December 20, 2020

by Steve Stofka

As bitcoin surged past $20,000 in value this past week, I wondered what the world would look like if bitcoin were the dominant medium of exchange on our planet. A little more than a decade ago the algorithm behind bitcoin was invented. From its inception, the supply of bitcoin was limited. Although it may function as a medium of exchange, its fixed quantity makes it ideal for buying – not being – currency.

When a currency is limited, the value of that currency increases, a matter of supply and demand. The goods and services that the currency buys fall in value, a process called deflation. It is the opposite of inflation or rising prices.

Limited currencies encourage saving, not spending. Bitcoin savers are called “hodlers” after a typo for advice to “hold” the currency on a message board in 2013 (Frankenfeld, 2020). In a deflationary environment, that is the best strategy because the currency will buy more next year. It pays to delay consumption. Businesses put off buying equipment that will make them more productive. People who own equipment are motivated to sell it before it loses even more value. These two impulses cause a deflationary spiral. At the bottom of that spiral, everything sells for dirt cheap.

A version of this happened during the Great Depression eighty years ago. In the years after the 1929 stock market crash, the central bank was, believe it or not, worried about inflation and limited the supply of money (Friedman, 1968). The central bank turned a sharp correction into a severe depression. Knowing that perverse history, former Fed chief, Ben Bernanke, assured Congress that the central bank would not make the same mistake in response to the 2008 financial crisis.

Let’s imagine a world where bitcoin is the medium of exchange. Because your car is eight years old, you anticipate more repairs. Is now the time to buy? The local dealership is offering a reliable car for 1 bitcoin, but you remember that just a few years ago, that same car sold for 1.5 bitcoin. If you wait until next year, you can probably get it for maybe ¾ bitcoin. You decide to drive your old car for another year.

A lot of people make that same decision and hold off buying new cars. Auto repair shops see an increase in business because people are repairing their cars instead of buying new. Car dealers, anxious to move cars off their lot because they owe the bank for those cars, lower prices even more. This induces some people to buy new cars, but it convinces even more people that their prediction was true; it is better to wait.

Car dealers start slowing their purchases from the factories, cause some factories to close. Those workers lose their jobs; why don’t all those workers just become car mechanics? First, car factories employ a concentrated workforce; auto repair shops are dispersed across a wide area. Second, building new cars and repairing old cars take two different sets of skills. Some workers will make the transition, but many won’t.

Because there are fewer cars being made, the price for new cars doesn’t fall as fast. People who had expected the price for a particular model car to fall to ½ bitcoin are disappointed. Some decide to buy now because car repair rates have gone up faster than new car prices are going down. But some people look around at the people losing their jobs and decide to play it safe. The buying power of the bitcoin currency holds steady for a while.

Uncertain about the growth of auto sales, auto manufacturers close more factories. The reasoning is simple. Although bitcoin as steadied in buying power, they anticipate that the currency will continue to grow faster than profits from making cars. As more auto factory workers lose their jobs, people become more cautious and hold off buying. The anticipation of future deflation contributes to further deflation.

For those who remember the hyperinflation of the 1970s, inflation does the same thing. That is why central banks are wary of a strong tendency toward inflation or deflation. They are self-reinforcing phenomena.

Let’s step out of the world where bitcoin is the global medium of exchange and back into the present world. What is bitcoin? Its limited quantity makes it like a collectible – a fine painting, or an old coin, but is not a collectible because there needs to be an agreement of the blockchain before anyone can buy a bitcoin. You can buy a painting without that consensus.

Its ability to act as a medium of exchange makes it like a currency, but it is not a currency because it doesn’t have a critical feature of a sustainable currency. As a unit of account, it behaves like an asset or commodity itself, not a ledger of account for a commodity. A stable and sustainable currency is an asset of the larger community, not just a store of value for an individual.  

So, what is bitcoin? It is a hybrid animal like the platypus, part bird and part mammal. Like the platypus, bitcoin is a species best suited to an island ecology. Bitcoin advocates point to the number of asset and hedge funds buying bitcoin as a demonstration of its growing acceptance as a global currency. Some funds have added bitcoin to their portfolios because it is a specialty, part of a broad asset mix. Like the platypus, it will only survive in a protected environment. Protected by? A stable currency like the dollar.

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Photo by Bermix Studio on Unsplash

Frankenfield, J. (2020, August 29). HODL. Retrieved December 18, 2020, from https://www.investopedia.com/terms/h/hodl.asp

Friedman, M. (1968). The Role of Monetary Policy. American Economic Review, 58(1). https://www.aeaweb.org/aer/top20/58.1.1-17.pdf. p.3.