Dan Ladds

Bitcoin is doomed to collapse — and that’s ultimately for the best

What has ultimately surprised me about Bitcoin how much attention it has received from the anti-capitalist left. Suddenly, those who have criticised capitalism as an unstable and unfair system have somehow fallen into the alluring-yet-naïve vision offered by the libertarian right. It seems that for many, frustration at our current government and banking system, fostering a perfectly valid desire to escape these issues, has led them to overlook the root of the problem and in fact, instead of moving away from that problem, to move closer to it. The anti-state and tech-cool status of Bitcoin has attracted many who have overlooked the fact that it is simply a wrapper for an unregulated monetary system; exactly what caused our current problems in the first place.

George Santayana said that those who do not learn from history are doomed to repeat it. The high-tech format of Bitcoin easily persuades many that it is immune to many of the problems of the past, but in fact it is doomed to the exact problems that have crippled currencies in the past. For all the flaws of our current monetary system, we must remember that we moved on from commodity currency, and then again from representative currency, for a good reason. Once the obfuscating shroud of computer networks and cryptography is distilled, so that we might look at Bitcoin in its conceptual form, it is clear that it will simply restore many of the problems of the past.

[Previous article: a summary of the different types of currency and money]

What Bitcoin is

One of the key problems with currencies tied to a resource — such as a precious metal — was the limited rate at which that resource could be mined, and the eventual absolute limit of its availability. In order for a resource-based currency to avoid the market being flooded by supply and the currency being completely devalued, the resource chosen had to be scarce, but if its scarcity was too great, the currency supply simply could not keep up with the amount of money required by the economy.

Bitcoin avoids this problem initially in a similar way to how physical currencies did. The transition to representative currency meant that coins could be minted to represent a smaller amount of the underlying precious metal than was practical. A single penny of gold is difficult to weigh out and easy to lose, but coins can easily be minted out of cheap metal that — by the fact that they are redeemable for the precious metal — have the same value, but can easily represent a fractional amount of the commodity currency. In the same way, Bitcoin seeks to resolve its issues by ensuring that Bitcoins are divisible down to tiny fractions of a Bitcoin.

If divisibility were the only issue then Bitcoin would have this problem solved. It is not. Dividing a currency into ever-smaller fractions however, is not the same thing as creating new currency. When the world was tied to the gold standard, the amount of currency was limited by the amount of gold. The economy was expanding far faster than the supply of gold. Making half-cent coins available would have done nothing to ease that problem because all prices, debts and savings were valued against the current value of the currency.

With Bitcoin, the problem is arguably even worse, because the value of the currency in terms of the commodity cannot be changed, because there is no underlying commodity. The currency itself is the commodity. It has the divisibility advantage of a representative currency, but is still fundamentally a commodity currency. It is literally the electronic version of dealing directly in gold. The production of Bitcoins is predetermined, limited in both rate and ultimate quantity.

To many, this might sound like a wonderful thing. Many have decried our current ‘imaginary’ money system and hailed a return to the gold standard. There has been much criticism of governments having the ability to ‘print money’ and so the idea of a currency that is naturally limited is superficially appealing. But if one truly understands inflation and deflation, it is a grim alternative.

How inflation occurs

In any economy there is a certain amount of circulating currency and a certain amount of productivity. Each transaction represents an exchange of commodities and currency. Commodities move generally from producer to consumer, whereas currency circulates in a full cycle. There is therefore a certain amount of currency that is transacted in any given time period, and in the same period, a certain amount of physical produce. The prices at which these transactions occur are determined by the collective demand curves of the prospective purchasing consumers. The amount of money that I am willing to pay for something depends not only on the utility of the thing, but also on the prices of other things and on the amount of money that I have. The more money that I have, the less valuable money itself becomes and the more I am generally willing or able to pay for everything I purchase. Simply, give me more money and I am able to outbid others for the things I want, raising the price. Give everyone more money and all prices rise, the distribution of commodities remains the same, but the value of money itself falls, relative to everything else.

‘Printing money’ does not inherently cause inflation. If I print money but do not spend it, it has no effect. Creating new money influences inflation when it is put into use. Whoever gains and uses the new money gains higher purchasing power, driving prices up. Whoever they buy from then takes more revenue and the effect cascades across the economy until the value of money has fallen universally and real prices are back to where they started.

Now here’s the bit that’s often forgotten, but is a actually one of the strengths of our current monetary system (for all its other flaws). Suppose I have an economy with one industry that pays out a thousand dollars per month to employees and shareholders, who then spend that thousand dollars on the produce of that industry, giving it a thousand dollars revenue. With a certain efficiency and level of production, the total work can be divided out and so also the wages and dividends. Those wages and dividends give the workers and shareholders a certain level of purchasing power, which when the produce is bidded on, yields a certain price. If I were to print extra money and simply give it to some people in this economy, their purchasing power would rise. The total amount bid for the produce would increase and so, divided up, the price of each unit of produce would also rise. This is simple inflation.

If however, I were to create a second identical factory, with identical workers and shareholders, and I were to print a thousand extra dollars to start off this factory, even if it were added to the existing economy, and workers and shareholders shopped around for their jobs, investments and purchases, inflation would not occur. Double the money would be spread over double the actors and double the produce. One divided by one is one; two divided by two is one. No inflation would occur, despite the fact that money had been printed.

Fundamentally, if it were not for this new creation of money, that thousand dollars would then somehow have to be stretched to cover the two factories and twice as many actors. The same amount would be bidding for twice the produce. The currency would deflate by half and become twice as valuable. This is why money is created by fractional reserve when businesses borrow to invest, but this does not cause rampant inflation. In fact, this creation of money is absolutely necessary as businesses and the economy expand, in order to avoid deflation.

Back to Bitcoin

Since we already know that Bitcoin has a limited amount of currency that can ever be produced, it is therefore doomed to rampant deflation as the economy that uses it grows. Ironically, those who favour Bitcoin and cite Weimar Germany for the consequences of rampant inflation overlook the fact that a similar fate awaits a Bitcoin-based economy. Instead of prices rising rapidly, they would go into free-fall. Savings worth a dollar would rocket to be worth millions, while tiny debts would turn into crippling burdens. The economy would completely break down.

While Bitcoin allows fractional reserve banking, ultimately, without the creation of new currency, the creation of money through fractional reserve is still limited to a multiple of the maximum number of Bitcoins. With 21 million Bitcoins and a reserve ratio of 3%, there is still a hard limit of 700 million BC that can be in existence of any form. The hard limit is delayed, but far from avoided.

What’s worse is that with Bitcoin, this scenario is hidden in a ticking time bomb. The amount of Bitcoins tails off over time. On the other hand, adoption rates are rising, so the size of the Bitcoin economy is growing at an increasing rate. We are currently on the early part of the curve, where adoption is relatively low and coin production is relatively high. In time however, if adoption remains high, the economy will boom while the coin production will drop off. The amount of coins, relative to economic productivity, will go into a nose-dive:

In fact, while the number of coins is far higher when fractional reserve is accounted for, this in fact makes the potential for economic danger even worse. Fractional reserve lends out money, creating that money, but the banks that do so also levy interest. It is quite possible therefore for the amount owed to banks to exceed the amount of money in an economy. This can be overcome in two ways: continual growth, eclipsing the debts of today with greater borrowing and money creation tomorrow; or quantitative easing, injecting enough base money and currency into the economy to keep the total money greater than the total debt.

Bitcoin cannot do the latter. It cannot create new currency or base money. In order to outrun the wave of debt that fractional reserve creates, it would have no choice but to have a continually growing economy, but the faster it grows, the more violent its uncontrolled deflation becomes.

The storm before the storm

Even  before this point is reached, there are many negative consequences.

One obvious inefficiency is the processing work that is done to create Bitcoins. This contributes absolutely nothing to the real world. Computational power that uses energy and hardware is being dedicated to making a virtual currency, when it could be used for a whole range of beneficial purposes.

Then, even before deflation becomes crippling, it still has negative effects. In the words of Paul Krugman,

“[bitcoin] has fluctuated sharply, but overall it has soared. So buying into [bitcoin] has, at least so far, been a good investment. But does that make the experiment a success? Um, no. What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in [bitcoin].”

Rather than functioning as an effective economic system, Bitcoin simply increases in value and serves as an investment for early adopters, dependent on others adopting later. This is not all that dissimilar to a Ponzi scheme.

Since the creation of Bitcoins is predetermined, there is absolutely no way for Bitcoin to cope with the way real economies change over time. The slow plod of currency creation carries on regardless of boom or disaster. Again, fractional reserve is no aid, because once reserve limits are hit, that supply of money also runs dry.

Despite the fact that the ability to create money has been abused by states, there are also some rarely mentioned positives of this ability. When spending stagnates in a recession, a swift and massive injection of new currency, directly to the working classes with the highest propensity to spend, has a good chance of kicking everything off again. Emergencies like wars and disasters might also require the state to create money. In these scenarios, taxation will take too long to collect and borrowing results in an unnecessary cost to the taxpayer. If money is created instead, then those who lose out from the resulting inflation are mostly those with hoarded capital, who, in a time of crisis, should be expected to lose a little, since they have gained most from the good times.

This ability does not exist with Bitcoin, and while it might save some money by restricting state spending in normal times, it could potentially cost lives in a crisis.

The most shocking aspect of the whole issue is that the creators of Bitcoin actually acknowledge that it will result in massive deflation:

Because the monetary base of bitcoins cannot be expanded, the currency would be subject to severe deflation if it becomes widely used. Keynesian economists argue that deflation is bad for an economy because it incentivises individuals and businesses to save money rather than invest in businesses and create jobs. The Austrian school of thought counters this criticism, claiming that as deflation occurs in all stages of production, entrepreneurs who invest benefit from it. As a result, profit ratios tend to stay the same and only their magnitudes change. In other words, in a deflationary environment, goods and services decrease in price, but at the same time the cost for the production of these goods and services tend to decrease proportionally, effectively not affecting profits. Price deflation encourages an increase in hoarding — hence savings — which in turn tends to lower interest rates and increase the incentive for entrepreneurs to invest in projects of longer term.

There are many good reasons to believe that deflation is incredibly bad. Firstly, it is simply conceptually wrong that a currency should increase in value with no relation to an increase in production efficiency. If I have a sum in the bank that I invest, and it increases because it creates productivity, that’s one thing. But the idea that my savings should just magically increase in value is absurd.

In fact, the author is completely wrong to say that the incentive to invest is increased. If my money is going to increase in value when not invested, why would I risk it on an investment?

Furthermore, having a slight rate of inflation is good because it counters the unstable equilibrium of capitalism. Those who possess money are able to put it to work for them, to earn rent; those who do not are at their mercy and must pay rent. Simply, it is in the nature of the system that those who have hoarded capital will tend to accumulate more, and those who have none will tend to sink further. A little inflation therefore devalues hoarded capital and partially restores economic equality, against a general tide to the contrary.

Deflation, on the other hand, would result in spiralling inequality, as savings and debts both expanded — for absolutely no good reason!

Imagine taking a mortgage out in a Bitcoin world. Your £200k mortgage might be 10 times your £20k salary when you start, but after 35 years of 5% deflation — your salary falling with deflation, to remain the same in real terms — it would be 60 times your £3,300 salary. It would be literally impossible for anyone to take out any significant credit, either for living or to start a business. For a business, the amount initially borrowed and invested would become relatively massive as prices and revenues fell over time. It is economically unthinkable.

Additionally, the disincentive to spend would certainly result in economic stagnation. Capitalism actively depends on spending and consumption. Those who do not own significant hoarded capital are dependent on the spending of those who do. Even with slight inflation, the rich have a low propensity to spend, and this would only be far lower if deflation was in effect.

Simply, the combined effect would be that a small number of people would have the majority of the money, with little reason to employ any more than a handful of the population. Everyone else would be left to starve.

So if Bitcoin fails — and it will — it will not be a tragedy, but a coup de grace.

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