I am seeing a good deal of misunderstanding arise with the popularity of Bitcoin. Much of this seems to stem from a gold standard style of thinking. It can basically be boiled down to this:
- Government debt is bad.
- Banks are evil.¹
- A fixed supply of money eliminates the ability of banks to be evil by expanding credit and doesn’t allow governments to issue debt as easily.
- Returning to the gold standard would fix these problems.²
- Since we’re not returning to the gold standard we’ll create this new decentralized form of money that can replace fiat money.
There are a lot of moving parts in that, but this idea that a fixed money supply is good is not consistent with the history of money or even the basic facts about how modern money works. Worse, it constrains our economy in ways that make us worse off in the long-run. Make no mistake, as I’ve explained before, the gold standard was silly and no one who understands money or the history of money should ever support it. But let’s get back to Bitcoin….
The fact that Bitcoin has a fixed supply of 21MM BTC is not an aspect that makes it a useful form of money. The reason for this is simple – while we generally think of money as something we have money is actually something we don’t yet have, but can tap into. That is the essence of having credit. If you have credit you can access money when you need it. After all, credit IS money.
For instance, most of the homes in the USA are bought with a mortgage. If you have good credit a bank will take credit risk to issue you new money so you can buy something you otherwise couldn’t have afforded. When this is done our economy has that much more output and real goods (the house and the millions of building components that go into it). The borrower gets a house they couldn’t have paid for with cash and our economy gets output it otherwise wouldn’t have had. Likewise, when people borrow too much the money supply can contract to offset this excess. This is called an elastic money supply because the money supply can expand and contract as we need it to.
Since many Bitcoin proponents are Silicon Valley based it might help to use a slightly different example – stocks. Stocks are a financial asset (just like a bank deposit that is created when a new loan is made) that can be created from thin air to help finance ventures. From the perspective of a corporation stocks are the most expensive form of borrowing. Firms issue stock and a venture capitalist or investment bank earns interest on the loan in the form of equity in the company. This is an elastic expansion of financial assets that helps the firm grow and innovate.
While this elasticity is generally a good thing it can cut both ways. For instance, during the tech boom there was too much expansion in the supply of stocks to companies that weren’t really creditworthy. The same thing happened in the mortgage market during the housing boom. So, this elastic nature can create booms that get out of control. But for the most part this elasticity gives creditworthy borrowers access to money when they need it. And this flexibility allows the economy to adapt and evolve across time as opposed to being constrained by a fixed force like the amount of gold that we can dig out of the ground.
I’ve highlighted some of Bitcoin’s weaknesses as a form of money in the last few weeks. Its primary weakness is that it is too volatile to serve as a reliable medium of exchange. But the inability to expand the Bitcoin money supply as the economy evolves is an equally problematic aspect that makes its network adoption relatively limited in scope. This can probably be resolved with some form of smart contract and alternative coin, but the fixed supply is an inherent flaw in Bitcoin’s design that contributes to its flaws as a medium of exchange.4
¹ – This one is particularly annoying coming from people in Silicon Valley where most of the ventures are funded by banks organized as hedge funds calling themselves “venture capitalists” charging their investors 2 & 20 (or more) and taking the absolute most expensive asset an entrepreneur has (the equity in their firm). I have absolutely nothing against VC’s (or most banks for that matter), but you can’t criticize banks for extending credit and charging fees on that credit when VC’s help firms extend shares in exchange for a % of the firm and underlying fund fees. A VC, after all, is basically just a bank with a fancier name.
² – The USA never really had a true gold standard where gold was the only form of money that circulated. We’ve pretty much always had some form of credit layered on top of gold reserves. In this sense, gold was never a strict constraint.³
³ – Another common response to this is that the USA experienced its highest growth during the era of the gold standard. Actually, the era of the 1800’s was a period when the USA was an emerging market. The growth was largely due to its status as a small emerging economy. But it was also due to the fact that the money supply was somewhat elastic during periods like the Free Banking Era. Ironically, it was the lack of a Central Bank that made many of the downturns in the 1800’s and early 1900’s far worse than they should have been because there was no efficient mechanism for payment clearing across banks.
4 – Some people argue that the fixed supply of BTC is its greatest strength and that the coin can simply increase in value to allow the money supply expand and contract. But again, this misses the crucial feature of credit as money that allows people who DON’T have money to access money. The price increases in BTC’s value only help people who already have access to the money. And in fact, this asset inflation hurts those who don’t already have BTC in the first place as it becomes more expensive to acquire.
NB – Don’t come at me screaming about how I hate cryptocurrencies and am some apologist for the “old” monetary system. I am not remotely against cryptocurrencies. In fact, I hope some of my critiques help resolve some of the current flaws.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.