Bitcoin, can it replace money as we know it?

December 10, 2017

 

 

Can Bitcoin succeed as a general all purpose money. And if it can or even if it can't, is it a good investment? Bitcoin's current price has skyrocketed this year, but in that climb it has been volatile. On Saturday, December 9 it opened at $16,057.15 for one Bitcoin, rose for a bit, before falling to a low of $13,314.56  by midday. But this is way above the $800 range it was trading at in December 2016. All this means that if you bought a significant amount of Bitcoin at those 2016 prices and you sell now, you could be making a lot of money. But if you buy now, will you be able to sell it at even higher prices. Is it a good long term investment?

 

I would propose that you do your homework. Learn or review what a money has to do to be accepted and used and therefore to be in demand. Think about what Bitcoin has to offer and what kind of demand there will be for it over the long term.

 

Is Bitcoin the wave of the future? Will Bitcoin or some other digital money replace the dollar, i.e., dollar currency and checking deposits and dollar credit card debt as the U.S. circulating money or for that matter other major currencies of the world?

 

Since Bitcoin proposes to be a form of money, let's go over the invention of money and what function money performs in, and for, an economy. This should help us to conclude whether Bitcoin is a positive development and whether or not it may be a good investment.

 

Money invented to move from barter

 

The productivity and efficiency enhancing effects of using money are so great that it almost always gets invented in some fashion wherever humans gather in communities to interact in trades and to make contracts. Money that can be used to purchase other goods and services evolved because it allowed a movement away from barter, the trade of a good or service that you have  for a good or service someone else has and that you want. The movement away from barter increased productivity of human activity by allowing specialization. People no longer needed to be largely self sufficient. They could work for wages or salary or profit and use the money they so earn to buy what they needed.

 

Stone money, a money must have general acceptance as a means of payment

 

The main characteristic that a money must have is general acceptance by the population that uses it. It can help if the money is easily stored and easily transferable and easily divided into smaller units and is durable and is difficult to counterfeit. But first and foremost it must be generally accepted as a means of payment.

The story of one of the strangest monies illustrates this characteristic of an effective money, the limestone money of Yap Island of Micronesia in the western Pacific Ocean. The official currency of Micronesia is the US dollar, but in the  island state of Yap they still use their own historic money, circular limestone "wheels" with holes in their centers. The holes are there because many of these circular lime stone wheels or discs are so heavy it takes two or more men to move them by using poles inserted through the holes in their centers and then lifting the poles on to their shoulders. The stones can be as small as several inches to up to 12 feet in diameter. The larger stones are never moved. They are too heavy to move easily. They just remain in place and the ownership is recorded and kept up to date by village elders. The largest are very valuable and are used for large transactions such as change of ownership of real estate and tracts of land or for dowries in marriages or for political deals and inheritances.

 

Yap has no limestone on the island, but limestone was discovered on a venture to other islands, quarried and shaped in wheels and brought to Yap. It became coveted, and then used as money. Yap islanders liked the limestone. It took considerable effort that involved some danger to acquire; that was one of the things Yap islanders came to value. Quantity was  limited relative to other goods and services produced by the Yap economy, and so it retained some value, mainly because it became accepted as a money by Yap islanders, a money that could be used in exchange for other goods and services and to pay debt. And because it was difficult to increase the quantity of the stone money, it retained a relatively stable value.

 

If its value were to rise (the amount of goods and services that could be got with one unit of the stone money increased, i.e., a fall in prices, deflation) because the Yap economy were to grow and more goods and services were available for exchange relative to the amount of stone money available, it would induce some Yap residents to make the trip and the effort to bring back more stone money and so keep the relationship between money and the Yap production of other goods and  services in a more or less stable relationship, so there was little or no deflation or its opposite, inflation, where prices rise.

 

The amount of money must change as the economy grows or falters

 

That is the crux of another important characteristic of a useful money. There must be some mechanism, natural or otherwise, that keeps the generally used and accepted money in a community or state in some kind of stable relationship with the level of output of goods and services produced by the community that is using that money, so the community experiences neither excess inflation - rising prices - or deflation - falling prices. Both situations, unexpected excess inflation or deflation, can harm and even impoverish large segments of the community and cause costly disruption to the community's economy, though who gets harmed is different under the two scenarios

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Golden money

 

Most modern states or economic unions now have what are called fiat money or money that is declared by law to be legal and which must be accepted as a legal means of payment. The United States dollar is declared legal tender by United States law. The dollar once circulated as gold coin or banknotes issued by private banks who held gold to back their notes. Later the dollar was backed by gold whereby any holder of a dollar could exchange it at the U.S. Treasury or at the Federal Reserve for a specific amount of gold, which meant that the U.S. government had to hold enough gold at Fort Knox and other storage vaults to be able to redeem the expected number of dollars that were presented for exchange.

 

The system of money where the dollar was either gold coin or gold certificates backed by gold and redeemable for a specific amount of gold ended in 1933 when President Franklin Delano Roosevelt issued an executive order requiring citizens to turn in all holdings of gold coin, gold bullion and gold certificates in exchange for Federal Reserve notes (our current paper currency) at the rate of $20.67 per Troy ounce of gold.

 

Because of this long history of the dollar and it's link to gold, the dollar became a currency that was generally accepted for commerce in the United States and internationally as well. That it came to be accepted as money just about universally was even more important than U.S. law which made it legal money or legal tender. The law helped, simply by reinforcing the general acceptance of the U.S. dollar as United States money.

 

Both of these systems of money, the one where gold coins (silver was also often used along with gold) or gold backed banknotes issued by private banks and the one where the government held gold in vaults and holders of Federal Reserve note dollars could redeem these dollars for gold, had the same flaw. The amount of money that circulated in the economy at any given time was ultimately restricted by the amount of gold used in coins or held in vaults to back banknotes that were in circulation plus the added amount of gold that could be added rather quickly by mining from existing mines.

 

As the output of the economy fluctuated, growing fast in exuberant times, more slowly but steadily in normal times but contracting in troubled times, the amount of money in circulation relative to goods and services being presented to the market would not always change in the most helpful direction to maintain full employment of the population and the capital stock, and business cycles would therefore be amplified with resulting bouts of deflation (falling prices) and recession and unemployment or excess inflation (rising prices).

 

The 1929 - 1933 deflation and Great Depression was the major reason why President Franklin Roosevelt ended the circulation of gold and gold certificates and their ability to be redeemed for gold. Roosevelt severed the relationship between gold and the dollar nationally. Internationally foreigners could still exchange dollars for gold held by the United States at a specified price until 1973, when President Nixon ended that ability. After 1973, gold could be bought and sold at the freely determined world market price by anyone, including U.S. citizens, but it wasn't used as money and no longer backed the U.S. dollar. With these changes, by Roosevelt in 1933, and by Nixon in 1973 the quantity of dollar money in circulation is not now limited in any way by the quantity of gold that is mined from existing mines or by newly discovered mines.

 

Managed money

 

The dollar is now a managed money, the quantity of it in circulation is managed by our central bank, the Federal Reserve, with ultimate oversight of the U.S. Congress. The Federal Reserve's charge is to manage that money towards the goal of full employment with no excess of inflation. It is no easy task, and it can't be done with pinpoint precision, but the Federal Reserve has several tools, including the buying and selling of government bonds from the public (buying bonds puts more dollars in the hands of the public and therefore into circulation, selling bonds does the opposite); and by setting the percentage dollar amounts that banks need to set aside to back their customers' checking account deposits.

 

The amounts set aside by banks to back their checking account deposits are called reserve requirements and the higher they are, the fewer checking account deposits banks can create as they make loans, and since dollar denominated checking accounts are used in transactions they are part of the amount of dollars held by the public. Checking accounts are dollar money, just as is currency. The most important statistic that the Federal Reserve uses to gauge the effect of the amount of dollars in circulation is the short term interest rate.

 

Before this system of managed money, booms and busts were typical of the pre WWII United States economy, and while such cycles still do plague us today, they have typically been less frequent and less pronounced and of shorter duration post war than they were pre war, the 2007-2008  Great Recession and subsequent slow recovery being an exception (we hope) to post war experience.

 

Not everyone likes managed money

 

But, and this is a big but, and it is where Bitcoin comes into the picture. Not everyone is enamored of a money that is managed by agents acting for the federal government. Probably the most intellectual challenge to a system of money managed by the Federal Reserve was the monetarist movement in economics which was at its high in the 1970s.

 

Nobel Prize winning economist Milton Friedman was a major proponent of monetarism, a school of economic thought that believed the amount of money in circulation was a major determinant of the performance of the economy. Monetarists weren't the only economists who thought the amount of money was important to the functioning of the economy, but the monetarists took its importance to a new and almost exclusive level.

 

Milton Friedman and many of his followers believed that the Federal Reserve would often mismanage the amount of money in circulation so as to cause too much inflation and then react by restricting the money supply too much and causing recession and unemployment. Friedman and his followers believed that the economy was inherently stable and therefore it was best that the Federal Reserve just follow a rule to allow the money supply to grow at a fixed percent per year, for example, three percent per year to accommodate the long term growth rate of the economy.

 

The monetarist theory and its acceptance has lost a lot of its glow and adherents since the height of its heyday, but it still has some sway among conservative economists, and it has left its mark in terms of current policy of the Federal Reserve which tries to follow a policy that aims at achieving an inflation rate of two percent per year. A little inflation is thought to be a hedge against deflation and a recession.

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The libertarians and those who like secrecy

 

In addition to the monetarists who don't really oppose a central bank managed money, but just oppose how actively it is managed, there are at least two other groups who oppose a central bank managed money. First are the libertarians who oppose much of what government does and who argue for limited and smaller government. Not liking much of government, they particularly dislike a central bank managed money. Many libertarians want to go back to gold money or at least to a money that is backed by gold and can be redeemed for gold.

 

Second, there are those who are interested in privacy and keeping their monetary transactions secrete from law enforcement and government in general. Transactions in Bitcoin are more likely to be anonymous and easier to keep from prying eyes, especially if one were to make special effort to do so, and this is especially so if the Bitcoins used were purchased with cash. Therefore, Bitcoin transactions can be easier to hide and harder to trace, though it has been done by law enforcement in some cases. The fact that Bitcoins are a relatively new form for making transactions probably keeps them more likely to be off the radar of law enforcement and government tax auditors. But that is likely to be temporary as government and law enforcement become more aware of Bitcoin transactions.

 

Libertarians can cn be interested in this privacy angle of Bitcoin. But there are others who are even more interested in keeping their monetary transactions secret, because they may be involved in trying to invade taxes or criminal activities,  such as illegal drug and arms dealing or laundering money obtained in illegal ways. It is these two groups, the libertarians, and the latter group, that a money like Bitcoin would have a large appeal, especially if difficulty in tracing Bitcoin transactions holds up or becomes reinforced.

 

There is perhaps a third group that is attracted to Bitcoin, one that is attracted by the very low costs of transactions made via Bitcoin and in how quickly Bitcoin transactions can take place and over very large distances, all across the Globe basically with no need to change from one country's currency unit to another.

 

Bitcoin is more limited than gold

 

There is one other attribute of Bitcoin that deserves mentioning before we conclude and make a stab at what the future of Bitcoin may be, and whether it may be a good investment. For now, the amount of Bitcoin in circulation is increasing. The anonymous creator or creators of Bitcoin started the ball rolling with a given small amount of Bitcoin, but created a mechanism via computing programming and the use of computing power by which those so interested can "mine" Bitcoins and thereby add more Bitcoins to the pool. You can do a web search for descriptions of this mechanism. Trust me. Unless you are very computer and computer programming savvy, it is esoteric and difficult to follow.

 

It gets more difficult to mine Bitcoins and takes more computer power and electricity and is therefore more expensive to run that computer power the closer the number of Bitcoins gets to a set upper limit of 21 million Bitcoins. No one knows when that number will be reached since it depends on the growth and cost of computing power and the cost of electricity to run that computing power which will affect the amount of Bitcoin "mining" over time. But that limit will eventually be reached (actually it won't ever be reached since it gets ever and ever closer to the limit but never reached, but as a practical matter when the difference between the amount of Bitcoins in existence and the upper limit is so small as to be negligible, the limit has been reached in all practicality).

 

Once Bitcoin does reach that 21 million limit, it will be a fixed quantity and as we learned from our discourse on the evolution of money, any money that is used in any significant extent and especially if it is the exclusive money or even just one of the major moneys used in an economy, it will need to grow in quantity to accommodate the growth in the economic output capacity of that economy. Otherwise deflation and all the problems that deflation can cause for the economy will ensue. That is a major reason to think that Bitcoin will never become a dominant money in the future. However, Bitcoin has competitive digital currencies and perhaps they can take over or replace Bitcoin were it to fail.

 

Conclusion

 

Here is what to consider when thinking about the future of Bitcoin and whether it would now be a good investment.

 

Bitcoin's value has risen dramatically in the last year, but it still experiences significant swings in that value. At this point it appears to be bought largely by speculators hoping for a killing and not so much by people using it for transactions, though there is some use in transactions and that may be growing. Some transactions of Bitcoin may be for illegal and tax avoidance transactions, though there are a growing list of legitimate and respectful companies that accept Bitcoin for payment, including one where you can pay for a pizza, and at Subway you can pay for a sandwich using Bitcoin (do a web search).

 

Because the number of Bitcoins has a finite limit it is not likely to become a sole or even a major currency of any major country. Gold used as money had this flaw, and Bitcoin's limit is more severe than was gold's.

 

However, while Bitcoin has a finite quantity limit, there are other digital moneys now, and there will probably be others in the future. But that won't help Bitcoin  specifically to be a major currency in any major country. And competitors can actually keep down the value of Bitcoin as it must share transactions with other digital currencies in addition to the dollar and other major currencies.

 

Bitcoin, the way it is set up, can never be a managed money like the modern U.S. dollar is, or the for that matter like Europe's Euro or like the British pound. It is set up so that no central authority can manage it. However, if Bitcoin were to cause significant trouble because of a significant increase in its use in tax avoidance and criminal activity and arms dealing and funding terrorist activity, governments, with the support of a majority of citizens,  may find the resolve and a way to regulate and even crack down on the use of Bitcoins, or any other private digital currency.

 

Why do we need a private digital currency like Bitcoin? The dollar and other major currencies are already largely digital. Rather than hold currency or even writing checks we are more and more making transactions via dollar digital transactions all the time, and we can even carry our balances on our smart phones and use our smart phones to make the transaction itself. And as we do more of this the transactions cost of doing so should only come down, so if a private digital money like Bitcoin currently has a small advantage in transactions cost, that may only be temporary.

 

Maybe Bitcoin has a small advantage in the speed of transactions, but again this advantage may also be temporary as digital dollar transactions get faster and more effiecient.

 

Maybe the only major difference with Bitcoin is that Bitcoin transactions maybe can be hidden from law enforcement, and tax collectors and other auditors.

 

And of course libertarians like a digital currency like Bitcoin because as it is now constructed it takes government out of the loop.

 

But a love for a private digital currency by libertarians and a predilection for a private digital currency by those who seek to hide transactions appears to be a slim reed on which to base the success of Bitcoin and therefore as a source of a good long term investment. It may be enough to allow Bitcoin a limited role in the future, providing there continues to be a way to sell Bitcoin for dollars or other major country currencies.

 

And if it finds this limited role, Bitcoin may even eventually, sometime after it reaches the 21 million cap that can be "mined," increase in value because of its limited supply. However, because there are competitor digital moneys to Bicoin, and more can be created, that may not necessarily be the case.

 

If you want to buy some Bitcoin, be sure you use money that you can afford to lose.

 

         

 

  

    

 

    

   

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