This blog post is intended for those new to crypto and those who might not fully understand the implications that Bitcoin presents. In order to understand Bitcoin completely, you have to understand the monetary factors that surround it. You need to understand:
What is money?
The technology behind Bitcoin
The economics of Bitcoin
And the Network effect of Bitcoin
Understanding each of these factors will lead you to a deeper understanding of Bitcoin and thereby a clearer understanding of crypto and where Crypto is headed. Let’s get started!
Note: if there are any mistakes or inaccurate statements, please let me know and I will fix accordingly.
What is Money?
In order to understand what money is, let me take you back thousands of years to the barter system. You see thousands of years ago, humans didn’t have a currency to transact with. Let’s say for example, I specialize in growing wheat and you specialize in growing fruits and vegetables. The barter system is where two parties exchange goods or services for one another. So, I can trade you 10 pounds of wheat for 5 watermelons, but what if you already have enough wheat? Or maybe you only want two pounds of wheat but I still want 5 watermelons, this wouldn’t be an equivalent trade and therefore I wouldn’t be able to fulfil my needs. Here in lies one of the main flaws of the barter system, not everyone wants or needs the same things. And this is why we created money, a common thing that everyone wants.
Now in order for money to work, it needs to fulfill 3 functions: it needs to be a store of value, unit of account and medium of exchange. This will sound like gibberish to my non economic majors so let me break these terms down for you.
Store of value: If I work my shift today and get paid $80, that $80 will hold its value tomorrow, and the day after and the week after etc. Whatever the money is, it can’t lose it’s value rapidly or else people lose faith in it and don’t believe in it as its purchasing power is eroded rapidly. If everyone was paid in corn, then I need to spend that corn this week before it rots.
Unit of account: Essentially everything needs to be able to be priced with the money. For example, in a store one thing priced in pencils, one item priced in wheat, one item priced in eggs etc. But you and all the other customers would find it more helpful if everything was priced in one unit of measurement which was also used for the rest of the economy.
Medium of Exchange: A medium of exchange simply means that the money is widely accepted everywhere throughout the economy. This is one of the most important aspects of money which I will touch on in more detail later but essentially I need to be confident that everyone will accept the money I have or else I would rather own a different form of money.
Now that we know the basic functions of money, let’s briefly go over the history of money in relation to gold.
Gold as a Form of Money
Money didn’t always start off as dollar bills and numbers in a bank account, the original common goods that people wanted and were used as money were shells but we eventually moved to the gold standard. Gold has been the bedrock for the world economy for the last 5000 years. It was used as the world’s currency for a long time, why is that? Gold as a currency is beneficial in many ways:
- Easy to identify fool’s gold
- Doesn’t burst into flames nor does it irritate the skin of whoever holds it
- Rare enough on earth that it isn’t easy to overproduce
- There has been a narrative for thousands of years that gold is valuable when in reality it has very little use case in the real world, we just believe it to be valuable because others believe it to be valuable
And so there you have it, gold is a precious metal with solid chemical properties that allowed it to be used as a currency for thousands of years since the Romans first adopted it. But gold had many issues with it including:
- Hard to transact with
- Hard to carry
- Not very divisible – If I bring a gold brick into a store and want something that costs less than the value of the brick, we need to shave off the brick to get to that value.
With these issues came the solution for gold certificates, these were paper claims that you used to identify how much gold you had and transacted with. Despite this, the gold standard was on its way out starting with World War 1 when governments wanted to create money out of thin air but were limited in their ability to do this due to their money supply being tied to gold. The United States and European countries abandoned the gold standard in order to fund their militaries during the war but realized after the war that the gold standard was limiting their ability and they didn’t need it anymore. The cold standard was reinstated with the Bretton Woods Agreement in 1944 and was eventually completely abandoned in the 1970’s under Nixon’s leadership. To this day, some aspects of the gold standard still exist. Gold has a market cap of 10 trillion USD, only 7% of its market value is attributed to actual industrial use, the rest is attributed to gold being adopted as a store of value.
Why is gold used as a store of value still?
Gold is still used as a store of value because it is an excellent hedge against inflation. For those that aren’t familiar, inflation is your money losing value overtime. This predominantly happens because governments print money on a yearly basis to fund various projects or as monetary policy to stimulate their economy. One of the basic “laws” of economics or laws of human nature is scarcity. We humans value things that are scarce, that is they are rare and hard to get. And so when more money is printed and added into circulation, money becomes less scarce and therefore loses some of its value. Example: Let’s say I live in a country with only 3 people, myself included and I sell burgers to the two other people that live here with me. Combined they both have 20$, so $10 each. Knowing this, I charge $10 a burger but if tomorrow each of them has $20 each well then I simply raise my prices as I know there’s more money available for me to charge. This is inflation. People make the mistake of thinking inflation is the rise of prices, inflation is your money being devalued. Governments control the money supply and typically countries have an inflation rate of 2-3% per year, so your purchasing power goes down around 2-3% per year. Gold on the other hand is a deflationary asset, there isn’t an unlimited supply on earth and so as time goes on it becomes more rare. This logic can be applied to all metals so why is gold most commonly used as a store of value? Exactly why is stated above, because of the narrative that has existed for thousands of years, that Gold is inherently “valuable” when in reality it’s not anywhere near as valuable as we give it but the narrative has stuck.
Now that we understand the history of money and how gold played a role in our history, let’s discuss Bitcoin. Bitcoin was created by an anonymous identity named Satoishi Nakamoto. This person or group of people, envisioned a global currency that was decentralized(not controlled by anybody). Without getting too technical, Bitcoin is a peer to peer network with a public ledger(think of an excel spreadsheet that has the history of all the transactions ever made)that anybody in the world with an internet connection has access to. Individuals can run software on their computer which will validate all of the transactions that take place on the Bitcoin network. This requires a lot of computing power, but these individuals compete to see who can solve an algorithmic puzzle first, which then validates the transactions on the new block being added to the blockchain and whoever accomplishes this first is rewarded with Bitcoin(therefore individuals are incentivized to secure the network). Individuals who are competing for the reward of Bitcoin are known as miners, think of gold miners who mine gold to add it to the global circulation.
The reason why Bitcoin is groundbreaking is because it is the first time in history(apart from the barter system) where I can transact money without there being a middleman to fulfill the transaction. Nobody owns or controls the Bitcoin network, it is the miners all around the world that secure and maintain the Bitcoin’s network. With this being said, Bitcoin’s initial design was to be the currency of the world, thereby replacing government backed currencies. There are several reasons why Bitcoin most likely won’t be able to accomplish this.
- Volatility: Bitcoin in the short term isn’t a great store of value, it tends to drop and spike everyday and has historically dropped over 50% in value in a short period of time. If i were to be paid in Bitcoin but it drops 10% in value overnight, I wouldn’t be too happy with being paid in Bitcoin. Bitcoin is still early in its life cycle and so as time goes on it may eventually reach a point where it has been so widely adopted that its price is stable and can be used as a currency.
- Limited Supply – This is probably the biggest flaw for Bitcoin in terms of it being used as a form of currency. Bitcoin’s design entails that there will only ever be 21 million Bitcoins mined and this will come to a conclusion in 2140. Because its supply is limited, holders of Bitcoin are incentivized to do just that, hold it. As time goes on, it becomes more rare and therefore spending Bitcoin today means you’re sacrificing purchasing power in the future.
This leads us to Bitcoin’s unintended but its adopted use which is Digital Gold. Bitcoin shares many of the same properties that we discussed gold has.
- It exists outside of the government’s systems
- It has a fixed supply(it does this better than Gold as we know exactly how much Bitcoin there will be but we only have estimates for Gold)
- It’s transparent – the public ledger with the history of all transactions that have ever occurred is available for everybody to see. One of the lies surrounding Bitcoin is that it is good for criminal use. In reality, law enforcement loves Bitcoin because they can easily track and link Bitcoin transactions to an individual’s IP address.
- It’s divisible – it does this better than Gold as well as you don’t need to own a full Bitcoin, Bitcoin is broken down into Satoshi’s where one Bitcoin is equivalent to 100,000,000 Satoshis.
Essentially, Bitcoin does everything that Gold does except better. It is a deflationary asset(gains value over time due to its limited supply), that exists outside of our current monetary systems and isn’t controlled by any one person or entity. It’s more accessible than gold, more divisible and less costly to transact with. Considering it does everything that gold does except better, gold has a $10 Trillion Market Cap and Bitcoin has a $1 Trillion Market Cap. Bitcoin still has a lot of value to gain in this sense.
It’s important to note that similar to gold, Bitcoin’s value is purely narrative driven. It’s a non productive asset, meaning it doesn’t actually produce anything. In this sense, Bitcoin’s value is purely derived from other people adopting it as a store of value. This is where Metcalf’s Law comes into play. Metcalf’s Law states: the value of a telecommunications network is proportional to the square of the number of connected users of the system. Although this law wasn’t intended for Bitcoin it can apply. Essentially, a social network grows in strength the more that people adopt it. Think of social media platforms like Facebook and Instagram. As more and more people adopt it, more and more people are incentivized and forced in a way to adopt it. Businesses have to use these social media platforms in order to stay competitive now. Money being the biggest social network in the world, would entail that it has the same effect. As more and more people adopt Bitcoin as a store of value, more and more people are incentivized to adopt it.
We’re currently exiting the first stage of Bitcoin adoption which was where it was predominantly retail and individual investors that have bought in. The network has grown to a size where big companies like Tesla, Square, Microstrategies etc. have allocated a potion of their cash on hand to be stored in Bitcoin. This will lead to a domino effect where more companies buy in eventually leading to adoption from countries. As the Winklevoss Twins love to say, the goal with Bitcoin is to not be the last person to the table. This network effect is growing, getting in sooner rather than later will be greatly beneficial.
Potential Issues with Bitcoin
Bitcoin as a store of value isn’t completely flawless. Personally, I believe it will succeed with respect to this but certain events can cause Bitcoin to collapse. For starters, if the identity of Satoshi Nakamoto was ever revealed or discovered, it could be catastrophic for the network. The original wallet held by Satoshi contains 1 million Bitcoin and has never been moved, and as long as the identity of Satoshi is never revealed, then the network remains completely decentralized. Another concern I have for Bitcoin is if another crypto is adopted as a store of value over Bitcoin. I don’t believe this is possible at this point as Bitcoin’s lack of a founder plus its well established network effect should put it in a solid foundation where it can’t be beat at its own game. Time will tell if this holds true but my intuition tells me that Bitcoin will be the global store of value for the next few decades with other cryptos co-existing for other problem solving purposes.
One of the main arguments people use against Bitcoin is that it is a non productive asset with nothing backing it and its value is completely derived from others valuing it. This is a flawed for these reasons:
- The current money system that we use has nothing backing it either, governments are free to print and create money out of thin air. Most notably, governments around the world have printed more money in the last 12 months than all of history. This is the devaluation of our currencies on a scale we have never seen before and we are a liberty to this.
- It is true that it is a non productive asset, but at the end of the day we aren’t adopting Bitcoin because it is a productive asset. We are adopting Bitcoin because it is a hedge against inflation, its sound money that exists outside of government control.
- Value is derived because others value it: This itself completely describes money on a fundamental level. Money is a belief system, it’s a piece of paper that only has value because we as a society believe it has value. In countries like Venezuela you see poor government management of the money supply and as a result the citizens of these countries try to sell their currency for more stable currencies like the U.S. dollar. Money is a belief system, if governments don’t manage the money well, then people stop believing in it. Simple as that.
I know this was a long post but I hope if you made it through, you learned something along the way. If you’re interested in learning more about Bitcoin and money to read the book “The Bitcoin Standard” and to give Anthony Polpliano’s interview on Lex Fridman a listen, super insightful. There’s still a lot about Bitcoin I could talk about like a more in dept explanation regarding the technology behind it and how it can counteract the suppression that the U.S. places on the world. I’ll save these topics for another blog post but thanks for reading and let me know what you think!