Why this article?
Because it’s been a hot topic for a while. I’ve been ignoring it so far because I tend to stay away from investing in currencies and commodities. It’s not my jam. But I’ve been asked several times about Bitcoin and Blockchain. Ask and you shall receive. This article is about Bitcoin. I’ve tried to answer one simple question: Can Bitcoin be a viable currency?
Why do we need Cryptocurrencies?
The short answer is: We don’t. The idea of Bitcoin and all the other cryptocurrencies is steeped in a pseudo-libertarian (almost anarchic) ideology that believes ardently in the blanket statement that “government is evil”. In the cryptocurrency world, the evil villain is the Federal Reserve Bank (or the Central Bank of your country). Ardent fans of cryptocurrencies will have you believe that these evil banks control how much money is sloshing around in our economic system, and that they have nefarious plans (as all governments do). They’ll print money willy-nilly, which will lead to inflation, even hyperinflation. And society will crumble into chaos.
In the developed world, that view is hogwash. In the developing world, the “cryptomaniacs” (my term for ardent fans of cryptocurrencies) may have a point. But the irony is that the very organization these cryptomaniacs despise – the Central Banks – are more sophisticated in developed economies, where inflation has been stable for the last 20-30 years. It’s one of the main institutions that keeps most developed economies from spiraling into becoming banana republics. I doubt cryptomaniacs understand how Reserve Banking works.
To counter the nefarious plans of evil governments and their authoritarian institutions, the renegades of the Tech world came up with a novel solution – and I’m not being facetious here. Bitcoin, as I understand it, is indeed a novel solution. But it can’t be a currency. Not yet. To understand why not, I’ll go through these issues:
- The origins of Bitcoin.
- The basics of Bitcoin.
- The Problem.
- Why the Federal Reserve has an important role.
This could be a Hollywood movie. Back in the 1980s and early 90s, there was a mysterious group in the Silicon Valley vicinity called Cypherpunks. They were an under-the-radar group that started circulating newsletters via a cool new thing called the internet. Among them was this person called Tim May, who formulated a “Crypto Anarchy” manifesto. This was the beginning of this, well, anarchic movement to take government out of our lives. The Federal Reserve was the recipient of all the anger in this Cypherpunk movement. As is the case with the “Tech Bros” of Silicon Valley today, they thought every problem in the world can be solved with technology. Usually, I agree with them – The Buylyst is heavily invested in Technology. But sometimes, their arrogance supersedes rationality.
A few years later, a rather cryptic individual came out of the Cypherpunk movement – Satoshi Nakamoto. Most people believe this is a pseudonym, but he/she is widely regarded as the creator of Bitcoin. His/Her invention was the result of a decade or more of rumination in these extremist movements. Satoshi wrote the seminal paper about Bitcoin, and allegedly went on to create a proof-of-concept. It took a few years before Bitcoins made it out of the Cypherpunk-type circles into mainstream society. And obviously, we know what happened – it became a hot commodity.
Yes, today Bitcoin is a commodity, not a currency. It’s trades like a commodity – on speculation about prices as opposed to estimates of intrinsic value. Well, that’s because there is no intrinsic value. Having said that, it is a novel solution, even if the problem is steeped in extremist fears of a few grubby hands in the government controlling all our money.
This is not easy for me to explain because I’m not a computer scientist. So, if you’re not a computer geek either, this may be a case of the blind leading the blind. But bitcoins are trying to solve an economic problem (political, really, in my opinion), which gives me some confidence in examining it. My take on Bitcoin is mostly from an Economics standpoint. So, bear with me. We'll get it.
The operational basics are these:
- Bitcoins are digital tokens – sort of like a piece of code – that exist only in cyberspace.
- These tokens serve as a medium of exchange for online transactions (or offline in some cases).
- The transactions are recorded in a decentralized ledger, otherwise known as a Blockchain. This is the piece de resistance of cryptocurrencies – a decentralized, public ledger that’s outside the jurisdiction of the grubby hands of Government.
- The “coins” themselves are “mined” at a predetermined rate, to support the volume of transactions.
- There is an upper limit to the total number of “coins”, which supposedly solves the problem of inflation.
This is obviously a summary that Satoshi will not approve. But for our purposes – to figure out if Bitcoin is a viable currency – it’s a good start. Now let’s look at the basics of viable currencies like the US Dollar, British Sterling, the Euro, Yen, Renminbi, Rupee and so on:
- They serve as a widely accepted Medium of Exchange.
- They serve as a Store of Value.
- They serve as a Unit of Account.
The currencies mentioned above, and many more, check those 3 boxes. I can go to sleep at night without really thinking about the value of money tomorrow, or next week or next month. Economists would put it like this: My expectations of inflation in the future are anchored to the current low inflation environment. Yes, Economists have a way of making any topic unsexy.
In my view, criterion #2 – Store of Value – is the most important one. If a currency can’t maintain its value, it’s not a great medium of exchange, and won’t be used as a unit of account. Ultimately, we want money to be predictable – so we can sleep well at night knowing that our salary or the money in our bank accounts will buy approximately the same stuff that it does today. The US and most other countries have been through periods of high inflation in the 20thcentury. Hyperinflation in the Weimar Republic, ignited with the Great Depression, fueled the rise of the Nazis in the 1930s. The Cryptomaniacs cite such events as justifications for cryptocurrencies. I’m paraphrasing but this captures the overarching economics worldview of the Cryptomaniacs: Corrupt governments cause inflation and hyperinflation by printing too much money just to get votes.
They’re not completely wrong. It has happened in the past and is still going on in some countries. Visionaries like Satoshi devised some creative solutions to tackle the problem of inflation. I’ll give an overview of those methods and how they work to rein in inflation. Then I’ll go back to my domain of Economics to point where their economics worldview is incorrect. And then I’ll give an overview of the role of Central Banks like the Federal Reserve.
Crypto-nomics: Mining and Blockchain
Inflation is bad. I agree with the Cryptomaniacs on that. Theoretically, there is no limit to how much money the government can pump into an economy. And so, theoretically, there is nothing to prevent a government from causing hyperinflation. But, as Yogi Berra said: “In theory, there is no difference between theory and practice. In practice, there is.”
In practice, Central Banks are much less inclined to let inflation spiral out of control. Argentina or Venezuela may make that hard to believe today, but central banking has matured over the last 40 years. In this age of instant communication of ideas and computing power, central banks are just better at combating inflation. I’ll go through why that is in the section after the next one. But first, let’s look at how Bitcoin is designed to be immune to inflation.
Satoshi came up with 3 main antidotes to the inflation problem:
- Control the “velocity” of increase in coin volume, referred to as “mining”.
- Decentralize the ledger of all coins created. Ever. This ledger, known as Blockchain, is public information.
- Cap the total number of coins to be created to about 21 million Bitcoins.
Mining sounds like somebody’s digging up gold or something. This isn’t a coincidence. Most Cryptomaniacs believe in tethering currencies to Gold. They seem to think that the days of the Gold Standard were stable. Empirical data flatly refutes this view. Even if you don’t know anything about economics, think about this: link the value of currency to gold because it’s rare and shiny? It may have worked in a world where gold was the prime currency for a long time. And indeed, it was. But we’re at least a hundred years away from that medieval relic. There are many reasons why the world got rid of the Gold Standard that existed for a large part of the 20thcentury. Stable, it was not. But I digress.
Bitcoin’s Mining process is actually very cool. Here is how I understand it:
- You want to buy something using Bitcoin.
- The transaction goes into a Block – according to the time it was logged. Your transaction is clubbed with a few others that happened around the same time.
- Obviously, as the “economy” is growing because you want to buy stuff (assuming somebody has stuff to sell), coins have to be mined.
- There is a mining community that does this. This is a programming exercise.
- 5.Satoshi’s software sends out a pre-determined mathematical puzzle that needs to be solved in order to “approve” a block of transactions. This is a very computationally intensive exercise.
- Once the puzzle is solved, the “block” is approved. And then miners (this is a profession now) move on to the next unsolved block.
- The chain of blocks is called…you guessed it…Blockchain. This is a public ledger that records all transactions. And it’s outside the banking system – those evil guys. The Blockchain is a widely distributed and replicated database that’s immutable, because once a block of transactions is created and sealed, all miners have this information. Changing the record on all of them simultaneously is impossible, which means that no one can get away with claiming they have more coins than they actually do.
- Who “mines”? I honestly don’t know but it seems like there are professional miners now. Most of them are supposedly in China.
- Why mine? Because they get paid. The first miner to solve the problem gets a prize – a few bitcoins. There is a formula that guides how much miners will get over time, as Bitcoin matures.
- So far, apparently 16 million bitcoins have been mined. The limit is 21 million.
- We’re told that the math puzzles get harder and more computationally intensive as time goes on. This is supposed to slow down the creation of new coins.
- Today, people forecast that the 21 million coins limit won’t be reached until 2140 or so. As with most forecasts, I suspect this one is wrong.
So, what’s the point of all that? Coins won’t be mined willy-nilly without a specific need for the coins to exist. There is a mechanism in place to control the pace at which coins are created, and there is an upper limit to the total number of coins. There won’t be extra money sloshing around in this economy, which means there won’t be any inflation. So, no evil government and no inflation? What’s not to like?
Alas, things that are too good to be true, usually are.
Bit of a Problem
For now, I’m going to ignore the questions about Satoshi and his algorithm. Let’s assume that the Bitcoin Miners as a community have vetted this framework. I suspect you’d need to be a computer geek to really do that sort of vetting. My concern is Economics.
There are 3 main problems with Bitcoin as it exists today.
- Computing Horsepower needed for mining.
- The problem with Deflation.
- The disconnect with the real economy.
Problem #1 is obvious, so I’ll get it out of the way quickly. Mining is a computer-intensive process that requires:
- A lot of electricity – we’re talking small-country-electricity-consumption levels.
- Superfast, super-cutting-edge computer chips like GPUs (Graphical Processing Units) that are normally used for AI applications.
It’s easy to see that Mining isn’t going to be dominated by regular folks who have a laptop and a Cloud account. This is cutting-edge stuff, even for the Silicon Valley geniuses. The fear – and it’s just a fear at this point – is that Mining will end up being dominated by a few people with the required resources. If that happens, Satoshi’s original libertarian idea of decentralization takes a beating. I don’t know about you, but I’ll take my chances with the Federal Reserve “controlling” money flow rather than some mega-data-farm-complex in China, Russia or Timbuktu.
Problem #2 is much more complicated. Deflation is the opposite of Inflation, which means prices decrease in the future. Bitcoin is designed to be inherently deflationary. This is not a good thing, especially with regard to Bitcoin’s aspirations of becoming a legitimate currency. The reason it’s deflationary – in the long term – is because there is a limit to the total number of bitcoins (21 million). To illustrate the problem, imagine this:
- There is wide adoption of Bitcoin. Transaction volume grows. The number of Bitcoins mined expands.
- You make a product. You want to sell it for Bitcoins. You need to set a price. What price will you set?
- Let’s assume your costs are in bitcoin as well (probably won’t be the case).
- So, you sell for a markup – let’s say 50%. Let’s say your cost per product was 1 bitcoin. You decide to sell for 1.5 bitcoins.
- If there is a cap on the amount of money that’s allowed to circulate, without regard for how large an economy grows, the value of each unit of that money will increase. Money can buy more, because the economy is growing faster than money supply. That’s deflation.
- In the case of bitcoin, expectations of deflation – that bitcoins will buy more later – will lead to two problems:
- People will expect prices to fall.
- So, people will put off their spending. They will save their bitcoins for when they can buy more with it. They will hold it like a stock.
- This is bad news for you. You’ve made a product. But now many people are holding off on buying it.
- So, you lower your prices to entice them. Deflation just happened to your product now. Expectation has morphed into reality.
- Now your profit margin is lower.
- People see that you lowered your prices. They’ll wait some more.
- At some point, they may buy your product, but now you’ve made less money.
- Maybe you’ll need to lay off some people because you’re not making enough profit.
- If you were paying them in Bitcoin, they have less buying power now.
- If other firms like you did the same thing, there is a systemic problem.
- This cycle can go on and on. If it happens on a mass scale, the economy will shrink.
- A lot of bitcoins will be sitting idle.
There is a reason Economists don’t like Deflation. It means contraction. People reduce spending. So, producers decrease production. People are laid-off. And the cycle becomes vicious.
I’ve made several assumptions in the scenario above. One of them is that your costs are in Bitcoin. Of course, that’s almost impossible. Your costs will probably be in USD or GBP or whatever your currency is. Maybe it’ll be a mix of these “real world currencies”. If that’s the case, you would have faced a tremendous amount of inflation! Just look at a Bitcoin to USD chart in 2018 – Bitcoin depreciated by about 45% so far this year. That means that your cost – if your cost basis is USD – increased 45%! Good luck passing through that cost to your consumers.
This points to Problem #3: the disconnect with the real economy. Nobody wants that kind of volatility when running a business – 45% increase in costs in 10 months – especially if people expect deflation in the currency you’re using to assign your selling price.
The economy is a complex system. Currencies are a way of facilitating the economy. This is worth repeating about currencies – they should exhibit these characteristics:
- They serve as a widely accepted Medium of Exchange.
- They serve as a Store of Value.
- They serve as a Unit of Account.
As I mentioned before, #2 is the most important. Bitcoin is not a store of value. It’s designed to increase in value, which is not a store of value. This is why Bitcoin has attracted so many speculators. Their thesis is roughly that: more people will start using bitcoin, the bitcoin economy will grow, and because the no. of bitcoins is capped, it’s value will appreciate. Like Gold, it’s supply constraint will ensure that its price will increase with increasing demand.
What the Fed?
The Federal Reserve Bank in the US has a congressional mandate: “Price Stability and Full Employment”. What does Price Stability mean? Former Chairman Alan Greenspan put it succinctly: “the state in which expected changes in price do not effectively alter household or business decisions…”. The key phrase there – changes in price – has another name: Inflation.
In the last 30 years or so, since Chairman Paul Volcker’s great disinflation moves, the Fed has slowly but surely adopted “Inflation Targeting”. In order to achieve the congressional mandate of Price Stability and Full Employment, the Fed (and many banks around the world) have figured out through empirical evidence that Inflation Targeting is a way to get it done.
The Fed has to balance many variables, but the main variable is the quantity of money sloshing around in the economy. There are 2 major considerations about this:
- Make sure there is enough liquidity in the economic system to support economic growth. But…
- Make sure there isn’t too much liquidity in the system.
#2 would lead to inflation, which could spiral out of hand. #1 is necessary to avoid deflation, which could also spiral out of hand. The Fed has, therefore, communicated to all of us that its inflation target is roughly 2%. This was an important step: now we don’t expect inflation to get out of hand in the medium-to-long term. There may be deviations in the short term, but most of us will sleep well at night knowing that our dollars will buy roughly the same stuff next month as it does today.
You’re probably wondering:
- How does Inflation Targeting transmit through the economy?
- Why 2%?
- How does the Fed achieve this?
Good questions, I say. And there are good answers. I’ll need to write a separate worldview on that. But here’s the key takeaway: The Fed targets inflation at 2% to achieve both price stability and full employment. In the short run, it may not work. In the long run, it usually does. And at 2%, we don’t consciously think about inflation.
Even if we don’t realize it, you and I implicitly factor in inflation in our decisions. This is true whether we’re producing something, working somewhere, or consuming something. Economies are complex, adaptive systems. If you think about it, price stability and full employment are not disparate concepts. Our expectations of inflation inform how we price our products, how many people we hire, what wages we choose to accept, what wages producers are willing to pay us, and how much we consume today.
Ultimately, an economy works if people are selling or buying goods and services. The questions we – as a collective economy – ask frequently are about the interplay between:
- Supply and Demand
- Pricing and Cost.
- Consumption vs. Savings
- Hiring more people or laying off people.
- Lend money or borrow money.
Those are some of the most important economic decisions we make. In the US, and in many other countries, we don’t consciously think about inflation or deflation when we make these decisions. That’s because the Fed has (by and large) done its job. It has achieved “the state in which expected changes in price do not effectively alter household or business decisions.”
That state exists in many economies. But it doesn’t exist in the Bitcoin world. Not yet. Bitcoin has to become a store of value first before it can become a widely accepted medium of exchange and a unit of account. At the moment, it behaves like a commodity because of the way the system is designed. In its passionate fervor about fighting inflation, it has set it up for deflation. As it stands today, its value lies in the expectation that many more people will start using it in the near future. I think that would be true, if we all had an anarchist, libertarian streak. But ironically then, the problem of deflation in the Bitcoin economy exacerbates. As more people adopt the currency, the closer the quantity of money gets to that 21 million limit. At some point, expectations of deflation will kick in. And that can become a vicious cycle.
Satoshi, if you’re listening…
My suggestion would be this:
- Get rid of the upper limit on Bitcoins. How do you know how big the Bitcoin economy will end up being?
- Swallow your rage and take a look at how and why the Fed targets inflation.
- Write some kickass code to automate what the Fed does using Econometric models and outdated software.
- Figure out a credit system, a banking system. The code should be able to spit out a “market-clearing” interest rate at which we can lend and borrow Bitcoins.
But Satoshi’s probably sipping a cocktail on a private island. I’m not. And “Investing” in Bitcoin will probably not get me there. If it’s not a viable currency, the future price chart will be rough. For now, I’ll stick with the evil government and its evil dollar for my daily needs.
Here’s the thing: I don’t see Bitcoin as less risky than electronic cash – my credit card, debit card and Apple Pay. And Bitcoin’s certainly not as useful. In fact, for all the reasons mentioned above, I see Bitcoin as riskier. I fear I’ll go in trying to use it as a currency but may be left holding a commodity with falling prices and little utility. And it’s not even shiny and blingy. I guess anarchy isn’t a compelling enough reason for me.
So, what should I do?
The best way to play the crypto market, in my view, is via semiconductors. I view this type of play as a call option on Cryptocurrencies. Let’s assume I’m wrong and Bitcoin, Ethereum and all the other cryptos become viable currencies. What will happen? Well, they’ll still need to be mined. And from what I’ve been reading the mining process for Bitcoin is incredibly computer-intensive an energy-hungry. It seems that at the moment, most miners are using GPUs such as those made by Nvidia and AMD. According to the latest quarterly earnings of those companies, their Crypto business has been slowing down. I guess not that many cryptocurrencies are being mined. I heard the same thing on TSMC’s earnings call.
But it’s also true the cryptos don’t make up a huge portion of their revenues. So, maybe that revenue stream will be lumpy for the next couple of years. But if cryptos become mainstream, it could be massive. Companies like TSMC manufacture chips for Nvidia and AMD. I think that’s the safest crypto currency play for now. But it’s worth looking in Nvidia and AMD as well, especially after the recent market correction.
There is one last point to support my theory that semiconductors may be the best crypto investments. Because mining is so intensive, and because the intensity is pre-ordained to increase as more coins are produced, the bitcoins of the world may face problems with the pace at which “money” is created. If the pace lags economic activity too much, it could exacerbate the deflation problem – too many goods chasing a small quantity of money. This could create violent short-term swings. Miners around the world are set up to compete in solving those mathematical puzzles to “create” more money. They want to do it faster, because the fastest miner gets the prize. The only physical way that can happen is if the chips become faster and more energy efficient. It seems to me that in order to have a smoothly functioning Bitcoin economy, semiconductor innovation is imperative. At the current rate of power consumption, where some miners consume as much electricity as Denmark, a bitcoin economy is not only cost prohibitive but also a disaster for the environment.
I will take a look at NVidia and AMD as a call option on the crypto market. And for the environment.