Bitcoin makes Lousy Money

Making it a lousy investment… since its sole ‘value’ is as a supposedly better form of money!

Bitcoin’s one saving grace is that it has spurred the search for something better than fiat currency… and better than Bitcoin (and its ilk).

This paper critiques Bitcoin as money, in the process identifying the key attributes that any new ‘money token’ must embody if it is to succeed in supplanting fiat.

To understand these claims, it is necessary to recognise that Money is just ‘information’.

It works best where there are ‘efficient markets’ to allocate community resources.

When a person makes a good or provides a service, ideally the good or service should add value to the community.

‘How much’ is best determined in a market between many buyers and many sellers that all have equal bargaining power and knowledge (rarely the case in real life — but good enough in most instances where there is sufficient regulation and enforcement to deter collusion and other fraudulent and anti-social behaviour, such as dumping toxic waste in the river to keep the cost down). In this situation, buyers will not pay more to any one seller than they could pay elsewhere; and sellers will not sell for less than their cost. The ‘market clearing price’ is the price at which all sellers can sell all their stock/services at or above their cost (including the value of their own time, and all ‘social costs’ that can be priced). This weeds out sellers whose processes are inefficient, whose cost price is greater than any buyer is prepared to pay.

While everyone makes their own ‘value judgement’, the net effect of the market is to determine the value of the product or service to the community at the time of sale.

In this situation, the buyer simply gives the seller a ‘record of the value’ contributed by the seller (in the form of the goods or service provided to the buyer).

We call this ‘record’ money.

The money then enables the seller to take back out of society the same value that they contributed — when they come to spend it (again assuming an efficient market, and no significant inflation or deflation between selling and buying).

At that point, the seller and society are square.

The seller will have received the same amount of real value (in goods or services) as they contributed.

In simple terms, each person gets to take out what they put in.

In general, this makes for a fair society.

(Though a separate problem is how to ensure those people who cannot contribute, share in society’s output — the young, old, incapacitated and their unpaid carers , as well as those without the skills required by the market — over 50% of the population. If we agree that, to maintain a fair and stable society, we must share our collective output with everyone who cannot contribute to its production; we need to recognise that this requires all of us to share some of our money. Without money, it is impossible to signal your needs to the market, making it impossible for the market to meet them. Traditionally, we share our money via family, charity, tax… and crime. But that’s another issue).

Money is nothing more than a convenient measure of the ‘value of resources’, like an inch is a ‘measure of distance’. An inch can measure a length of copper pipe or a road or anything else. Imagine if our ‘inches’ fluctuated minute to minute! How could we reliably measure anything? The same is true of money. Our money measures the value of the pipe and the road, and anything else.

For this to work effectively, money needs to have no value or price itself. So a dollar note is only ever exchangeable for a dollar note (or a dollars worth of coins, or an eDollar when it comes) within the community that accepts the dollars.

When money has its own intrinsic value (as in the case of gold coins), it leads to market distortions. For example, where the price of gold has exceeded the face value of the coins it is formed into, people have hoarded the coins for the gold, rather than spending them to buy goods and services for the face value of the coin (most recently in the Great Depression, resulting in a universal move away from the ‘gold standard’). This is quite rational behaviour since, at the time, the value of the gold in the coins has exceeded the value of the goods or services that could be bought with the gold coins at face value.

Notice this whole analysis makes sense only because the comparison in prices (between the gold and other goods and services) can be made in a standard unit, for example: the dollar.

It is the ‘dollar’ that is the measure, not the gold.

Bitcoin fails on this account too, as the coins themselves are traded as though they are good, which gives the coins a ‘price’ (like gold), while transaction costs include huge amounts of electricity.

The ‘backing’ for fiat currencies is orders of magnitude more valuable than gold. It is quite simply the sum total of the real resources (natural, human, organizational and technological) that exist within the society that accepts the money. It is these resources that generate all real wealth within the society… not the money. The money is just the measure.

Another misunderstanding about money relates to exchange rates.

Unfortunately, many people in the crypto-sphere seem to equate exchange rates between currencies with the prices traded for different crypto-currencies. Yet these are two very different markets.

While exchange rates between currencies may fluctuate due to ‘speculation’, they do so within a limited band, reverting in time to the relative worth of the respective economies. While trading algorithms may take into account non-economic factors relating to ‘trading patterns’, ultimately traders are not betting on the ‘value of the money’ or ‘demand for the token’, they and/or their algorithms are betting on the relative worth of the economies whose currencies they are trading.

This is very different to trading in Bitcoin and other crypto markets where the pricing is entirely dependent on the relative demand for the currencies themselves! This gives a price to each token (as a token) which goes against the fundamental nature of money.

Money is simply the measure of all prices, having no price itself. To price ‘money’ would be like pricing ‘inches’!

The exchange rate between, say, dollars and euros is like the conversion factor between inches and centimeters. It is simply the means of equating two different measures of the same quantity. In the case of money, the problem is complicated by the fact that the relationship between each monetary unit and its underlying economy is not perfectly stable.

This instability has problems not only for equating different currencies. It also has the potential to significantly impact the fairness of the system within each economy.

To return to the example of the seller having sold their goods or services in exchange for a ‘record of the value’ provided by them (money).

While the seller holds the record unspent, it is important that the ‘unit of account’ remains relatively stable in relation to society’s resources.

That is, the unit’s ‘purchasing power’ should not be subject to EITHER inflation or deflation.

(A small amount of inflation — a few percent per year — need not be a major problem as most people spend their income soon after receiving it, and those with surplus to invest can usually earn more than inflation. It is a problem for people on ‘fixed incomes’… which is why the last 30 years have become more difficult for many people whose wages have been held in check. But that too is another issue that cannot be solved by Bitcoin).

Inflation advantages the holders of assets over the holders of money for doing nothing but holding the assets (which happens with fiat currencies to varying degrees in different times and places).

Similarly, deflation advantages the holders of money over the holders of assets for doing nothing but holding the money (which is the case with Bitcoin and other crypto-currencies that have a limited supply not matched to the size of the economy).

Both situations are inequitable — in effect giving one group something for nothing at the expense of the other group.

In 2010, someone sold two pizzas for 10,000 Bitcoins then worth around $40. At their peak in December 2017, the pizza seller could have sold those coins for around $200 million!

Imagine if the reverse had been the case. Imagine if $200 million in 2010 was worth only $40 today due to inflation! Society would be in uproar!

Because it is ‘deflation’, and especially because it seems to only impact the pizza buyer and seller, most people seem to think ‘good luck’ to the pizza seller, and ‘what a bummer’ for the pizza buyer! But the fact is, even today, the pizza seller still has $75 million of ‘purchasing power’ they did not earn. That is, they have not ‘added value’ (beyond the $40 of pizzas they provided) as a seller of goods or services which would entitle them to take out what they put in… they have simply got $75 million for doing nothing but holding the coins!

The problem is that most Bitcoins that will ever be issued are already issued. Many millions were derived from mining and/or buying coins when they were relatively cheap and easy to obtain (if you knew how and had the interest). In December 2012, there were around 8 million Bitcoins on issue. Many mined for near zero cost, with the price at the time a mere $13 per coin. The holders of those coins could now trade them for $52 billion. Even if traded in the meantime, the small group trading Bitcoins has put themselves in a position to extract resources from the rest of us for doing nothing but trading the coins.

Most Bitcoins are still held by very few people (with a mere 1,000 people holding 40% of all Bitcoins). As a group, they stand to gain enormously — if their wildest dreams were to come true and Bitcoin was to become a global currency. Though it will never happen (for no reason other than it cannot process more than a few transactions per second), it would mean that each coin would have to be split into the maximum 100 million units that could each be worth one cent, making each coin trade-able for $1 million. This would give holders of these coins the ‘right’ to claim trillions of dollars of our resources without adding a single thing to our collective wealth.

Is this really the basis for a fair money system?

As regards fiat currencies, the fear is that a failed state will simply print money devaluing the currency. While this does happen, it is a rarity. However, price manipulation within crypto-currencies is anything but rare. As crypto-currencies are still largely unregulated, people trading in them have few protections, and because the owners of crypto-currencies are essentially ‘anonymous’, once someone has your money, there is little chance of ever getting it back, even if the trades are held to be illegal. This is a very poor basis for a sound money system.

To avoid either of these scenarios (inflation or deflation), the number of money units on issue should match (the growth in) the ‘quantity’ of resources being transacted within the economy over time. This is very difficult to achieve in practice; as tastes, technology and access to markets change the nature of each economy — now faster than ever.

Nevertheless, it is important to aim for this goal for two reasons:

First, it is only possible to know if a ‘transformation’ of resources (into a product or service) has ‘added value’, if the units of account that measure the cost of its inputs are the same in real terms, as the units used to measure the value of the good or service they comprise. That is, the ‘purchasing power’ of the unit used to calculate ‘cost’ must be the same as the ‘purchasing power’ of the unit used to determine the ‘selling price’.

Only then will a ‘profit’ signal a process that has added value, while a ‘loss’ signals a destruction of value.

Only then can we be sure that our economic activity is a net benefit to society. With one proviso: that all costs are properly accounted. This is especially difficult where the costs are to the ‘commons’ — like ‘pollution’, or ‘moral hazard’ in finance. But this is not a ‘money’ problem. It’s a recognition and accounting problem and applies to Bitcoin just the same as any other token.

Secondly, a ‘stable’ unit is required to ensure the seller gets back the same value they contributed — not more or less. There is no fairness in a seller getting less back than they put in, nor more.

Bitcoin is hopeless on this account given its huge fluctuations in ‘price’ vs underlying economic activity; and the fact that it designed to be massively ‘deflationary’. A seller of a good or service may disproportionately lose or gain simply due to massive fluctuations in the ‘purchasing power’ of a Bitcoin. Where’s the ‘fairness’ in that?

Ideally ‘money’ should have zero cost to produce and transact — instantly from anywhere to anywhere, regardless of the number of transactions.

Bitcoin fails on all these measures too. Processing the sale of, say, a cup of coffee may take hours to confirm and cost more than the coffee! Yet, the new settlements system just established in Australia can now confirm transactions direct from bank account to bank account in seconds at zero cost to the buyer.

Ideally, money should be simple to use. Bitcoin is anything but — as anyone (who is not a coder) who has tried setting up an account and keeping their codes safe knows.

Money should also be without risk of theft, loss, destruction, unlawful seizure, or counterfeiting.

Bitcoin offers these protections — at least as far as on-chain transactions are concerned — though, if you lose your access codes you lose your Bitcoins. There is no ‘re-setting your password’. It is reported that millions of coins have been irretrievably lost in just a few short years. What happens if you have a sudden accident or illness and die and have not let anyone else know about your codes, or (as has happened regularly over the years) the exchange you are using gets hacked or just stops trading? What happens is your coins are gone forever! Also, there is no absolute protection against fraudulent or violent theft.

Another problem is that Bitcoin also avoids ‘lawful’ seizure.

Money is a ‘social asset’, as such, it assumes a functioning society, where only a small minority engages in antisocial behaviour (crime).

As a social system, our money should facilitate the seizure of the proceeds of crime. Ideally, it should also avoid loss in the event of a ‘failed state’.

Bitcoin does not facilitate lawful seizure; though it does offer some protection against a failed state. The problem is that if a failed state (or any state for that matter) outlaws the use of Bitcoin and imposes significant penalties for attempting to pay with or accept it, you either run the risk of finding someone to accept it, or you have to flee the (failed) state. That is, Bitcoins protections are not absolute.

It should also be possible to reverse transactions that are found to be fraudulent. Again, impossible with Bitcoin.

And last but not least, new money should only be issued either to everyone equally (which is self-evidently fair), or for real value.

In the case of fiat, most new money is created via the issue of ‘bank loans’. These give the borrower unearned purchasing power. As the borrower works or invests, they create new value that enables them to repay the loan. As the loan is repaid, the money is destroyed. (It does not go to the bank. This Bank of England paper explains the process). Once the loan is repaid, the borrower and society will be square. They will have put back in the same amount as they took out when they spent the proceeds of the loan. This too is fair.

Bitcoin is much like counterfeit money. It is issued to ‘miners’ for doing nothing but confirming transactions. This sounds like real work, but most ‘transactions’ are just buying and selling coins. Especially in the early days, it was literally a ‘licence to print money’ — but without the need to pay for any licence. The miners simply ran the algorithm and produced millions of coins for themselves using standard home computers. How is this different to counterfeiters who spend money on paper, ink, plates, equipment, premises, power and people to make and distribute new tokens (fake currency) that enable them to buy real resources for no ‘added value’? To say the Bitcoins are used by normal people for real transactions once spent into the economy (by the miners) is no different to saying counterfeit money is used by normal people to signal real transactions (once it is spent by the counterfeiters). In both cases, the producer of the token gets real value from the rest of society for doing little more than producing the tokens used by other people.

Counterfeiting is rightfully seen as fraud. Unfortunately, the technical nature of Bitcoin (and its ilk) has enabled the miners to hide its true nature: counterfeit money.

This is not to say that all is well with the current banking system — clearly there are many problems (not least ‘moral hazard). Just that Bitcoin is not the answer.

Nor is it to say that the technology underlying Bitcoin is worthless. Indeed, it has triggered a search for new variants that have all the benefits, without the pitfalls.

There are already many new proposals to create stable eMoney that is easy to use, which has minimal cost to create, hold, transact and secure, that can be transacted ‘instantly’; and is issued only for value, and/or equally to everyone.

Keeping eMoney subject to lawful seizure by a functioning state is not a problem. The challenge is in also keeping it secure if the state fails. (A ‘failed state’ includes a state that undertakes arbitrary seizure).

One way to solve many of the problems with the current system would be to convert all money to Central Bank eMoney. These electronic deposits could then go on a ‘decentralized crypto-ledger’ managed by all the Central Banks — enabling ‘instant’ transfer from one account to another (like the new Australian National Payments System). These banks could agree to abide by decisions of the International Court of Justice to collectively lawfully reverse transactions or seize accounts. Otherwise, this system would protect your money from arbitrary seizure, or loss due to the failure of any banks or State. Commercial banks could continue to operate as ‘agents’ for each Central Bank — making loans of ‘newly created money’ on its behalf (remembering that, as per this Bank of England paper, all bank lending already comes from new money created ‘out of thin air’ — NOT from lending deposits). The loan repayments would not go to the bank making the loan, as now, they would be written back into the thin air from which they came. As the commercial banks would be earning income from making and managing the loans, they should remain liable for any losses due to failure of a borrower to repay their loan. This would remove ‘moral hazard’ from the system, as any bank failure would only impact the bank’s, employees, officers and shareholders. Importantly, it would enable new money to continue to be created based on the individual decisions of borrowers and banks about the likelihood of the loan being repaid. This keeps the ‘new money creation process’ in the hands of the people best able to judge if the use to which it is to be put will result in added value to them… and the community (subject to a robust legal framework designed to protect common interests). This system would also enable Central Banks to better counter ‘demand bubbles’ (when herd mentality sends markets to extremes). Especially aided by AI algorithms it would be possible to better target the ‘overheating’ sectors by simply requiring all lenders (not just banks) to add an extra interest charge for, say, loans to buy existing houses in a specific city. This would make it more expensive to buy an existing home vs building a new home — which is what you want if prices are rising due to a lack of supply. This charge would be paid direct to the Central Bank to be written off. Its sole purpose would be to make existing houses more expensive relative to new homes by increasing the cost of borrowing for them.

This system would also allow new Central Bank eMoney to be created and allocated to every citizen equally, without the need to repay it. This ‘Universal Basic Income’ could be another way in which we ensure everyone (especially those who cannot contribute to the production process) get to share in our collective output. A growing concern, as more and more of the supply chain is automated. That of course, is a whole other topic which is discussed here!

When one or more of the new (or yet to be created) tokens succeeds in meeting most (if not all) of the ideals of ‘money’ (as one will), Bitcoin will be worthless. Until then, ‘Ponzi’ will keep the market for Bitcoin going as whales pump and dump it on unsuspecting neophytes.