In my post, Currency and the Riddle of Scarce Abundance, I offered what I thought were the ideal traits of a cryptocurrency that had the ability to replace fiat currencies.
Since then, Bitcoin, the current cryptocurrency poster child, has once again embarked on a roller coaster ride of volatility, prompted mainly by the defection of a prominent developer in the Bitcoin community, Mike Hearn. In his post, The resolution of the Bitcoin experiment, Hearn refers to Bitcoin as a “failed experiment.” Many conflated Hearn’s statement to mean that Bitcoin was “dead” and gleefully pointed to the exchange rate and transaction volume to paint him as a bitter opportunist who also had the ignominious condition of being dead wrong.
Here’s the thing though… Hearn never claimed that Bitcoin was “dead” he only claimed that it had failed. In that respect, I think there is a lot of evidence that he may be correct. Despite the claims that Bitcoin transactions are increasing, there is almost no evidence that its use for common financial transactions is increasing. As for its exchange rate, there are many incentives to trade in Bitcoin, few of which are relevant from a currency standpoint. The truth is that Bitcoin, in its best case, only shows utility as a speculative vehicle and, in its worst, shows signs of being heavily manipulated.
The simple reality is that, if a cryptocurrency intends to replace central bank-issued fiat currency, people, first and foremost, have to have an incentive to use it for common financial transactions. As I’ve stated before, no one truly has an incentive to use Bitcoin every day. Why? It’s too volatile and doesn’t really do anything significantly better than the current currency paradigm.
My thinking is that Bitcoin suffers from an abundance, or lack thereof, problem. Its scarcity is used as a means to trap value but it works against the currency being used every day. I’m willing to admit that this may strictly be a matter of psychology. But the truth is, Bitcoin feels scarce. Its deflationary bias exacerbates that feeling. Not only is it not practical as an every day currency, it feels like it’s not practical as an every day currency. People intuitively understand that Bitcoin doesn’t work because there isn’t enough of it to go around (yeah, I know, “divisibility,” blah, blah, blah).
In my opinion, the best use case for a cryptocurrency in today’s world is as a reserve currency. People may choose to buy U.S. dollars for that purpose but I think there would be something uniquely encouraging for many people if there was a popular currency that was not controlled by any nation that could also be used seamlessly across borders. But I think it also has to feel like a currency as well. There has to be both an actuality and an intuitive sense that the currency is stable yet flexible, that it can grow effectively with demand without destroying its ability to store value. Call it “faith.”
What I came to understand is that a currency can expand as long as it remains in lockstep with demand. There has to be effective mechanisms to destroy money as well as create it in an economy. I think many of the problems faced in our current economic system stem from a fundamental disequilibrium in the creation and destruction processes of money. The imbalance is caused by the demand for interest on debt-based money which creates a net-negative sum bias. The result is that, as debt is serviced and profit is protected, an artificial scarcity of money is being produced in the every day economy which is encouraging a deflationary environment.
As an aside, many people believe that technology is a major factor driving deflation. This is an interesting theory. My first response is that this leads to a very strange syllogism:
- Software allows more to be done with fewer resources;
- As a result of software “eating the world” and efficiencies of scale, fewer resources are being consumed;
- The result is deflation as there are more resources available in relation to demand.
Here’s where this gets tricky for me: how does this reconcile with an expanding money supply? At the personal level, if I have a smartphone that can substitute for a myriad of devices, it stands to reason that I should have more money in my pocket. Now scale that out to hundreds of millions of people. If deflation is less money chasing more goods but tech is helping people keep more money in their pockets, then how is technology causing deflation? Indeed, technology should be having an inflationary effect, at least monetarily, relative to the expanding money supply. The expansion of markets globally easily translates into greater use of resources in aggregate. It should not be possible for technology to have a deflationary effect. Quite the opposite actually.
Indeed, there is a massively deflationary element counteracting the naturally inflationary bias of technology. There is mounting evidence that rents, particularly in housing, are contributing to that effect. So, even in an environment in which technology should be putting more money in people’s pockets, the demand for that money in the form of rents is systematically eroding people’s personal wealth. So even with more income and personal wealth, many people are actually poorer as the result of the increased demands on it. This seems to validate Thomas Piketty‘s research on economic inequality. The economist Branko Milanović has coined the term “wealth-poverty” to explain this phenomenon.
The money supply is expanding at an amazing clip, more natural resources are being consumed now than at any time in history, yet disinflation/deflation is a problem in all but the most corrupt countries. This is a strange contradiction, one that has many central bankers puzzled. Disinflation and deflation suggest that the expansion of the money supply can’t keep up with even the tepid amount of growth that we are now experiencing.
So how does all of that relate to cryptocurrency? Well, one of the advantages of a cryptocurrency is that it can provide insulation from the current economic forces. A stable cryptocurrency can provide a completely liquid safe haven and act as an effective counterbalance to central banking monetary mishaps. Think of it as a safety net for the global currency system.
So getting cryptocurrency right is very important, so much so that I think even central banks would be able to get behind a good one. It could be used as an escape hatch should the worst happen.
But, as I’ve shown before, Bitcoin is already rigged in favor of its early adopters. Increased demand would only ensure that each subsequent purchaser of it gets less and less while the fortunes of those who accumulated early and cheaply would go through the roof.
The answer is the creation of a cryptocurrency that allows true supply/demand equilibrium. Everything necessary to create it now exists. As in many things, it is not a lack of capability but a lack of will that is preventing it.