Bitcoin: Connecting the Bits
Bitcoin: Connecting the Bits
  • S
    By: Sanjay Pawar

The purpose of this writing is to express my thoughts and opinion on cryptocurrencies in general and Bitcoin in particular. My objective here is in no way to predict the future price of Bitcoin or any other cryptocurrency. So please do not see this article as an investment recommendation. I am writing this because clients have often asked me about my thoughts on Bitcoin and cryptocurrency.
Bitcoin: Existential question: As you know Bitcoin came into being because of an anonymous (nobody knows who Satoshi Nakamoto is……) white paper written about the use of blockchain technology to directly confirm transactions between two parties in order to eliminate third party intermediaries (like big banks) and therefore reduce/eliminate transaction costs. The risk of double-spending was solved by using an electronic coin that would in some way pass on from payor to the payee.

On paper, I see how the theory behind electronic coin and the need to eliminate third party intermediaries to reduce transaction costs is interesting. And I think third party intermediaries can be eliminated by just using blockchain technology without the use of bitcoin or any other digital currency.

However, as they say, devil is in the details. Meaning details of concepts like proof of work, time stamp, ability to reverse a block, need for more honest nodes than dishonest or attacker nodes, someone or some corporation or some government (or quasi government) with large enough resources could in theory and also in practice (in my opinion) reverse or falsify a block in the blockchain. And what happens when 21 million bitcoins are mined? What is the incentive for miners to stay in the network and provide transaction confirming, security services, keep the block (honest nodes) ahead of dishonest nodes etc.

Bitcoin raises so many more questions when you think about the creation of bitcoin, use (transfer) of bitcoin, future pricing, and value changes and then the ongoing maintenance of bitcoin network.

Creation of Bitcoin: Bitcoins are said to be created through a process of “mining”. I use quotes around the word mining because somehow by calling the process mining it seems to conjure up a belief that somehow these bitcoins were extracted from a mining operation or something like that and are therefore viable assets. Most proponents of bitcoin, just run with that without trying to go into the details of this mining process and how it has so far created about 20 million bitcoins. Bitcoin mining, as I understand it, is supposed to be a process of confirming transactions in a block and also process of securing the network. Sounds legit right? But if you think about it….what transactions are being confirmed and how are people sitting in different corners of the world confirming transactions that they have no means of confirming.

Please note that I am not against Blockchain technology that bitcoin involves. I am only thinking about bitcoin from an economics and practical money use standpoint. And therefore, the details of the technology and mining process does not matter for this discussion.
 So here are my thoughts:

  1. Inflation hedge: One of the biggest reasons to support Bitcoin is that it is a great inflation hedge. The reason given for that is that only 21 million bitcoins can ever be created. And therefore, the problem of excessive printing with fiat currency would not exist for Bitcoin. Sounds great, doesn’t it? Sold! We all hate inflation, so bitcoin is great, lets run with it.

But hold on, think about it some more….Only 21 million units for the rest of eternity…… Alright, let’s just start with next five years to keep numbers simple. Today the US GDP is about 21 trillion. If Bitcoin is the only currency in use, this would mean that 21 million bitcoins would represent $21trillion of US GDP. But remember 21 million bitcoins are for the entire world! Now when you try to think about the amount of GDP each bitcoin has to represent…, your head should start to spin. But that is not the problem. The problem is in the two key words I used earlier, eternity” and “today”. Meaning only 21 million bitcoins can ever be created (eternity) and US GDP today being $21trillion.

What I am thinking is that as the US economy grows each year, each year the higher amount of US GDP would still have to be represented by the same number of bitcoins. And wallah! There lies the problem. It is not inflation, but it is perpetual depression. If anyone thinks inflation is a problem, how about depression? Much! much! much! worse.

Why? let me explain, if there are only 21 million bitcoins, as the US economy (let’s ignore rest of the world economy for now) grows, meaning as factories produce more goods, farmlands produce more food, service providers provide more services etc. The additional goods produced and services would still have to be represented by the same number of bitcoins. Let’s say a farm produced 10,000 oranges in 2022 and they were worth 1 bitcoin. Next year, 2023, if the farm produced 10,200 oranges (just a 2% increase in production), guess how many bitcoins they would be worth? 1 bitcoin. Because there are no more bitcoins created or produced, there is no choice.

Along similar lines of reasoning, no one would/should ever get a pay increase. How would the proponents of Bitcoin like that?
Bitcoin sure would prevent inflation but in turn create a much worse problem.

  1. Store of Value (Asset Class): When the inflation argument was no longer really working or viable, proponents of Bitcoin started calling it an asset class and a store of value. How can it be a store of value when it costs a lot of power and resources (computer nodes etc) to maintain the 21 million bitcoin network. Essentially, it would be like keeping your car running in order to store fuel in it. Not sure why anyone thought that was a great idea. Not to mention the risk of total loss of value if dishonest nodes take over honest nodes.

Another reason, I think, it was described as a store of value or an asset class is because the price of Bitcoin had risen substantially (thanks to extreme speculation) and people (including some institutional investors) thought they should allocate some portion of portfolio to cryptocurrency. The rise in price of Bitcoin, in my opinion, is a classic example of the “Bigger fool theory” (Person A buys it today hoping that person B will buy it from them tomorrow for a higher price and so on……).  Another fact that baffles me is that how often institutional investor investment is used as a reason to justify an investment. Just because an institutional investor makes a certain investment (read speculation) does not make it a good speculation!

  1. Alternate to Fiat currency: Crypto was conjured up as an alternate/replacement of fiat currency, essentially currencies created by central banks around the world. I can understand the urge to replace central bank currency. But I cannot understand how that would solve any problems created by monetary, fiscal or public policies. I mean would crypto stop governments from around the world from raising debt? Would it stop stimulus programs like we saw during covid? What happens to Sovereign debt around the world? With one currency, how is the quality of one economy differentiated from another? We are seeing some of those issues surface with the European union with one currency. The more you think about it the more problems surface. Also, how would public spending programs work in an economy represented by Bitcoin where there is no room to create value unless there is proof of work. It gets more and more complicated, the more we think about it.

Right now, with central bank currencies, at least there is some way (exchange rate) to put a relative value on different economies around the world in terms of exchange rates, relative debt rating, excessive (wasteful) government expenditure etc.

  1. Security: Security is another concern that I can think of.  No one can tell me if there is a way to identify a fake bitcoin from a real bitcoin (a fake blockchain from a real blockchain). And if there is what is the remedy/recourse? If a group of individuals or a government or quasi-government agency allocated enough resources, it should be possible to create fake nodes (blockchain or Bitcoin or crypto currency). Not only no one would know fake from real crypto but also no one would know where the fake crypto came from and who is responsible. I am not sure how the proponents of bitcoin who cannot trust central banks for currencies would trust nodes (people) around the world that they do not know and have no way of knowing!

Essentially, they would be creating a world of finance filled with chaos and lawlessness. 
There are so many reasons why Bitcoin, crypto or any similar currency as an alternative to central bank currencies would be detrimental to global economy. Again, please note that I am not opposed to the underlying technology, and I think that the application of blockchain to financial transactions and business processes could provide significant economic value. One example could be stock, bond or ETF trade settlement time be reduced to minutes from the current 2 days.

I just don’t think that cryptocurrency is the right application of Blockchain technology.

I hope this helps you see how I think about Bitcoin and cryptocurrency. Please make your own opinion based on your understanding of the world of finance, economics and medium of exchange.