But no one knows the path- Does it go to $1m first and then 0? Or almost 0 first before going to $1m? There are too many moving parts. For every bullish argument, there are compelling bearish arguments. It could be either, and perhaps both, one after the other.
Isn’t fiat money bad since supply is unlimited and created from thin air?
Until 1971, we always had some form of precious metals standard- gold or silver. Its supply wasn’t fixed, but increased at a slow rate as it was mined. Luckily, economic growth rate was also very slow, as most people were farmers. It is only in the mid 1800s that growth took off with industrialisation.
After the end of World War I, there was a global boom and a bust cycle, ending in the Great Depression of 1929. The world’s industrialised economies were on the gold standard. This meant there could be no stimulus spending! Interest rates were hiked instead, to attract gold deposits, even though it crushed businesses. Unemployment skyrocketed to 30% in the US. It wouldn’t be until World War 2 that it recovered fully. The recovery took over 10 years! This was not the first such boom and bust cycle, there had been such crises at regular intervals. These cycles are inevitable- both growth and eventual recessions.
In the fiat era (post 1971), we have a comparable event- the 2008 Great Recession. Unlike 1929, we had a lot more tools at our disposal. Interest rates were immediately cut to zero. Despite this, the demand for government bonds was surging as a safe haven. The government could issue more debt that could be used to save the economy, at an even lower cost. The government spent borrowed money on infrastructure projects, providing direct assistance to people through food stamps and Medicare etc. The result? The economy recovered within a couple of years. Instead of a lost decade of high unemployment, social unrest, and economic downturn, the damage was greatly reduced. This is impossible to do under a gold standard, let alone crypto.
Fundamentally, what is money? It is a way to store labour across space and time. If I create some value for someone else, money is what enables me to store this and transfer it elsewhere. Over time, as the population grows, and economic output grows, so does the amount of real ‘wealth’ and value in existence. To represent this, the supply of money must increase by the same amount. If it does so exactly, inflation would be zero. But if we have a bit more money than needed, then prices will go up- reflecting excess money chasing fewer goods. If we have less money than needed, prices will drop. In a fiat economy, the money supply keeps growing through creation of more debt. This money is spent and creates economic activity. This activity leads to profits, taxes, and more credit, which in turn creates more money. When economic activity shrinks, the supply of fiat adjusts downward accordingly.
When you go to a bank and take a loan, this money is created at the bank and credited to you. The amount of money the bank can create is constrained by reserve ratio requirements- for each $10 created, the bank has to have $1 of deposits to cover bad loan losses. When the loan is fully repaid, that money is destroyed, and only the interest paid- the bank’s profit, is retained. Thus, fiat can create and shrink credit at will. This flexibility makes it possible to reduce the impact of economic downturns, and slow down excesses in manias.
Assume a steady state crypto economy where all the coins are already mined. With the supply fixed, rising wealth means prices have to keep falling, causing permanent severe deflation. Why is this so? If you have 10 widgets today, and 10 coins. So to represent the value of these 10 widgets, you get a price of 1 coin per widget. In a year’s time, you make 10 more. Total 20. But coins stay the same. So now you have to represent 20 widgets of value in the same 10 coins. Now the price is 0.5 coins per widget, to get a total of 10 coins.
In such an economy, doing nothing and hoarding wealth is the most productive activity. If you had a choice whether to do some productive economic activity like making widgets, or just holding the coins, holding the coins will always work better, since prices will drop over time, increasing your purchasing power. This is not a sustainable economic model- any kind of productive economic activity must be more rewarding than idle hoarded money. Everything will keep dropping in price- your house, your car, your salary, your company’s revenue. This is an unsustainable economy.
A counterargument often goes- technology is inherently deflationary. The price of smartphones, computers etc has dropped by more than 90%, hasn’t that been beneficial? Yes. Because this is not a deflation in the entire currency, but instead in a part of it. When the cost of your smartphone went down, more people got access to smartphones, opening up new opportunities for them. A consumer who spent 90% less on his phone now spent it elsewhere, increasing net spending. This is not comparable to an economy in perpetual deflation where everything declines in price. The deflationary era of 1929 is not called ‘The Great Depression’ for nothing- it led to 30% unemployment, riots, suicides, 90% drop in the stock market and the rise of extremist political ideologies. Severe and sustained deflation has happened multiple times in the past, and never with good outcomes.
Can you effectively increase the supply of coins by a fork, or having a coin whose supply grows at a steady rate? Maybe. But then why not just use fiat? The constraint on fiat isn’t mathematical- its political. It is implicitly assumed that a free country with a free currency will not print it to the point where it starts damaging its value vs others. The market price is a real time feedback- a currency that stats falling when overprinted by the central bank is a signal that it should stop. This is no different from miners using sound judgement to not keep forking a blockchain, or someone with 51% hashrate not attacking the chain to double spend and thus make the entire currency worthless as people lose trust in it.
On the blockchain, you cannot create credit, and the world growth would slow down very drastically if no loans were possible through creating credit. Available currency would be rationed out, and debt would be far smaller, as you could loan out a fraction of what you have.
Is Bitcoin’s volatility problematic to use it as a currency?
Currencies need to be a steady store of value. Trillions of dollars are traded each day, but it doesn’t affect the price much. Stability is crucial. The more volatile an instrument is, the more attractive it is for speculation, and thus more liquidity.
As a currency, you need near-infinite liquidity but without volatility.
Supply of fiat doesn’t change overnight, but reflected through the price of money- interest rates. Inability to create credit in crypto means you cant price it- you can neither control the supply, nor the price of money (interest rates). Supply demand will not find equilibrium- volatility cannot stay low!
Bitcoin costs a lot to mine and maintain, is that a problem?
The cost of extracting gold is significant. Out of one ton of ore, you get a few grams of pure gold. The cost of creating $1 billion in bank deposits, is zero. The cost is political willingness and risk aversion.
The cost of mining bitcoin is high. Costs much more to store it too - by maintaining the blockchain. The BTC network consumes ~121 Twh of energy per year. If we assume an average price per Kwh to be half of the average US residential rate, we get 6c. This makes the total cost at a whooping $7 billion dollars a year. When all the coins are mined, the network will sustain itself on transaction processing fees. This design is a double edged sword.
If the fees are too low and makes it no longer worthwhile to be a miner, the total network will shrink, and make it easier to attack the network and take over. This puts everyone’s assets at risk. To prevent it, you’ll have to spend an ongoing cost in the form of wasted computing power. If the fees get too high, it won’t be cost effective.
As far as transaction costs go, it costs about 1% to swipe a card physically, and 2-3% online. This comes with legal recourse and protection in case of frauds. In countries where the financial plumbing has been modernised- India/China, the cost of transactions is practically zero. You can send virtually unlimited sums of money in real time 24 x 7 to any bank account and it shows up instantaneously. With the UPI (Unified Payments Interface) you can send money P2P without knowing the recipients bank details, at zero cost. In China, Alipay dominates the payments landscape. For crypto to be a means of making payments, it can’t be cheaper than zero. The costs borne to support the current financial networks is subsidised through other services by the banks, so it is sustainable.
Mining Bitcoin, is more like mining uranium. It is very expensive to acquire. It is expensive to store- since its storage cost is the ongoing cost of maintaining the blockchain through wasteful compute cycles. In case of uranium, it means building radiation proof secure storage and spending for its maintenance. The only difference- is the speed at which you can move it over a long distance- you can’t send a ton of uranium across the planet in a few minutes, but you can do that with bitcoin. So the correct question is, do I want to use a commodity as currency that is very expensive to mine, store and transact, but easy to transport across large distances fast? If yes, then crypto is likely to be a good fit…IF you cannot access the existing financial system.
How does it stack up vs gold?
Gold is also hard to acquire, not too expensive to store- in your vault or a bank locker. It can go hundreds of years without any problem, and doesn’t need electricity either. It is hard to transfer to far off places, but quite usable for short distances. If you keep the gold at a bank, the key difference is trust- in this case, you are relying on a 3rd party- a bank which can offer you low costs due to doing it at scale.
Fiat costs nothing to create. The central bank can create infinite amount of money. It costs almost nothing to store, and can be transferred instantly anywhere. What’s the downside? trust. If the bank or government cancels you, you have nothing. Bitcoin can’t be cancelled- Technically it can, but its hard. Would you do business and buy things from businesses you don’t trust? Probably not. You implicitly trust that the bank you have your money at, isn’t defrauding you. Neither is your grocer, nor your employer. What’s more, you have legal protections when using established financial intermediaries. Fraudulent transaction on credit card? Your bank will reverse it. Account hacked? You can drop by in person to your branch, and have it restored. Paid for something and got no service? You can go to consumer court and get reimbursed. If you are already operating on a baseline level of trust, there is no extra benefit from relying on crypto.
Isn’t Bitcoin or other such new coins good for privacy?
If you operate through a registered exchange and ecosystem, then the privacy is gone. Otherwise, if you remain anonymous, your legal protections are gone. If this is a worthwhile tradeoff, then Bitcoin is for you. Moreover, if your address is identified in future, all your previous transactions become traceable. Whenever you interact with the real world in some way, where money exits or enters, you lose privacy anyway.
When I pay for something in cash, unless it is on camera, it is not traceable. Not now, and certainly not 5 years from now.
But isn’t crypto great for trading?
This is one area where crypto scores a big win- and by a really wide margin. The exchanges are API first, very tech driven. the platforms are open, the entire infrastructure in unregulated. An automated trader’s dream come true.
It does come with risks- several big exchanges operate without clear details of who owns them, where they bank, their capital and financials. A crypto exchange is your counterparty. There is no governmental insurance against fraud or hacks. A stock exchange and brokers have public financials, external auditors and regulatory oversight.
What about HODLing? Bitcoin has gone up more than any other asset class in the last 10 years?
Its incorrect to compare it to an equity index or commodity, simply because of the total market value. In 2008-10, it traded at cents or dollars. A single person could move the price up or down. It was not an asset that any large investor could buy into. Counting those returns vastly inflates the total. You couldn’t, in fact have bought into it then at size. The ones who did were few. It is no different from buying a lottery ticket at the time.
An apt comparison may be the value of earliest investors in Facebook like Peter Thiel, who netted 1300x when it IPOed. This is a return similar to buying BTC at $35 in 2012 and selling at $50k in 2021. You didn’t need to be Peter Thiel. Lots of such startups were raising funding and you could have bought those shares too. There are deep out of the money options on commodities like natural gas that go up 100-200x once in a few years. There is no shortage of lottery ticket like opportunities!
There is always a risk with HODLing, that the instrument you’re holding doesn’t in fact go to the Moon, but goes up and crashes down just as fast like $GME. Those who can hold on during the drawdowns in an uptrend, are also unable to sell when it finally turns. True wealth is not built by being all-in on a lottery, but bit by bit with a repeatable process.
What about using crypto as a hedge against the financial system’s collapse?
That depends. What kind of collapse? Are you in a small country whose collapse wont rock the global financial system? Then keeping Bitcoin will preserve your currency.
But what happens if the US banking system as a whole implodes? Or China? UK? Japan? Can the power plant providing electricity for the miner get loans for working capital to continue providing cheap electricity? If it goes under, and knocks off a large part of miners, can you continue to transact? Is it still safe from a 51% attack?
Can it survive another financial crisis like 2008/2020 where public opinion shifts against it and there are calls to shutdown miners and block access to any miner and exchange IPs? What is the exit point for your crypto if you cant convert any of it into real world currency?
There are quite a few scenarios that can play out- some fast, some slow. Each of them have multiple 2nd order effects- some of which we can predict, others are too complex to predict. It should be obvious no crypto is a panacea for all kinds of tail risks.
Exchanges and decentralisation
The existence of a market is at the heart of capitalism- one where demand and supply sets the equilibrium price. Lots of buyers and sellers leads to more competition, and pushes the price closer to true equilibrium. With too many buyers and not enough sellers, price stays too high. Too many sellers, price stays too low. To pack all the traders into one place is the job of an exchange- which is always going to be centralised. Being centralised also lets it offer trading at very low fees since the trades are internal entries in its accounting, from one account to another. This is an inherent tradeoff that crypto cannot avoid- it will always get traded the most at centralised exchanges, bringing with it the same risks that existing financial institutions have. It is arguably more risky, since there is an elaborate set of intermediaries in the stock market that are missing in crypto. The broker, the custodian, the exchange, clearing agent are all separate when you trade stocks, while it is usually all rolled into one in crypto.
What about NFTs?
Non Fungible Tokens are receipts. If I paint a picture and post it online, I can sell a “claim” to this online photo on the blockchain. Someone can pay me to get this receipt, and now they’re recognised as the owner of this receipt. Note that there is nothing preventing someone from saving this image to their phone. If they share it elsewhere, I have no means of enforcing my claim on it. What I could do, is enforce copyright- but that doesn’t require NFTs anyway.
In theory, if everyone agrees to abide by ownership as recorded on the chain, it may be unique. But there is no incentive as such for anyone to do so! What you can do with NFTs, can be done without it.
Marketplaces for digital goods already exist. Massively Multiplayer Online Games (MMOs) like Diablo, World of Warcraft, have very active markets where players buy and sell digital goods. The game publisher who runs the servers keeps the records. Even if you transact something on the chain using an NFT, unless the game server recognises it, it is meaningless. The game developer takes a cut of each transaction, and controls the database anyway. They don’t need an NFT. So who really needs it? I don’t know.
How does this end? A crash?
Not at all. In any market, price is everything. At present, crypto is too big to explicitly ban. It may end up being a currency regime in parallel. Something other currencies trade against instead of the gold standard. Its long term success rests on creating a permanent use case for crypto where it is the best suited for it.
What makes it great for speculation also makes it worse for use as a currency. You wouldn’t want to speculate on the price of your milk and bread going up and down 50% every month.
What if big money moves into Bitcoin later when its @ $1million? Everyone is buying now. There is a halving, stock-to-flow-model, etc
This is an argument similar to $TSLA. When it was at $50, there were all sorts of arguments for why it would go to $500-1000 and why it couldn’t. Unless it is mathematically impossible, there is no way to say something won’t go to some arbitrarily high price. When it does, it looks obvious in hindsight. For every stock that goes up 50x, there are 10 others which don’t, or go to zero. Nobody remembers those. I don’t know if BTC will go to 1million. Why can’t it? It can. But because something can happen, isn’t a sufficient reason to buy it. $TSLA can also go to 1million. So can gold. The number of assets you can buy is almost infinite.
At the peak of the Japanese bubble in 1991, the land under the Imperial Palace was supposedly worth more than all of California. Was this a real price? Were there really enough buyers to sell that land and buy all that land in California? Obviously not. The price was ridiculous. Yet, someone could sell small parcels at that price and make a fortune. After all, the price got there BECAUSE someone was willing to pay. For someone who HODLed it, they either found it very overpriced and exited before the peak, or failed to see the top and gave back most of that mark to market gains.
Remember, the marginal buyer and seller price the whole. Most of BTC is never traded, it remains idle. When the buyers vastly outnumber the sellers, the price goes up, and shows a mark-to-market gain for everyone holding from lower prices. But to actually be able to exit at that price requires liquidity. Lots of it. The bigger your position, the more you need. Since crypto itself doesn’t create any credit, this liquidity has to come from outside the system- the dollar system. Some other asset of equivalent value has to be sold to make room and buy that BTC. At a max 21mil coins @ $1million each, you need $21 trillion of liquidity moving into the coins if all of them were traded. Lets be conservative and assume only 10% will be- that’s still $2 trillion. Is there enough spare liquidity in the world for 2 trillion $ to move out into an asset with zero yield only for speculation? Very unlikely. So if the price does go astronomically higher, very few people will actually be able to exit at that price. The price is a mirage. If a large number try to take their profits, the sellers will overwhelm the buyers, and trigger a decline in prices. The only way this CAN work, is if the system replaces the current one, or Bitcoin becomes officially an asset that is used as collateral against fiat currency. This won’t happen overnight, and certainly does not mean that it will be the only asset to retain value. Many currency failures have happened throughout history, and gold, land, art, durable material goods have all retained value.
Crypto is an ongoing experiment at decentralisation. Maybe it will work eventually. Maybe it wont. This wasn’t the first experiment. It won’t be the last. I don’t see governments giving up control of their currency. Its not a sustainable hedge against most kinds of tail risks, but definitely for some.
If you want to take a speculative view on it, or totally convinced its the future, by all means- trade it, or HODL it. Price is king. But remember that the risk reward tradeoffs that apply to you, don’t necessarily apply to others. Don’t go all-in.