A Crash Course on Digital Cash (Part 3)
Debunking Crypto Monetarism: A Critical Analysis of Bitcoin's Monetarism
I always value the insights and recommendations by
which led me to a newsletter produced by Lyn Alden. She describes a number of important issues. In fact, she addresses critical insights missing from the mainstream understanding of how crypto or stablecoin work, hence why the regulatory response is what it is these days. Particularly, I found her discussion on the different preference for the issuance network as a function of relative wealth and transaction costs comparing TRON and Ethereum extremely useful. I also very much agree with her perspective on the utility of crypto in markets with weak institutions and high inflation.Alden describes her thesis as follows: “new monetary technologies have significant potential to disrupt the existing legacy money system.” Other than the curious term ‘monetary technology,’ this is a statement I can subscribe to in abstract terms. In my previous article on digital cash, I emphasised how the advent of digital technology could transform our understanding of money.
However, Alden and I have very different ideas about what that means. Alden's focus on crypto as an alternative form of payment or store of value mirrors a common debate which, in my view, is often backward-oriented and oversimplifies or confuses economic theories, thereby missing the actual broader implications of digital currencies.
Take, for example, Alden's view that the hard-capped supply of 21 million Bitcoin would act as a safeguard against inflation. That same notion is already in the Bitcoin whitepaper, claiming that a fixed money supply would miraculously create a “completely inflation-free” system. We don’t know who Nakamoto-san is, but he probably failed his university seminar on 'Introduction to Monetary Theory'. But in this instance, shouldn’t common sense be enough? So where does idea come from?
And why is a fixed supply a very bad idea (#leadingquestions)?
The Quantity Theory of Money (QTM) is one of the main principles underpinning our modern financial system. It posits a direct relationship between the quantity of money in an economy and the level of prices. It was developed by economists like Irving Fisher in the early 20th century and became orthodox thinking with Milton Friedman's restatement in the 1950s.
The QTM was and still is influential in monetary policy, but it had its heyday during the late 1970s and 1980s when central banks, such as the U.S. Federal Reserve under Paul Volcker, targeted money supply growth to control inflation. However, the results were mixed; the relationship between monetary aggregates and macroeconomic variables like inflation and interest rates was found to be unstable for a variety of reasons. The specifics I think are not so interesting but I want to note some high-level comments:
The circumstances when QTM was developed and our modern economy are very different. The shift from industrial production to a service-oriented economy, and the complexity of global economic interactions through the internet are new phenomena and, as far as common sense is concerned, one question this should raise: how can a theory developed under very different circumstances apply to today? Not saying it cannot, but surely some caution is advisable.
The QTM primarily addresses the long-term relationship between the money supply and price levels (inflation) in an economy. However, it does not focus on short-term price changes as a result of immediate supply and demand changes, market sentiment, rumors, upcoming train strikes in London as a result of which I have to change plans for a Christmas party. These kinds of things.
Alden also expresses a view that higher levels of adoption of Bitcoin would lower volatility and, on the expectation that’s where we are headed with Bitcoin, one should assume more price stability of this asset as well. Sounds very reasonable but in this case is also misguided because the 21 million Bitcoin cap acts as a price destabilization mechanism - a fixed supply can react to changes in demand only through price changes. In other words, if Bitcoin became widely adopted the first thing that needs to happen is to get rid of the cap or the whole arrangement will blow up. And this brings me to another point. Even if the protocol says there is a cap of 21 million bitcoin now, nothing stops the Bitcoin community from forking the whole affair and getting rid of the cap. There is no absolute certainty here.
I could go on quite a bit here, particularly how empirical data since the 1980s gives further evidence that the 1:1 relationship between money supply and inflation is perhaps not as strong as the QTM suggests and this fact is widely acknowledged by central banks. Inflation is influenced by a multitude of factors beyond mere money supply, including but not limited to fiscal policies, global economic conditions, supply chain dynamics, and consumer behaviour.
But crypto monetarists don’t have to believe a word I say. How about we do a little thought experiment instead. What would it look like if the world adopted a strict Bitcoin monetary system?
Welcome to the Bitcoin-Optimist Economy of 2023
Let’s make a few assumptions
The economy is only using 21 million bitcoin.
And whilst our real economy has a GDP of US$80 trillion our fictional one would be worth 21 million bitcoins
Banks are not allowed to create private bitcoin based on bitcoin deposits (lets assume banks are still with us in such a scenario)
Lets assume we go to get a Starbucks coffee which currently cost 5 US$. A bitcoin can be split into 100 million satoshis so we have 21 million Bitcoin which equals 2.1 quadrillion satoshis. This also means that the lowest price one could pay for anything equates to 1 Satoshi under the following set of assumptions:
The global Bitcoin transaction system is not capable of handling fractions of a satoshi, which currently does not exist in the Bitcoin network as it stands. And we also rule out the possibility that Starbucks says: minimum units of coffee you must purchase is higher than 1. In other words, unless you buy 3 coffee for instance Starbucks won’t serve you.
Back to the Starbucks coffee counter.
Me: “One salted caramel cold brew, please.”
AI Robot running the store: “Certainly, 1 Satoshi please.”
Here is the exam question: How much did we just pay for coffee?
Answer: 1 Satoshi!
Yes Sherlock, thank you! No that’s not what I meant. We know that a coffee today costs US$5. So if US$5 represents the same proportion of the world economy as 1 Satoshi does of the total Bitcoin supply, then we can calculate the US$ value in our terms of 1 Satoshi in the parallel universe. Who knows, a wormhole may have just appeared allowing inter-dimensional travels to visit the Bitcoin-Optimists hence making this comparison extremely relevant and useful.
Solving the equation gives an value of approximately $131.25 per satoshi. And with this I think it becomes obvious that we should be asking ourselves two questions:
Is a finite amount of money really a smart idea?
Does the fact that Starbucks has so much to gain in a Bitcoin-Optimist economy create sufficient evidence that Mr Sakamoto was in fact the IT department of Starbucks. Hmm, what an intriguing idea! I even found some secret footage where this idea was discussed.
At the end of the day, this example is just a bit of meaningless maths. But the oversimplification of economic theory or disregard for unintended consequences of what one advocates is a problem. Without the ability to adjust the money supply in response to economic growth, the currency might struggle to function effectively. As the Bitcoin-Optimist economy grows but the money supply remains fixed, the share of the total economy each unit of currency represents increases over time creating a deflation. And that’s not necessarily a good thing. The pricing of low-value items could become problematic, potentially leading to a situation where prices lose practical meaning. And then we either live in a Star Trek utopia without the need for money because we have replicators and therefore unlimited supply of anything or markets cannot function and supply is dropping leading to some post-apocalyptic scenario. So next time you hear somebody tell you how amazing the 21 million supply cap is ask them: Do you really want to live like Will Smith in “I Am Legend” when you could be him in “Men in Black”. That’s a no-brainer.