Amid all the furor over bitcoin – the virtual currency is trading around $6,000 currently, following six-fold growth in 2017 – a key detail on how the currency actually works has been lost. Or perhaps this detail has been deliberately omitted by bitcoin bulls because it damns bitcoin as a viable future currency. I’m speaking of the currency’s much-ballyhooed limit of 21 million bitcoins in circulation. The very feature hyped most by the bulls is bitcoin’s Achilles heel. I’ve seen only economists discuss this limit but then be drowned out by a chorus of bitcoin bulls who say the economists “just don’t get it.”
Why bitcoin bulls just don’t get it
Bitcoin bulls love to cite this limit as proof that the cryptocurrency is a store of value and that it can be a viable currency. They usually say something like the following: “The pre-set limit of the number of bitcoins means that governments and central banks can’t debase the currency.” “Debase the currency” is a shorthand “dog whistle” for all those who think inflation is evil, in other words, those who do not understand the value of inflation in managing the economy and keeping people employed.
However, this belief in a fixed limit on the money supply belies some tremendously important discoveries in the field of economics in the 20th century, notably around the dynamics of the Great Depression. In practice, bitcoin’s fixed money supply would ensure that an economy would grind to a halt during a recession or bust cycle, and guarantee deflation, a state that is crippling to an economy.
The reason is simple. In a recession consumers hoard their money, slowing the velocity of money through the economy. If they hoard so much money, the economy slips into deflation – a state where money buys more tomorrow than it did today – then consumers are tempted to delay their purchases another day and then another, because their money will buy even more later than it will now or tomorrow.
Deflation is a situation that is not self-correcting and in fact can be self-reinforcing due to incentives. Each individual has an economic incentive to put off their purchases as long as possible – because they can buy more later – harming the overall economy for everyone and ensuring more deflation — a truly horrific state of affairs. The economy craters because everyone is waiting to buy something later.
Economist and Nobel laureate Paul Krugman explains this situation masterfully using a baby-sitting co-op as a model. The upshot for managing the economy is this: we need central banks to stoke economies by expanding the money supply – what the cranks call “debasing the currency” – when times get tough and consumers hoard money. An increased money supply helps stoke inflation and keeps money moving through the economy.
The fact that bitcoin bulls tout the currency’s limited money supply as a positive feature instead of a very detrimental bug shows how little they understand that a reasonable level of inflation is great for the economy overall. By prudently using inflation, central banks can put people to work, shorten the length of recessions, and keep the economy growing.
The necessity of managing the money supply was a key lesson from the debacle of the gold standard. In ye olden days of the gold standard, the economy had to fight back from pernicious recessions that dropped millions into poverty every time there was a recession. Fortunately, economists figured things out and cooler heads took the U.S. off the gold standard – a fact still lamented (wrongly) today by many.
It’s bitcoin bulls who would love to repeat this sordid history with their fixed money supply. And that’s why bitcoin will be worthless.
Heed the wise words from great investors
But you don’t have to take my word for it. Warren Buffett called this one in 2014, when bitcoin was just emerging. Buffett stated: “Stay away from it. It’s a mirage basically. It’s a method of transmitting money. It’s a very effective way of transmitting money and you can do it anonymously and all that. A check is a way of transmitting money too. Are checks worth a whole lot of money? Just because they can transmit money?” He added: “I hope bitcoin becomes a better way to do it. But you can replicate it a bunch of different ways. The idea that it has some huge intrinsic value is just a joke in my view.”
Bitcoin bulls will laugh at Buffett for not understanding bitcoin, given the currency’s meteoric rise in 2017, but let’s remember that Buffett was not enamored of dotcom stocks back in 1999-2000 – he was called a dinosaur and lambasted for his views – only to emerge with a ton more money. He deftly sidestepped massive losses. Do bitcoin bulls think they’re smarter than the world’s greatest investor?
Of course, just like the dotcom bulls, bitcoin bulls will point out that the price of bitcoin has skyrocketed since these comments have been made. So, they say, it’s proof that Buffett is wrong. (How often has that been uttered, only to have the Oracle of Omaha be proven right yet again?) But bitcoin’s meteoric rise shows again exactly why bitcoin is useless as a currency – it lacks the stability to make it useful. Writer Charlie Stross provides more on why bitcoin would be a nightmare.
Someday the bitcoin bulls will learn their lesson, but for now the party rages on with no end in sight.