Why Bitcoin?
The Gist: Private currencies are typically ended by government but crypto is designed to be more resistant.
The most attractive promise of Bitcoin is that it is relatively resistant to government regulation and seizure. This is why Peter Thiel refers to crypto as a libertarian technology, why dissidents around the world are excited about it, and why our own government worries and warns about its use by criminals. This feature is also crucial to understanding how Bitcoin might function as insurance, a currency, or an investment.
Figure 1. Privately owned firearms might also be described as a libertarian technology that excites dissidents but that governments warn will be used by criminals.
+
As insurance against political risk - that possibility that three centuries of Romanov monarchy (or your local supposed stability) will end in the blink of an eye with Communist seizure of private assets - crypto promises to be the only opportunity to avoid forever being dependent on a third party for your wealth and, relatedly, to be the only asset you don’t need anyone’s permission to transfer. No bank, no government, no ship captain stands in your way - it is almost infinitely easier to escape a jurisdiction with $1 billion of bitcoin than $1 billion of gold bullion or $1 billion cash. And as Bitcoin podcaster John Vallis has colorfully argued, if the government can’t stop marijuana, it can’t stop Bitcoin. But is your Bitcoin truly secure from the government?
Figure 2. Some legal advice: just because the government can’t totally stop the general product does not mean you won’t find yourself in a jail cell for its use.
Bitcoin’s creation was inspired by a rather good book by the Austrian economist Friedrich Hayek calling for the denationalization of money - and its brand new asset category is often referred to as cryptocurrency. Another Bitcoin promise is to be a private alternative to infinite government fiat currencies. Historically, free private currencies backed by precious metals have functioned quite well in various places over multiple decades-long runs - but their fatal flaw has always been a jealous government who would prefer to control the mint for its own insatiable spending needs. As early Bitcoin adopter Erik Voorhees has argued, if you want a market-based money that does not get shut down when it grows past the size of a novelty, it has to be decentralized. The nature of Bitcoin is such that even totalitarian governments would have a difficult time shutting the whole network down - the crypto just needs some computers somewhere running the code. But assuming that Bitcoin is indeed secure from the government, is that sufficient to function as a currency?
Larry Swedroe is an investment advisor who bases his recommendations on analysis of long term returns - predictably, he's an advocate of index funds (though he also wrote an interesting book on alternatives.) For understandable reasons, he concludes: "Bitcoin is purely speculation, and smart investors don’t speculate. It’s important to understand that no one has yet to provide a fundamentals-based valuation model for bitcoin. And for good reason. There simply is no tangible relationship between any economic or financial parameters and bitcoin prices." All seemingly reasonable, though if you had listened when he wrote that in 2017, you’d have missed out on a 60x return. And yet… Hindsight is 2020. The person who warned against a tulip bubble was wrong until he was right, the person who doubted the deployment of venture capital might not have been prepared to take the risk of losing everything even if it meant a chance at gaining much. And, today, how much more can it go up?
Figure 3. Joseph Kennedy claimed that he got out of the stock market before the crash when his shoeshine boy started giving him stock tips. I thought about that quite a bit as I drove through Iowa a few months ago and several gas stations displayed handwritten signs “WE SELL BITCOIN”
+
Alas, Bitcoin’s resistance to government is relative rather than absolute.
A significant aspect of Bitcoin is that every single transaction is recorded in a public ledger that anyone can see (unlike, say, the exchange of unmarked bills on the street). Bitcoin’s transactions are not anonymous - but they are pseudonymous. Determined governments have figured out who was transacting when owners of Bitcoin have overestimated their privacy. Vigilant Bitcoin owners can, with effort, try to hide better, though that can mean relying on third parties. But then governments can drive Bitcoin use underground (as China is doing), criminalizing its possession and use, which leaves it primarily as an insurance policy you can tap into if you can get out of the country. If the government detains you, it will have a far easier time getting at your Bitcoin key than your property physically placed abroad. Notably, other crypto could improve upon Bitcoin in this respect: Monero, for example, was designed to completely protect the privacy of its users - but mainstream crypto exchanges avoid carrying it for fear of a government crackdown.
Figure 4. That being said, you can start to prepare counter-interrogation techniques at home with just a hose and a rag!
An underappreciated and related Bitcoin problem is its transaction cost. If you are holding Bitcoin directly in your own wallet and do not do anything with it, you pay nothing. But if you actually try to transact, you have to pay a commission to incentivize miners to process your transaction - and the cost to miners grows by the year (to the point where some question whether there might eventually be an electricity problem). Further, a core Bitcoin design feature is that it only processes so much data per day - and that data is a fraction of what, say, Visa does. Various solutions have been proposed as to how to deal with this problem, but the most popular answers right now have to do with layering in third parties, which, of course, endangers one of Bitcoin’s key promises to avoid counterparty risk. Relatedly, most Bitcoin transactions take place on exchanges that are of course third parties that can be regulated by the government or have their own problems: Mt. Gox was an exchange that handled over 70% of Bitcoin transactions until it was notoriously robbed of crypto then valued at over $450 million.
+
The least attractive feature of Bitcoin - at least so far - is its extraordinary price volatility. Bitcoin can still change in price 30% in a weekend. From its 2021 height, its value dropped almost by half before recovering. What has made Bitcoin attractive as a speculative investment - that it jumped 60x in value from 2017 to 2021 - also has made it unsuitable as a currency for goods and services. This is partly why 80% of Bitcoin owners are “hodl”ers who are holding it to the moon. Why would you spend something that is rocketing upwards in value?
Even as some merchants accept Bitcoin, they still price their goods in dollars - who could regularly risk pricing their goods and services in something so presently unstable as Bitcoin itself? How could a bank wisely simultaneously assess the risk of a Bitcoin loan applicant and the price range of Bitcoin itself upon repayment? As a Bridgewater analysis puts it, “Compared to established storeholds of wealth, such as gold, real estate, or safe-haven fiat currencies, Bitcoin faces a much wider range of outcomes in terms of its future value.”
Figure 5. With a 50% swing, the same amount of bitcoin might buy you a new F-150 one day and a used Fiat hatchback six months later.
As insurance, so far it has worked out because, over its very short time frame, waiting meant that the price would only go up if you held. But there are limits to how far it can go up. And it is currently up at a time when every asset is up - the next crisis should be interesting to see whether Bitcoin is fled to or from for safety. One Cornell professor has noted that Bitcoin’s price is much more sensitive to regulatory changes and tweets than economics fundamentals which, I suppose, is one way of ensuring a diversified portfolio with 0.2 correlation to stocks and bonds but it’s quite risky as a currency that you hope to build society around (or even to use as your safe reserves).
Figure 6. To be fair, recently our politics has also been correlated to tweets, so maybe they are more fundamental than you think.
The U.S. dollar, of course has much less purchasing power volatility (though still too much) and that, along with its global recognition and acceptability has meant that even in places like hyperinflationary authoritarian Venezuela people still prefer Benjamins to bitcoin.
Still, over the last century, the dollar has lost 95% of its purchasing power, so many people long for the days of currencies (private or public) backed by precious metals. Gold’s purchasing power over the last century (indeed, millennia) is just about the same. Over the very long term, an ounce of gold would have gotten a man a very nice suit across most times and places (or been useful in buying your way out of a country). But you might be surprised to know that gold has pretty bad short term volatility itself - in 2021, it has ranged 13%. Since 2017, it has ranged 45%. Worse, between 1981 and 2001, as the US dollar lost almost half of its real value, gold lost 80% of its real value. But back when gold was actually used as a money, in the classical gold standard of the 19th century, average inflation was just 0.1% (though there were swings of value between inflation and deflation).
But because gold is physically unwieldy - it’s hard to store in your wallet - you historically would be using currency backed by gold in a vault somewhere - and the value of that currency would be dependent on the confidence in the issuing bank or government. In this, non-universal acceptability was actually a good thing because it helps stabilize the banking system by punishing imprudent banks. But crypto’s promise is that you’re always dealing with the real thing (to the extent the thing is real!)
Nassim Nicholas Taleb warns about newfangled innovations by citing a particular rule of thumb: how long something has been around is a decent prediction of how long it will be around. In other words, if Shakespeare has been read widely for 400 years, it’s a good bet that he will be read widely for another 400 years - unlike, whatever new hot thing is on the bestseller list. If you apply this to currency, the bet is that gold will still be useful in a thousand years and that Bitcoin might not be useful in 20. (And, for that matter, that we’ll still be using government fiat currencies for several decades.)
Bitcoin’s enthusiasts say that the market is immature and that the price eventually will settle down, perhaps because people will just come to expect Bitcoin to represent what they want out of money, perhaps because Bitcoin's market cap will be so large that large movements will be difficult. And its volatility has been dropping. But Detractors insist that there is no real theory behind why the price should stabilize and that a mass loss of confidence is just as conceivable: Going to zero is a very real possibility for Bitcoin.
A significant underlying question here surrounds fundamental value. As Swedroe mentioned, returns on equities and bonds can be estimated because of dividends and income and ties to real world companies and institutions that can be evaluated. But when you start talking about currency, there are more feelings than you might think. The dollar is valuable mostly because the government mandates that it be accepted and accepts it as taxation (and we all agree thus that it is valuable, though it loses value according to our feelings). And before you think that gold is fundamentally priced, tune into FoxNews and watch as every commercial break contains a plea to buy gold before it’s too late. But of course gold does have something the dollar and Bitcoin does not - it can be used in jewelry and industry and would be used even if it had absolutely no monetary use.
Figure 7. Notably, Pablo Escobar discovered a fundamental value of cash: kindling for fire. Bitcoin can’t keep you warm at night!
If gold’s value is partially derived from old conservative men’s fears of a crash, Bitcoin’s value is at least partially derived from FOMO. Austrian economists typically are goldbugs, but there are some Austro-futurists who insist that the subjective theory of value suggests that everything is priced by feelings and that this concern about fundamental value is misplaced - Bitcoin is the best money and therefore will get accepted - and may even be better if it does not have any fundamental demand.
And ultimately, there actually is real value in Bitcoin’s greatest strength - its easy transferability around the world. The question is how to price that. You might compare the price of Bitcoin to Bitcoin Cash - they have identical origins except Bitcoin Cash forked to try to become easier to transact and yet Bitcoin Cash, despite having the same technological advantages of Bitcoin (maybe even better ones), is worth 1% of the value of Bitcoin. Beyond speculation, the best reason for that is that Bitcoin has a brand and a network - but what happens if people stop believing? How different is that than the fiat we are supposed to be fleeing? Consider for a moment the $29 billion market capitalization of joke crypto Dogecoin. JP Morgan has alternatively tried to price its fundamental value on the computer power necessary to mine a new bitcoin - but, for what it’s worth, Bitcoin trades well above that price.
A related feature that Bitcoin advocates often herald is its inherently limited supply: there will only ever be 21 million Bitcoin and there will practically be even less in circulation because owners lose their passwords. This limited supply is what Bitcoin advocates refer to when they say that the crypto is “hard money” and, naturally, they love to contrast it against the unlimited future supply of government fiat currencies. Saifedean Ammous has even asserted that hard money always prevails over easy money - but then why has the dollar not already been displaced by gold or even shares in real estate trusts? Certainly what has made gold so attractive as a money over the years is that it is fairly rare and its supply grows at a steady low rate - though some major innovation could occur that enables cheap space mining. Gold also is virtually indestructible, with most gold that has ever been mined still accounted for.
But perhaps most importantly, gold has risen to the top of real world options to be the best hard money with some real value that society has found over thousands of years of market experimentation. In contrast, there’s an unlimited supply of additional crypto out there - if you were determined, you could start one this week. Why will the first crypto be the best? Why won’t the privacy features of Monero or the smart contract aspects of Ethereum take over instead? If Bitcoin is not the best, what value will it retain? Can we ever be certain hat whatever the latest improvement is will be the last? Is Bitcoin the MySpace of Cryptos? Or is it truly the gold to the silver and copper and lesser precious metals that might still be discovered?
Two other things that Bitcoin has going for it that are real advantages: verifiability and extreme divisibility. So long as you’re not buying Chuck E. Cheese coins, the network quickly verifies whether bitcoin is real (whereas verifying gold in large quantities can be cumbersome.) And parceling out into fractions of a cent (or precious metals) is practically infeasible.
+
Ultimately...
As political risk insurance: you are essentially betting that Bitcoin (or a privacy-focused crypto) retaining its value is more likely than the government going after you. But fairly compare that to your opportunity to store gold abroad or buy foreign real estate.
As investment: you are speculating that Bitcoin will rise in value because more people will demand it. The unkind way of putting this is that “some greater fool” will pay for it. Personally, I find Bitcoin to be an intellectually interesting asset class that is worth watching but extremely risky. Billionaire Ray Dalio has suggested that he would consider it if he didn’t mind losing 80% of his money - and that was when the price was much lower than it was today. And I’ll confess that I myself bought bitcoin years ago - but I sold most of it (at great speculative profit!) because I could not figure out how to price it.
As currency: I am rooting for Bitcoin. If the price does stabilize over time, then it’d be delightful to have an alternative to government money. But it’s more hope than confidence that the price will stabilize so much that it will become a generally accepted means of exchange (and, incidentally, if it does, there’s no particular reason to get in early - you can be patient). Still, that leaves people who would prefer a private currency in quite the bind: on the one hand, gold has historically worked very well as a preservation of wealth over the long term and a stable foundation to build commerce around -- but it has always been usurped by government. On the other hand, bitcoin - or some other crypto - is far more resistant to government intervention but it is untested over any lengthy time horizon and is, so far, too unstable to serve the purposes people typically assign their money.
Figure 8. To understand how money works without government, check out F.A. Hayek’s Denationalization of Money (which inspired bitcoin), Lawrence White’s Free Banking in Britain (a history of how gold-backed private currency worked in Scotland for over a century), and George Selgin’s The Theory of Free Banking (which delivers on its title to explore conceptually how private money works).
This newsletter was inspired by a number of debates about the viability of Bitcoin as a currency. See historian and economist Lawrence White debate Bitcoin promoter John Vallis; free banking economist George Selgin debate Austrian economist Saifedean Ammous; and gold investor Peter Schiff debate Bitcoin investor Erik Voorhees.