Bitcoin has undoubtedly taken the world by storm, with a parabolic gain of approximately 478% from mid-September 2017 to mid-December 2017, highlighting a period of heavy euphoria. People have followed the blockchain hype and stories of Bitcoin-made millionaires, yet this is contrasted by cries of it being the largest speculative bubble in history. Since then, it has fallen approximately 64% from its peak. This brings about the question – are the days of Bitcoin over?
It seems that the premise on which Bitcoin was propagated was inherently flawed from the very beginning. It stems from a fundamental misunderstanding of how the money system operates in modern times, brought about by the fear of government intervention and credit. Supporters of Bitcoin view it as a form of global digital currency or a form of digital gold, anchored by the scarcity of tokens, resulting in the irrational group who buy and ‘hodl’ forever.
If one views Bitcoin through the lens of modern monetary theory, where the economy is viewed as a set of interlocking balance sheets, with all banking essentially being a swap of IOUs, comprising of a hierarchy (Figure 2) and the dynamic swings between the scarcity of ultimate money and the elasticity of derivative credit in the monetary system, one would realise that credit and intermediaries are necessary characteristics of the monetary system. It is a representation of the lessons learnt from the past few centuries. Thus, the premise on which Bitcoin is based, one that is a form of digital gold that represents freedom from central banks’ credit, is simply incompatible with present-day capitalism. This is compounded by the unsustainability of Bitcoin in the energy sphere, low liquidity and high volatility, and risk of government regulation which goes against the Bitcoin fantasy of independence and freedom.
Modern Monetary Theory
The Bitcoin narrative is definitely enticing – a form of money free from sovereign states, one which is not subjected to government control and manipulative actions such as quantitative easing. A realm of freedom where there is decentralisation and independence, where power is transferred from the state-banking elites to the common man. This narrative is anchored by the scarcity of tokens and the view that Bitcoin is digital gold while fiat currency is just paper, subject to inflationary troubles and over-issuing by central banks.
Supporters of Bitcoin tackle the fact that sovereign currency issuers have no inherent financial limit as there are no unfunded liabilities for the US federal government and it is able to fund them by authorising spending as they come due. Yet one has to note that the discipline factor of the current monetary system, while previously was the peg to gold, is now the risk of inflation. To prevent inflation, the government has to drain the currency which it has issued via taxes (Figure 3).
The Flawed Argument of Scarcity
The scarcity of the tokens supposedly underpins the value of these tokens. Interestingly, the system is becoming increasingly credit based on futures contracts and the promise to pay bitcoin. Discipline in the current monetary system comes from the credit limit and terms imposed by the bank on each borrower, with the need to settle imbalances in money eventually. The elasticity comes from the willingness of the bank to swap its own IOU for IOUs farther down the hierarchy, resulting in the expansion of the bank balance sheets during the day, where corresponding balances may be debited or credited. These get settled at the end of the day, mostly via offsetting credit balances. Bitcoin fanatics will soon realise that credit is a necessary feature of the monetary system, and the increasing shift towards such credit based transactions further enforces this.
In order to understand why the argument of the scarcity of Bitcoin and its function as digital gold is flawed, it is crucial to look back at how the gold standard failed. The main reason why people favour the gold standard is due to its payment discipline. Gold was the ultimate money and all payments were ultimately the promise to pay gold. However, it turned out that gold was far too rigid for the dynamism of capitalism. The rigidity of gold meant that a nation would be unable to bring idle resources into productivity. Resources are left idle when they are needed because money is pegged to gold. This is the whole point of sovereign currency issuers being able to create money via their own spending, with discipline still in place via taxes which help to regulate spending. Gold supplies grew slower than the economy, which led to the contraction of the money supply relative to the total number of transactions. The resulting fall in liquidity and the refusal to revalue gold led to deflationary issues.
Today, rather than operating under the veil of ‘scarcity’ and ‘discipline’, this is solved by central banks issuing more money. The scarcity of Bitcoin in maintaining its value as a form of digital gold is simply incompatible with the dynamism of capitalism. Furthermore, it is important to note that gold also operated as a credit system. Government-issued currencies promised to pay the ultimate money, which was gold at that time. The shift of Bitcoin towards a similar credit based system represents more of the same economically rather than a seismic shift, which is one that has already proven to be ineffective.
Bitcoin is also built on the basis of eliminating the hierarchy in the money system, where currency issued by the US central bank is sitting at the top. The issue which it seemingly tackles is the inequality between currency issuers and currency users, where currency users have to earn money to spend it while currency issuers have the unique power to issue national currencies by simply adding numbers to bank accounts on the computer, with their monetary liabilities being everyone else’s asset. Distrust towards the hierarchy was exacerbated in 2008, with the huge bailout of banks deemed ‘too big to fail’ and the FED starting quantitative easing, which sparked fears of depreciating the value of currency held. This was seen as the misuse of taxpayer money and the abuse of central bank power. Yet, ironically, hierarchy also emerges in Bitcoin through mining and the maintenance of a distributed ledger. Rights are giving to users with the computing ability, who are then placed at the upper echelons of the hierarchy.
Unsustainable Electric Consumption
With the economics of Bitcoin settled, it is time to look at other issues which pose a threat to the sustainability of Bitcoin. Most prominently, the unsustainability of its electricity consumption. To maintain the scarcity of Bitcoin, a maximum of 21m tokens are allowed to be mined. This is done by allowing the cryptographic problems involved in the mining to get progressively harder, meaning it takes longer to earn them. Miners resort to increasingly powerful computers to complete these tasks and earn Bitcoin. As a result, mining is using up greater and greater amounts of electricity. In fact, according to Dutch Bank ING, a single Bitcoin trade consumes as much electricity to power a house for a whole month. If Bitcoin electricity consumption keeps increasing at the rate of 29.98% as observed in November 2017, Bitcoin mining will consume all the world’s electricity by February 2020. Figure 4 reflects this exponential growth.
In 2018, HS Orka estimates that Icelandic data centres mining cryptocurrencies will use 840 gigawatt-hours (GWh) of electricity, which is more than what the country’s entire population consumes in the same year to power their homes. Thus the energy consumption of the Bitcoin mining process is clearly unsustainable in the long run.
Low Liquidity and High Volatility
Another issue is the liquidity and volatility of Bitcoin. The large price spreads shown in Figure 5 indicate liquidity problems and a lack of active professional dealers or traders who would normally arbitrage these differences away rapidly. While there is more liquidity with the introduction of the futures market at the end of 2017, which should make Bitcoin prices less volatile, it could also exacerbate volatility. For example, a fall in the futures market may exacerbate a fall in the actual Bitcoin market. For something touted to be a potential global digital currency, the current volatility and lack of liquidity certainly do not point towards that.
Furthermore, freedom from government supervision and regulation does not seem to be playing out for Bitcoin, as governments increase crackdowns and regulations on cryptocurrencies. Potential further regulation would certainly go against the Bitcoin premise which is something independent and free from regulation.
Figure 6 shows a falling wedge forming and hence a potential breakout to the upside may be in play for Bitcoin. However, based on the fundamentals of Bitcoin discussed above, it is not sitting on a steady foundation.
Ultimately, the language of cryptocurrency is still the dollar and not Bitcoin. The misunderstanding of the modern monetary system and the fear of credit is the false premise which drives Bitcoin. Despite the fear of credit and hierarchy, Bitcoin is inevitably morphing into the system it is supposed to be opposed to. Potential government regulation, low liquidity and high volatility, and extremely high amounts of electric consumption will continue to weigh down the potential of Bitcoin. More importantly, Bitcoin advocates would soon realise the impossibility of the utopia they propose and the necessity of the modern day credit based monetary system, one that is compatible with capitalism. While Bitcoin advocates do have a reason to fear the management of central banks and governments, as evidenced in the 2008 financial crisis where instead of lending unlimited amounts above the market rate of interest against good collateral, the central bank did not lend without limit, lent below market interest rates and auctioned off funds. This saved institutions that should not be saved, creating a moral hazard.
What is needed is not Bitcoin but rather better management both in the public and private domain, and ”that’s where the problem lies because a prerequisite of management is legitimate authority”.
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