The Problem with Bitcoin

I love the idea of bitcoin. Well, I love the idea of a crypto currency with zero transaction fees, and no government intervention. But the problem I see with Bitcoin is demand.

Like fiat money, Bitcoins are another “make believe” money that has value only because we say it does. Many argue it is superior to government issued fiat money as the its money supply is deterministic and slows in growth over time (rather than at the whims of the government of the day).

To say it is superior though, one must consider why fiat money has value. The core reason if which is that at the end of the day you have to pay your tax in fiat money. This is the core principle of Modern Monetry Theory1 and also common sense.  Regardless of how much gold, silver, things, or bitcoins I have, at the end of the year I have an obligation to the government to pay my tax in their fiat money. So if I want to keep my liberty I must purchase or earn fiat money. This gives it it a baseline value. Extrapolating from that, because I know others will need to do this, it is reasonably safe to say if I have some extra, perhaps even a lot extra other liberty-loving folk will have demand for it, so fiat money has and will always have  baseline demand assuming taxation is a certainty2.

What about precious metal? Precious metal has two things made-up money does not: there are physical applications, and it looks pretty. For those two reasons it is safe to assume a basline demand for precious metal.  Non-precious commodities likewise have a usefulness that drives demand. How about bartering chickens? Well chickens are delicious3 and can be turned into KFC – again, baseline demand.

Which brings us to Bitcoin. What is the baseline demand for bitcoin?

Fee Free Transactions?

One of the biggest features of bitcoin is the ability to send a transaction virtually without fees. One could say the demand for bitcoin was that people are demanding ways to save money on transaction fees, and thus will want to use it. This is a good argument, but the main problem I see is that while sending Bitcoins is fee-free, converting them to-and-from fiat money is not. In fact, it’s not only fee-bearing, it’s also a ripe pain in the arse (you basically have to walk into a bank and deposit money into the account of a merchant who you hope won’t steal it). So the only way this is going to work is if everyone starts accepting money in Bitcoin.  

It’s not good enough that I can sell you say a web-hosting package with bitcoin, but I must be able to pay for all the supply needed to provide that service in Bitcoin as well, right down the chain. This scenario would seem hard to imagine, and even if happens, at the end of the day I still have to convert some percentage into fiat money to pay tax.  Thus, the bitcoin value of an item can never be totally separated from the fiat money of the “host” country, except in the case of digital products, which once produced (which itself probably entails fiat costs), can be replicated for free. But because all physical items today have costs in fiat currency, most transactions that use bitcoin are still denominated in fiat.

It would be like buying a Coke where the pricetag was in USD, but you can only pay in EUR. At the time of sale, the shopowner checks online to see the latest price and charges you that many euros. But since their supply of Coke is also in USD and they are holding EUR, they are now exposed to the risk fo the euro decreasing in value against the dollar. Of course, this is why most things tend to be sold in the currency of their supply, and companies who don’t are at risk from exchange rate movements and often try to take steps to mitigate this risk.

BTC has actually been extremely volatile these last few weeks, so anyone selling physical fiat-based goods using BTC would need to cash out almost immediately to avoid the risk of losing money. Given both parties pay fees to enter and exit BTC from fiat, the 3% you pay for PayPal doesn’t seem so high anymore.

Due to this currency risk, using BTC as a transfer currency for non-BTC denominated goods doesn’t really help BTC demand (since the seller will need to cash out to avoid exchange rate risk). Thus I believe for bitcoin to succeed a great many things must become denominated in BTC.

Deflationary Pressures

Compounding the idea of denominating directly in BTC this is the fact that prices in BTC are designed to deflate. The money supply is limited4, as more people start to use it there is less of it to go around causing the fiat-cost to go up, and prices of BTC goods to inevedibly deflate. A Coke in BTC was 0.1BTC a year ago, and today is 0.01BTC (that’s 1000% deflation in 12 months!).  Deflating prices discourages spending as because you know an item will be cheaper tomorrow than today, you hold off your purchase. Ask Japan if you don’t believe me5.

The hyper-deflation of Bitcoin denominated goods seems to be inevitable if Bitcoin succeeds.

Thus, even if all of a sudden everything was denominated in BTC, the incentive is to horde, and not spend which basically defeats the point of currency.

Theft Risk

Finally Bitcoin is often touted as a store of value (and one that due to the above point is designed to increase in value). The biggest issue with this is that transactions are anonymous (traceable yes, but anonymous – unless you can ID someone from a 34bit string), and irreversible  While these are also good points (a merchant need not worry about a charge-back), it throws up some large hurdles. Firstly any reversible form of payment (like credit cards) cannot be used with BTC removing what could be a very easy way to transfer fiat money to BTC online. But more alarmingly, it makes it a very attractive target to hackers6. You can store your bitcoins yourself, or on a third-party server. Either way there is significant theft risk in holding Bitcoins, so the safest option would be not hold too many of them (meaning you again hit the USD->BTC fee issue). Would you walk around with your life savings in your pocket? Probably not. Sure you can have multiple levels of security for your spending money and savings – but either way, your “safe” as it were is connected by an ethernet cable to the internet. This is a solvable problem, but due to the instant and connected nature of Bitcoin, the risk of theft and fraud will always be high.

Conclusion

So, you have a currency with a highly volatile exchange rate forcing you to quickly convert to USD for real-goods transactions negating the “low fees” argument. You have a currency whereby prices are designed to deflate and a real world where many supplies will be fiat-denominated, countering the idea of everything one day being denominated in BTC. You have a high-risk environment whereby it is possible to lose a fortune to a thief just by visiting the wrong website.

So what exactly is the baseline demand for Bitcoin?

 

  1. Modern Monetary Theory has a bunch of interesting ideas, most which are better left to another discussion. []
  2. in this world, nothing can be said to be certain, except death and taxes – Benjamin Franklin []
  3. ducks are even more so []
  4. “Currently, 25 bitcoins are generated every 10 minutes. This will be halved to 12.5 BTC within the year 2017 and halved continuously every 4 years after until a hard-limit of 21 million bitcoins is reached within the year 2140.” – Wikipedia []
  5. Japan has experienced deflation for decades leading to the term “The Lost Decade” []
  6. For example, this is the transaction record for the alleged theft of USD$3,000,000 in bitcoins at today’s exchange rate. More stories: List of Major Bitcoin Heists, Thefts, Hacks, Scams, and Losses []

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