All eyes on bitcoin, it seems, as the price hits new all-time-highs, its proponents celebrate, and the economists who have long pronounced it dead and useless scratch their head in confusion (any “bubble” pronouncements as of late?)
“The discomforting reality for the early idealists,” wrote Izabella Kaminska, a long-time critic of cryptocurrencies, before the price explosion in recent months, “is that 12 years on, the bitcoin ecosystem has more in common with the incumbent one it was hoping to displace than that original utopian vision.”
She’s more right than she knows. In one sense, we should probably celebrate this as it means that bitcoin is approaching the monetary commodity dream it always harbored: it is running into some eternal troubles common to all monetary systems. Even better, we should take the opportunity to teach some monetary history, as those in the crypto world have never been particularly well-versed in our monetary past. The audience they cater to is even less informed and so the “bitcoin heroes” – Saifedean Ammous, Robert Breedlove etc – are celebrated for their wisdom, no matter how rudimentary or inaccurate.
It’s easy to discard an entire field of centuries-long academic inquiries, especially if you’ve never been exposed to it, or only investigated a caricature. Some humility is recommended since, as Denis Patrick O’Brien writes in his collection of scholarly articles The Development of Monetary Economics, “Monetary economics has attracted some of the very best people to have written about economic problems.”
In contrast to Bitcoin’s money supply mechanism, set in stone since its origin, many of bitcoin’s rivals – “alt-coins” or “sh**coins” – want to set their own monetary policy, laid down arcane rules in fancy white papers that only the insiders have the discretion to change. This dispute over rules and discretion about who runs the printing press is about three centuries old if not more, and was thoroughly investigated by the likes of Adam Smith, Benjamin Franklin, Thomas Tooke, Horsley Palmer, Walter Bagehot, John Clapham and others.
Some of the seemingly novel features of many cryptocurrency innovations are not so novel, and quickly run into precisely the problems that plagued past economies; these were promptly examined and argued over by monetary economists long since dead and forgotten.
When Bitcoin was small and insignificant, the dollar-cost of sending value across the network was minuscule. For the first few years of the cryptocurrency’s existence, this was among the best reasons to use it: you could send any amount, to anyone in the world, much cheaper and much faster than the legacy banking system of the 2000s. That was roughly correct. Legacy systems were slow and expensive, and doing international banking only 15-20 years ago caused headaches to plenty more people than money launderers.
The Internet, effective competition, and the rise of fintechs changed all that – but the most vocal bitcoiners remained in the past that the legacy system had long left behind, thinking that their magnificent invention still trumped the system against which bitcoin was created. For most uses it doesn’t: unless you’re living under authoritarian regimes or are trying to do business in the legal grey (two very important, yet comparatively small, market segments), using bitcoin for its initial transactional purposes isn’t that great.
How our monetary past informs Bitcoin’s current troubles
Exhibit A: Second Layers. After 2017 – the bull-run, the congestion, the forks and battle over block sizes – the winning faction found an enticing solution to their crowded-mempool problems: second layers like the “Lightning network” or similar services like Liquid (with plenty of others in the works). Instead of settling on Bitcoin’s main blockchain, most minor transactions would take place on a second layer that only occasionally settled on the main network. That way, every on-chain transaction could include many more underlying transactions, netted against each other. Second layers make perfect sense against bitcoin’s inherent supply-schedule problem.
Except that for anyone who looked, this was just old commercial banking systems reinvented, trust sneaking in through the back door. A commercial banking system (with or without a central bank) that freely issues notes and deposits redeemable in some outside currency was also a second layer on top of the main currency layer of the realm (which in our monetary past was often gold or silver). The second-layer solutions sketched right now are supposedly full-reserve and don’t have maturity mismatch, but so started early banking before they developed into the (safe!) fractional reserve banks that bitcoiners detest so much.
Just like you must put trust in your commercial bank not to risk your deposits or excessively inflate the notes they issued, with bitcoin you must place faith in second-layer networks you join not to run off with your bitcoin or revert your transactions. Not your keys, not your… em, transactions.
Why would anybody in the past take paper money, the value of which could be inflated away and had counterparty risk on the bank that issued it, over “hard currency” like gold? Easy, noted Ray Perman in his superb financial history of Edinburgh: “The first paper notes were seen as holding their value better than coin because they could not be debased and clipping them did not affect their worth.” There’s no risk-free baseline; you pick your poison. And sometimes, to the fury of bitcoin maximalists, that poison isn’t the technical hurdles of bitcoin but the sweet insecurity of political governments and central banks and our well-established systems of international commercial banking.
Exhibit B: Speed and Cost of Payment. Making a high-priority transfer on the Bitcoin network, i.e. having a great chance for your transaction to be included in the next few blocks, requires you to pay something like 30 cents during low-traffic times, and closer to $20 or $30 in high-traffic times. Many bitcoin wallets allow you to send transactions with “Low Priority” settings meaning that they will clear on the network perhaps a day or two later. This usually inches the price closer to that 30 cents than the 30 dollars I mentioned.
But hang on, wasn’t the beauty of Bitcoin that transactions were cheap and fast compared to the banking system it supplants? It seems this brilliant piece of tech ran into precisely the trade-off between speed, cost, and finality with which our legacy systems have struggled for centuries. Surprise, surprise, the revolutionary bitcoin network went full circle. You can have efficient and thus cheap payments, fast payments, or secure payments – but not all three. When Satoshi Nakamoto programmed finality into the bitcoin protocol, users could not compromise on that dimension; instead, they were left with choosing between fast or cheap payments. Just like the regular banking system.
Exhibit C: Black Boxes Moving Around. Another version of this is bitcoin on side-chains, like the tBTC project or Wrapped BTC, where trusted custodians hold your bitcoins in exchange for a token claim to that bitcoin, a token that itself lives on a different cryptocurrency chain (say Ethereum). Ideally, users could then move bitcoin around at much lower cost than on the Bitcoin main chain; instead of moving actual bitcoin, the user moves a digital box that contains said bitcoin.
In many places of our financial past, we used the shiny metal gold as base money. Moving it, especially in large shipments, was clunky and expensive. In the high seas, ships carrying it could founder and sink; in the woods of Europe lurked thieves. So far, that gold-bitcoin analogy should be clear and obvious.
Financial systems in Britain or the Dutch republic solved this expensive transportation problem by using paper claims to deposited gold. For centuries of international trade Bills of Exchange moved across the world, and only rarely did the underlying base money move. These “Wrapped BTCs” of the past let the expensive underlying asset lay still while paper claims to it moved instead. The financial system in different locations of international trade used bills of exchange – papers of credit – to net out transactions between them, supporting the real economy with a sophisticated and efficient banking system running in the background. In past times that made gold easier to use as money; in crypto times that makes bitcoin, with its highly variable transaction fees, easier to move around.
For all the revolutionary creed that surrounds the emerging monetary commodity that is bitcoin, it seems that its future more and more resembles the past it tried to escape. Happy times for us monetary nerds.
This article was first published by the AIER, and can be found here.
Chart of the Day
Steve Jobs at the D8 Conference 2010.