From Crypto Snake-Charming to a Bitcoin Gulag

This a re-post of my article published on Cultural Analysis Net.

Bitcoin has a number of structural features that limit its capacity to serve as a reliable medium of exchange and expose investors to a significant risk of currency collapse. I examine its ability to recover from a major crash and the prospect of maintaining user anonymity if the currency were legitimised by the State.

In order to assign realistic value to Bitcoin it is necessary to understanding what Bitcoin is supposed to do and how well it is suited for satisfying its intended function. I will consider some of the economic and logical merits of cryptocurrencies in light of their supposed ability to facilitate for the exchange of goods and services without the inconvenience of matching two parties, each of whom would have to offer exactly what the other party wanted (that is, to overcome the double coincidence of wants problem).

One of the key design features of Bitcoin is the absolute limit on its supply. Bitcoin will never exceed 21 million coins, about 80% of which have already been issued (‘mined’). The fixed supply makes Bitcoin a deflationary medium of exchange: assuming a constant rate of use (velocity of money) in a growing economy of goods and services accessible to purchase for Bitcoin, its purchasing power must increase. This is a necessary consequence of the law of exchange formulated by Irving Fisher (for a detailed explanation of Fisher’s theory of exchange see Kowalik 2015). In other words, prices of goods and services denominated in Bitcoin or any other coin of limited supply will decrease under the conditions specified above.

The rate of price deflation would also be proportionally higher if the volume of purchases over a period of time had decreased, which is precisely the case when bitcoin owners have an incentive to hold on to their coins as an investment rather than use them for purchases. The more coins are hoarded as an investment rather than spent on products and services the more profitable they become as an investment and the incentive to hoard becomes stronger. Since all of these conditions are currently present we are witnessing a spectacular rise in the purchasing power of Bitcoin. This deflationary feedback loop is naively interpreted by Bitcoin enthusiasts as a proof of its success, but it is in fact a proof of failure as a medium of exchange.

According to Gresham's law, as long as there is a currency in circulation that people are willing to accept instead of Bitcoin, and that currency has a lower total rate of return as an investment, then that other currency will be generally preferred as a medium of exchange and Bitcoin will be preferred as a profit generating asset and therefore rarely used to make purchases. This can further drive up Bitcoin’s purchasing power... but only to a point. Since the commodity-value of Bitcoin is effectively zero, just like fiat-money issued by the State but without being backed by the taxation system of the State, it is bound to be eventually devalued. As the exchange value of an asset reflects expectations about the rate of return associated with its ownership, at some point doubts are bound to arise about sustainability of the desired rate of return. A major investor may decide to cash out, initiating devaluation and, ultimately, a crash.

Gresham law does not apply in cases where no other currency is deemed acceptable, for example, if the rate of devaluation of the national currency is so high that no one will accept it as payment. People are then forced to use even their most profitable investments to fund the necessary expenditures. Situations such as these are highly atypical for the western economies and are always only temporary, but they can happen. It may be a viable niche for Bitcoin and other reliable Cryptos, for example Ether, to be regarded as a temporary currency under extreme shortage or inadequacy of the state-issued money. It does have some economic and political advantages over straight ‘dollarisation’ with a currency of another state which would amount to paying seigniorage to that state and a windfall for its credit issuing institutions. Conversely, emergency reliance on Bitcoin would benefit only Bitcoin investors and miners, although a proven high-return crypto could be easily bought out by major financial institutions. Bitcoin therefore has practical value as a hedge against hyperinflation or shortage of State-issued currency: it may be a readily available currency for dark economic times even if it were used as the medium of exchange only sporadically.

Whether Bitcoin could recover from a major crash in its own exchange value is uncertain, but there is one critical factor that makes it unlikely. Validation of transactions, otherwise known as mining (since it also generates more bitcoins, for now), is energetically expensive in Real terms. It uses real electricity, a lot of it, and relies on state-of-the-art hardware to maintain the Bitcoin system of exchange. A major crash could make blockchain calculations not economically viable, in effect killing Bitcoin. Without blockchain calculations a cryptocurrency cannot be exchanged or cashed out in legal tender. It ceases to function. (CME Grouop, Bitcoin News)

“As the true cost of Bitcoin transactions rises, utility at the margin falls, and the platform’s fundamental value as a tool for human economic interaction declines alongside.” (Money And State)

There are several other risk factors associated specifically with Bitcoin. Its anonymity is both a strength - if you want to evade taxation or tyrannical authorities - and a weakness - it is unclear how many bitcoins are controlled by single players and who may be capable of manipulating the price of Bitcoin, causing crashes and profiting from cornering the market. There are also no effective means of preventing such behaviour if a hostile bitcoin portfolio were distributed across many wallets. The founder of Bitcoin, for example, is said to own 1 million units in multiple wallets. Considering that recent average daily volume of transactions is about 200 thousand BTC , a portfolio of one million BTC is more than adequate to corner the market. Anonymity also entails that the founder could be a private person or a state agent, and this constitutes a risk about motives. Since all investors who are driving the growth of bitcoin primarily create nominal wealth for the founder, a Ponzi scheme is one possible motive and a hypothetical investment risk.

The final consideration in evaluating the capacity of bitcoin to function as a currency is its future legality. Every state reserves the exclusive right to issue currency intended for circulation. If Bitcoin had succeeded as a functional currency in its own right it would be almost certainly violating the sovereign prerogative over the issuance of money and could be banned with no notice, rendering all wallets worthless, for example, by shutting down the exchanges. Alternatively, the State could simply nationalise the exchanges and demand that buyers and sellers be de-anonimised, obtain backdoor access to all the nodes, miners and wallets, turning blockchain into a monstrous and energetically expensive surveillance gulag. This last prospect is an almost inevitable scenario associated with the possibility of bitcoin’s, or any other cryptocurrency’s success. The recent ruling by the federal court in IRS V Coinbase suggests that the era of Crypto anonymity is about to end.