The case for bitcoin

People are often surprised when they ask economists, what is money, and the reply is, well, anything that fulfills the functions of money is money: money is as money does.

The classic definition of money is anything that is: i) a means of payment; ii) a store of value; and iii) a unit of account. For more than a decade, Cambridge Master of Finance students have argued about whether bitcoin is money. While there are differing views, the consensus is, not yet (and perhaps never). But bitcoin may nonetheless have a long term role in the financial system.

Bitcoin as money

Taking the three criteria in turn, bitcoin clearly can be used as a means of payment, most recently including paying for a new Tesla, but for the most part it is not at all widely used and faces well known operational constraints. Brilliant though Satoshi Nakamoto’s creation is, it is not optimised for large volume processing, compared with for example Visa and Mastercard (the scalability problem). And currently there are relatively large costs in buying and selling bitcoin (Coinbase fees are in the range of 0.5% according to estimates based on its IPO prospectus).

Both of these problems may be overcome by innovation and greater competition. But the deeper issue is that for most people in advanced economies, payments already work pretty well and there is no obvious problem to be solved (this is not true for international payments, which are very expensive, hurting migrant workers who send remittances home). There are doubtless plenty of niche applications of fintech to improve efficiency in wholesale markets, but this is not likely to be transformational. McKinsey’s 2020 Global Payments Report doesn’t mention bitcoin (but does mention blockchain).

Bitcoin can be used as a store of value but its high price volatility means it’s not a close substitute for cash or other low risk financial assets. It may, however, have a role in a diversified portfolio, as we’ll discuss below.

Lastly, bitcoin and other cryptoassets currently aren’t considered as practical units of account: generally when people use these assets to buy something the price is denominated in dollars (or euros, yen etc). It’s conceivable that with greater adoption, you could imagine many items being priced directly in bitcoin, but again there isn’t an obvious problem to be solved here.

A case for owning bitcoin

So what is the case for owning bitcoin?

Bitcoin may be an imperfect store of value but could nonetheless have a role in a diversified portfolio, similar to that of gold. In fact many people have been discussing the idea of bitcoin as “digital gold”. Gold is a non-financial asset, meaning that its value is not dependent on any other party (financial assets have a counterpart liability, which raises counterparty risk). It has no yield and its price is volatile, but many individuals and some institutions hold gold in their wealth portfolio as a hedge against what economists call “states of the world” in which conventional financial assets may fall in value.

Chief among these is inflation, especially hyperinflation. It is widely believed that gold is a hedge against these. Hyperinflation is thankfully pretty rare and is often associated with a fundamental breakdown in the normal operation of the state (such as after a war), in which case gold may be a good thing to own (along with other real assets like real estate). Gold is actually an imperfect hedge against more normal levels of inflation, since a lot depends on what caused the inflation. Equities, while not a short term hedge against inflation have tended to beat it in the longer run (as well as providing an income through dividends).

Why might bitcoin be an alternative to gold? Like gold it is limited in supply, by design, and the concept of “mining” bitcoins is clearly a reference to the slow, steady mining of new gold supplies. Bitcoin is better in this respect, because gold supply historically has been subject to random sudden increases at time of new discoveries such as the gold rushes in California (1848-1855) the Klondike (1896-99) and the discovery of the gold reef of South Africa’s Witwatersrand (1886).

Bitcoin also has practical advantages: gold is bulky and needs to be stored somewhere, which has a cost. Both bitcoin and gold can be stolen, but it might be hoped that bitcoin theft will become less of a problem with major financial institutions like BNY Mellon now offering a custody service.

We can presume there is some general level of demand for an asset which may plausibly retain its value when other financial assets are all in jeopardy. If that service is currently provided by gold, but bitcoin offers a competing and possibly better service, then some of the global asset allocation to gold could shift to bitcoin. The total demand for gold and bitcoin would be limited to the extent that both offer a competing service, that of insurance against rare but catastrophic events.

Gold or bitcoin?

As noted, gold and bitcoin share a key feature of finite (or slowly growing) supply. Gold is pretty much indestructible, though in the James Bond film Goldfinger the eponymous villain tries to use an atomic bomb to irradiate the US gold supply at Fort Knox, thereby rendering it unusable and radically decreasing effective supply in an instant, to raise the value of his own gold holdings. (Unusually, Bond, once he grasps that Goldfinger is not trying to steal the gold, complements him on a “brilliant” plan – usually Bond tells the villains they’re mad, which indeed they usually are.)

It is also not clear if bitcoin will be around in 10 or 20 years. It may be that we look back from later this century and see bitcoin and other cryptoassets as clever and fascinating early pioneers of technologies that have evolved far beyond them, a bit like the mainframe computers of the 1960s, which now look quaint compared with modern laptops. I suspect that we will also look back on the process of “mining” – using high end computers to generate random numbers, using a lot of electricity, as a very late 20th century way of doing things.

But then in the 19th and early 20th century during the Gold Standard, gold was dug up at great cost and risk from deep underground, only to be transported to Paris, London or New York, to then be re-buried deep underground. This is a curious way to organise an advanced economic civilisation.

Another threat to bitcoin’s use is from central banks. If bitcoin or any other fintech product threatens to take too important a role in the financial system they will be tempted to regulate it or ban it. This is particularly true in China, which is well on the way to implementing a central bank digital currency, which is almost the opposite of bitcoin in being centralised, regulated and completely under the control of the authorities. I suspect that the Fed, Bank of England and European Central Bank are all intrinsically rather suspicious of bitcoin, a point that its supporters see as one of the reasons for holding it.

Of course it would be hard to actually get rid of bitcoin. Like the distributed AI presence that is Skynet in Terminator 3, it can’t be switched off and could linger on indefinitely so long as enough people keep hosting the computational problems that make the blockchain work.

If supply of something is fixed, then the price depends entirely on demand. For both gold and bitcoin, demand is a social convention, meaning that it depends entirely on what you think other people will do. There is no intrinsic value in bitcoin; gold’s limited intrinsic value comes from use in wedding rings and electronics.

With social conventions there can be multiple equilibria. There could be a “high” equilibrium where many people believe that many other people will own bitcoin into the indefinite future; the price could be high, indeed far higher than today.

But there is a “low” equilibrium, where most people believe that most other people won’t own bitcoin, perhaps because a superior new electronic store of value has been invented, or central banks try to supress it. It’s possible to switch from the high to the low equilibrium quite quickly, which is what happens at the bursting of a speculative bubble or the collapse of an exchange rate.

What form do you think disaster will take?

Assuming you think bitcoin will survive, the question of which to hold comes down to what sort of event or state of the world you seek insurance against. Gold’s claim to be a disaster-proof form of value rests on thousands of years of history of humankind’s lust for its unique, elemental beauty: kings, chiefs and priests use gold and other precious metals and stones to indicate their status. Gold’s resistance to tarnishing and malleability makes it ideal for use in in jewellery, which also provides an alternative source of demand (along with industrial use in electronic components). Refugees in times of war and persecution sometimes carried gold with them, though a better form of portable wealth is diamonds.

Bitcoin hasn’t been around long enough to have a track record in crises. If you think that the biggest threats come from financial dislocation and hyperinflation, but that the rest of the economic system may survive, then bitcoin could perhaps retain its value in a crisis and warrant a place in your portfolio.

But if you worry that the bigger threat is rogue AI, cyber warfare and a collapse of our extraordinarily computer-dependent civilisation, then bitcoin will vanish along with all other financial assets (except old fashioned cash) and you may prefer to stick to gold (or a tin-opener).

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UPDATE

Here is further work casting doubt on gold as a hedge against inflation.

2 Responses to The case for bitcoin

  1. Do you think a Bitcoin or crypto ETF will be approved by regulators anytime soon? This would open the market to retail investors who don’t want to deal with the security aspects of owning crypto.

    • I understand why regulators are cautious about this. There isn’t much upside for them in allowing (probably a small number of) retail investors to own bitcoin ETFs, but lots of downside if it all goes horribly wrong, which is quite possible. There are indirect investment strategies, such as buying blockchain ETFs or investing in a few companies that hold bitcoin on their balance sheet. I cannot stress enough, I am not providing any kind of investment advice here.

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