The Bitcoin Flaw (Part 2)
Quick Overview of ‘The Bitcoin Flaw (Part 1)’
A couple weeks ago, I published a post explaining ‘The Bitcoin Flaw’ as described by George Gilder in Chapter 22 of his book Life After Google: The Fall of Big Data and the Rise of the Blockchain Economy.
The following excerpts are from Chapter 22 (The Bitcoin Flaw) of Life after Google :
In debates with Steve Forbes, I strongly resisted his insight that though bitcoin could serve for transactions as a store of value, it could not perform the central role of a currency as a unit of account and a measuring stick. (emphasis added, :254)
bitcoin, as now constituted, cannot be a currency [because] ... The price of bitcoin changes with demand. (:255)
Gilder’s proclamation that bitcoin is ‘flawed’ follows directly from the principle that “the central role of a currency [is] as a unit of account and a measuring stick” (emphasis added, :254).
In support of this view, Gilder quotes Mike Kendall, author of Man on the Margin, who stated “No other basic unit of measure,” whether it’s the second, the meter, the ampere, or the kilogram—”changes in value with demand” (:255).
Summary of ‘The Bitcoin Flaw’ Argument
George Gilder’s and Mike Kendall’s arguments against the feasibility of bitcoin as an exchange currency can be summarized as follows:
- The cornerstone of any good measurement system is a standard (i.e. widely accepted), unchanging unit of measure.
- The cornerstone of any good exchange currency is no different. The primary purpose of an exchange currency is to eliminate the need for bartering, by facilitating the temporary ‘parking’ of the exchanged value from one transaction so that an equivalent value can be retrieved (i.e. exchanged again) at a later time for some other desired good or service.
- The fact that bitcoin’s ‘value’ changes with demand undermines this ‘primary purpose’, making the notion of bitcoin as an exchange currency inherently untenable.
A Bit More from Mike Kendall (The Man on the Margin)
In his July 2018 blog post Notes on The Bitcoin Standard II, Mike Kendall summed up what he viewed as the fundamental flaws of bitcoin. Kendall’s views follow from two basic assumptions:
Monetary Standard [is best defined as] an optimum monetary reference that eliminates inflation or deflation. Debtors and creditors are in equilibrium when an optimum reference is maintained. The exchange of goods, services, and trade are most efficient when the monetary standard remains fixed. (emphasis added)
Bitcoin’s fixed supply design is by definition problematic. … It is deflationary, so it is a decline in the monetary standard.
Kendall goes on to suggest that
[because bitcoin] has a predictable and determinate deflationary increase in value, there is no incentive for it to act as a transactional currency. Any use as a medium of exchange today means you are giving up a predictable and determinate increase in value in the future.
In other words, Kendell asserts that people will be reluctant to make purchases with bitcoin because, in so doing, they will be ‘losing out’ on the future increases in the value of bitcoin.
I, personally, find this argument non-persuasive. Any purchase, any use of an exchange currency, conceivably requires liquidation of ‘investment assets’ into the exchange currency prior to initiating the exchange. In fact, having an exchange currency that ALSO doubles as an investment with ever-increasing value simply eliminates the need to liquidate the investment prior to initiating an exchange transaction -- this would seem to make bitcoin’s potential for investment returns a benefit, not a liability, in the exchange-currency use case.
As such, I view Kendall’s “determinate deflationary increase in value” argument as actually supporting the notion that bitcoin can readily function as an exchange currency, if it were merely as simple as that.
No, the ‘flaw’ does not lie in bitcoin’s potential to steadily increase in value; however, the flaw is indirectly related to this ‘feature’. Bitcoin’s ‘flaw’ lies in the unpredictable nature of that steady increase in value and that unpredictable nature lies in the fact that bitcoin ‘can’ (and thus will) serve (at least for some) as an investment vehicle.
My Twist on the ‘Bitcoin Flaw’ Argument
Contrary to one of Mike Kendall’s primary assertions, the ‘flaw’ with bitcoin (as a viable exchange currency) lies not in the fact that its supply is deflationary per se. Rather, the problem arises
- because bitcoin’s valuation will always fluctuate (up and down)
- because demand for bitcoin will always fluctuate (up and down)
- because bitcoin (also) functions as an investment vehicle
- because demand for bitcoin will always fluctuate (up and down)
Because bitcoin can always be viewed as a potential investment, its valuation will constantly be judged in relation to other possible investments. As such, investors will move into and out of bitcoin (as an investment) relative to other investment alternatives, which are and always will be constantly changing. In other words, the ‘length’ of bitcoin, as a measuring stick, will be ever changing because investors and speculators will be forever re-evaluating how valuable they believe bitcoin is, as an investment.
In order for any currency (fiat or otherwise) to serve as a reliable exchange currency, its ‘length’ as a measuring stick must remain stable, or at least highly predictable and slow-to-change.
Bitcoin’s demand is unpredictable because its supply is predictable
Even though bitcoin’s supply is inherently fixed and thus perfectly predictable, its demand will forever remain unpredictable. Although the argument can be satisfactorily made that bitcoin’s value will increase over time (similar to the argument that the total stock market’s value will increase over time), demand for bitcoin (just as demand for stocks) will continuously fluctuate in the short term, as history has shown, even if long-term gains seem assured.
There are only five ways to maintain a stable ‘valuation’ for a currency
- Fix both supply and demand
- Fix demand while continuously adjusting supply (to keep the valuation stable)
- Allow demand to float while continuously adjusting supply
- Fix supply while continuously adjusting demand
- Allow supply to float while continuously adjusting demand
Regarding Option 1, it would be impossible to fix both supply and demand, unless that ‘fix’ is at zero, in which case the ‘currency’ is both worthless and meaningless.
Option 2 is, for all practical purposes, also impossible; whereas ‘demand’ is a function of the individual preferences of millions of individuals, there is no way ‘demand’ could be ‘fixed’ in any practical sense.
Option 3 is the method typically used by central governments to control the ‘valuation’ of their fiat currencies.
Option 4 represents the space occupied by both bitcoin and gold (and, consequently, engenders the central challenge associated with ‘the bitcoin flaw’).
Gold vs. Bitcoin vs. POB ...
Gold has a feedback loop ...
The supply of gold is fixed by its physical scarcity and the difficulty associated with discovering and mining new sources of gold. However, the supply of gold is inextricably (though not perfectly) linked to the demand for gold by virtue of the ‘gold mining’ process. Whenever demand for gold increases, the marginal profitability of mining gold increases, thus increasing the immediate supply via the following (effective, though imperfect) feedback loop:
- increased demand for gold leads to
- increased gold mining activities, which leads to
- increased supply of gold, which leads to
- downward pressure on the demand for gold.
- increased supply of gold, which leads to
- increased gold mining activities, which leads to
Bitcoin has no such feedback loop ...
However, with respect to bitcoin and the ‘bitcoin mining’ process, no such feedback loop exists:
- increased demand for bitcoin leads to
- increased bitcoin mining activities, which leads to
- zero change in the supply of bitcoin, which leads to
- zero downward pressure on the demand for bitcoin.
- zero change in the supply of bitcoin, which leads to
- increased bitcoin mining activities, which leads to
But, what about POB ... ?
When I first read the recent white paper by 
However, upon further reflection, I have begun to question my initial assessment. Although POB, like bitcoin, has a rigidly ‘fixed’ supply curve, I have, over the past few weeks, been actively pondering whether POB might actually be superior to bitcoin.
I believe I have identified a couple reasons why that might actually be the case.
To that end, I guess I need to begin writing ‘The Bitcoin Flaw (Part 3)’.
Stay tuned …