Why Bitcoin is doomed
The Case for Crypto Part IV: Bitcoin cannot be an asset and cannot support markets emerging alongside innovation... but Ether can.
Click here for Part I of this series.
Click here for Part II of this series.
Click here for Part III of this series.
Click here for Part V of this series.
This series starts with a notional potter. She has taken the raw materials of the earth (clay and water) and formed and fired it into the coffee mug I hold tightly in my hands on a cold winter morning. I see my breath as the hot coffee in the mug warms my hands. She is ‘unbanked’. But she has rent to pay, then must drop by one of the many storefronts where she can pay her utility bill. She buys groceries with what is left. The money that makes this possible is paid to her in exchange for these wonderful coffee mugs she makes.
She is a wealth creator - even if she doesn’t realize it.
But she is in crisis mode. Her rent is soaring, along with the related utilities. As less and less of what she is paid is left over, even that is buying less and less at the grocery store. What can she possibly do?
Yield: a substitute for labor
The genius of market capitalism that is truly “free” (as opposed to the bastardized version we now have) is found in how it incentivizes people to save, and in turn invest, in enterprises that can convert that savings into income. The financial world is familiar with the term “income-producing assets.” Our potter’s income is now entirely from selling her coffee mugs. But if she is able to save some of the proceeds and invest in other enterprises, little by little, what she earns from those investments subtracts from the labor she otherwise has to expend for her own upkeep. Ideally, when arthritis sets in and she is no longer able to make coffee mugs, her savings are ‘yielding’ enough income to replace her labor.
For us to evaluate whether crypto-currencies can become an asset, we must nurture the self-awareness necessary to reflect on the labor of the unbanked. Many well-known writers from the financial sector are skeptical of Bitcoin. They are right to be skeptical, but their explanations either lack understanding of the underlying Blockchain technology, or descend into a black hole of specialty language, (or both). I’ll try to remedy this with the following criteria of an ‘asset’. For something to be an asset:
1) Ownership must be recorded;
2) Ownership must earn an income; and
3) Ownership must be easily transferrable.
It is imperative that the finance pro not miss my focus on ownership: No one likes a thief.
For something to be an asset:
Ownership must be recorded;
Ownership must earn an income; and
Ownership must be transferrable.
The Blockchain alleviates us of our reliance on the Ruling Class and their unwillingness to enforce the rules to secure our property rights. Bitcoin not only passes our first test, but is superior as an asset because its recording enjoys the immutability of math. The second part is where the problem lies.
If I am going to explain the concept of ‘yield’ to my unbanked potter I will appeal to what she spends on rent. If she owns something that pays her some amount of money that she then applies to rent, that thing subtracts from the number of coffee mugs she needs to make and sell to pay her rent. An “income-producing asset” replaces some amount of labor otherwise required to earn income. While the accounting professional will disagree with me, remember, I am not writing for them when I say that an ‘asset’ that does not produce an income is simply not an ‘asset’ at all. Without descending into the rabbit hole of Proof of Work vs. Proof of Stake, it is enough to say that no crypto currency which arises from Proof of Work can be an asset because the design of its Blockchain does not produce a yield.
An asset that does not produce an income is not an asset at all.
For my third test I am, again, writing for the unbanked. If she is paid in something she cannot ‘transfer’ to her landlord in return for shelter, that something is not an ‘asset’. She also needs to transfer that thing to the utility company to keep the lights on. And to the grocer to have something to eat.
Crypto - in the form of Ether on the Ethereum 2.0 Blockchain, can qualify:
1) It enjoys the immutability of the Blockchain, securing record of ownership.
2) The staking mechanism allows stakeholders to earn extra Ether by granting their computing resources priority for the validation of transactions.
3) ??? - Herein lies the current challenge, and the answer lies with the unbanked. How can a ‘staking pool’ accomplish the following?
a) Accept Ether from the unbanked and ensure they receive a proportional share of the extra Ether (the yield) earned from the stake;
b) Allow that unbanked staker the ability to add spendable Ether to their wallet.
c) Create a smart-phone based exchange mechanism (e.g. QR Code) with available Smart Contracts.
Success is easily measured: When a traditionally unbanked person can pay her rent, utilities, and obtain groceries via an Ethereum 2.0-based membership staking mechanism, we can have a fully functional monetary/payment system where the Ether staked to support the network earns a yield.
The finance pro might complain that this yield is merely ‘nominal’ and not ‘real’. And apart from an exchange mechanism which allows our potter to pay for rent, utilities, and groceries, they would be correct. Who cares what percentage of Ether your stake earns if you cannot do anything with it!
Bitcoin’s fixed ceiling: a feature or a bug?
If a Bitcoin advocate were to join me and my unbanked potter friend over coffee on a cold winter morning, they might argue for Bitcoin by appealing to how its Blockchain fixes the total amount of Bitcoin at eventually 21 million. He might note that because there is no fixed rule putting a ceiling on the amount of dollars, as long as dollars are added, prices will keep rising. Our potter will likely not latch on to the underlying principles, but to the way price increases is destroying the value of her labor.
The assumption is that this hard ceiling of 21 million is a feature. I'll try to explain to her that it is actually a ‘bug’ - a critical design flaw.
I’ll point out that while not all of us are banked in the traditional sense, we all do have one thing in common: our smart phones. Here it helps that I am old enough to remember life without these things. I am also old enough to remember that “Wow, I want one of those” sentiment. But back when they were the new thing, they were quite expensive. So maybe I used a credit card to buy my first smart phone. When I did this, the bank which issued the credit card essentially allowed me to create new money.
The specialty language of economics will call this ‘monetary inflation’. But the addition of money to the money supply is only one part of ‘monetary inflation’. The other part is the volume and value of transactions using that money. An increase in this volume and value is called economic growth. A decline is called a recession. If the number of dollars increases by twenty percent over a year, and the volume and value of transactions using those dollar increases by ten percent, your rate of inflation is ten percent. Inflation is the growth of the money supply minus the growth of the economy; price inflation then follows. I’ll then point my potter’s attention to the price of her groceries and explain that price follows money - everywhere and always.
Inflation is the growth of the money supply minus the growth of the volume and value of transactions in the economy.
The problem with Bitcoin’s fixed ceiling will eventually be seen in the friction it creates in the face of innovation. When truly innovative products and services are created, Bitcoin will not be able to support the formation of the new markets that emerge alongside the innovations.
Ethereum 2.0 and transaction-based monetary growth
It will be this friction in the face of innovation that will eventually doom Bitcoin. Ethereum 2.0, on the other hand, does not have a fixed ceiling for Ether. Rather, the rate of growth of the Ether money supply is fixed at two Ether per transaction on the Blockchain. Remember that inflation is the growth of the money supply minus the growth of the volume and value of transactions in the economy. By not having a ceiling, but tying monetary growth to transaction growth, Ethereum 2.0 will scale up the supply of Ether alongside the growth of transactions which emerge from innovation. And it will do so automatically according to clearly understood rules enforced by the laws of mathematics.
When I started this series, I had a rough, four part outline. It is clear now that I will need at least a fifth essay to explain the difference between a crypto currency and a crypto token. I will also use the fifth (and hopefully final) essay to discuss how the Blockchain renders obsolete literally everything we take for granted today when it comes to money - everything from a central bank like the Fed to the need for a Certified Public Accountant (CPA).
Disclaimer: I am a cyber security professional, not a financial advisor. I hold no licenses in the financial sector. I have relatively small positions in ETHE and GBTC which hold Ether and Bitcoin in trust on behalf of shareholders. I am weighted toward ETHE for reasons that will become clear in this series of essays. It will also become clear in these essays why I believe crypto currencies are not an investment. This does not mean there is no case for owning crypto. It just means the current case has nothing to do with traditional investment theses. In any event, do not - under any circumstances - make investment decisions on the basis of anything I write.