What Satoshi Got Wrong

wrong

Bitcoin Mathematics

It’s been awhile since I’ve written anything about Bitcoin. Yeah, it’s trading at about $750+, has a market cap over 12 billion dollars, blah, blah, yada, yada. The truth is that Bitcoin, as a currency, simply isn’t relevant anymore. Don’t take my word for it, Timothy B. Lee, Vox Media “journalist” and former Bitcoin cheerleader, wrote what I consider to be a salient article titled Bitcoin was supposed to change the world. What happened?, pretty much making my case.

Let me tell you what happened to Bitcoin: math. I’ve written a number of posts regarding Bitcoin but most of them can be summed up simply as this:

Satoshi was wrong.

Don’t get me wrong, there was quite a bit that Satoshi actually got right with Bitcoin. Solving the Two Generals’ Problem with a Proof-of-Work system as a method for significantly increasing the marginal cost of creating a digital file was pretty brilliant. It allowed Satoshi to exploit a condition that only exists electronically and cannot be duplicated in the physical world. The key word is “divisibility.” Unlike a physical commodity, like gold, a purely mathematical concept like Bitcoin that has the same dynamics as a physical commodity that is used as money can practically be divided infinitely. The concept of infinite divisibility is what made Satoshi think he(?) had found an elegant way to create the “scarce abundance” necessary to allow Bitcoin to become both a viable method of exchange and a great store of value. It was a clever math trick which has failed utterly.

What Satoshi got wrong is not fully grasping that dividing something is not fundamentally the same as expanding it. The metaphor that I used in The Currency Paradox to describe the effect of divisibility with Bitcoin was it was like using an eye-dropper to divide a bucket of water vs. using a cup. The fallibility of that concept is obvious in the real world. However, some think that in the purely mathematical world of Bitcoin, the same limitations to such a tactic do not apply.

To state that they are incorrect would be kind. While Bitcoin is indeed a largely mathematical concept, it interfaces with the actual world in very real ways. A Bitcoin economy is very real and each actual bitcoin represents real economic activity. The very act of dividing bitcoin into smaller fractions is, by nature, monetarily inflationary. As Bitcoin is divided into smaller fractions, each subsequent fraction represents a smaller portion of Bitcoin’s total purchasing power in absolute terms. When you look at it in terms of tokens, Bitcoin’s inflation rate can never be lower than ten times its current total number of tokens. In other words, the token supply at minimum must increase by a factor of ten when Bitcoin is divided. Imagine if our Federal Reserve could only increase the money supply by a factor of ten. You wouldn’t just be dealing with inflation, you’d then be dealing with hyper-inflation.

The way Bitcoin addresses this problem is by being tied to a growth component that counterbalances this hyper-inflationary bias. While it could theoretically be any commodity, Bitcoin is currently tied to fiat currency in a very clever way: Bitcoin is debased with it. In other words, as it regards divisibility, Bitcoin acts as a scarce high-value component mixed with an abundant low-value component. In traditional debasement with physical commodities, a scarce high-value component, such as gold, would be mixed with an abundant lower-value component, such as copper. Traditionally, the effect is that far more tokens could be created than by just using the scarcer, higher value component alone; this would increase a commodity money supply without necessarily compromising the purchasing power of each individual token.

What makes Bitcoin extraordinarily clever is that, because its supply has been arbitrarily capped at 21 million units, it has artificial scarcity and acts like a scarce, high value commodity. I emphasize the word “acts” because Bitcoin itself has very little practical utility and absolutely no intrinsic utility. It is literally just a mathematical construct representing scarcity which is completely artificial yet reinforced through the extremely energy wasteful and very expensive Proof-of-Work system used as its validation method. Through currency exchanges, the mathematical concept called Bitcoin is tied to a very real and relatively abundant commodity called fiat currency. In essence, Bitcoin has flipped the concept of debasement on its head because it is the abundant, “lower value” component (fiat currency) that actually gives the “scarce, higher value” component (Bitcoin) its actual worth. Without fiat currency as a reference, Bitcoin is less than worthless as they can only be produced with energy and equipment that costs actual money yet have very little real utility.

In any case, the mathematics of a fixed currency inversely correlate to that of a non-fixed currency: while it is excessive supply of a non-fixed limit currency that degrades its average per-unit purchasing power, it is excessive demand for a fixed limit currency that degrades its average per-unit purchasing power. As demand for Bitcoin increases and it is divided into smaller fractions, each subsequent holder will own a smaller amount of its total purchasing power in absolute terms. There’s simply no getting around that.

The argument has been that it is Bitcoin’s increased value in fiat currency that makes such divisibility worthwhile. When tied to fiat currency, Bitcoin is indeed deflationary; high demand would cause a spike in the exchange rate of Bitcoin with associated fiat currencies.

However, does that mean that Bitcoin’s purchasing power in relative terms will increase? In other words, would a spike in Bitcoin’s value in an associated fiat currency actually increase its purchasing power? In November of 2013, Bitcoin’s exchange rate with the US dollar hit an all-time high of about $1200 per bitcoin or about the price of a good computer. As of today, a single bitcoin is worth about $770 US dollars, roughly the price of a good computer. If I had to guess, I’d posit that every bitcoin is and will always be naturally worth little more than the average costs associated with creating it, including energy, processing power, and infrastructure. It’s debatable whether such “storage of value” is useful or even relevant.

I find it hard to believe that someone as intelligent as Satoshi could not understand the dynamics of dividing a currency to meet demand for that currency. Bitcoin is great math but terrible economics. As I stated in The Currency Paradox, no amount of rationing with an eye-dropper can overcome the problem of needing another bucket of water.

It’s obvious that, as a currency, Bitcoin has utterly failed. Its fatal flaw lies in its fixed limit which even the benefit of being an almost purely mathematical concept cannot overcome. A good currency needs to be “scarcely abundant” but Bitcoin is actually “abundantly scarce.” Divisibility cannot and will not ever make Bitcoin abundant enough to use as an every day currency.

That’s what Satoshi got wrong.

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