Chapter 8: Decoding Bitcoin Through a Monetary Lens

btc, bitcoin, cryptocurrency-6272695.jpg

Understanding Bitcoin involves delving into its role in the monetary landscape and how it aligns with the fundamental attributes of money.

1. Grasping the Essence of Money

To comprehend Bitcoin’s worth, it’s pivotal to grasp the nature of money itself. Money serves as a facilitator of trade, streamlining transactions in an economy. In the absence of money, barter systems pose logistical challenges. Imagine wanting to trade potatoes for bread but finding that the bread vendor doesn’t need potatoes. This predicament necessitates seeking alternative exchanges, complicating trade.

Money, throughout history, has taken various forms. Yet, most traditional forms failed due to their replicability. For instance, shells, once used as money, lost their value as traders flooded regions with an oversupply, undermining their scarcity.

Essential Functions of Money

Money performs three crucial functions:

  • Medium of exchange: It enables transactions, fostering confidence among participants in its value.
  • Unit of account: Money determines the price of goods, providing a consistent measure for pricing.
  • Store of value: Money serves as a repository for the results of labor, allowing savings for future use without significant loss of value due to inflation.

The Yap Rai Stones Saga

The intriguing tale of the Rai stones in Yap emphasizes the labor-intensive process involved in creating money. These colossal stones, brought from distant islands, held immense value due to the effort required for their creation and transportation. Placed strategically on the island, ownership was recognized by consensus among the locals. This shared consensus echoes the principles underlying the Bitcoin blockchain.

However, the arrival of a Westerner disrupted this ecosystem. Using modern tools, he swiftly mined stones from nearby islands and introduced them to Yap, leading to an influx of stones. This sudden increase diminished their value significantly, demonstrating that when money becomes easily replicable, its value declines sharply.

Scarcity and effort

The saga of the Rai stones from Yap Island echoes the precarious nature of money. Bitcoin’s value is inherently tied to its scarcity and the difficulty involved in its creation. Understanding these monetary principles unveils the significance of scarcity and effort in defining the value and integrity of money—principles that Bitcoin seeks to embody and uphold in the digital age.

2. Evolution of Money: From Precious Metals to Fiat Currency

Embracing Precious Metals

Human civilizations have perennially favored precious metals as ideal forms of money. Gold, with its resistance to decay, presents an enduring value store. Its scarcity, coupled with the labor-intensive mining process, prevents sudden increases in supply, cementing its monetary value. Initially, transactions involved weighing gold nuggets, but advancements led to minting coins with specified values. Silver and bronze complemented gold for smaller transactions.

Take the Roman Empire’s gold coins, universally accepted due to their recognized value. However, the empire’s devaluation tactics, where coins were melted and adulterated with other metals, sparked public distrust. As more coins flooded the market, prices soared, contributing to the empire’s eventual decline.

Paper Money and the Fiat System

The evolution of money progressed to paper currency, a more convenient mode of exchange. Initially, these notes were backed by gold reserves, guaranteeing their value. But when excessive paper currency was printed, leading to an inability to redeem every note for gold, trust in paper money eroded, often resulting in financial crises or “bank runs.”

In the 20th century, the Bretton Woods Agreement in 1944 pegged the dollar to gold at $35 per ounce, with other currencies linked to the dollar. However, the Vietnam War led the US to print more money, prompting other countries to redeem their gold reserves. Consequently, President Nixon’s decision in 1971 to suspend the dollar’s convertibility into gold marked the onset of the current era.

Presently, the global monetary system operates on fiat money—currency that gains value from public trust rather than being backed by tangible assets like gold. Central banks possess gold reserves, yet these reserves don’t cover the entirety of fiat currency in circulation.

The evolution of money underscores its intrinsic link to trust, scarcity, and value. From precious metals’ enduring value to the paper money system’s fragility, each stage in monetary history reveals how trust and scarcity underpin the perception of value. The transition from tangible assets to fiat currency emphasizes the reliance on trust and collective faith in the system—a paradigm shift that defines our modern monetary landscape.

3. Bitcoin: A Store of Value in a Digital World

Fidelity’s 2022 report spotlights Bitcoin as a monetary asset, echoing gold’s attributes as hard money in a digital realm. It appraises the qualities that solidify an asset as hard money: durability, divisibility, fungibility, portability, verifiability, and, crucially, scarcity. Bitcoin aligns with these benchmarks, except for a shorter track record compared to gold. Yet, it boasts a maximum cap of 21 million coins, ensuring scarcity, a cornerstone of hard money.

Adjusting this hard cap is theoretically plausible but practically Herculean. It necessitates consensus across the decentralized network of nodes and miners. This decentralized structure makes major unilateral decisions impossible. Altering the cap would devalue existing Bitcoin holdings, disincentivizing any such modification and further fortifying Bitcoin’s scarcity.

Network Effects & ‘Winner Takes All’ Scenario

Fidelity identifies network effects as a critical catalyst for Bitcoin’s adoption. As more entities—individuals, corporations, or countries—join the Bitcoin ecosystem, the snowballing user base elevates demand. Bitcoin’s fixed supply collides with heightened demand, stimulating price surges. These escalating prices allure more miners, fortifying the network’s computational might (hashrate). An augmented hashrate fortifies network security, amplifying Bitcoin’s allure—a self-reinforcing loop that potentially ushers in a ‘winner takes all’ scenario.

4. Current Monetary Dynamics & Paradigm Shift

Contemporary monetary policies, characterized by central banks’ burgeoning debt and money creation, stir skepticism among Bitcoin proponents and gold advocates. Governments historically resorted to printing money during financial strife, triggering currency devaluation.

However, the economic landscape has undergone a paradigm shift. Governments are adopting monetary financing more liberally, fueled by the COVID-19 pandemic. Monetary financing sees central banks generating fresh money for governments, effectively funding expenditures by minting new currency.

This unconventional method circumvents direct monetary financing bans in many regions. For instance, the government issues bonds, snapped up initially by large banks or primary dealers. Instead of reselling these bonds, the oversupply causes them to remain on banks’ balance sheets. Central banks then purchase these bonds using newly minted money.

The autonomy of central banks to create money at will unlocks vast possibilities. Economists like Paul De Grauwe advocate for erasing 30% of government debt by nullifying bonds purchased by the central bank. The debt vanishes without repayments. Willem Buiter proposed similar plans, reflecting the rising prominence of Modern Monetary Theory (MMT) in policy circles.

The narrative surrounding Bitcoin’s potential as a store of value intersects with the evolving monetary landscape, where traditional fiat systems confront growing skepticism. Bitcoin’s attributes aligning with hard money principles, coupled with network effects propelling its adoption, set the stage for a transformative financial future, challenged by unconventional monetary policies steering economic paradigms.

The Impact of Modern Monetary Theory on the Future Economy

Modern Monetary Theory (MMT) presents a radical economic perspective, advocating that governments with control over their currency should prioritize fresh money printing to fund investments, shunning concerns about budget deficits and national debt. This theory, championed by figures like Alexandria Ocasio-Cortez and economist Stephanie Kelton, asserts that the government can fuel major projects simply by printing additional currency.

The Core Tenets of MMT

Kelton’s book, ‘The Deficit Myth,’ emphasizes that national debt is inconsequential as long as inflation remains manageable and the country commands its own money printing. MMT proponents argue against issuing bonds to finance government endeavors, asserting that governments can solicit fresh money from the central bank sans any obligations or the issuance of bonds. According to this theory, governments could ensure full employment by creating jobs during economic downturns and transitioning these workers to private sector roles in more prosperous times.

Critics fear that MMT could engender an extensive government presence, possibly leading to state capitalism or, worse, a shift towards communism. MMT’s proposition of a government that independently prints money without the need for tax collections has earned it the nickname ‘Magic Money Tree.’ Proponents argue that taxes serve primarily to modify behavior, such as imposing levies on carbon emissions to encourage eco-friendly alternatives.

MMT: A Politician’s Dream

The pressing need for extensive investments in climate change initiatives aligns with MMT’s philosophy. Implementing the European Green Deal—a plan to render Europe climate neutral by 2050—requires significant annual investments, estimated at around 260 billion euros. This astronomical figure, significantly surpassing the regular European budget, poses financing challenges, making the prospect of money printing increasingly enticing for policymakers.

The ECB’s response to the COVID-19 crisis accelerated reliance on monetary financing. Over a trillion euros were injected into the economy to tackle the pandemic-induced economic slowdown, signaling a trend towards increased money printing.

Risks and Concerns

As politicians wield control over central banks, concerns mount regarding a potential shift away from prioritizing price stability. The temptation to repeatedly resort to money printing for various needs—enhanced social programs, increased security, healthcare investments, and pension payouts—poses a risk of inflation and currency devaluation.

Public sentiment might increasingly demand recourse to money printing to meet specific needs, nurturing a belief that money creation bears no adverse repercussions. This populist appeal of MMT, the promise of funding social programs without burdening taxpayers, is gaining traction, evidenced by protests advocating for the use of money printing over taxation.

MMT’s proposition of governments printing money at will challenges traditional economic principles. While it offers enticing prospects of financing significant projects without tax hikes, concerns persist regarding the potential consequences—primarily inflation and currency devaluation. The allure of easy money without apparent drawbacks resonates with public sentiment, fueling a growing debate about the role of money printing in shaping future economies.

5. Unpacking the Dynamics of Money Printing and Inflation

The debate around printing money remains contentious, stirring strong opinions among both proponents and detractors. Critics are wary, fearing that widespread money creation could inevitably steer economies toward inflationary chaos or even hyperinflation, rendering people’s savings worthless.

The Impacts of Free Money

David Hume’s 18th-century inquiry sheds light on the potential aftermath of injecting fresh money into an economy overnight. He posited that doubling the money supply without a commensurate rise in available goods would merely cause the new money to chase existing goods. Consequently, prices would soar, potentially leading to hyperinflation.

However, Hume’s model assumes a fully operational economy. If capacity allows, production could be ramped up to meet increased demand, curbing the extent of inflation. Real-world scenarios are multifaceted, encompassing the complexities of, for instance, deflationary shocks like the recent COVID-19 crisis.

Distributing fresh money post-deflation doesn’t instantaneously spur inflation; rather, it counters the deflationary gap. But sustained use of the money press to fund diverse expenses raises the specter of impending inflation over the long term.

Understanding High Inflation

The precise factors catalyzing high inflation or hyperinflation aren’t definitively understood. Notably, a former Fed chief, Daniel Tarullo, conceded the absence of a reliable theory explaining inflation’s causes, leaving the Fed bereft of a precise model guiding its policy decisions.

Commonly cited contributors to heightened inflation include increased money supply, an economy operating at full capacity, and waning public confidence in currency value, leading to a surge in money velocity. Heightened insecurity prompts extensive saving, stowing away money outside the economic flow. Yet, regaining confidence triggers increased spending and money turnover, fostering inflationary pressure.

The critical point is public faith in money’s value; once eroded, a self-reinforcing cycle can precipitate hyperinflation, rendering currency effectively worthless.

Quantitative Easing’s (QE) Impact

During the banking crisis, the US implemented QE, pouring billions into the economy. Critics argue that QE, while seemingly devoid of inflation within the US, globally drove food prices up by 60%, severely affecting those surviving on minimal incomes. Additionally, QE inflated asset prices, propelling shares, real estate, and bonds to potentially precarious levels, leading to concerns of market bubbles.

MMT’s Outlook on Inflation

MMT proponents consider rising inflation an indicator of robust economic growth initially. In the event of soaring inflation, they propose a strategy to reassert control.

Taxing Excess Cash

To prevent hyperinflation, MMT suggests taxing away surplus liquidity rather than relying on central bank interest rate adjustments. However, practical implementation poses challenges.

Real-World Examples: Venezuela and Zimbabwe

The Venezuelan government’s excessive bolivar printing fueled inflation rates exceeding 130,000% in 2018, causing a crisis marked by high money velocity and hoarding behavior, leading to dire shortages. The practicality of withdrawing excess cash via taxation, exemplified by Venezuela’s plight, proves intricate in real-world applications.

The Zimbabwean scenario stands as a poignant testament to how swiftly a currency can spiral into worthlessness, depicted by banknotes issued in 2007-2008, ranging from $1 to $100 trillion, exemplifying hyperinflation.

Zimbabwe hyperinflation trillion dollars

The discourse on money printing’s consequences encompasses a complex interplay of economic, social, and political forces. While some view it as a potent tool for economic stimuli, cautionary tales from Venezuela and Zimbabwe underscore the perils of unchecked money creation, underscoring the intricacies and risks involved in wielding this monetary lever.

6. Navigating Money Creation: Gold, Bitcoin, and Inflation

The current landscape of massive government support packages, bolstered by money printing, has left many pondering the true value of money. Individuals question its sustainability and ponder preserving purchasing power amidst a regime of ongoing money creation. As this experiment unfolds, the risk of potential catastrophic consequences looms on the horizon.

Seeking Value Beyond Fiat Currencies

In response, investors are exploring alternatives that transcend traditional banking systems and fiat currencies, seeking a ‘store of value’ that’s impervious to arbitrary printing. Throughout history, precious metals have embodied this role, sparking a surging demand for gold and silver coins. These commodities serve as insurance against hyperinflation fears. Even in the absence of doomsday scenarios, investing a portion (5-10%) of portfolios in precious metals serves as a hedge against prolonged periods of high inflation.

Forecasters suggest an inevitable transition toward a monetary system where gold will regain prominence, potentially triggering a reset where fiat currencies, such as the dollar and euro, depreciate in value against gold. This shift would surge the value of gold, compensating for losses and helping investors retain purchasing power.

Bitcoin: The Digital Gold

Bitcoin, heralded as digital gold by many, shares similarities with gold as a scarce, non-inflatable asset. With a capped maximum of 21 million bitcoins, its scarcity mirrors that of precious metals. Investors like Paul Tudor Jones are drawn to Bitcoin as a hedge against inflationary pressures resulting from massive money creation. Jones advocates that owning the fastest horse in this race could mean owning Bitcoin, citing its scarcity as a decisive factor.

The impact of massive money printing may likely favor gold and Bitcoin, although predicting their price surge due to inflation remains uncertain due to the complex nature of inflation. Nonetheless, including these assets in one’s portfolio could serve as a prudent insurance strategy.

Bitcoin as an Inflation Hedge

A case study conducted by the St. Louis Federal Reserve examines the price of eggs, revealing distinct trends when priced in dollars versus bitcoin. While the dollar price of eggs fluctuated over time, the price in bitcoin (satoshis, Bitcoin’s smallest unit) displayed greater volatility. The study notes transaction costs on the Bitcoin blockchain, failing to acknowledge advancements like the Lightning Network, enabling near-free Bitcoin transactions.

price of eggs in bitcoin
The price of eggs in dollars between January 2021 and May 2022

ou can clearly see that the eggs became more expensive in dollar terms during this period, which therefore reflects inflation. The cheapest eggs were $1.47 and the most expensive $2.52.

The price of eggs in bitcoin between January 2021 and May 2022
The price of eggs in bitcoin between January 2021 and May 2022

The St. Louis Fed points out that the price of eggs in bitcoin is much more volatile. The cheapest eggs were 2,829 satoshis and the most expensive 6,086 satoshis.

The Tale of Price Trends

Zooming out on the graphs reveals a contrasting narrative. In dollar terms, the price of eggs fluctuated over time. Conversely, when priced in bitcoin, the cost of eggs witnessed a starkly different trajectory. In 2016, the price in satoshis was significantly higher, dropping substantially by 2022.

The price of eggs in dollars between January 2016 and May 2022
The price of eggs in dollars between January 2016 and May 2022

The price of eggs was relatively high in 2016, but then dropped somewhat and remained more or less constant. From 2021 onwards we saw that the price was starting to rise again.

The price of eggs in bitcoin between January 2016 and May 2022
The price of eggs in bitcoin between January 2016 and May 2022

Bitcoin is very volatile in the short term and can therefore fluctuate significantly in value. However, if we zoom out and take into account more than 5 years, we see that bitcoin was effectively a good means of protecting against inflation during this period. The price of eggs in bitcoin has dropped significantly during these years.

Bitcoin: An Inflation Protector?

Bitcoin’s short-term volatility contrasts sharply with its long-term narrative. Despite fluctuations, an extended view spanning over five years positions Bitcoin as a promising hedge against inflation.

The ultimate query remains: Will Bitcoin continue to serve as an inflation hedge in the years to come? The answer to this question resides within the complex dynamics of evolving economic landscapes and the multifaceted nature of inflation.