Bitcoin - Beyond the Moon

In this article I'll try to contemplate what will happen to the world in macro economic terms when bitcoin (both the currency and as the mother blockchain) takes over the entire financial system. There has been some vivid concerns among traditional economists that a deflationary currency will seriously hurt the economy. However, I'll argue that it won't.

First, it's very important to understand that GDP, and other metrics of economics, is a social construct and is one source of many what determines the current state of economy. It's easy to have a fantastic GDP (a huge nominal growth) and yet have an enormous underclass that are all unemployed (with no social benefits.) It's also interesting to note that the definition of GDP is extremely complex (read "GDP A Brief but Affectionate History," by Diane Coyle.) It is redefined over time, ultimately by politicians, who consistently like to rewrite the future in positive terms.

Traditionally, a GDP growth of 2% is considered a good economy, which should be matched with 2% inflation. If the GDP measurement is considered valid, then this would mean that world output in terms of new products and services has grown with 2% and 2% more money has to be "created" to match that extra output in order for all the "other" prices to remain fixed.

In a bitcoin only world, where the money supply is fixed, a 2% productivity growth means that prices are not fixed, but slightly deflationary. The world supply of money will internally rearrange itself to attribute some money to the world output growth, that is some money is moving away from the traditional merchandise supply causing a nominal price decrease. In terms of purchasing power, if salaries are also decreased with 2%, then nothing has changed. In some sense, if all numbers are calibrated, a deflationary economy will work the same as a inflationary economy.

Some say that the loan market will be so different in a bitcoin only economy, as that would make people hoard it instead of investing. This is completely wrong. Let's ask the question "what is a loan?"

A loan comes with an amount and a term (the period for which the loan is supposed to be paid back.) For the person or business that receives the loan it includes a cost, usually expressed as interest, or a fraction/percentage on the amount. People or institutions with money never wants to lose money. As money in an inflation based economy loses purchasing power over time, that needs to be compensated by banks and institutions who want to make more money, not only nominally, but in terms of purchasing power. Therefore, the inflation rate is always added on top of the interest rate based merely on risk and reward.

In a bitcoin only economy, there'll be a slight deflation for every productivity increase. Imagine that all product, services, assets are denominated in bitcoin, then just holding bitcoin makes it the perfect index fund. Although holding bitcoin will be the safest investment, it is far from the best investment. So this means that unless the business plan cannot beat the world's index fund (holding bitcoin) it means it won't get funding. This means that all money in investments that performs less than world's index will be removed from circulation. Is this a problem? No, it's already the case in the fiat world. I cannot possibly imagine any investor actively pumping money in something that will perform less than an ordinary index fund. In the bitcoin only world, it just means the remaining money will still be in circulation (as it is (practically) infinitely divisible.)

However, there's one important difference in a bitcoin only economy: no fractional reserve banking. The bank has the power to issue credit at will if the bank can justify it based on its balance sheet. In a bitcoin only world, banks will have lost their power to issue money yet again. A long time ago private banks lost that power to central banks, but as physical notes are minuscule in comparison to "electronic money," the power to private banks issuing new money is back. Today, a modern bank only has to back the money issues with a fraction of what it owns. Every asset is graded, and the bank is allowed to issue credit based on the risk weight of that asset class. In a bitcoin only economy all of this will go; the bank can only use the money itself owns.

So there's a very interesting question. What will happen and what does it mean?

Today, banks can make huge profits by issuing new loans. They can approximately issue 9x more credit based on their assets. If the bank goes bust and is big enough, the government will step in and rescue it. In a bitcoin only world it will not be that easy anymore.

In the current economy booms are followed by busts (in cycles.) The credit expansion lately has been so large so that a relatively small bank (Lehman Brothers) can have enormous consequences on global scale. So the only way of avoiding a bust (after a boom period) is to issue even more credit, but that also mean the number of people in debt is growing. Look at the state of the world and guess what happened?

In a bitcoin only economy, banks and financial institutions will be forced to invest what they own. This means that much less loans will be issued as compared with today. Some economists will say that will hurt the economy, but I don't think so long-term, because the plus side is that there'll be no busts either. The good effect of forcing banks to use their own funds for investments is that money will flow to good investments; things that bring revenue long-term will be beneficial over cheap crap with low profit margins. I think this will be good both for our environment and the economy. To summarize: We'll have a continuous slow growth with no booms and busts unless we encounter cataclysmic events such as wars, deceases and/or natural disasters.

If you're willing to change your mind and look at things differently, there's no issue with using a deflationary currency as the world's only currency. All the current economic models are based on fiat, and that's why things look so bad when they're applied to bitcoin. Remember that the role of money is to make it easier to exchange things. Those "things" have their intrinsic value regardless what monetary units we ascribe them. This role has become diluted as politicians and central banks have manipulated the basic concept of money. Bitcoin will just bring back the concept of money to its roots; a labeling system to relatively compare different type of merchandising on a free market.

The only difference is that bitcoin is far superior over fiat money, because it requires no trustee intermediaries when exchanging. An amount of equivalent $1 billion can be exchanged between parties and settled within 10 minutes using the Internet. It's completely frictionless; it's the superconducting state of money.