Given that Bitcoin recently passed the 10 year anniversary of its first commercial use (2 pizzas were purchased with Bitcoin in May of 2010), it’s long overdue for the Unrepentant Capitalist to opine on cryptocurrencies and Bitcoin.
Bitcoin is the first of what, in recent years, has become a crowded field of cryptocurrencies. Cryptocurrencies like Bitcoin are virtual currencies. Virtual means that Bitcoin only exists electronically on computers and other electronic devices. Bitcoin is designed to live and trade outside of centralized institutions like commercial banks or government central banks. The crypto part of cryptocurrency means the currency is protected from hackers and counterfeiting by cryptology.
Central to understanding Bitcoin is the Bitcoin Blockchain. The Bitcoin Blockchain is an electronic ledger similar in function to an old school physical ledger that records transactions and shows who has what. The Blockchain is an electronic record showing a cumulative record of all Bitcoin transactions ever made.
A crucial aspect of the Blockchain is its decentralized nature. As opposed to an old school ledger whose accuracy is maintained by a bank or other central entity, the Bitcoin Blockchain employs a radical idea to maintain the ledger’s sanctity. Everyone in the Bitcoin Blockchain network has a copy of the ledger and validates and confirms Bitcoin transactions in an operation called mining. As an individual Bitcoin transaction occurs, both parties use their public and private codes (or keys) to identify themselves and approve that transaction. In a very simplified example, Ann sells a 1965 VW Quarter Cab to Bob for 3 Bitcoin. Ann and Bob approve the transaction using their keys, and the Bitcoin Blockchain network confirms the Ann-Bob transaction along with other transactions that have occurred around the same time as the Ann-Bob transaction.
Multiple transactions combine to form a block and the Bitcoin network (miners) earn Bitcoin as payment for confirming a block of transactions. In that confirmation process, the Bitcoin miners race to solve a mathematical problem that results in the creation of a cryptology protected identifier for the block called a hash. The hash prevents forgeries or alterations to the block and its transaction data. As blocks are logically linked together with each block referring to the hash of the prior block in the chain; altering a block changes that block’s hash and all prior blocks’ hashes too.
Excellent Blockchain 101 video at: https://youtu.be/_160oMzblY8
Governed by rules that are beyond the scope of this blog post, only one miner earns the Bitcoin reward (called a ‘block reward’) associated with confirming a block and creating its hash. Mining is the mechanism by which new Bitcoin is minted and added to the Bitcoin monetary base.
With the basic description of Bitcoin in place, the logical follow-up question becomes ‘is Bitcoin money?’
According to traditional definitions, for something to be considered money, several criteria must be met. Namely, money is a medium of exchange, is a store of value, is scarce, is portable, is divisible, and is fungible.
The ‘is it money’ chart below shows how Bitcoin, Gold, and the US Dollar measure up against these criteria.
Bitcoin scores high in the scarce, portable, divisible, and fungible dimensions, but isn’t practical for many transactions, and hasn’t performed well as a store of value as its market price vis-à-vis the US Dollar has historically swung wildly. In 2020, Bitcoin’s price has ranged from $4,800/Bitcoin to $18,700/Bitcoin—hardly a stable store of value. Maybe more importantly, Bitcoin failed a critical test as a hedge against general world chaos earlier in 2020 when the onset of the COVID-19 crisis tanked the US stock market, Bitcoin tanked too falling by more than 50% vs the US Dollar. As the Bitcoin user community becomes deeper and more confident, the currency may hold up better in future crises. Time will tell.
While Bitcoin comes up short with respect to some of the ‘is it money’ criteria, it should be noted that Gold and the US Dollar have some shortcomings against these criteria too.
The US Dollar is one of the world’s most widely accepted currencies (the dollar even serves as the currency of some countries) and is a reasonable short term store of value. Longer term, the US Dollar is not a good place to park wealth as a dollar locked away in a safe in 1920 would have current day buying power of about 7 cents. Ouch!
The US Dollar’s decline in value/purchasing power is due to the cumulative effect of years of inflation. The US Dollar was historically backed by gold which capped the amount of dollars that could be created. The US went off the gold standard in two phases. In 1933, US citizens could no longer exchange paper for gold (FDR’s Depression Era version of Quantitative Easing), and in 1971, foreign central banks could no longer exchange their dollars for gold. Completely unhinged from gold, the US Dollar became a ‘fiat’ currency backed by nothing other than the US Federal Reserve’s good judgment to not print too many of them. According to the Monetarist’s school of money and inflation, as long as the rate of growth of the money supply doesn’t get ahead of the general rate of economic growth (usually gauged by GDP) inflation won’t be a problem. If the central bank’s rate of money growth gets ahead of that country’s economic growth for too long, that currency will experience a loss in buying power as there will be too much money chasing a fixed supply of goods and services leading to inflation. If central bank printing gets out-of-control, the result can be hyperinflation like 1920’s Germany or Zimbabwe in more recent times.
The rate of money creation impacts the store of value aspect of that currency as well as its scarceness. Despite some bouts of inflation in the US (see the 1970’s and early 1980’s) the Federal Reserve has historically done a decent job of keeping monetary growth (and inflation) under control. Looking at very recent data on monetary growth suggests we may have a problem on the horizon. M2 growth (M2 is a common measure of the US monetary base) year to date in 2020 has been 24%, and the year isn’t over yet. For the 10 years prior to 2020, M2 grew at an annual rate of 6%. We’ll see if this recent spike in money supply growth leads to a spike in inflation.
Gold has been used as money for thousands of years and, no surprise, measures up well against the ‘is it money’ criteria. Its main weakness is that it’s hard to use for everyday transactions. If you think you’ll stop down the line at Starbucks Friday morning paying for coffee with folding money, just imagine shaving off a $2.95 sliver from the gold bar you’re carrying around in your pocket to pay for your Vente Soy Latte.
As mentioned, the US Dollar is a ‘fiat’ currency backed by nothing. There was a time when you could trade your paper currency for gold, but no more. Bitcoin proponents like to point out the US Dollar’s fiat thing, but in fairness, Bitcoin isn’t backed by anything either. I wouldn’t get too worked up about the fiat thing. Money was invented to represent value, but not necessarily to be valuable itself. Valuable is somewhat subjective notion anyway. Even gold is of little intrinsic value when you get right down to the essentials of life. A tired, cold, wet, hungry caveman would value a comfy chair, a warm set of clothes, a roof over his head, and an 8 oz filet mignon with a baked sweet potato much more than a heavy chunk of shiny metal.
Evidently, Bitcoin’s inventor(s) envisioned a long life for the technology as the 21 million coin lifetime mining cap is expected to reached sometime around the year 2140, and the fixed pool of coins would then trade indefinitely beyond that date. So, what’s the future for Bitcoin?
Firstly, the Unrepentant Capitalist is amazed to see how far Bitcoin has come in its 10+ years since launch with no owners or ongoing team to maintain it. Having seen a few software development projects up close, it’s amazing to see something so complex and revolutionary be successfully stood-up and launched with no pressing need for a version 2. Bitcoin has successfully withstood hacks and other threats and continues to motor ahead.
Having said all that, I have a mixed view on Bitcoin long term. I think there are areas where Bitcoin can have a future, but I question the system’s long term staying power.
Unless modifications are made to make Bitcoin better suited to process smaller, more frequent transactions, Bitcoin will be ill-suited as a general medium of exchange. For several years the Bitcoin community has discussed modifications (called the ‘2nd Layer’ or ‘Layer Two’) that would allow Bitcoin to accommodate smaller, higher volume transactions. Time will tell if the Bitcoin community comes together to develop a solution that can economically handle lots users paying for their morning coffee at the same time.
In its current incarnation, I think Bitcoin is better suited to serve as a store of value. In this mode, Bitcoin is a sort of Swiss bank account where user’s deposits and withdrawals tend to be large and infrequent.
I also think Bitcoin has a future for citizens of countries with governments and central banks that have a checkered financial history. People in countries like Venezuela, Brazil, and Argentina have historically had their wealth robbed from the inflation/currency devaluation resulting from their government’s poor policy decisions. Bitcoin gives them an attractive alternative to store their wealth.
Bitcoin can also serve the billions of people around the world that don’t have and can’t get bank accounts, a.k.a. the unbanked. Since Bitcoin lives on the Blockchain outside of the banking industry, the unbanked don’t need banks to hold their modest wealth.
The Unrepentant Capitalist’s skepticism of Bitcoin’s longer term staying power is based on relentless innovation and technology churn that changes everything all the time. The Bitcoin network is said to be un-hackable and its encryption technology is unbreakable. Think about how far technology has come in the last 100+ years, but we’re to believe that the Bitcoin technology foundations will endure? Look at Herman Hollerith’s tabulating machine compared to modern computers, the Wright Brother’s 1903 Flyer vs. the Boeing 787, or Henry Ford’s Model T vs. the self-driving Tesla. We recently celebrated the 50 year anniversary of man walking on the moon. Technology moves fast, and the pace of change will only accelerate in the future. It seems highly unlikely that Bitcoin will be unaffected.
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Some Bitcoin fun facts:
· No one really knows who invented Bitcoin. The original Bitcoin whitepaper was authored by someone using the name Satoshi Nakamoto, but no one with that name has publicly stepped forward to claim credit. Given Bitcoin’s sophistication, it was likely developed by a team of people.
· The first documented Bitcoin purchase occurred on May 22, 2010, when two Papa John's pizzas were purchased for 10,000 Bitcoin. Valued at $41 at that time, the current market price (as of May 2020) would value those two pizzas in excess of $90 million.
· The original block reward was 50 Bitcoin and the reward is cut in half for every 210,000 blocks processed (which has occurred approximately every 4 years). The current block reward is 6.25 Bitcoin.
· Block time confirmation/validation takes ~10 minutes
· At the current block reward rate of 6.25 Bitcoin/block, ~900 Bitcoins are created every 24 hours
· Bitcoin’s current monetary base annual growth rate is ~1.8%
· A typical block contains ~2400 transactions
· The lifetime Bitcoin mining limit of 21 million coins is expected to be met around the year 2140
· A good way to think of Bitcoin public keys and private keys is that a public key is similar to a school locker number, and the private key is similar to the locker’s combination. Others know the student’s locker number, but only the student knows the locker’s combination.
· The Satoshi is the smallest unit of Bitcoin and is equal to one hundred millionth of a Bitcoin. As of September 2020, 1 US Dollar equals 9,110 Satoshis.
Some Dollar fun facts:
· Bitcoin isn’t the only virtual currency. According to a Forbes article from March of 2020, 90% of US Dollars in circulation are entries on a computer, i.e. virtual. Speaking globally, 92% of the world’s currencies exist in virtual form.
· The US Federal Reserve was formed in 1913 and started issuing bank notes in 1914 in denominations of $5, $10, $20, $50, and $100. Starting in 1918, bank notes were also issued in denominations of $500, $1,000, $5,000, and $10,000.
· The US Federal Reserve is technically not a governmental agency, but rather a privately held company owned by its member banks. So, as the Unrepentant Capitalist is a shareholder in Bank of America, and as the Bank of America is a shareholder in the US Federal Reserve, that means the Unrepentant Capitalist owns a sliver of the US Federal Reserve???
Some Gold fun facts:
· As of 2019, the world’s total above-ground (mined) gold stock was ~198,000 metric tons, and is worth ~$12 trillion based on a gold price of $1800/oz.
· Each year, worldwide gold miners add approximately 2,500-3,000 tons to the cumulative above ground gold stock which equates to an annual base growth rate of ~1.4%.
· If the world’s total above ground gold were melted down and combined into a single cube, that cube would measure ~20 meters on each side.
· Executive Order 6102 signed by FDR in April of 1933, compelled US citizens to surrender their gold holdings to the US government at an exchange rate of $20.67/oz. With COVID-19 increasing the attractiveness of gold and other safe havens, gold prices have recently touched $1900/oz.
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