The Required Component For A Viable Cryptocurrency

Tuesday, 6 March 2018 21:23 by The Lunatic


There is no doubt that the ‘blockchain’, Bitcoin’s amazingly successful distributed ledger, is one of the most ingenious concepts ever invented.

Blockchain's importance, and potential scope of influence, could eventually rival RSA public key/private key encryption (the algorithm developed in 1978 that all modern-day financial transactions rely on - including, ironically enough, blockchain transactions). It really is spectacular.

So … am I investing in Bitcoin or other cryptocurrencies?

Absolutely not!

My reasoning is simple: the function of a currency is to be an intermediate thing that holds value temporarily, so you can easily trade for something of real value. There is no reason to ever ‘invest’ in any currency. That is not its purpose.

You may, however, want to avoid a currency. Let’s say you live in Mexico and own a business, and that business generates nice profits. You take your profits, and decide to hold that value in cash while you look for something else to invest in, or maybe you're saving up for a nice yacht.

However, if you expect that the Mexican Peso will fall in value, you can convert your holdings to U.S. Dollars in the meantime. You are not ‘investing’ in dollars – you are avoiding Pesos in favor of a currency with greater stability!

The goal of any government backed currency is to be as stable as possible. While consumer spending is mostly based on cash transactions, the majority of business transactions are on ‘terms’ … payment in the future for the trading of good or services that occurs today.

If you hold cash in a transaction (“I will pay you for the goods in 90 days”) or if you hold debt (“you can pay me for this in 90 days”) – both parties expect the ‘value’ of the currency to be the same at the end of the transaction. It doesn’t matter which direction it moves; if the currency goes up or down, one party will suffer.

Here’s a true story: about six months ago, my son’s best friend was in our driveway and neglected to put his car in park. When the car started to roll, he jumped in – and in his haste he slammed on the gas instead of the brake … crashing into our garage door. He actually pushed our car, parked in the garage on the other side of the door, into the chest freezer at the back of the garage, pinning it to the wall!

The garage door repairman came out immediately – but ordering a door that matched our specific dimensions and color was going to take 8 weeks. I gave him a small down payment, and he ordered the door with an agreement that I would pay the balance when the installation was completed.

Now ask yourself: would either you, or the garage door repairman, want to conduct this transaction in Bitcoin? That would be crazy. Who knows what the ‘value’ of Bitcoin will be in 8 weeks!

Let’s step back and review some basic economics.

Throughout most of human history, trading was done directly with no currency involved. I have a house, and you have 50 cows, and we agree to trade. The exchange rate is 50 cows to one house. Simple.

Currency just adds one more variable. The exchange rate of dollars to cows is 2000 dollars to one cow, and the exchange rate of houses to dollars is one house to 100,000 dollars. It still works out that 50 cows to one house.

Trading goods for services is the same. If I am a plumber, I will fix your sink for either $70 – or two bags of groceries. This means I will trade my labor directly for goods … or for cash, and cash is just a thing that temporarily holds value, so I can easily trade it for something else like the two bags of groceries.

But in either of these scenarios (trading cows/houses/cash or plumbing work/groceries/cash), you want the value of the CASH to be fixed.

So how do we keep the value of any currency stable? It is difficult, and some governments have certainly been more successful at this over the long term than others. There are many factors to contend with.

Let’s say there is a village with just 1,000 people. They have their own currency. They buy houses, horses, food, supplies. Their population is stable, as is their economy, and the value of their currency never changes.

But one day they decide to ‘merge’ with a neighboring village of 100 people. Suddenly they have 10% more houses to buy and 10% more people to feed with the same amount of money in circulation.

They can live with the fact that all prices will change by 10%, or they can stabilize the currency and ‘inject’ 10% more money into circulation (print more bills) to keep the relative value of the currency the same for the number of people.

This is what the USA has been doing for decades, as our population and economy has grown. Money is printed to match the current economic conditions (or it is taken back and shredded to reduce the funds in circulation) … all to stabilize the value of the dollar.

By itself, this is not a bad thing! It really isn’t – but it can be abused (and is especially harmful if done to pay off government debt).

Printing MORE money than is needed, in general, results in lower value of the currency and higher cost of goods. This is the basis of inflation.

Unfortunately, banks rely on a small amount of inflation. Typically, the government targets 1 to 3% inflation per year. If we get too close to ‘parity’ then we risk slipping into deflation, which is worse for the economy.

Why do banks rely on inflation? Because it gives them ‘built in’ protection on the assets that they finance.

For example: if you buy a house, the value of that house will rise with inflation. So, if you buy a house for $100K with a $20K down payment, the bank has $20K in security to start with. But if you default on your loan after 5 years, the house should be worth at least $110K with inflation. The bank’s security has gone from $20K to $30K, a 50% increase over 5 years! In addition, the bank’s cost basis comes from cash deposits, and the cash value has actually gone down with inflation, so their liability is even lower the original $80K (plus whatever principal has been paid on the loan in the meantime).

The end result is this: the bank can sell the house and recoup the amount on their loan, even if they have to sell the house at a substantial discount. The value of the house has gone up and the value of the cash that they need to pay back to their depositors has gone down.

Without inflation, banks (and other lenders, both private and public) will always charge a higher interest rate to make up for the extra risk that they will bear. Their risk goes up even if the average number of loans that go into default stays the same.

With inflation, the value of “real” assets go up, and cash-based assets go down. We celebrate the increased value of our homes, but from a psychological standpoint we just tend to get used to the value of the currency as it does down. How much can you buy for a penny now? Not much … and that’s because of inflation. Do you really care? Only if you reminisce about the good old days.

Hyper-inflation, on the other hand, is horrific. This is the worst scenario. Some ten years ago, Zimbabwe was going through inflation with rates of thousands of percent daily. When you ate at a restaurant, you had to pay when you ordered – because the price would be more than double by the time you were served, and double again by the time you finished eating. Similar things happened in Brazil and Argentina in the 1980’s.

Inflation is when the value of a currency goes down. If a cryptocurrency such as Bitcoin has a value that is going up, that’s actually a form deflation. It’s good if you’re holding the currency – but bad if you’re holding debt based on that currency. Either way, it’s not stable.

Government backed currencies have this one advantage – it is in their country’s best interests to keep currency stable (plus/minus the inevitable small amount of inflation).

The advantage AND disadvantage of cryptocurrency is that it is decoupled from any government. Everyone loves to point out all the advantages of having an independent currency, not backed by any government, and many of these reasons are quite valid; but the disadvantage is that no one has a vested interest in keeping the value of the currency itself stable.

Inflation favors those holding debt. Debt is an ‘asset’ if you’re a lender. Inflation also favors those holding “real” assets such as houses – so people with a loan on their homes theoretically come out even, or hopefully slightly ahead, over the life of their loan (as long as they don’t default on the payments along the way).

But people holding cash are at a disadvantage! Holding large amounts of cash long term is bad, as it will lose value over time due to inflation. People with debt (borrowers) and no assets that rise in value are at a double disadvantage. We always hear that the poor get poorer. This is a major contributing factor.

“Low” inflation – one or two percent – doesn’t significantly impact short term transactions. The business to business 30/60/90-day payment terms can absorb the small difference, it just gets built into the cost of the goods that were sold.

But in an ideal world, currency inflation would be precisely at zero and this is a huge problem for cryptocurrencies.

Don’t get me wrong, the blockchain concept is brilliant – but Bitcoin (and all other cryptocurrencies) fail miserably when it comes to this fundamental reason to have a currency in the first place.

We deal in government backed currency because the government has a vested interest in keeping the value of currency stable; but even then, the stability isn’t good enough to avoid deflation, so to err on the side of caution (and to appease the banks) we live with some inflation.

So here is a question: how do we create a cryptocurrency that automatically adjusts itself – perfectly and predictably over the long term – to accommodate fluctuations in global economy and population, and ensure that the currency itself does not exhibit either short-term or long-term inflation or deflation? Could that then become a “fixed-standard” for all national currencies to be traded against?

Think about it – ‘currency’ is an intermediate thing that holds value, so you can easily trade for something of “real” value (stocks, real estate, goods and services). But individual governments usually need to keep stockpiles of their OWN currency on hand, which might fluctuate based on their own local economic conditions. A government might want to take on debt, fund public infrastructure projects, invest in education, or deal with a natural disaster like a hurricane or earthquake; their currency may rise or fall during these times and they may decide that this is ok. Wouldn’t it make sense to have a perfectly stable over-arching currency – not government backed, but which governments themselves (as well as individuals and businesses) could use as an intermediate thing to hold value?

If you’re looking for a challenging problem, this would be a great one to solve.

Categories:   Economics
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Comments (4) -

March 7. 2018 04:45

Exceptionally useful and insightful. Makes me think of ALL currencies in a different way - not just bitcoin.


March 7. 2018 09:33

Excellent explanation as always! The one thing you didn't address was the 21 million limit on Bitcoin, that alone will keep it from becoming 'ubiquitous'. I believe that the questions you pose are all solvable. People will look back at "first generation cryptocurrencies" in the same way we look at first generation computers, or first generation anything else. You are also right about RSA - wow, what an impact that has had on our society. We just take it for granted, but it is as important to us as the internet itself.

Bob Weaver

March 8. 2018 12:56

Enjoyed reading this and learned a lot...thanks, David.  One question/observation: you say that there is no reason to ever "invest" in a currency.  Isn't this what Soros and others do, aka arbitrage, profiting from the changing values of currencies?  Or is this different from what you mean?  Cheers!

Tom Welsh

March 8. 2018 16:51

Tom, yes you are correct and I did think about delving into that - but didn't want to stray too far off topic. People who earn a wage or run a business and work strictly within the bounds of their local currency, they should not expect to see obvious fluctuations in the value of that currency relative to the value of goods and services they are buying and selling. That's mostly what I'm saying. You hold cash as a 'secure and temporary place to hold your value' (a savings account) - but holding cash is not an "investment" that you are making in your own currency. However, if a government prints too much or too little money, or if the economy grows faster or slower than expected, then yes - the currency will change RELATIVE TO OTHER CURRENCIES and currency traders do play in that arena. With Bitcoin you do have obvious fluctuations relative to the value of everyday goods and services.

The Lunatic

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