Why Bitcoin Makes Sense
Michael McGuiness • February 28, 2021
16 min read
Over past few years, quite a few people have reached out to me asking if they should buy Bitcoin. I usually respond with links to several of the best resources I know but have found that this can be a bit overwhelming. So I made an attempt at writing one definitive guide that I can send to people instead. In the essay below, I do my best to explain the following topics:
- The problem Bitcoin solves
- What is money and why are some forms of money better than others?
- Will society converge on Bitcoin as a store of value?
I hope it's helpful.
The problem Bitcoin solves#
Bitcoin was launched in 2009 as an open source, decentralized digital currency by the pseudonymous programmer Satoshi Nakamoto. Satoshi called this currency Bitcoin and described how it would work in a white paper in October 2008. This paper laid out the first practical solution to a longstanding problem in computer science called the Byzantine Generals Problem, which poses the question of how to establish trust between otherwise unrelated parties over an untrusted network like the Internet. This was a massive breakthrough in computer science—built on decades of research from thousands of researchers around the world—and its practical consequences are hard to overstate.
For the first time ever, Bitcoin allowed economic value to be quickly transferred, at a great distance, in a completely trustless way. Before Bitcoin, it was impossible to transfer value between distant peoples without relying on a trusted intermediary, such as a bank or government.
Many people had tried to build digital currencies before Bitcoin, usually by issuing digital money that was backed by a national currency or a precious metal such as gold. Although these earlier digital currencies worked, they were centralized (operated by an individual or company) and, as a result, were targeted by worried governments and eventually litigated out of existence. To be robust against intervention by antagonists, whether legitimate governments or criminal actors, a decentralized digital currency was needed to avoid a single point of attack. Bitcoin is such a system, decentralized by design, and free of any central authority or point of control that can be attacked or corrupted.
But why do we even need digital currencies? And who really cares if we have to trust a bank or a government to use it?
In Satoshi's words from 2009:
"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. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible."
In the United States, we don't really have to worry about these issues yet. But in countries with high economic volatility, such as Venezuela or Turkey, the value proposition is immediately clear. In his terrific essay "The case for a small allocation to Bitcoin", Wences Casares (CEO of Xapo who sits on the board of PayPal) describes how he saw his parents--sheep ranchers in Patagonia, Argentina--lose their entire savings three times: "the first time because of an enormous devaluation, the second time because of hyperinflation and the last time because the government confiscated all bank deposits." Unfortunately anecdotes like this are all too common outside of the U.S.
This is ultimately the problem that Bitcoin hopes to solve and why it is such a big deal. It is a store of value, and it will eventually allow billions of people to safely send, receive and store money as easily as sending or storing a picture. This is also a massive development for citizens of countries with generally trustworthy institutions, such as the United States. A 2% inflation rate may not sound like a lot. But if I phrase it as: "your dollars will lose half of their purchasing power every 30 years" (0.98 ^ 30 = 0.55), are you a little more concerned?
What is money and why are some forms of money better than others?#
Bitcoin is ultimately a savings technology and, even in developed markets, we have to look no further than last year to see what it can protect us against. In March of 2020, the U.S. Federal Reserve was buying securities at the globally unprecedented pace of $60-75bn per day. To put this into perspective, the Fed was basically printing more than the monetary equivalent of daily GDP—the collective daily labor of all 328 million U.S. citizens—each day. Futhermore, this is actually a very rational late-cycle response to a difficult predicament. It follows the playbook many governments have used throughout history to debase the currency in which they are borrowing and pull consumption forward to the present, letting future generations foot the bill.
I have no doubt that the leaders of global central banks are well-intentioned, but humans are not supposed to have this kind of power over other humans. Money is essentially a claim on human time. People sacrifice their time for money, which enables them to trade their time for the sacrifices of others. From the 2008 financial crisis to today, western governments—issuing unprecedented quantities of bonds and then buying that debt with money created by their central banks—have basically stolen time from some (particularly the less-powerful non-asset owners) and redistributed it to others (existing asset owners), exacerbating today's already-horrendous wealth-inequality issues. This may sound a bit ideological, but it's important to understand because Bitcoin is the way I expect rational actors (citizens, corporations, foreign governments, etc.) to eventually protect and hedge themselves against this aggressive monetary policy.
Contrary to popular belief, it is not some predetermined natural law that money must be pieces of paper issued by government authorities. In fact, a global fiat monetary system is only a 50-year experiment that began when Nixon decided to decouple the U.S. dollar from gold in 1971. Oddly enough, it appears that this is around time when we started to see the start of a massive wealth transfer from labor to capital and growing wealth-inequality (check out the site: wtfhappenedin1971.com). To be fair though, I'm sure the rise of globalization and information technology played a role as well.
Money is simply technology that makes our wealth today available for consumption tomorrow.
Throughout human history, many things have served as money: gold and silver, most notably, but also copper, seashells, large stones, salt, cattle, government paper, precious rocks, and even alcohol and cigarettes in certain conditions. What makes money unique is that we value it not for its own sake, but for its prospective exchange utility—we hope that whatever we choose to store our money in keeps its value long enough so that we can trade it in the future for stuff we actually want. Nobody actually wants little green pieces of paper. Nobody wants Bitcoin either. What people actually want is the things they can trade these monies for in the future, such as a car, a house, a vacation, etc. It's also untrue that only one money can exist at a time. Throughout history, various monies have coexisted along a continuum of "soundness" (how well they keep their value), and they've always been subject to competitive network effects. In my view, Bitcoin is the most sound form of money we have ever come across for reasons described below.
Carl Menger, the father of the Austrian school of economics, came up with an understanding of the key property that leads to a good being adopted freely as money on the market, and that is salability--the ease with which a good can be sold on the market whenever its holder desires, with the least loss in its price. There are three main dimensions that salability can be evaluated across for any monetary good:
- Salability Across Scales. A good that is salable across scales can be conveniently divided into smaller units or grouped into larger units, thus allowing the holder to sell it in whichever quantity he or she desires (e.g. a house would not be good money if you wanted to use it buy a pair of shoes).
- Salability Across Space. Salability across space indicates an ease of transporting the good, and this has led to good monetary media generally having high value per unit of weight. This has a lot to do with how paper notes became the dominant medium of exchange versus gold.
- Salability Across Time. A good's salability across time refers to its ability to hold value into the future, allowing the holder to store wealth in it.
The first two characteristics (salability across scales and salability across space) are not very hard to fulfill by a large number of goods that could potentially serve the function of money. It's the third element, salability across time, which is the most crucial. For a good to be salable across time it has to be immune to rot, corrosion, and other types of deterioration, but it is also necessary that the supply of the good not increase too drastically during the period during which the holder owns it. The relative difficulty of producing new monetary units determines the hardness of money: money whose supply is hard to increase is known as “hard money,” while “easy money” is money whose supply is amenable to large increases.
For example, the oldest fiat money in existence today is the British Pound. When it was devised 371 years ago, one British Pound bought you one pound of silver. Today, one pound of silver buys you 174 British Pounds. The key here is to understand what changed and what did not change. The silver did not change—one pound of silver 371 years ago still weighs one pound today. What changed was the supply of British Pounds in circulation. Their supply increased at a dramatically greater rate than that of silver, and as a result the British Pound depreciated more than 99% over the passing years. The same is happening with the U.S. dollar today.
Have you ever wondered why gold emerged as the predominant store of value throughout human history? Why not copper or silver or one of the other 118 elements? The primary reason is scarcity. One could argue that its aesthetic and certain chemical properties that made it almost impossible to destroy or synthesize from other materials certainly helped, but scarcity was the most important factor.
The growth rate of gold's supply has historically hovered around 2%. Only silver comes close to gold in this regard, with an annual growth rate historically around 5-10%, rising to around 20% in the modern day. For thousands of years, gold was the best we could do in terms of a monetary good that could maintain its value over time. However the invention of Bitcoin has created the first truly scarce form of money to ever exist. With Bitcoin, we have a precise measurement of supply: 21,000,000, that anyone can audit with their home computer. Furthermore, the supply of gold, is only increasing as extraction technologies advance, and if you just do the math, over the course of 30 years, the purchasing power of gold, relative to Bitcoin, will be roughly half of what it is today. Maybe less.
Bitcoin is also the first form of money in human history where its supply is totally unaffected by its demand. No matter how its price rises or falls, the pace of production follows a preset path, halving every four years until 2140 when the last of the 21 million Bitcoins will be mined. When the price of gold rises abruptly, production increases. The same holds true for oil, copper, condos, equities, bonds, tulips, and everything in an infinite universe. If the Bitcoin price rises 10x or 100x, production will not increase.
Thus, Bitcoin is actually an even better embodiment of gold's most essential monetary property—scarcity. Not to mention the fact that gold is extremely difficult and costly to transport in a globally-connected world where the ability to interact with others over the Internet is everything (Germany just spent 5 years and ~$10mm repatriating its gold reserves from the U.S.). Meanwhile, just the other week an anonymous holder transferred 19,600 Bitcoin (nearly $1 billion) in less than an hour, for just a $39 fee. This happens to be several orders of magnitude better than even our current fiat payment system, when compared on the apple-to-apples basis of final settlement.
"As a thought experiment, imagine there was a base metal as scarce as gold but with the following properties: boring grey in colour, not a good conductor of electricity, not particularly strong, but not ductile or easily malleable either, not useful for any practical or ornamental purpose... And one special, magical property: can be transported over a communications channel" - Satoshi, August 27, 2010
Will society converge on Bitcoin as a store of value?#
While people are generally free to use whichever goods they please as their media of exchange, the reality is that over time, the ones who use hard money will benefit most, by losing very little value due to the negligible new supply. Those who choose to store their wealth in easy money (see "cash is trash") will likely lose that wealth as supply grows quickly, bringing its market price down. Whether through prospective rational calculation, or the retrospective harsh lessons of history, the majority of money and wealth will be concentrated with those who choose the hardest and most salable forms of money.
Beyond scarcity, the other important aspect of a monetary medium’s salability is its acceptability by others. Unlike stocks, bonds, real-estate or even commodities such as oil and wheat, monetary goods cannot be valued using standard discounted cash flow analysis or by demand for their use in the production of higher order goods. Their value is set game-theoretically. Each market participant values the good based on their appraisal of whether and how much other participants will value it. The game-theoretic dilemmas of money have played out countless times throughout history and there are lessons we can draw from them.
Each person and country must ultimately decide which monetary good to accumulate by guessing which objects will be desired by other humans. If they correctly anticipate the "right money", a tremendous benefit is conferred on them in their ability to trade and acquire wealth. The earlier the anticipation of future demand for a monetary good, the greater the advantage conferred to its possessor: it can be acquired more cheaply than when it is widely demanded and its trade value appreciates as the population which demands it expands. Furthermore, acquiring a good in hopes that it will be demanded as a future store of value hastens its adoption for that very purpose. This seeming circularity is actually a feedback loop that drives societies to quickly converge on a single store of value. In game-theoretic terms, this is known as "Nash Equilibrium." Achieving a Nash Equilibrium for a store of value is a major boon to any society, as it greatly facilitates trade and the division of labor, paving the way for the advent of civilization. Ultimately, as long as a supply boost doesn't accompany the convergence, the feedback loop is hard to stop once it gains momentum. (See Vijay Boyapati's "The Bullish Case for Bitcoin" for more on this topic).
The harsh reality is that we are all forced to guess—-implicitly or explicitly-—which monetary good society will converge upon as a store of value, and as Paul Tudor Jones puts it:
"At the End of the day, the best profit-maximizing strategy is to own the fastest horse. Just own the best performer and not get wed to an intellectual side that might leave you weeping in the performance dust because you thought you were smarter than the market. If I am forced to forecast, my bet is it will be Bitcoin."
I agree with PTJ. This movement started with early adopters. We are now seeing companies like MicroStrategy ($MSTR) and Tesla ($TSLA) hold Bitcoin on their balance sheets. And as Balaji Srinivasan argues in his essay, "Why India Should Buy Bitcoin", we may soon see governments get involved. The odds of Bitcoin succeeding are increasing every day, and oddly enough the higher Bitcoin's price goes, the less risky it becomes because the higher price is a signal that more people believe in it. The volatility is currently an issue to widespread use as a medium of exchange, but I don't see how something could go from zero to global reserve asset in just a few decades without tremendous volatility. Money has always evolved in stages, with the store of value role preceding the medium of exchange role. Meanwhile, I'd much rather own something that's appreciating at 200% per year with high volatility than something that's losing 2-10% of it's value each year with no volatility (e.g. the dollar).
Long story short, holding Bitcoin over the long-term aligns yourself with the macro mega-trends of technological advance and currency debasement, both of which appear to be accelerating. The market appears to be warming up to this view if you look at how it has been pricing gold and bitcoin since the summer of last year. Just for reference, if Bitcoin's market cap eclipses that of gold ($10 trillion), that would put the price of roughly $500,000 per bitcoin. But Bitcoin's total addressable market is probably much bigger than that of gold. You don't have to look much further than the world's $18 trillion pile of negative-yielding debt to realize that. But time will tell.
Thanks for reading if you made it this far.
Sources & Further Reading#
- The Bullish Case for Bitcoin by Vijay Boyapati
- The Bitcoin Standard by Saifadean Ammous
- The case for a small allocation to Bitcoin by Wences Casares
- Why India Should Buy Bitcoin by Balaji Srinivasan
- Bitcoin Macro Strategy with Michael Saylor and Ross Stevens
- The Great Monetary Inflation by Paul Tudor Jones and Lorenzo Giorgianni
- Why Bitcoin Matters by Marc Andreessen
- The Case for Digital Assets by One River Asset Management
- A Brief History of Money by Haseeb Qureshi
- Modeling Bitcoin Value with Scarcity by PlanB
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