Bitcoin and Gold

Thursday September 2, 2021 — San Francisco, California

It’s interesting that Bitcoin was designed as a non-inflationaryI use “non-inflationary” here to mean that there is a fixed maximum number of Bitcoins that can ever exist, not that the value of Bitcoin can’t or won’t go down. currency, since it’s such a bizarre and inexplicable choice. It’s generally pretty widely accepted that having some level of inflation is a good idea — inflation is a tool for causing people to partake in economic activity by making hoarding money costly, and economic activity is generally seen as on the whole being good for society.This is sort of a simplification — you’ll get a bunch of answers about why a positive inflation rate is good if you ask different economists, but it’s pretty widely accepted that a low, positive, stable inflation rate is good.

Given that the orthodoxy of 21st century economics is that 2-3% is the ideal inflation rate, why was Bitcoin designed not to be inflationary? In order to answer that, we’ll need to look at the ideology of Bitcoin, which is primarily libertarian, or perhaps “free-market anarchist,” if you prefer that term. The initial announcement of Bitcoin writes:

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.

A common libertarian talking point in the past was that the United States should return to the Gold Standard, instead of allowing the Federal Reserve to control the money supply. This isn’t as much of a talking point anymore, now that consensus among economists is that the Gold Standard is not a good system, but it used to be a very common libertarian view. The primary libertarian argument for the Gold Standard is that it removes control of the money supply from the government. The limited supply is a sort of accidental side-effect of this, so much so that modern libertarians don’t really consider it important or desirable — the essay A Libertarian Vision for Money and Banking writes:

[…] a quantity rule offers a more reliable (or far less expensive) alternative for nonbureaucratic control of the dollar supply. […] any desirable rule should satisfy at least two requirements. First, if consistently abided by, it should guarantee a reasonably stable and predictable value for the dollar, especially in the long run. Second, the rule should be “hardwired” into the monetary system, as it might be by enshrining it in a constitutional amendment, or by allowing the public to trade in existing Federal Reserve dollars for new “cryptodollars” whose supply, like Bitcoin’s, is regulated by a tamperproof computer algorithm.

While that does advocate for “a reasonably stable and predictable value for the dollar,” that’s not the same as advocating for a fixed supply of currency. If you have a fixed currency supply, you should expect the value of currency to go down as economic activity increases. In order for a currency to have a stable value, inflation (in the money-supply sense of the word) must go up at about the same rate that economic activity goes up.

Most people expect that the amount of economic activity in the world will essentially go up over timeThis is basically what passive investment is staking itself on — if your assumption is that the amount of value in the world will generally keep going up, then investing in an index fund is probably a good plan. (This doesn’t quite take into account that index funds aren’t a index of all economic activity, but instead just a slice of the largest firms, but I think most people who advocate passive investing basically want the most comprehensive index they can get), which explains why it’s widely considered good to have a low but positive inflation rate.

Let’s get back to Bitcoin, though. In a comment in the announcement thread, the creator of Bitcoin writes:

In this sense, it’s more typical of a precious metal. Instead of the supply changing to keep the value the same, the supply is predetermined and the value changes. As the number of users grows, the value per coin increases. It has the potential for a positive feedback loop; as users increase, the value goes up, which could attract more users to take advantage of the increasing value.

That was written in 2009, by which point the Gold Standard was widely considered a poor choice for a monetary system. And while these days, cryptocurrency is basically seen as a speculative bubble, with paying for goods and services an afterthought (if people even think about it at all), back in 2009, the story was that Bitcoin was The Future of Money — the Bitcoin whitepaper opens with:

Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. […] What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.

Given all that, why cap the supply of Bitcoin at 21 million? I think it’s essentially an accident — Bitcoin came from a libertarian political philosophy, which idolized the Gold Standard, since they saw it as a way of preventing the government from controlling the money supply. The Gold Standard has several problems — gold isn’t a stable store of value (since it’s used to manufacture electronics, jewelry, etc), and it’s also deflationary (or will be, once it’s all mined). Bitcoin had an opportunity to fix these problems, and thus to be useful as a currency, but instead chose to limit the supply, also limiting its utility as a currency.

The funny part here is that Bitcoin seems to owe much of its “success” to this mistake: as Satoshi wrote, there’s a positive feedback loop of speculation, which is driven by scarcity. People saw the value of Bitcoin increasing, and wanted to get in on it, which primed the entire cryptocurrency space to focus on creating speculative bubbles. NFTs are the latest and so far most extreme version of this — since each one is “unique”, it’s by definition scarce.

Bitcoin could’ve chosen to be useful as a currency, but it instead chose to be useful as a speculative asset, which essentially poisoned the entire fieldThis is a somewhat extreme claim, especally given that the other well known and popular cryptocurrency, Ethereum, does not have a fixed supply. However, Ethereum keeps on hard forking and changing their block rewards in an effort to draw down inflation — it’s quite amusing that Etherieum then ended up with a bureaucratic process to control the money supply (EIPs), and yet also is trying to draw down inflation in order to reward people who are holding. That’s the subject of another post, though, which I’ll hopefully never be goaded into writing. — almost everyone who’s interested in cryptocurrency is trying to get rich, but the properties that make a currency macroeconomically useful also make it harder to get rich on.