portions of which could be measured in ounces.

For all I know, these conditions may not be terminal to a Bitcoin economy. Let’s assume that such issues are indeed not issues. That leads us to another problem:

How do we get to a pure Bitcoin economy? How do we get to the point in which pure Bitcoin pricing exists?

Pretty much anything produced in today’s economy will have an associated cost measured in fiat currency. To my knowledge, there are no items priced in Bitcoin without a direct correlation to fiat money. Without its relationship to fiat money, there is no reference for pricing purely in Bitcoin. What is a bitcoin in its own right actually worth in goods and services? There is no basket of goods priced in Bitcoin. Plus, the arbitrary nature of pricing items in Bitcoin, even without a relationship to fiat currency, creates the exact same imprecisions and distortions in market economies as fiat currency, the problem for which the innovation in The Currency Paradox was designed to solve. As I’ve stated, Bitcoin is indelibly linked to fiat currency.

More importantly, relative to the global currency scale, there is almost no real demand for Bitcoin as a medium of exchange. It literally does absolutely nothing that other solutions don’t do better, including the ones in developing nations, such as M-PESA. Based on its usage, people generally only care about Bitcoin in as much as it appreciates in value as measured in fiat currency.

The reality of Bitcoin is that it doesn’t solve any of the problems of fiat currency and creates a few new ones. What would be the advantage of having a completely fractional monetary system that had, for all intents and purposes, infinite denominations? This would introduce a huge amount of complexity into accounting. A substantial amount of research has already been done that shows that almost none of the perceived benefits of Bitcoin as a currency have long-term viability. It’s less secure for consumers from its lack of third party protections, its network requires a massive amount of energy to run creating high operational costs, and its low transactional costs relative to its competitors are unsustainable in the best case scenario and overstated in the worst. The things for which it is best used are the very traits that will likely ensure it maintains niche status: speculation and anonymous payment for questionable or illicit purposes.

A Debasement Redux

I made somewhat of a controversial claim that dividing Bitcoin into smaller units without the benefit of fiat currency is “instant debasement.” Before I address this, let’s explore the concept of currency debasement. For the most part, currency debasement involves three main factors:

  1. An increase in the money supply in units;
  2. A decrease in the purchasing power of a money;
  3. For a fixed money supply, a decrease in the ratio of the total money supply as encapsulated by each unit of currency. In the debasement of coinage, this would represent a reduction of the ratio of high value material relative to the coin’s perceived worth; for instance, a reduction in the gold content of a minted gold coin by adding a higher proportion of cheaper base metal.

Let’s explore the concept of debasement when it comes to Bitcoin. According to Bitcoin fans, the fact that there is a fixed money supply means that it is, by definition, deflationary. So is it really possible for Bitcoin to be debased?

The first point I’d like to make is that debasement in the form of creating more units of money is not necessarily inflationary if it leads to economic growth. Economic growth generally means that more resources are produced relative to the money supply which, by nature, is captured by the money supply as value.

However, if the purchasing power of a money must decrease as a result of more units being produced for debasement to have truly happened, then let’s look at this example:

Let’s say that $1 represents the total money supply of an economy and one soda represents the complete resources of the economy. This would be the starting point:

1 soda = 1 dollar or 1 dollar = 1 soda

If one person had that $1 and wanted to purchase a soda, there is no problem, it is simply one for one:

1 dollar = 1 person = 1 soda

However, what if there is demand for the money from nine other people? Since $1 is the fixed limit of the money supply, there would be no choice but to divide that dollar into 1/10th units (dimes). Now it looks like this:

1 dollar = 10 people = 1 soda

The money supply hasn’t changed and the resources haven’t changed but the demand for the currency has increased. As a result, the purchasing power of the currency has decreased per person by having divided one whole unit into 10 fractional units. Each person cannot buy the whole soda, but only a fraction of the soda. In a world in which a fixed money supply represents a fixed level of resources, simple population growth will degrade the purchasing power of the money. At this point, both criteria of the debasement definition have been fulfilled: the number of units of the currency have increased while the purchasing power of the currency per person has decreased.

In fact, all three criteria for debasement are represented because each unit also represents a smaller ratio of the total money supply.

In the reality of a pure Bitcoin world, the only way the total money supply can truly increase in value is if it encapsulates greater resources. However, the Earth is a fixed resource as well. So the Bitcoin money supply and the Earth have a 1:1 correlation. Under these circumstances, purchasing power directly correlates to population. If the population grows, the purchasing power of Bitcoin for each person decreases, if it shrinks, the purchasing power for each person grows.

It’s easy to see how this plays out when you consider how much Bitcoin is controlled by its creators as well as early investors and adopters. It is estimated that 10% of Bitcoin owners hold as much as 85% of all current Bitcoin. If that ratio were to hold until all Bitcoin were mined, the amount of Bitcoin left for the rest of the population to use for matters of exchange and transaction would be tiny. In the end, most people will be left with a tiny fraction of Bitcoin’s total purchasing power.

The fiat currency system gets around this problem simply by increasing the price of the soda. So, instead of the soda costing $1, it becomes worth $2, then $3, then $4, etc. This is intuitive because massive population growth has made total resources more valuable therefore more expensive on a per person basis. The money supply generally reflects the total value of the fixed resources of our planet which is, by nature, increasing as our population increases and technology makes more resources accessible to more people. Bitcoin makes the determination that all resources that will ever be created, discovered, or produced will only ever be worth 21 million units. This works as long as resources increase. In a pure Bitcoin reality, value as measured in total bitcoin can never increase, it is limited to 21 million units.

As an aside, what makes the innovation in The Currency Paradox so compelling is that, unlike Bitcoin, it is completely compatible with the current banking system. Indeed, it actually makes 100% reserve banking completely practical whereas Bitcoin is practically incompatible with lending.

In summary, the divisibility of Bitcoin is moot. Bitcoin is indelibly tied to the fiat currency system which acts as a growing resource in relation. As I’ve shown, this is not very different from traditional currency debasement. Any Bitcoin value increase in fiat currency reflects a demand increase …

which will, by nature, exacerbate the scarcity of the currency …

which will then be sold in smaller and smaller ratios …

which will result in a decrease in the purchasing power of each unit relative to the total money supply …

simply because more people will own less of it in proportion to the total money supply.

I welcome all feedback from any Bitcoin fans.

P.S. – I’m in the process of reading a book by Tim Swanson entitled, The Anatomy of a Money-like Informational Commodity: A Study of Bitcoin, which I personally think is very comprehensive and makes a compelling case for why Bitcoin is highly unlikely to disrupt the current fiat currency paradigm. Bitcoin investors would do very well to read it.

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5 thoughts on “Bitcoin and Divisibility

  1. Pingback: The Currency Paradox | Why the Value of Fiat Currency Shrinks Over Time

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  3. Pingback: The Currency Paradox | The Post Where I Fix Bitcoin

  4. Pingback: The Currency Paradox | Fixing Bitcoin Part II: Pricing with Bitcoin Units

  5. Pingback: The Gold (and Bitcoin) Fallacy | The Currency Paradox

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