Bitcoin: The Rise and (Inevitable) Fall by Elliot Turner of Compounding My Interests

Bitcoin is receiving much attention these days for its parabolic ascent. The attention seems to stem from people’s concerns with monetary policy and the growing disdain with government intervention and oversight, generally speaking. It is no coincidence that Bitcoin’s surge this year corresponds with the growing public backlash over these large issues. To that end, Bitcoin is a great story, but is it a great idea?


A Bitcoin Economy?

The textbook definition of money holds that it must be a medium of exchange, a unit of account and a store of value. Colloquially when many say “currency” they in fact mean “money,” especially with regard to Bitcoin. We will ignore the argument as to whether Bitcoin is an effective store of value given its volatility and focus purely on the philosophical question of whether Bitcoin makes sense as money. For Bitcoin to truly emerge as “money” there must be an economy with the actual transfer of goods built on top of it. In such an economy, there will be some people who “save” money. This means that some will put off consumption today for the capacity to consume at a future date.

It’s hard to project exactly how much commerce will be done on Bitcoin, or how big the “economy” will be, but we do know that venture capitalists like Fred Wilson are investing in the Bitcoin ecosystem, and Marc Andreessen has expressed interest in following suit. Further, the US government’s arrest of the Silk Road founder and crackdown on the black market drug trade via Bitcoin could help lend great legitimacy to the broader Bitcoin economy. Given the evolution of credibility and interest amongst venture capitalists to grow an economy on Bitcoin, we can presume that Bitcoin’s price today reflects a belief that an economy will in fact be able to develop.

The Monetary Mechanics of Bitcoin

Before we can answer whether Bitcoin can work as “money,” let’s talk about the mechanics behind it (and by mechanics, we will ignore the cryptography and security element and focus purely on the monetary mechanics). Here are the mechanics for how Bitcoins are created:

The reward for solving a block is automatically adjusted so that roughly every four years of operation of the Bitcoin network, half the amount of bitcoins created in the prior 4 years are created. 10,500,000 bitcoins were created in the first 4 (approx.) years from January 2009 to November 2012. Every four years thereafter this amount halves, so it will be 5,250,000 over years 4-8, 2,625,000 over years 8-12, and so on. Thus the total number of bitcoins in existence will never exceed 21,000,000.

With this informatino, we can plot exactly what the money supply of Bitcoins will look like over time:

As such, we know that somewhere around 2040, the entire supply of Bitcoins will have been “created” and that no new incremental supply of will emerge from that point, onward.

The next important feature of Bitcoins that’s important to understand is the “granularity” of the currency. As they are constructed, each Bitcoin can be broken down into denominations of up to 8 decimal places (with 0.00000001 BTC being the smallest denomination). The currency was created this way, so that as Bitcoins increase in value, people are able to make purchases with fractions of the increasingly valuable coinage, rather than needing to use whole things at a time.

Lastly, and related to the idea of granularity is the deflationary bias embedded in Bitcoins, as explained by the Bitcoin community itself:

Because of the law of supply and demand, when fewer bitcoins are available the ones that are left will be in higher demand, and therefore will have a higher value. So, as Bitcoins are lost, the remaining bitcoins will eventually increase in value to compensate. As the value of a bitcoin increases, the number of bitcoins required to purchase an item decreases. This is a deflationary economic model.
So we know that people are trying to build a real economy on Bitcoin and we know mechanically how Bitcoin is designed to work, but how does it work in practice? For the purposes of this analysis, the two features of money that are most important are its role as a medium of exchange and its role as a store of value. As an economy grows, more Bitcoins will be used in exchange for goods and services, while at the same time, some who use Bitcoin will use their currency as a store of value in order to “save” money. In theory, Bitcoin is admittedly designed to increase in value over time (ie the deflationary model of currency) and therefore, “savers” will be rewarded simply by not spending their Bitcoins. This is a problem we’ll discuss shortly, but until then, I digress.
Over the past decade, the US has a fairly low savings rate compared with the rest of the world. Americans save between 11-12% of GDP per year. If we were to apply this savings rate to Bitcoin, already knowing the future path of the Bitcoin money supply, a problem starts to emerge–were 11.5% of Bitcoins saved per year, by 2021, 95.3% of the entire supply of the currency will have been stashed away as savings rendering commerce effectively impossible. A system of credit can be built on top of the Bitcoin economy (and most likely will be built), but while this can push back the date at which savings account for too large a share of the entire economy, it can only delay the inevitable. At some point, Bitcoins saved will start to approach total Bitcoins in circulation, making commerce effectively impossible.
Bitcoin is Good as Gold
This is in fact how the gold standard worked as money for years. While there is a finite amount of gold on planet earth, humans still have yet to mine all gold, and the supply of gold accordingly increases at some kind of modest annualized rate. When the price of gold spikes, miners are incentivized to increase their exploration and production efforts, and as such, spikes in the price of gold tend to come with spikes in production. Hard-money types tend to hate the growth of the money supply, though they like gold because the supply growth is not controlled by a centralized pseudo-government actor. Because no government controls supply growth, hard-money types are able to ignore the fact that gold’s supply growth tends to be lumpy (ie how the California Gold Rush led to a rapidly increasing money supply and its subsequent end led to stagnation) in focusing on how it is largely immune to inflations.
Bitcoin and gold are similar right now in how “mining” (alongside savings) is incentivized by a rising price. The increase of supply and rising price encourage those who have “saved” to spend by offering a price that is too good to

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