The Bitcoin Explainer: Part I – The Economics of Bitcoin

 

This will be the start of a multi-part series introducing Bitcoin and cryptocurrencies to the general reader. In this article, we will be going over the broad economics of Bitcoin, and what it actually means. In next few parts, I’ll be going over the technology itself and how it works.

A revolution is here

We are on the precipice of a revolution, something on the scale of the information revolution of the 1990s. During the 1990s, the world wide web transformed the way the world communicated and did commerce forever. It replaced the old post office with the email, and gave way to subsequent developments such as smart-phones, social media, peer-to-peer sharing, online shopping, online banking and a new era of freely available knowledge. Knowledge was no longer relegated to only special interests. Business was no longer relegated to those with large start-up capital. Fame was no longer relegated to celebrities. Any average person could now compete with the powerful and wealthy. The world wide web transformed the world fundamentally by levelling the playing field across a broad spectrum of industries. One no longer needed to invest in expensive camera equipment to become a photographer, – tools were now widely available to empower anybody with an interest, such as Instagram and smart phones. One no longer needed to rely on nepotism and money to become a celebrity, – tools were widely available to empower anybody with a talent to find an audience, such as Youtube, Twitter and Facebook. One no longer needed to invest in an expensive bricks-and-mortar business to become a business-owner, – tools were now available to enable anybody with a good idea to gain a large audience and start making money online. One no longer needed to go to libraries or record stores to read books and listen to music, – tools were now available to enable anybody to access them – streaming, P2P sharing and direct downloading. This is what disruptive technology does – it disrupts entire industries and forces a fundamental re-think of the old ways, across the board. Anybody facing this scale of disruption to their business models, will have to face an existential re-think, a potential extinction level event, – adapt or die. SimilarlyBitcoin (blockchain) is now compelling individuals, banks and institutions to re-think newer and more efficient ways of establishing and adjudicating trust between players who don’t know each other directly, potentially disrupting corruptive practices and removing entire industries of middle men in global supply chains.

Born from a broken financial system

In 2008, the modern Western financial system was rocked by a series of gross market failures, due to systemic corruption and fraud that crippled the global economy. It was the first truly global financial crisis with irreversible ramifications, and this event marked the beginning of the end of the Western empire as we know it, forcing a visceral re-think in alternative power, and eroding trust in the ruling elite, especially bankers. It was only a year later, that an anonymous cryptography expert under the nome de plume Satoshi Nakamoto, proposed a radical new way of establishing trust without the need of any central intermediary such as a bank. The brainchild was called Bitcoin, which served as a decentralised peer-to-peer currency, and the underlying technology that made this possible was called blockchain, – a network, or public ledger of all transactions. Blockchain operates on cryptographic principles applied across information networks, establishing trust between transacting parties without the need for any intermediary or central clearing authority. The tradeoff for trust to be established without the need for private banks acting as transaction intermediaries was to have a public ledger of all transactions available for all to see. This technology heralded a new era in decentralised peer-to-peer (P2P) finance. Finance was no longer relegated to only bankers and brokers. Suddenly, anybody could now manage their own finances in a permissionless way, and financial freedom no longer required the services of the middle man with a vested interest. Bitcoin was the fusion of computer science with finance, cutting out the middle man in an intelligent way, and empowering individuals over corporations. With this technology, individuals can transact voluntarily and in a permissionless manner across borders, without any intermediary such as a financial institution hindering the transaction for whatever political, financial or security reasons. The implications of this are huge.

Since the 2008 financial crisis, central bank balance sheets have exploded

The bubble of central bank fiat currency

Many people call Bitcoin a ‘bubble’, and they miss the bigger picture. I recall back in 2013, people were calling Bitcoin a bubble and that was at $1K. Today, it’s near $17K. Ever since the 2008 financial crisis, central banks around the world have pumped endless quantities of fiat currencies in the hopes of galvanising growth and offsetting all the toxic liabilities on the banking sector’s toxic balance sheets, with assets. What have they achieved? Meagre growth at best, and patching band aids on a fatally flawed system. As a result, we saw epic equity bubbles, property bubbles and now, crypto-currency ‘bubbles’, as all that devalued cash is chasing fewer and fewer well returning assets. But the greatest bubble of all, that most people seem to miss, is paper fiat currencies themselves! Central banks worldwide have printed mind-boggling quantities of cash in the last 10 years. The US Federal Reserve at one point was printing $85 billion a month, for years on end! How did you think this would affect your purchasing power, if you are a US tax-payer? Central banks are rapidly devaluing national fiat currencies at an alarming rate, and this is manifesting in asset price inflation. Equity and property bubbles are only one symptom of the inflation. Bitcoin’s meteoric rise is partly due to its inherent algorithm in limiting the supply at a pre-determined rate, but it is also indicative, more alarmingly, of how worthless fiat currencies are becoming, on the backs of all this central banking folly. People are choosing to throw more and more worthless dollars into growing assets like equity, property and crypto-assets. Who would blame them, when central bankers have crushed interest rates for 10 years, punishing savers severely?

What Bitcoin shows is that we are witnessing a rapid global inflation of fiat currency. Bitcoin’s rise is only symptomatic of that, just as President Trump is symptomatic of all the rot inside America. Central banks, even at 3% inflation per year, are halving the purchasing power of your cash every 23 years, or in other words, prices are doubling every 23 years. This is mathematics, not propaganda. Are wages keeping up with this pace? No way. Since 1913 when the US Federal Reserve bank was formed, the US dollar has lost 95% of its purchasing power, or in other words, $1 in 1913 buys you 5 cents today. Again, this is mathematics, not propaganda. The moral of the story is that every fiat currency in history is eventually killed by its bankers through inflation. It’s once an empire is no longer able to generate the required growth to meet wage inflation, that it collapses, and a new currency is issued. We are approaching that point globally. There will be undoubtedly more sovereign defaults in the decades ahead, higher taxation, and the breakdown of government payout promises. People who have any wealth to protect, are wise to prepare ahead.

A Bitcoin log chart shows a much more stable price trend, dispelling any fears of an imminent bubble collapse

Digital gold 2.0 and a new asset class

Bitcoin and the crypto-verse are new asset classes, just as there are stocks, bonds, property, precious metals and cash. Never before have there been cryptographic-based currencies that have generated trust in a decentralised manner. For the time being, the market has deemed Bitcoin more as a store of value rather than a transactional currency. But that could change with technological upgrades to its network. Some even call it a digital manifestation of gold, or Gold 2.0. Gold markets are well known to be manipulated by central bankers, and Bitcoin is merely doing what gold is supposed to be doing in the current rigged environment, at least in terms of price action.

Because Bitcoin is not only a digital currency, but also a network, this is very important to understand, to help dispel notions about its ‘unsustainable’ exponential price action. What it means is that it follows Metcalfe’s Law, which states that the value of a network is proportional to the square of the number of participants. Fiat currencies do not abide by Metcalfe’s law, and as such, Bitcoin derives a great deal of its utility and worth from this underlying network and its users. The more people in the Bitcoin network, its value increases parabolically, as proxied by its fiat value, which actually behaves more exponentially and is best viewed for underlying trends in a logarithmic chart. And since its supply is capped at 21 million coins, it will always be scarce relative to cash, because cash is being devalued at an alarming rate globally. This is because money is debt in the present fractional reserve banking system. The system is based on the generation of endless debt, hence money supply, due to there always being more money owed than exists to pay that debt. Paying off debt en masse under such a system actually shrinks the money supply and causes a deflationary collapse! For more information how modern banking works, I have written articles here, here and here.

Bitcoin on the other hand, is not backed by debt. Traditional financial analysts would panic at the sight of parabolic movements, but Bitcoin is fundamentally a computational phenomena, and exponential moves are a norm, whereas in paper markets they are not. Bitcoin is programmed to increase its supply in a diminishing (logarithmic) rate, so that with each year it becomes harder computationally to mine the same amount. Approximately every 4 years, the Bitcoin supply halves. At present rates, 99% of the Bitcoin supply will be mined by 2036. As its supply is increasing at a logarithmic rate, its demand must be the inverse of that, – exponential, and this is exactly what we are seeing in terms of number of transactions and mining revenue with time. In Bitcoin, it is important to remember that supply and demand are inextricably linked algorithmically up until mining ceases (that is, supply is maxed out at 21 million) and all Bitcoins are mined, after which miners will no longer increase supply (‘mine’), only become purely fee generating businesses. If you don’t understand any of this, don’t worry, I will cover how Bitcoin mining and transactions work in a later part in this series.

Bitcoin is doing what gold should be doing in the current financial environment

The exciting future that Bitcoin brings

Presently, Bitcoin has only just began to go mainstream as of this year. I wrote recently on Bitcoin futures markets being offered to institutional investors. This is a sign of things to come for an industry that is slowly emerging into mainstream consciousness. What began as a movement of libertarian misfits, anarchists and nerds, has spawned into a global digital payments network that has made all of the above the new millionaires on the bloc. As such, there will be new industries that will want to cater to this market of nouveau riches, by offering goods and services for Bitcoins. And it will not only be the nouveau rich that will drive this market, but once adoption goes mainstream and Bitcoin becomes a widely accepted currency, people will begin to earn money for Bitcoin by trading their skills, and this opens up the possibility for a truly global digital economy that could rival the economic value of entire nations states. It stands to be the first such economy that knows no national bounds, merely sharing one common currency amongst all its users, that is decentralised and belongs not to the control of any bank nor nation-state.

Bitcoin is also in a race with other emerging crypto-currencies, who are competing for its status and market share. However, it reigns supreme as the king of crypto ever since 2009, commanding the biggest market share, having first mover advantage in the space (reputation and brand), attracting the biggest software dev team and holding down the longest history in resisting any attempts at hacking or breaking its open source code by all the world’s malicious actors. Thus, by being open-source, it has become anti-fragile by developing immunity by virtue of being exposed to a sea of endless threats.

For the time being, Bitcoin and other crypto-currency payment and smart contract networks (Ethereum, Litecoin, IOTA, Ripple etc…) are not fast enough to replace the banking sector, SWIFT, VISA, Mastercard or Paypal. This is known as the scalability problem in the cryptoworld, currently one of the biggest hurdles facing the industry. In order to become globally scalable for mass adoption, the transactions per second must be on the order of thousands, if not millions per second. Bitcoin currently can process only 7 transactions per second, due to inherent limitations. But these limitations can be changed by community consensus. Software dev teams across all crypto-currencies are working feverishly on solutions, and there are some very promising ones in the works. As such, crypto-currencies are not yet mature enough to replace fiat currencies, but they make for great complementary currencies working alongside traditional paper currencies as alternative investments and payment methods. One day all that may change, and they could actually rival and replace VISA, Paypal and SWIFT. However, central banks by that stage will unlikely adopt Bitcoin as a substitute for their increasingly worthless national currencies, instead they will try to invent their own blockchain systems and issue their own national crypto-currencies, probably forcing them onto their respective populations as legal tender. Corporations could also adopt their own crypto-currencies for their clientele. Bitcoin in this scenario may remain a decentralised, alternative crypto-currency outside of the control of any central bank or corporation, but more regulated within the frameworks of fiat currencies and central bank/government/corporate issued crypto currencies, where it could face stiff competition.

In the worst case scenario, Bitcoin could be outlawed by authorities, however this looks unlikely, as if outlawed by certain countries, there will always be other countries where it will be welcome for business and market share will simply move there. The outlawing country will only lose tremendous financial leverage and economic potential, not to mention potential tax revenue. At the moment, Japan has recognised Bitcoin as an official currency, and is adopting it much quicker than any other nation in the world. South Korea may soon follow. Only a handful of countries have made Bitcoin fully illegal; most have opted a cautious approach towards regulation, out of fear of missing out on this potentially ground-breaking industry. Bitcoin’s supply is too limited for it to become a global currency as some have speculated, however, it could well become a global digital reserve asset held by not only individuals, but corporations, banks and governments. And it will likely not be the only one, there will be competition from other crypto-currencies. Bitcoin will however, retain a first mover advantage for some time to come. In short, Satoshi Nakamoto’s Bitcoin has ushered in a revolution, and it is here to stay.

In Part II, I will go into how Bitcoin works at the technical level.

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5 Comments on "The Bitcoin Explainer: Part I – The Economics of Bitcoin"

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peteypies
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AJ….A good analysis…none of the usual talking heads / commentators are making any sense…cryptos have everyone stumped….

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