Hello Puru Saxena,
a friend of mine just wrote me, that you have some theoretical and economic questions about Bitcoin. So, I try to answer you these questions. This article is going to start from the ground, because I don’t know your expertise. So, let’s start.
First of all: Behind the idea of Bitcoin is the Austrian School of Economics or also called Praxeology. This science is using a different method than today’s mainstream economics (i.e. Keynesianism or MMT…). Today’s economists try to explain the world and human behavior with empiric studies. Though Austrians say, that empiricism is the wrong method, because humans don’t behave like stones or planets, because we act, learn and can make decisions. They are using logical-deductive reasoning to explain the world. Doing this, they can’t predict any human action, but the logic behind it. It’s like grammar. We can’t predict what someone is going to say, but we know that he will use verbs, nouns,…
Logical statements are i.e.:
- Human act.
- Action needs time.
- Humans need goods/means to reach their ends.
- A price is an exchange ratio.
- A free trade benefits both sides.
If you are not familiar with Austrian Economics, I highly recommend visiting the Mises Institute mises.org. They have a lot of free literature from Ludwig von Mises, Hayek, Rothbard, Hoppe, Menger, Böhm-Bawerk,…
If we are talking about Bitcoin I highly recommend “The Bitcoin Standard” by Saifedean Ammous. He explains the history – and a possible future – of money from an Austrian perspective.
Let’s start with your questions. I changed the order, so it’s easier for me to explain them.
1.How is Bitcoin a medium of exchange?
Every good can be a medium of exchange, if we are choosing to use it. We can use apples, nails, coins, gold or Bitcoin. People are buying and selling it, so Bitcoin is already a medium of exchange. And a price is just an exchange ratio. I guess you are asking if Bitcoin can be a commonly accepted medium of exchange like today’s currencies. Ludwig von Mises explains in his ‘money regression theorem’ how money arises. He says that once people start trading goods there is a tendency that people are all using one common medium of exchange and this is going to be the denomination for every economic transaction and calculation. Money allows us to do indirect exchanges and easy calculations. There is no need for a central bank that money exists. Therefor gold was used around the world. To be the commonly accepted medium of exchange a good needs to have some unique characteristics. Because we are using money for savings and indirect exchanges it should keep it’s purchasing power. Therefor scarcity is a crucial factor for money, so nobody can print or produce it. Other characteristics for money are: fungible, durable, divisible, portable, uniform. The negative effects of an increasing money supply can be described by the Cantillon-effect. Inflation leads to inequalities and erases our savings. There is going to be a point when people don’t trust their currency anymore and start to save another good. That’s the idea of Bitcoin: We, the people, need a store of value to resist todays central banks policies. And to create a digital, scarce, borderless and transnational money we use encryption and the blockchain.
2. How is Bitcoin a ‘store of value’ when it moves up and down 15-20% in a day?
3. How is Bitcoin a ‘store of value’ when it crashes 80-85% in a year and then rallies 100s of % within months?
4. How is Bitcoin a safe haven/hedge when it is tied to global liquidity i.e. it goes up and down with other risk assets?
As I explained, a good needs to be scarce to be a good store of value. The best money we had so far was gold, but the governments and the central banks got off the gold standard (in 1971) to finance themselves and their agendas. Since than we are living in a fiat ponzi system where the money supply and the debt increases exponentially and the people get rubbed their time and savings. The goal of Bitcoin is clear: it’s like the invention of the zero in mathematics. We need a sound foundation for every economic calculation to allocate resources wisely. Nobody should ever have the power to manipulate our money, our time preference and our savings.
This is the fact why Bitcoin and the surrounding businesses are growing and prospering. People and companies all over the world need a save haven in times of inflation and manipulated interest rates. The central banks only can print money, to stop the worldwide economy from collapsing. Today’s money is credit and not a property.
There are two reasons why the price is volatile. First, the code of Bitcoin decreases the new Bitcoin supply every four years. This is known as Bitcoin halvings. The stock-to-flow-ratio gets reduces by a factor of two. This creates hype-cycles if the demand for Bitcoin stays the same, as you have seen in 2017. (Here you can see the s2f model).
Second, we are in a phase of monetization and in times where the worldwide monetary system is fragile. This leads to volatility in every asset classes (stocks, gold, bonds,…).
Bitcoiners are long-term thinking. That means we don’t care about short-term volatility at all, because we know the fundamentals and the theory of money. As more and more people understand the long-term value proposition and invest in Bitcoin we will come to a point where people start to sell their Bitcoins to get goods and services. Right now, this is not a good strategy, because we rather spend our fiat money, because it’s losing purchasing power. If the monetization phase is over, it will be like every other currency. Everybody calculates with the purchasing power on a daily basis. Some people rather spend for something better and some keep their savings.
5. With this level of volatility, how can Bitcoin be a means of payment i.e. how can merchants accept this as a payment? If Bitcoin swings wildly during a long duration transaction (i.e. purchase of property/business etc.), won’t merchants go broke or make out like bandits (depending on which way the wind has blown)?
As I already said, we are in a phase of monetization, but more and more businesses allow payments in Bitcoin. But as long the fiat system is not collapsed, people probably rather spend their fiat and more and more long-term savings go into Bitcoin. The founder of Bitcoin Satoshi Nakamoto once said, that this is going to be a self-fulfilling prophecy while todays monetary system is on a downwards spiral and Bitcoin on an upwards spiral. Or in other words: trust in fiat money decreases, while trust in Bitcoin increases (you also can see that in our political systems; we see a lot of structural conflicts between decentralized networks and centralized hierarchies (i.e. internet vs. mainstream media, renewable energy vs big oil…).
6. How is Bitcoin a unit of account when people all over the world earn in fiat (not in Bitcoin) and governments collect taxes in fiat (not in Bitcoin)?
These questions are all very similar. The point is, that every person on earth needs to think about inflation because of the negative consequences. So, every person is searching for solutions to save for the future.
Bitcoin is your unit of account as soon as you choose Bitcoin as your unit of account. It’s your decision. And if you do so – 1 BTC is 1/21 Mio. BTC. And you are gonna see, that the Bitcoin price isn’t volatile at all, because 1 BTC is still 1/21 Mio. BTC. That’s not the case with 1 Dollar, because the dollar supply gets inflated. If you go deeper into this you will notice that all fiat-currencies are going to zero.
(Of course, you can choose every good as your unit of account, but Bitcoin is the scarcest asset we have.)
As you get more and more into Austrian Economics and into the theory of money, you will notice, that the libertarians are the only economists left with a logic-deductive foundation. Saying that, Bitcoin is also a Trojan horse to set us free from taxation and national states. It’s a technology to implement a free market society, because if money is encrypted and decentralized. How is the state gonna tax us? They can’t. This is why Bitcoiners are also cheering for free private cities or how we call it: ‘citadels’.
7. How can Bitcoin be a widely used means of payment when it can’t process many transactions per second unlike Mastercard, Paypal and Visa which are able to process thousands of transactions per second?
That’s a good question. One of the challenges for Satoshi Nakamoto was to find the optimal rate between decentralization, security and block sizes (one block ~every ten minutes; one block has a maximum of transactions). If you would increase the possible transactions this would lead to a bigger block size and all the decentral nodes would need more data storage. So, this would be an economic centralizing force and bad for the long-term security.
Since the start of the Bitcoin network the value proposition for Bitcoin changed. At the start, people were fascinated by the proof of concept. After that people thought that Bitcoin is the next payment system. After that they saw it as a digital gold and today it is seen as a financial asset.
Actually, there are developers who are working on a second layer for Bitcoin transactions. This is called ‘lightning network’ and it can send thousands of transactions within seconds with near zero transaction costs. It is actually in a beta phase.
8. Will governments allow the world to get off fiat money and get on the ‘Bitcoin standard’? If yes, why?
In today’s world the governments need the fiat money and the central banks for their agendas (social welfare…) and to prevent the system from collapsing immediately. But with that tactic they just prolong the path dependencies, because inflation rises, inequality rises, resources can’t get allocated wisely because no sound economic calculation is possible, …
Will governments allow a disruption of the fiat money system? No. Can they prevent the system from collapsing in the long-term? No. Can they prohibit a decentralized, encrypted monetary network running on the internet? Not really.
Maybe you heard of “Fix the money, fix the world” or “Bitcoin fixes this.” or “Just a few understand this.” Bitcoin is really our hope and our change to create a world without wars (because no one wants to finance them) and with a monetary network which sets the incentives to cooperation instead of regulation and taxation. A lot of us are kind of religious about Bitcoin, because we see the divine path of cooperation. (It might be similar to Buddhist’s path of enlightenment or Christian’s commands by Moses.)
9. If Bitcoin replaces fiat and it’s supply is fixed (can’t be increased) – during future recessions and economic crises, how will the central/banks/governments provide stimulus?
As more you read into Austrian Economics you will understand, that central banks and government interventions are the reason for economic crises and inequalities. There is no need for a stimulus. Stimuli are the reason for our path dependencies. Only the free market can allocate resources wisely. We need price signals which aren’t manipulated by the government, to produce efficient and to create wealth for the masses.
10. During the Great Depression, ~5000 banks went bust, Dow tanked 90% and millions of people lost everything – primarily due the fact that back then, the government/Fed just stood by and did nothing to support the banking system/economy. With so much leverage in the system today, without stimulus which can’t occur on a Bitcoin standard, there will be a global deflationary depression, no?
Yes, we know for sure that there will be a big global recession and depression, because nobody can pay all the debt. Saying that, I mean that our wealth is just an illusion. There is just not enough capital to service all the debt and money claims. We think that we are rich if we are calculating in fiat money, but this illusion is going to burst. The incentives are set and whoever leaves the system first, can buy assets relatively cheap. This is what we call crack-up-boom at the end of our monetary system because of hyperinflation. This is also the main reason why asset prices go up since years.
11. If the world gets onto a Bitcoin standard and its supply can’t be increased, how will banks create credit and how will households/companies take loans?
The same way as people used to lend money back in history. You give Bitcoin to the person who needs it for his specific use case including your conditions. Of course, there is going to be a chance that he cannot repay it and you will never see your Bitcoin again. That’s the risk of the lender. If he is paying you back, you will get an interest for your risk and time. Getting interests without risk is an illusion and never possible. In a sound money system, there will not as much leverage as in today’s fiat money system, because people are going to be more risk averse.
12. If a currency doesn’t have some intrinsic value relative to real-world assets/liabilities or the full backing of the government, even if you can send it around the world within minutes, its value will swing wildly based on others’ willingness to take it off your hands – it won’t be a store of value. How will Bitcoin get around this issue?
Okay, let me repeat some Austrian Economics fundamentals here. A price is just the last observed exchange ratio. If people change their needs and desires than the prices change. Always has been and always will be like that. If you are measuring fiat money from a sound money perspective the price fell a lot in the recent years. It’s wrong to assume that the dollar or the euro have a constant price. They are in a free fall. Choose your reference wisely (Bitcoin is built to be our reference).
Intrinsic value. There is no intrinsic value. Not in gold, not in real estate, not in Bitcoin. Value is just in your mind. If you are in a bakery and there are two cakes. Let’s say chocolate and banana. Which do you value more? If you decide to buy chocolate cake, then you are valuing the chocolate cake more than the banana cake. Other persons might value the banana cake more. Never confuse price and value. Value is a subjective measurement.
13. Bitcoin is a zero-sum game i.e. it doesn’t produce anything. At any point in time, the sum of all cash put in by the losers is equal to the sum of all cash taken out bx the winners (excluding mining costs) So, if Bitcoin doesn’t produce anything and it doesn’t have any intrinsic value (only whatever value others assign to it based on the prevailing sentiment), are you suggesting that if everybody on the planet concerts all their cash to Bitcoin, each participant will become super wealthy? After all, if Bitcoin is a store of value with 30-35% potential (some calling it to climb to $1 million!), why shouldn’t everybody just sell every other asset and just hoard Bitcoin?
I already said, that there is no such thing as intrinsic value.
Let’s consider the characteristics of a trade. Every trade is a zero-sum game if you just measure the goods. If you trade one banana for one chocolate bar with your friend, then the goods don’t change. What did change? Your and your friend’s valuation changed. You both wouldn’t have done the trade if you both wouldn’t value the other good more than your own good. A free trade always benefits both sides, because otherwise we wouldn’t do it (that’s one of the logical conclusions in Austrian economics).
“are you suggesting that if everybody on the planet concerts all their cash to Bitcoin, each participant will become super wealthy?”
Of course not everyone. Just the ones who guess right that there will be a future demand and are buying early. It’s like the gold rush in the 19th century.
“After all, if Bitcoin is a store of value with 30-35% potential (some calling it to climb to $1 million!), why shouldn’t everybody just sell every other asset and just hoard Bitcoin?”
There are a lot of Bitcoiners who invest a high percentage of their portfolio into Bitcoin. They do that, because they bet on a high future demand, because interest rates are zero, inflation rises, central banks are printing, Bitcoin’s idea is based on an economic theory… So yes, there might be good reasons to think that Bitcoin is the fastest horse and outperforming every other asset class.
$1 million dollar seems a little bit low, if you ask me, because if fiat goes to zero, then sound money goes to the moon. If the fiat money system collapses, then we don’t measure prices in fiat anymore, because a price is just an exchange ratio.
I hope that I could solve some confusion. Feel free to contact me. And as I said, I highly recommend you Austrian Economics and “The Bitcoin Standard” by Saifedean Ammous.