This article tries to explain why Bitcoin can become the successor to the current monetary system that we use. It is focused on the fundamental aspects of good monetary technology and compares the imperfections that each system has.
What is money?
Money was invented - yes, it is a technology- to participate in a highly specialized economy. Individuals and companies can focus on specific goods or services and get money in exchange for those. Long before we had our current monetary system, human beings experimented with many different technologies called money. Back in the day, people used goods like wheat, tulips, or salt to exchange goods and services. However, those were not very durable, and you were forced to either use the wheat or quickly exchange it for something else. We also used to rely on metals like gold and silver, but those had their shortcomings too. Metals are durable but not so easy to carry between countries and continents. It also takes a lot of effort to make ounces or coins. Today we use the so-called fiat money (e.g. USD or EUR), which we digitalized and now have physical as paper money and digital in our bank accounts.
No Matter what type of money people use. There are typically three jobs that money is hired for.
- Store of Value: I want to store the value that I created by selling a good or service to someone else, so I can later use the value to exchange it for a good or service.
- Medium of exchange: Most of the time, money is 1/2 of the transaction. We use this monetary technology to enable trade between parties.
- Unit of account: To measure the value of something, we agreed to use money as the unit. Money, therefore, expresses the value of goods, services, labour, assets, etc.
Building a great money product.
If you were in charge of creating a new technology that humanity could use as a medium of exchange and store and measure value. What would the requirements look like?
- Durable - I don't want my money to rot like wheat or tulips.
- Portable - I want to transfer money to everyone on the planet(s), instant and ideally without cost.
- Verifiable - I don't want to care about fake money and other fraud.
- Divisible - unlike gold or silver, I want to use it for all goods or services, no matter the value. Therefore I want to be able to make divide it into small bits of money.
- Scarce (Can only be done digitally) - I don't want my money to become worthless.
A great monetary system should be self-sustaining. Every intervention or fraud caused by humans should be viewed as an error. The reason for this is that humans or even institutions can change their interests. As long as this is a factor, it's not guaranteed that all participants have aligned interests. The ultimate goal of creating such a system is to reduce any sort of distraction -it should just work, people shouldn't waste valuable time thinking about their money as a risk factor- caused by an insufficient monetary system. I don't want to worry about my stored value becoming worthless because someone manipulates the system. The time and energy I spend on being worried should be allocated differently. I would do something useful for society instead of being scared to lose something.
Flaws of our Current Technology (Fiat Money)
Our current system is based on constant human intervention. Central banks are mandated to balance the money supply, so they use interest rates to change the velocity of money generation in a given economic system.
The underlying assumption is that money creation through issuing debt is necessary to allow economies to grow. Therefore, our current system is designed to issue a lot of debt, which is fine as long as the experience economic growth.
So basically, we play the game of synchronizing two compounding forces, hoping that the compounding force of debt collection doesn't exceed the compounding force of economic growth.
And this game is played by many local central banks in a globalized economy. Each of them is part of governmental structures. And it's a delicate job to align all the interests of the participants. The mandate of the central banks often includes keeping a certain level of inflation (often around 2%), which is a historical best practice. In times of economic growth, balancing the money supply is usually doable. But with economic instability rises the conflict of interest. Imagine your economy is deeply in debt, and the economic growth was outpaced by compounding debt. As a central bank, you can keep interest rates low and the money supply high. Allowing the economy to grow and at the same time keep the cost of money - yes, also for the governments- low. Now imagine an economic crisis on a global scale. While the economy tumbles, central banks use their instruments and decrease interest rates to boost the economy. It's should only be a matter of time when the money supply is out of balance. No problem right, increase interest rates to slow the issuance of new money, and while the economy will keep growing, the balance will be restored. This would probably be correct when your economy is isolated. But we live in a globalized economy, so there is a twist - here comes the conflict of interest. Now imagine you are the only central bank on the planet that increases interest rates, and the rest keeps the interest rates high. The next second people - investors who are hungry for interest rates- will probably buy your currency and your debt because your debt now offers higher interest rates. The side effect is that the price of your currency will rise, which makes your goods and services more expensive for customers in other countries. This effect will probably be bad for your economy, especially if your economy relies on the export of goods and services. So managing the money supply properly brings side effects that will make it even more difficult to balance it because you will harm the second compounding force of economic growth.
So this is only one example of conflicting interest, and this example should demonstrate the constant human intervention within our current monetary system. I chose this example to draw attention to the current state of monetary policy. Which might end up in inflation rates that our generation has never seen in their lifetime.
To sum it up and add some other aspects - our current financial system:
- Is not immune to conflicting interests that can lead to inflation or hyperinflation.
- It was not made for a global economy: Banks use local technological standards (protocols) that cause high friction - the interconnection of systems causes a remittance problem resulting in high fees for transferring money.
- Difficult to build and maintain: Many people still are unbanked and do not have access to money. Building a monetary system has a lot of prerequisites and needs capital and political trust.
- Has a huge fraud problem. Fake money can be printed, and complying with regulations to prevent fraud requires a lot of resources.
With the premise of creating a simple and easy-to-maintain system that allows individuals to focus on other things than money, the current system is extremely fragmented, causes a global race for inflation, and has a huge problem with fraud. Moreover, it's so inefficient and expensive that it is still not available for many people and hinders the global economy's growth.
So it's fair to look at the upcoming Bitcoin system and understand if Bitcoin can be the better monetary system for our global economy.
Bitcoin is a monetary system native to the internet and is not owned by a single economic entity. It's a decentralized system, and that is developed and maintained by a community. To ensure trust, many -hopefully- independent participants verify transactions independently to come to a consensus. Similar to our current monetary system, the value of Bitcoin originates with the trust of the system's participants towards the system itself. The more people trust the system and use it as a monetary system, the stronger the network and the monetary system becomes.
Bitcoin also has other properties that differentiate it from our current monetary system.
The most fundamental difference is that Bitcoin is not controlled by anyone. It's a protocol that can be used by people. Those people can use it as a monetary system (Users), continue developing the protocol (Developers), and get rewards for verifying transactions (Miners) in the protocol. By having those different "types of users", there is a separation of powers, which helps keep interests aligned.
Unlike currencies that are issued by central banks, Bitcoin has a build-in cap of supply. It's scarce by design, and there will only be a max. 21 Million Bitcoin ever. This fixed supply allows all participants to predict the supply of the money in the future. It's just not possible to exceed the overall supply of Bitcoin to balance the prices of goods or services (inflation or deflation).
Bitcoin is native to the internet, so there is no local variation of Bitcoin. Everyone with access to the internet can join the network and start using Bitcoin for transactions. It theoretically allows a quick adoption rate, similar to the adoption rate of the internet itself, where protocols for email and websites were standardized and spread quickly. Reducing the friction of fragmented local banking protocols, chances for lower remittance fees are high. Especially for economies where monetary systems are not ready yet, Bitcoin can allow businesses to use Bitcoin. Bitcoin can be a great instrument for individuals in those economies to store their labour value, which might be the only way to create savings and build wealth.
The most mind-bending fact is that Bitcoin is the only money individuals can "save" in their own memory. You don't need a bank that stores and ensures that you are the owner of your money. By memorizing your private key, you can access your Bitcoin (money), and there is no third party needed to grant you access to your money.
Bitcoin has its own drawbacks
The way the protocol is designed makes it relatively slow and expensive compared to centralized systems, at least for now. Technological improvements like higher bandwidth and lower latency can help adjust the protocol design and allow a higher transaction rate. To reduce costs that will probably be protocols running on top of the Bitcoin protocol, which also shows that the development is not done yet. However, those are issues that time will help to solve since we live in a constant technological progression. As long as the community of developers continues to improve the protocols, chances are high that Bitcoin will evolve to become competitive on the cost and throughput.
Other non-technical issues make imagining the adoption of Bitcoin as a monetary system difficult.
People in most parts of the world are used to using currency as a unit of accounting. Central banks try to balance the two compounding forces of money supply and economic growth. But what is going to happen if you introduce a non-exponential unit of account -Bitcoin- and use this to measure the value of economic growth (the sum of all goods and services). When you try to measure something that is exponentially growing with a unit of account that is fixed. Well, without doing the math and try to model the outcome. It's a mechanic that we as humans need to get used to. It's a different paradigm of thinking about money as a unit to measure value.
The other aspect to think about is debt generation. Today debt is issued by banks in the form of loans, which immediately creates new money and increases the overall money supply. With Bitcoin, the mechanics are not replicable in the exact same way. I can give somebody a loan in Bitcoin and expect the other person to pay me back somewhere in the future in more Bitcoin. That would be the current model. To do this, I will have to get Bitcoin from someone else, which is only possible if someone is willing to give me the Bitcoin in exchange for something else. So there is no such thing as a fixed rate of interest. Compared to the current system, issuing debt might be an interesting aspect because debt is a fundamental force of economic growth. So radical changes in the way to offer debt might change the mechanics of economic growth.
The last two aspects mentioned need more thought to be fully understood. So if you have any thoughts or interesting resources to share, please let me know.
What needs to happen to let Bitcoin stay or become successful?
- The community needs to grow and diversify - more miners, more users, more developers.
- It needs to be adopted as a payment system and a unit of account - more companies need to let you use Bitcoin as a payment method and display the price of their products and services in Bitcoins or Satoshis.
- Current monetary technology becomes less reliable as a store of value - Monetary premium on existing assets increases, and trust in this systems decreases. When this happened, monetary systems were simply reset, and the game started all over due to the lack of alternatives. This time we have Bitcoin and other monetary systems (name any other cryptocurrency).
- Regulations must change to allow the use of Bitcoin as a monetary system - The way Bitcoin is treaded by policymakers is not a potential monetary system. Instead, it's treated like an asset, which makes it more difficult to use in the sense of accounting and taxation, resulting in a slower adoption for the mentioned use-cases.
Both monetary technologies, fiat money, and Bitcoin have their characteristics and, therefore, pros and cons. For the first time in decades, we have a promising alternative to the technology we used before Bitcoin. Some aspects of Bitcoin, like the finite supply and the debt issuing mechanics, make it difficult to see it as the perfect alternative to the current system. At the same time, it has clear advantages like reducing friction, becoming accessible, and being no object to conflict of interest. It's interesting to observe the adoption of the new technology called Bitcoin in the upcoming years. There will likely be different phases in adoption, all happening in parallel to our existing monetary system.
Phase 1: Store of value for everyone.
Today Bitcoin is used by people to store value similar to assets like gold, bonds, stocks, or property. The adoption will probably continue by institutions doing the same. More and more companies, investment funds, and other institutional investors might adopt Bitcoin as a store of value, leading to a shift from gold, bonds, property, and other asset classes to Bitcoin.
Phase 2: Medium of exchange between corporations and individuals.
With the adoption of Bitcoin as a store of value for companies, it becomes "easier" for them to start accepting payments using bitcoin or satoshis for goods and services. Once shareholders are okay with companies using Bitcoin as a store of value and accountants got used to the rules of accounting of Bitcoin, companies figured out how to buy and sell Bitcoin, using it as a payment system will become less of a pain to implement. In countries where the internet is already adopted and monetary systems are still not there, Bitcoin will become extremely valuable as a complementary technology.
Phase 3: Unit of account, replacing the current units of accounts.
This probably will take a very long time. When the EUR was introduced in 2001, many people kept converting EUR prices into their former local currency. It took years, even decades, to stop using their "old" measuring tool and adopting the new one. This might be the last phase of adoption because it will lead to a change of habits and the prior unit of account is available. People will find it easier to use the long time used unit of account to compare prices and values of goods and services.
It's an exciting time to observe Bitcoin going mainstream and humanity having an alternative technology to their prior monetary systems. Competition is usually good for consumers. Bringing a new player to the game and threatening the monopoly of monetary systems should increase the pressure to innovate and develop a product that serves the users in the best way possible. So no matter what system we will continue using, simply the fact that we have a potential alternative will lead to debates, innovations, and a better tomorrow.