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.
Here’s how the Bitcoin community explains this problem:
Worries about Bitcoin being destroyed by deflation are not entirely unfounded. Unlike most currencies, which experience inflation as their founding institutions create more and more units, Bitcoin will likely experience gradual deflation with the passage of time. Bitcoin is unique in that only a small amount of units will ever be produced (twenty-one million to be exact), this number has been known since the project's inception, and the units are created at a predictable rate.In fact, infinite divisibility should allow Bitcoins to function in cases of extreme wallet loss. Even if, in the far future, so many people have lost their wallets that only a single Bitcoin, or a fraction of one, remains, Bitcoin should continue to function just fine. No one can claim to be sure what is going to happen, but deflation may prove to present a smaller threat than many expect.Also, Bitcoin users are faced with a danger that doesn't threaten users of any other currency: if a Bitcoin user loses his wallet, his money is gone forever, unless he finds it again. And not just to him; it's gone completely out of circulation, rendered utterly inaccessible to anyone. As people will lose their wallets, the total number of Bitcoins will slowly decrease.