Shattering the Illusion: Bitcoin's Limitations as a Currency

There is a fascinating story, taking place during World War II, inside a concentration camp, built by German forces, for Western prisoners of war. This gripping tale explains the reason and the way a currency is created, the rules that govern its transactions and the needs that shape them. At the same time, the story explains, in simple words, some economic terms like arbitrage, default and equilibrium, using a few packets of cigarettes, some grams of coffee and a few chocolate bars. It is a story told in chapter 7 of the book “Talking to my Daughter” by Y.Varoufakis. Yet you may ask – how does this link to Bitcoin's Limitations as a Currency?

Let's take a moment to get a clear picture of the difference between money and currency, so we can put any misunderstandings to rest once and for all! Money, my friends, is the intangible stuff that's all about numbers, while currency is the physical money you can hold in your hands - you know, coins and paper notes. Now that we've got that sorted out, let's look back to the war story. Aside from the main lesson of that chapter, which is that money cannot be kept separate from the state, the author goes on to argue (after a supply of quite a lot Red Cross packages) that the fixed quantity of Bitcoins, their scarcity, raises two important issues: firstly, a deflationary effect (Bitcoin is deflationary by design due to its limited supply) and secondly, as a result of the first, the impossibility of reflating the economy by increasing its quantity. The author has also, using this specific chapter to make his point, highlighted that Bitcoin is definitely not the answer to the question “What is money, really?”

Staying for a while on the deflationary question, there are opposite voices through time, either arguing between price and supply deflation or highlighting that Bitcoin is designed to experience predictable and low inflation rates. In fact, it is worth mentioning that there will never be more than 21 million Bitcoins. This hard-set limit (that can be modified only with a change to the Bitcoin code and a general consensus of the Bitcoin community) creates a sense of ingrained value, and it was the result of a well-thought-out process when figuring out the right supply-and-demand dynamics at the launch of the Bitcoin project. It was intended to mimic the characteristics of a scarce asset like gold, diamonds or even art.

In other words, this limited supply is intended to increase the value of each individual bitcoin over time, as demand for the cryptocurrency grows but the supply remains relatively fixed. In contrast, fiat currencies are often vulnerable to inflation due to their reliance on central banks or monetary authorities for issuance and regulation. These governing bodies possess the authority to manipulate monetary policies, including the control of money supply and interest rates. When expansive monetary policies are implemented, such as the injection of additional currency into circulation, the value of the currency can gradually diminish over time. This ongoing increase in the money supply can erode its purchasing power and undermine the stability of fiat currencies.

However, this deflationary nature of Bitcoin can also be a double-edged sword. While it can increase the value of individual Bitcoins over time, it can also lead to hoarding and a reluctance to spend the currency, as people may believe that its value will continue to rise in the future. This can hinder the adoption of Bitcoin as a medium of exchange, as people are less willing to spend their currency if they believe it will be worth more in the future.

There are even inherently incorporated disinflationary measures inside Bitcoin (like “halving” which, every four years, reduces the number of Bitcoins that can be mined and enter into circulation). The truth is that:

• Already 19,306,581 Bitcoins (or 92% of the total supply) have been produced so far (according to coinmarketcap.com on 3^rd March 2023)
• A large amount of bitcoins (around 20-23%) are lost forever, mostly due to the loss of private keys
• The last new bitcoin will be generated around the year 2140

The design intention was that, as the overall supply of Bitcoin decreases, the market value of the currency increases, and its purchasing power goes up. The truth is that the success and stability of Bitcoin's value are subject to market dynamics, regulatory developments, and mostly investor sentiment. Bitcoin's volatility and the lack of intrinsic value make its long-term success as a widely recognized and stable asset quite uncertain. Based on the above, there is no reason to believe that Bitcoin is something that will replace money and there is no reason we should treat Bitcoin as such.

But let's try to take a less harsh view and take a closer look at what needs to be in place for something to be recognized as "money". Economists around the world agree that money has three basic functions: as a unit of account, as an acceptable medium of exchange and as a store of value. It should also be able to be used as a means for deferred payment.

Bitcoin does not sufficiently provide even one of these functions!

It performs poorly as a unit of account – that is: it is not a standard, widespread measurement for value, with prices of goods and services denominated in that currency. The (relatively few) merchants around the world that accept Bitcoins, invariably list their products’ prices in the national currency of the country in which they are based (the volatility of Bitcoin would dramatically impact their prices, otherwise).

Bitcoin is also not widely used as an independent unit of account for other currencies to be measured with (while Bitcoin has gained some acceptance as a unit of account in certain circles, it is certainly not widely used in this way today).

Bitcoin has a very restricted use as a medium of exchange – money exists to make transactions possible, and this may be achieved only when it is accepted by buyers and sellers to pay debts or financial obligations.

Although more and more sellers are accepting Bitcoin, the reality is that they are doing so more from a marketing/publicity perspective, and this trend is most likely to be halted once the Bitcoin price enters (again) bear market territory.

Trust is also at the core of any system of money. Bitcoin’s trust challenge lies in the fact that not many people are filled with confidence by its overall image — its sense of insecurity (not being backed by a Central Bank or a Government), its volatility, the constant threat of the regulator. Having all these in mind, we may conclude the poor function of Bitcoin as means for deferred payment

And with this statement, we return to the final function of money: the store of value. According to Karl Schumpeter, one of the greatest economists of all time, along with Maynard Keynes & Milton Friedman, in his book published in 1930 "A Treatise on Money", the store of value can be defined as “…the will to possess something precious now…and in the future”, which brings us back to the Bitcoin’s volatility issue.

According to Bankrate, "Bitcoin's price history: 2009 to 2023": “Bitcoin’s price has been on a roller coaster ride since it first debuted in January 2009, but the long-term trajectory has been higher – ‘up and to the right,’ as they say.” Even, at the time of writing, and so far, this year, bitcoin has a change of 42,03% (according to coindesk.com on 27th February 2023). The extreme volatility of Bitcoin is mostly attributed to it not being intrinsically valuable: there is nothing that is backing up its value, other than feelings and projections.

Why, then, should you consider Bitcoin as a viable replacement for traditional money? After careful examination, it is clear that Bitcoin falls short of being a true form of money. While it boasts precise accounting facilitated by digital specificity through cryptography and is often hailed as a digital store of value, it is unrealistic to expect Bitcoin to fully supplant money in a vast and diverse economy. While it may find utility in certain scenarios, Bitcoin's limitations and its fundamental divergence from the characteristics of traditional money suggest that widespread adoption as a complete substitute remains unlikely.

Read my next article about Bitcoin’s Future: The Great Deception and the Real Promise

The opinions and ideas expressed here are my own and I would be happy to discuss them - contact me at Makis.Malioris@worldline.com