Bankers are crying in the corner, economists are throwing out textbooks and the government is lost. The bitcoin revolution has arrived. Ushering in a new age, the people’s currency is now the only form of money - let the madness begin.
Comparison of Bitcoin & Fiat
You may be forgiven for thinking there’s not much difference between bitcoin and regular money; and in some ways you would be correct. On a daily basis it’s business as usual. Making transactions online, paying by debit card at the shops - the practical differences are not significant. However, the fundamental differences are huge.
Every current transaction involves a trusted third party, or what we call a bank. Suppose it’s late at night and you’re making a regrettable online purchase. You need to exchange your British pounds with a seller in return for their good. Your pounds are not actually with you - they are managed, controlled and accessed via the bank. The bank is trusted to safeguard your money. Assurances are then made to the seller that you have the required funds - the bank is trusted to verify ownership of money. Finally, the payment is executed with the bank trusted to validate the transfer of money. In every cashless transaction between two parties the bank is always the necessary third wheel.
With bitcoin there is no bank (hence bankers are crying in the corner). Or rather, we all become the bank. When dealing with traditional fiat money, such as pounds or dollars, the bank is the central authority that keeps a record of all transactions and how much everyone owns. They write this down in a big book called a ledger. This ledger can only be seen by the bank, so all trust is with them. In bitcoin the ledger is seen by everyone. The seller doesn’t need to trust that you have enough money or that you sent some their way - they can simply look it up in the big book because all transactions are visible and verified. Nobody can secretly add to their balance because they must first prove the additional money was transacted to them. With a small investment of computing power anyone can run a node, and it's these nodes that come together to verify transactions and maintain the ledger. The fiat system is discreet with authority and trust centred at the bank; in comparison the bitcoin method is open and transparent - power is decentralised and issues of governance are reached through joint consensus.
How many pounds are currently in existence? The correct answer today won't be the right answer tomorrow, because the amount of money in a fiat system is constantly changing. Whenever a loan is granted, money is created out of thin air and central banks frequently print more money for purposes such as quantitative easing. The answer for bitcoin is rather simple - 21 million. That's the maximum number of bitcoins that will ever be created. Most of the early coins have already come into existence through a process called “mining” and the remaining coins are created at an exponentially decreasing rate as we approach the 21 million mark. This difference leads us to our final point of comparison between fiat money and cryptocurrency.
In the current world of fiat currency, inflation is what we are all familiar with. Intentional expansion of the money supply nudges prices upward at an average rate of 2% each year. The value of the pound gradually declines in relation to what it's able to purchase (does anybody else remember when 99p flakes actually cost that amount?). In contrast, the limited supply of bitcoin creates conditions for deflation. Economic growth and rising popularity for the currency create additional demand, which is accommodated by bitcoins becoming more valuable. Prices continually decline against the cryptocurrency's rising value; textbook deflation. We’ll examine the profound effect of both on consumer behaviour, the viability of a currency and the ability to exert influence by setting nominal interest rates.
Advantages of the Bitcoin Economy
Freedom & decentralised trust. The beauty of a cash transaction is its simplicity - physical coins are handed over in return for a good. There are no bouncing cheques, pending payments or credit card fees. Cash upholds the simple right of people to transact, without the need for a bank and away from the government's prying eyes. Discard cash and you throw away control - your money sits in the bank and buying a house or a hot dog is equally impossible without their permission. In this cashless world the banks simply cannot fail. Except they did. The fall of Lehman Brothers and the 2007-08 financial crisis showed us the dangers of relying heavily on banks; they are a single point of failure that can take everything down with them. The only way to reduce our over reliance on banks is to use cash, but that means sacrificing modern conveniences we have come to enjoy; we need the benefit of cash without its physical burden and the benefit of going cashless without relying on banks. Enter Satoshi Nakamoto’s revolutionary white paper, “Bitcoin: A Peer-to-Peer Electronic Cash System”. Bitcoin retains the advantages of cash - money is transferred between two parties, potentially anonymously, without an intermediary. There is no single point of failure, no reliance on a bank and no need for trust. Enjoy your freedom responsibly.
Resistance to counterfeit. One in every 40 of the old pound coins are fake and it’s led to the Royal Mint issuing a new ‘cutting-edge’ coin this year that’s much harder to replicate. Criminals printing counterfeit money is clearly not ideal, but the full consequences are not always apparent. The uncontrolled and illegal printing of currency wreaks havoc with inflation - war-time Germany and more recently Pakistan have both attempted this to destabilise rival economies. In fact, India took the drastic measure of de-monetising its Rs500 & Rs1000 notes last November and cited counterfeit currency as a major reason for the policy. Bitcoin changes all of this. In the new age of cryptocurrency, creating counterfeit money has never been so easy! Simply write into your ledger any extra money you feel you deserve. All done? Well, not quite. To be of any use the bitcoins must be spent, and everyone else has a copy of the ledger. A simple comparison will swiftly lead to a rejection of any transactions involving counterfeit bitcoins. Criminals are free to produce all the fake money they want; they’re only fooling themselves.
Deflation as a consequence of bitcoin. Defined as a general fall in prices, the Austrian School of Economics believe deflation is no bad thing. Improvements in technology and productivity occur over time; goods are produced more efficiently so that prices decline and living standards rise. Let’s contrast this to inflation. Every year the same goods cost more than before. Without an annual pay rise your wages erode and purchasing power dilute leaving you less well off - the effect extends to savings in the bank and fixed incomes like pensions. In this current world of inflation there’s a simple rule for money; if it doesn't move it will lose, and the effect is not always so slow and gentle. The economy of Venezuela is rapidly being crushed by hyperinflation caused by the government printing money to cover losses from falling oil export revenue. Prices have spiraled out of control as the currency becomes worthless. Life long savings have atrophied to nothing. In the new world of bitcoin this simply isn’t possible - no government, bank or entity can increase the supply of money. It’s goodbye to traditional economic thought and never ending inflation; economists seeking new textbooks please contact your Austrian colleagues - there might be something new to learn.
Low fees and fast transactions. Bitcoin has never been done before; nobody knows how it will evolve or what it can achieve as the technology continues to push boundaries. Today, the average bitcoin transaction has a fee of 60 pence and takes between 0-25 mins. That’s a dream for international transfers, but a nightmare for buying a coffee. Other cryptocurrencies such as Litecoin, Ethereum and Monero are already showing the way forward with speedy transactions, and bitcoin isn’t so far behind; the addition of the Lightning Network will maintain security whilst providing near instant transactions and micro fees. Scaling issues and technology improvements will battle each other to determine the final price and speed of bitcoin transactions. For now, the signs are good and the potential is there. Just as Visa, Mastercard & PayPal made a dinosaur of the cheque book, bitcoin might just reveal the inner T-rex of our current transaction system.
Pitfalls of the Bitcoin Economy
Deflation. It’s time to hear the other side of the story. As the population grows and demand for bitcoin increases, the fixed cap of 21 million effectively reduces the money supply - there are less bitcoins to go around. A real world example of deflation shows how it can cripple an economy. Japan suffered this fate at the turn of the new millennium; unemployment, reduced consumer spending and increasingly expensive exports stunted growth over a period of time labelled ‘the lost decade’. The loss of export revenue, together with reduced consumer spending, was a perfect storm for negative economic growth. The prevailing mantra for bitcoin investors is to ‘HODL’ - a tongue-in-cheek misspelling of ‘hold’ that has come to mean ‘hold on for dear life’. The price of bitcoin may fluctuate in the short term, but the deflationary pressure will mean it always rises in the long term, so hold onto your bitcoins and never spend them! The problem is when bitcoin is the only currency and the whole world behaves this way; there’s less money to go around, less employment and less growth. Perhaps we shouldn’t be so hasty to ignore the economists.
Lack of monetary policy tools. Now that we’re listening to the economists, they have a few more words for us. Central banks use interest rates and the money supply to promote steady growth and mitigate economic downturns. Deflation in Japan made this impossible. It removed the ability to set minimal interest rates. The result was stunted investment - salt in the wounds of an already shrinking economy. One hand tied behind its back, the central bank still has one trick up its sleeve - quantitative easing. By pumping money into the economy they can induce inflation, reducing real interest rates and boosting investment. Arguments over the effectiveness of these tools are valid, but in a world on bitcoin we would be without them completely, at the mercy of economic turbulence.
Borrowing mechanisms. Banks lend money by creating it from thin air - good or bad, this results in lots of capital available to borrow. It promotes government spending and investment into the economy. In the bitcoin only world things work a little differently. Since more bitcoins can’t be created, all borrowing must come from saving deposits; borrowers must now fight over a vastly smaller pool of funds. Investment will reduce at least tenfold. Interest rates, representing the cost of borrowing, will rise exorbitantly - slamming the brakes on the economy. The central bank would love to help but someone took away all their tools.
One currency to rule them all. Bringing diverse economies together under a single currency, such as the euro, can create problems. 2008 was a bad year for Finland - the financial crisis hit, demand for their paper exports fell and the new iPhone banished Nokia to the realm of fond memories. Sweden similarly suffered from the global recession. The similarities? Both economies grew nearly identically from 1989 to 2008, after which both suffered a shock. The difference? Sweden was able to devalue its own currency, ensuring Ikea furniture and meatballs remained irresistibly good value. Finland, bound by the Euro, had no such option available to them. The two economies diverged 20% in growth with Finland falling behind in the world. Such are the potential perils of a bitcoin only world. A quick note on wealth distribution; currently the poorest 70% own 3% of the world’s wealth, but only 1% of the world’s bitcoin. One must wonder - with most poor countries still largely offline, will there be any left for those late to the party?
Corruption and crime. Contrary to popular belief, bitcoin is not inherently anonymous. However, if you try hard enough, or use coins like Monero, you can probably keep your money and transactions out of sight. The thought of anonymity is certainly welcome in these times of prying eyes and government surveillance. Unfortunately, rebels at heart might not be so welcoming of the consequences; tax evasion, money laundering, corruption and funding of criminal organisations. The government would be lost - powerless to collect taxes, unable to seize illegal funds and helpless to enforce law. Society would degrade as weapons and drugs are freely traded on the black market. The age of cryptocurrency would become the age of anarchy.
Consensus and governance. There are three stakeholders in bitcoin - users, developers and miners (those who expend computing resources to keep bitcoin running). Miners are incentivised by the transaction fees they receive. Users are incentivised to seek the lowest transactions fees possible. Developers… well, nobody knows exactly what motivates these strange creatures. The advancement of bitcoin relies on these three parties reaching joint consensus on all issues. The problem is this doesn’t always happen. The debate over scaling raged on for nearly two years; there was mud-slinging, sabotage and fighting. Only recently has the community found some sort of compromise. The advancement of bitcoin is linked to our ability to all get along - isn’t that a scary thought?
Conclusion
Nothing I’ve written above really matters, which is great news for everyone who skipped straight to this section (you know who you are!). No committee can decide that bitcoin will be the new world currency. There will be no debating of pros and cons in parliament, there will be no inquiry, there will be no jury and no judge will pass a verdict. It’s the people who decide. And quite frankly, as they go about their lives using bitcoin, they really don’t care about the effectiveness of monetary policy, or what economists have to say about deflation. Adoption of the currency depends solely on the immediate advantages it gives people.
Bitcoin arrived in 2009. The surrounding ecosystem and infrastructure did not. There needs to be a new way of thinking, new economic thought and new systems of governance to foster a world where the cryptocurrency can flourish. But with or without, people are increasingly choosing a world on bitcoin. We best be ready for it, because in many ways, the age of cryptocurrency is already here. It won’t wait for us.