Can Bitcoin become money?

Introduction

Bitcoin was conceived as an alternative to the traditional fiat monetary system, but its feasibility has been a subject of debate among economists from various schools of thought. A primary argument against Bitcoin’s feasibility as a commonly used medium of exchange revolves around its 100% inelastic supply curve. It is argued that Bitcoin’s rigid supply schedule leads to inherently high levels of volatility that will forever preclude its use as money.

This paper aims to challenge this argument on two key grounds. Firstly, it questions the assumption that Bitcoin’s current volatility is primarily a result of its inelastic supply curve, positing instead that it is largely a function of a natural process of price discovery. Secondly, it challenges the presumption that human behavior is inherently predisposed to selecting the least volatile monetary alternatives, overlooking other attributes and factors that might influence the choice of a monetary asset.

Methodology

This inquiry into Bitcoin’s viability as money is undertaken maintaining a strict separation between the realms of normative and positive economics. Discussions surrounding Bitcoin’s feasibility as a medium of exchange often get entangled with normative assessments of Bitcoin’s desirability as money.

For instance, monetary equilibrium theorists like Selgin (2011), Rallo (2019), White (2023) and Cachanosky (2019) have argued that a monetary system with an inelastic supply would cause frequent price adjustments that would lead to economic inefficiencies due to price stickiness. Thus, these authors favour an elastic money supply that can mitigate the distorting effects of this “sluggish” price adjustment process.

Notice that the above argument is not positive or descriptive, rather, it is entirely normative in nature. It examines the desirability of a specific monetary system by assessing its impact on broader facets of the economy, such as employment, production, or more abstract notions like utility and welfare. But human action is not subordinated to any such macroeconomic notions, humans make choices — monetary and otherwise — based on their individual, subjective preferences.

The aforementioned arguments deviate from the fundamental question at hand which is a purely positive one, namely, about the feasibility of bitcoin becoming money, not its desirability.

Introducing normative considerations is unhelpful for several reasons:

• Firstly, it shifts the inquiry from a matter of possibility to one of desirability, which is inherently subjective and dependent on individual ethical perspectives. Whether a given monetary system is desirable will be answered very differently by a socialist, a classical liberal, a libertarian, a communist or a social democrat because each of these ideologies have different ethical foundations which lead to divergent considerations of what is desirable.
• Secondly, delving into normative considerations about a hypothetical monetary standard based on Bitcoin is only worthwhile if one has first established, on a positive basis, that Bitcoin can function as money. Only after addressing the positive question concerning Bitcoin’s feasibility as a currency can we delve into the realm of political economics, exploring arguments both for and against the establishment of a monetary system founded on Bitcoin.

In light of these considerations, the scope of this inquiry is deliberately confined to the purely descriptive and positive facets of Bitcoin, specifically concerning its feasibility as a medium of exchange.

Why Bitcoin was Created

In 2009, Satoshi introduced Bitcoin to the world, utilising a peer-to-peer network powered by a set of incentives designed to prevent double-spending and censorship. This unique system operates autonomously, without relying on trusted third parties, providing universal accessibility and resistance to censorship.

However, Satoshi’s vision extended beyond just offering censorship resistance; it also aimed to address the issue of currency debasement. This objective was prominently articulated in the following statement:

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.” Nakamoto (2009)

Satoshi was aware of the challenges (perhaps insurmountable) of creating a currency that is both decentralised and can adapt its supply to changes in demand, hence, he conceived Bitcoin with an inelastic money supply as he articulated in the following passage:

“I don’t know a way for software to know the real world value of things. If there was some clever way, or if we wanted to trust someone to actively manage the money supply to peg it to something, the rules could have been programmed for that.”

Thus, Bitcoin was designed with a supply of coins that are produced at a predetermined rate. Bitcoin is the first monetary asset with a production of units that remains entirely unaffected by fluctuations in its price, resulting in a 100% inelastic supply schedule. It is a singular innovation with no historical parallels, and market participants have grappled with the challenge of assessing its value. When examining Bitcoin’s price evolution, we observe a meteoric rise interspersed with several sharp crashes from 2009 to the present day.

The nature of this volatility and the implications for Bitcoin’s feasibility as money are the central question of this paper.

Macro argument against Bitcoin being money

One of the primary macroeconomic objections to Bitcoin’s suitability as a form of money arises from the perspective of monetary equilibrium theorists. Economists such as White (2023) and Chanosky (2019) propose that the current significant volatility observed in Bitcoin can be attributed to its inflexible monetary policy. They contend that due to Bitcoin’s 100% inelastic supply schedule, any shifts in demand inevitably translate into price fluctuations, resulting in inherent and high volatility. This high level of volatility will preclude its widespread adoption as money.

The following chart shows the argument in its graphical form presented by Cachanosky (2019). The chart on the left depicts Bitcoin’s perfectly inelastic curve, which causes volatility in response to changes in demand. The chart on the right depicts an alternative with a perfectly elastic supply curve, which maintains price stability by adjusting the supply to changes in demand.

The argument has three underlying assumptions that will be discussed individually:

• The nature of Bitcoin’s current volatility.
• The ability of monetary substitutes to mitigate Bitcoin’s volatility.
• The assumption that human action prioritises price stability over other monetary attributes.

1- The nature of Bitcoin’s current volatility.

The first premise that warrants closer examination is whether Bitcoin’s current volatility stems inherently from its supply schedule, or whether there are additional factors exerting influence.

One major factor that could be contributing to today’s volatility is the market process of finding an equilibrium or target price. The unique attributes that we alluded to at the start of this article, the lack of historical parallels and the risks to the system, make the search for Bitcoin’s equilibrium price extremely challenging. This is manifested in the disparate viewpoints held by even seasoned economists and investors: skeptics like Buffett, Munger, or Krugman regard Bitcoin as “rat poison” with a fundamental value of zero. Conversely, Bitcoin enthusiasts like Cathie Wood or Balaji project price targets well beyond the million-dollar mark.

Given this inherent divergence in perception, it’s hardly surprising that Bitcoin exhibits extreme volatility. Initially, Bitcoin was priced at just a few cents and experienced an unparalleled surge in value, now boasting a market capitalization of approximately 500 billion dollars. This substantial appreciation has come with a high level of volatility, but there is no reason to believe the market will remain in this state of extreme disequilibrium indefinitely.

At some point, consensus will form that Bitcoin’s appreciation potential has diminished, and speculative demand will subside; Nakamoto’s innovation cannot appreciate ad infinitum. It’s tautological that as Bitcoin’s market capitalization climbs, its growth potential diminishes. The market will naturally gravitate toward a point where consensus forms that Bitcoin is no longer the compelling investment it is today. This is the natural outcome of the free market process; markets trend towards equilibrium, albeit perpetual changes in the world and shifts in subjective valuations make it impossible to ever reach equilibrium. There’s no reason to expect otherwise in the case of Bitcoin.

In line with this perspective, White (2023) makes voices a similar viewpoint in the following passage:

“It is defensible, then, to argue that Bitcoin’s purchasing power would become less volatile if the demand to hold Bitcoin as a medium of exchange were to grow relative to demand to hold it as an investment. Transactions demand for money is more stable than speculative demand for a financial asset, so demand curve shifts would be smaller.”

Indeed, that is what one would expect from the market process: as market participants become acquainted with Bitcoin and consensus over its fair value grows its fair value grows, it naturally becomes less attractive as an investment.

The data seems to support this case. The following chart illustrates how Bitcoin’s volatility in recent years has significantly decreased compared to its initial trading period at the beginning of the past decade.

If the Bitcoin software continues to operate soundly, there is no reason to believe the above trend will not continue; with increased regulatory clarity and broader knowledge of Nakamoto’s creation, we should anticipate continuing consensus on Bitcoin’s fair value, which will naturally curb volatility.

This does not imply that Bitcoin will attain stability, as its inelastic supply curve will always render it more volatile than an asset that can adapt its supply in response to changes in demand, such as a well-managed fiat currency.

2- The ability of monetary substitutes to mitigate Bitcoin’s volatility.

A second factor that could further accentuate a reduction in Bitcoin’s volatility is the issuance of Bitcoin fiduciary media. As the market forms a greater consensus on Bitcoin’s fair value, volatility will naturally decrease to a level where financial institutions can introduce monetary substitutes that can partially satisfy changes in the demand for money.

Some interesting proposals in this respect come from heterodox Austrian economists like Rallo, Bondone and others who propose a modern version of the real bills theory. They claim the issuance of fiduciary media backed by real assets could be a natural, self-regulating mechanism for adjusting the money supply in lockstep with economic activity.

Presently, Bitcoin’s price discovery process is so tumultuous that such instruments would carry substantial counterparty risk and are unlikely to trade at par. However, as Bitcoin’s price discovery continues to mature, one can anticipate these instruments being issued by financial intermediaries or even through smart contracts. To the extent that monetary substitutes are produced sustainably, without leading to credit booms and financial crisis, they have the potential to further dampen Bitcoin’s volatility.

The issuance of fiduciary media could reduce volatility but it could never lead to a perfect match between the supply and demand for money. This is particularly pertinent during periods of uncertainty when users may lose confidence in monetary substitutes and demand inside money Bitcoin as their preferred form of currency, causing the substitutes to lose their par value.

These risks of fiduciary media are inherent to any monetary system, whether it is backed by gold, Bitcoin, or even fiat currency. However, in the case of Bitcoin they are more prominent since there is no mechanism to adjust the supply of inside money to changes in demand.

The extent to which the issuance of fiduciary media can be undertaken sustainably, leading to a reduction in volatility, will depend on factors that go beyond the scope of this essay.

3- The assumption that human action prioritises price stability over other attributes.

Finally, it’s essential to recognize that even if the market process moves Bitcoin closer to a more stable equilibrium and fiduciary media are issued, Bitcoin will still be more volatile than an optimally managed fiat money. This stems from the inherent nature of Bitcoin’s inelastic supply curve, which ensures that shifts in demand, unmet by monetary substitutes, will inevitably result in price fluctuations. In contrast, under the fiat system, currency issuers have the flexibility to adjust the base money supply according to shifts in demand.

However, the admission that Bitcoin will consistently carry more volatility than an optimally managed fiat currency does not preclude it from being widely adopted as money. This would only hold true if human action adhered to a deterministic process that invariably favoured the least volatile currency, regardless of other considerations. Yet, the reality is quite different; Human action is not deterministic, there is no objective cost/benefit function that predisposes it to select the least volatile among monetary alternatives.

In the author’s view, the prevailing fixation on possessing a currency with stable purchasing power is based on a flawed assumption that underpins the existence of centrally managed fiat currencies. Empirical evidence demonstrates that, prior to the advent of fiat currencies, human societies effectively utilised monetary alternatives that were characterised by greater volatility, serving their roles for extended periods.

The 19th century provides empirical evidence of a monetary asset gaining purchasing power over time, even in the face of substantial volatility, and continuing to be used by economic agents. In the United States, from 1880 to 1896, the purchasing power of gold increased by over 30%. A similar situation occurred in the United Kingdom during the early 19th century, with the currency appreciating over decades while experiencing significant volatility.

It is entirely plausible for individuals to prefer a more volatile asset as money, provided it offers additional benefits not found in the less volatile alternatives. This distinction becomes evident in the Bitcoin versus Fiat debate.

While fiat currencies can be managed for greater stability compared to Bitcoin, they are perennially susceptible to currency debasement that may lead to high inflation. The Damocles spade of debasement, which always hangs above the heads of fiat currency holders, is not it’s only drawback. With the advent of Central Bank Digital Currencies (CBDCs), fiat money could pose a threat to our utmost freedoms such as freedom of transaction, of movement, privacy, or association,

In this context, it appears entirely reasonable that market participants might opt for Bitcoin, even if it is more volatile than fiat money, due to the benefits it offers such as: censorship resistance, transparency, lack of supply shocks, absence of counterparty risk, and appreciation with productivity increases.

Ultimately, we cannot know a priori whether the market will favour a more volatile asset with additional benefits such as privacy or decentralisation over a less volatile but centralised option. What we do know is that the perception of these benefits and costs is inherently subjective, which makes it feasible that individuals will choose the more volatile option despite its associated costs, due to its other perceived benefits.

The latter scenario becomes all the more likely if Bitcoin’s volatility comes down due to the price discovery process and the appeal of fiat currency diminishes with the introduction of Draconian and surveillant CBDCs.

Additional Considerations

While the primary objective of this inquiry is to scrutinize the arguments put forth by those who assert that Bitcoin can never attain the status of money, it’s crucial to clarify that the author does not contend that Bitcoin will inevitably achieve that status. Several factors could preclude Bitcoin from becoming widely adopted as money.

These factors include the prospect of high taxation, government restrictions, a failure of the public to recognize the value proposition of the Bitcoin system, or potential vulnerabilities within the protocol’s architecture. Expanding on the latter point, it’s worth highlighting that the Bitcoin protocol represents a fairly novel innovation, and it remains to be seen whether the economic incentives at the heart of Bitcoin will continue to ensure the system’s reliability.

From an engineering perspective, the two greatest risks pertain to the uncertainty around the security budget and the centralization of mining operations. These two risks could render the system insecure against double spending and erode its censorship-resistant attributes.

Conclusions

This paper challenges the prevalent perspective held by many economists regarding Bitcoin’s potential as a form of money. It questions the conventional belief that Bitcoin’s 100% inelastic supply curve inherently leads to prohibitive levels of volatility, which preclude its widespread adoption as a monetary system.

It asserts that Bitcoin’s current volatility stems from the market’s quest to establish a fair value for Nakamoto’s invention. The process of establishing such value is naturally volatile due to Bitcoin’s unique attributes, and the lack of any historical precedent.

As regulatory clarity increases and understanding of Bitcoin broadens, the market process will converge towards greater consensus over its fair value. This convergence will result in diminished price volatility, thereby increasing the likelihood of it becoming more widely accepted as a form of money.

Crucially, this analysis highlights that the choice of a monetary system is not solely determined by price stability. Human action is inherently subjective and multifaceted, and individuals may opt for a more volatile monetary asset if it offers additional benefits such as censorship resistance, transparency, and freedom from counterparty risk. In the evolving landscape of Bitcoin’s adoption, individuals might embrace it as a currency choice despite its higher volatility.

In a future environment where CBDCs threaten our most basic individual freedoms, the merits of Bitcoin could push the scales toward Nakamoto’s invention. To reiterate, economists shouldn’t rule out this possibility because human action doesn’t invariably prioritise stability above all other currency attributes.

It’s important to acknowledge that the path toward Bitcoin becoming widespread money remains uncertain and fraught with potential obstacles. These hurdles may include high levels of taxation, the imposition of Draconian regulations, vulnerabilities within the protocol, or simply a failure on behalf of the public to appreciate Bitcoin’s value proposition.

Even if we assume the system will continue to operate soundly and State regulation is friendly to Bitcoin, we cannot know a priori whether the market will prefer Bitcoin to fiat currencies despite its higher volatility. The subjective nature of human preferences makes it impossible to predict human preferences within the competing landscape of centralised and decentralised currencies.

References

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