Economics of Bitcoin

Central banks control the money supply of a nation. In Bitcoin, the monetary policy is part of its algorithm and this will never change

Does a computer program called as Bitcoin or rather any future cryptocurrency on similar principles really have the potential to replace our banking system partially (if not fully) ? Before trying to figure out the answer, we should understand a few key economic concepts of our modern world.

What are central banks?

Each country or even a group of countries has a central authority which is responsible for defining, monitoring and support its monetary policy. These are not traditional banks per se in the sense that residents cannot open a bank account or they do not issue credit cards. Rather they are more like a bank for the banks. Central banks control the monetary base of a nation. The monetary base is usually only liquid currency (currency notes, coins)

Monetary base = Total money in circulation with public + Commercial bank deposits held in the central bank’s reserves.

Functions of central banks

  • Inflation management, formulating monetary policy and management of currency printing
  • Implement regulations and work with Governments for formulating laws around them.
  • Manage the settlement and clearing process of funds between banks.
  • Act as a last resort for commercial banks if they fail or lend them money

We have already read in History of Money (Part 1 and Part 2) that each financial system has failed or has some serious drawbacks — most notably each was a centralized economy.

In almost all economies around the world, the money is just printed without even statistics and economics model. There is no tracking or the money is not backed by a physical commodity like gold

Drawbacks of centralized economy

  • Monetary policy is decided by few individuals and backed by the political agenda of the ruling party. Policy makers with the poor financial vision of a nation lead to implementing bad or corrupt financial practices in that country.
  • One key component of the monetary base is the money in circulation with public. However, Govt only has a high-level estimate and they only have an idea of how much currency is ‘minted’. Once the currency notes enter public domain it is impossible to track how each note/coin has exchanged hands
  • Inflation is direct result of printing currency without any statistical model or an actual need
  • Government creates money ‘out of thin air’. This is the most vital factor to understand. There is no real forecast, mathematics, statistics or backing of a physical commodity.

Decentralized economy real world example

We are deviating from the topic and hence I would like to keep it short. One such example exists in my own home country of India. This has been implemented partially and with success in the state of Kerala. For further reading check this and this link.

Annual inflation (in blue) and deflation (in green) rates in the United States from 1666 to 2004 (Source : Wiki)

Inflation Vs Deflation

Source: Link

Monetary policy of Bitcoin

I have already explained that Government creates money out of thin air. If Government, with all its lunacies, can create money — then why not a computer system whose code and behavior is known to everyone?

The Bitcoin protocol implements an algorithm and this algorithm contains the Monetary policy. The entire Bitcoin network system is designed in such a way that one cannot change the policy even in the extreme situations.

Bitcoin follows a deflationary model. The total supply of bitcoins is fixed and is extremely controlled. The most important and vital aspect of Bitcoin is that its monetary policy is 100% transparent as opposed to a Government monetary policy. Hence the libertarians were one of the early adopters of it and firm believers that Bitcoin has the potential to replace banks.

This policy by no means can ever be changed by anyone and hence the trust factor is very high. The system is designed such that it can easily find out if someone is trying to change the policy (hack the system).

Decreasing-supply algorithm of Bitcoin. This approximates the rate of gold mining

Only a handful of developers can change it but this will happen through a democratic ‘consensus’. The probability of this taking place is extremely unlikely. Key parameters of Bitcoin’s monetary policy —

  • Block generation rate: After a fixed time, a block of bitcoin is created. This fixed time is approximately 10 minutes. This will never change. (There is a proposal to decrease it to manage scalability but it does not have the approval of most parties involved as of now)
  • Bitcoins per block or block reward: The number of bitcoins created every 10 minutes follows a decreasing rate. After every 210,000 blocks (period of approximately 4 years), the block reward is halved. For the first 4 years, starting from Jan 3, 2009 — this was set to 50. So 50 bitcoins were created out of thin air and rewarded to one entity called as miner (can be an individual or a group of individuals). Then on November 28, 2012, the block reward was halved to 25 and then on 9 July, 2016 it was halved to 12.5. The next is scheduled for 2020.
  • Last Bitcoin mining date: The bitcoin creation will continue till somewhere around the year 2140. The exact date can never be predicted since this is dependent on the total computing power of all nodes connected to the Bitcoin network.
  • Total Bitcoins: The total number of Bitcoins created will never be more than 21 million. This does not mean that we will have 21 million Bitcoins to spend by 2140. Many bitcoins are lost since Bitcoin owners lose the secret keys (or they die!!). There are many more reasons like Bitcoins being sent to an address where those bitcoins cannot be spent. Financial institutions or online exchanges can (and have already) introduced products based on bitcoins where bitcoins can be lend or enable all elements of fractional banking. Ironically, Bitcoin was adopted to be an alternative to fractional banking :). Already more than 75% of the Bitcoins that will be in circulation have been created.

Bitcoin as a central bank?

Many libertarians, economists, financial experts etc very strongly believe that Bitcoin or probably even a Govt. controlled cryptocurrency has the potential to replace many features of the Central banks. Let us see the ground reality as of today

It is clear that cryptocurrency can replace only a small subset of the functions of central banks.

How Bitcoin controls Inflation. Chart created from this website.

Is Bitcoin’s deflationary model really a bad thing?

Any book on economics talks about the deflationary model as a bad thing for the nation. Even the comparison chart above says that deflation is not a good thing. If we are talking about Bitcoin replacing the monetary policy of a nation then there are many experts who say that it is actually a good thing. Consider the analogy of ‘cholesterol’ in our body. Everyone says that it is bad for the body. But then scientifically speaking there is ‘good cholesterol’ and ‘bad cholesterol’. Similarly, there is ‘good deflation’ and ‘bad deflation’. Here are few explanations —

  • In deflation, the value of money increases. Hence people hoard it. Since there is less supply of money in the market the price of goods decrease. But traditional money has very poor divisibility. But remember, Bitcoin is highly divisible. The smallest unit is called as satoshi and 1 satoshi = 0.00000001 Bitcoins. People do not need to transact in full value of Bitcoins. An increase in value will actually lead to less amount of bitcoins needed for the transaction. With divisibility upto 8 decimal places, the system can easily handle it. Bitcoin hoarder is not really going to gain much as value is going to increase on a steady upward trajectory and NOT rapidly so hoarder is forced to bring Bitcoin in circulation.
  • As value increases (Eg: Bitcoin to USD rate) then the block reward is decreasing and the miner (i.e the person who wins the block reward) has to spend more resources (costlier equipment using higher energy). So not everyone can start mining Bitcoins right away.
  • In traditional deflation cases, there are many unknown factors and uncertainty of the future hence it creates a chaos. In case of Bitcoin, the algorithm is known to everyone and every user of the system (including financial institutes or average consumer) can plan accordingly. We can predict with confidence the entire bitcoin supply for the next century.
  • With Bitcoin the supply of bitcoins is halved overnight. In the long run this adjustment does not affect the value of commodities since the value of every commodity falls proportionally.
  • If price of goods measured in Bitcoins is falling that means it is getting more valuable. So actually you need less amount of bitcoins to buy the same good. However, with time the price of goods measured in fiat currency like USD will always increase. But an increase in dollar price for goods also means an increase in dollar price of Bitcoin.

This is a big debate topic in the community and every student of Bitcoin should discuss it with her colleagues.

One more point. What happens when all the bitcoins are created? To answer this think of what will happen if all the gold in the world is mined? Will it increase or decrease its price and value? Humanity will think of some alternative (Google : ‘Asteroid mining’ :) ). We know in advance when this is going to happen so the world will be better prepared for it.

Bitcoin Charts

You can also check Bitcoin Block halving website for real time data of many more parameters

Bitcoin V/s USD. Perhaps, the most important chart which attracts everyone. Source:
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Source: Link
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First 2 stock images are from Pixabay.