Why Bitcoin Matters
A beginner’s guide to economics, government and Bitcoin
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Economics is boring. It’s full of complicated terms, obscure references and people who seem to live in a different reality. Yet economics is at the core of our societies — it defines the rules of human coordination. That’s kind of a big deal.
Bitcoin is annoying. It’s full of complicated terms, obscure references and people with laser eyes shouting at each other. Yet many say it’s the future of money — that it fixes everything. That’s a rather bold statement.
Why should we care about any of it? Aren’t there more pressing issues, like, I don’t know. Climate change? Isn’t Bitcoin consuming as much energy as Argentina anyway? Or is it Norway? Either way, that can’t be good.
As often, it’s not that simple. Bitcoin may very well have a shot at fixing a number of things, but to decide whether that is the case, we need to understand what is broken in the first place. And to do that, there’s no other way than to look into the current workings of the economy.
This post sets out to articulate the dynamic between economics, government and Bitcoin, in simple terms and as succinctly as possible. We will cover topics like central banking, inflation, money supply, digital currencies, and tie it all back to Bitcoin. By the end, you will better understand what a lot of Bitcoiners are about.
Disclaimer
I am not an economist and what follows is the result of personal research over the years. I will provide sources throughout, however, and essentially string them together to support my conclusions. Whether or not you agree with them is up to you.
Also, this is not financial advice. I am not telling you to buy Bitcoin — I’m merely explaining why it’s important that it exists. Please do your due diligence before you invest any money (in anything, really).
So, central banking
According to Investopedia, a central bank is:
a financial institution that is responsible for overseeing the monetary system and policy of a nation or group of nations, regulating its money supply, and setting interest rates
I know. Bear with me.
Examples of central banks are the European Central Bank (ECB) and the US Federal Reserve (Fed). Another way to describe what they do is that they maintain price stability with moderate inflation (usually around 2%).
What’s inflation? It’s the mechanism whereby the purchasing power of your money decreases over time. In other words, it’s when the same amount of money allows you to buy less tomorrow than it did yesterday because prices have gone up.
Inflation means that the actual value of government debt decreases over time.
Governments like inflation for a few reasons. One is that it encourages spending and investing — if you know your money is losing value over time, it’s better to spend it today than tomorrow, or to put it to work so it generates some returns.
In this context, inflation helps to ensure that money keeps circulating in the economy, boosting consumer demand and driving economic growth.
Another reason governments like inflation is because most of them rely heavily on debt to support various policies and programmes like infrastructure projects (schools, roads, hospitals, etc.). Taxes don’t cover everything, so governments borrow money to increase their budget.
Inflation means that the actual value of government debt decreases over time. The money they owe is worth less when they have to pay it back than when they spent it in the first place, which makes it easier to repay (which is usually done with more debt).
Central banks mostly control inflation by regulating the money supply. The base logic is that the more money circulating in the economy, the more inflation is likely to go up. Conversely, the less money circulating, the more inflation is likely to decrease.
For instance, the Fed controls the money supply by changing how many dollars circulate in the US economy. How? By setting interest rates and reserve requirements, and by printing money.
The reserve requirement is the percentage of deposits that commercial banks (e.g. your bank) have to hold in the vault. In the European Union, that value is currently 1% — if you deposit €1000 in a French bank today, it has to hold €10 in the vault, and can lend the rest.
If a central bank wants to decrease the money supply, it can increase the reserve requirement, meaning commercial banks have less money to lend. Conversely, decreasing the reserve requirement allows banks to lend more, increasing the money supply.
Another way to control the money supply is by setting interest rates, which is the rate at which your bank can borrow money from the central bank. In turn, this influences the interest rate your bank can offer you, to borrow from them.
When rates are low, people and companies are incentivised to borrow — and spend — more, because it’s effectively cheaper to do so. When rates are high, they borrow less.
Basically:
- low interest rates = more money circulating
- high interest rates = less money circulating
A third way central banks control the money supply is by buying or selling government securities — essentially debt that governments issue to fund the things we mentioned earlier (e.g. infrastructure projects).
If the Fed wants to increase the money supply, it can buy securities from commercial banks, which as a result have more dollars that they can lend. When it wants to decrease the money supply, it sells those securities.
Central banks need money to buy these securities when they want to increase the money supply. Up until 2010, they were mostly using their own reserves to do so, but the 2008 financial crisis changed everything.
Enter money printing
When the crisis hit, the Fed first used its traditional tools to try and fix the economy. But by December 2008, the situation hadn’t improved — interest rates were near zero already and couldn’t be lowered further (I’ll get back to this), and other solutions were needed.
A way to quickly increase the money supply is to buy securities (government debt) using printed money — a process also known as quantitative easing, or QE. Central banks essentially buy securities by creating money out of thin air, instead of using their reserves.
They can do that because today’s currencies aren’t backed by anything. Up until 1971, many currencies were pegged to the dollar’s value, which in turn was backed by gold. This was the result of the Bretton Woods Agreement of 1944, which the US eventually ended.
Years of low interest rates and QE aren’t without consequence.
Thus the world went from a gold standard to a “fiat” standard, whereby currencies aren’t backed by a commodity like gold, but issued by central banks and supported by governments (money by decree, essentially, which is synonymous with “fiat”).
Central banks can create money easily because most of it is digital already and increasing or reducing their balance sheet (a document listing their assets) is done by essentially changing a number in a database.
The Fed had to do this because of the nature of the 2008 crisis — commercial banks didn’t trust each other because toxic assets were all over the place, so it had to inject money and buy these assets to keep things running until confidence was restored.
QE wasn’t a new thing at the time (the Bank of Japan had already done it in 2001), but central banks were reluctant to use it because of its unconventional nature, its unpredictable outcome and the risk of high inflation it creates.
But now that most major central banks have started doing it, they can’t seem to stop. Following the 2008 crisis, the Fed used QE up until 2014 and resumed the programme in March 2020 because of the pandemic. The ECB has never really stopped since 2009.
The Bank of England (BoE, the UK’s central bank) ran a QE programme from 2009 to 2012, another one in 2016 (because of Brexit), and again in 2020 (because of the pandemic). In all these places, interest rates have been near zero, at zero or slightly negative for years.
Ok, time for a quick recap before we continue:
- Inflation is money losing value over time.
- Governments like inflation because it encourages consumption, boosts economic growth and makes their debt more sustainable.
- Central banks control inflation by regulating the money supply.
The main ways central banks regulate the money supply are:
- by setting reserve requirements;
- by setting interest rates; and
- by buying and selling government securities, mostly by money printing (QE).
More money tends to increase inflation and less money usually reduces it.
Setting interest rates and QE are currently the main levers to control the money supply and therefore inflation. In many countries, interest rates are already very low, so central banks rely heavily on QE to expand the money supply.
But years of low interest rates and QE aren’t without consequence. Low interest rates means people can’t save by holding cash (think about the interest rates your bank is offering you at the moment and compare that to inflation), so they look for alternatives.
The clear “winners” here are real assets like stocks, commodities (raw materials) and real estate, whose prices have skyrocketed. In the UK, for instance, a house now costs 8 times the annual salary on average, versus 4 times in the 1990s.
This environment predominantly benefits higher-income households (who already have access to or own these assets) while contributing to raising the entry barrier for lower incomes.
Low interest rates and QE also encourage taking on debt, as the former makes it cheap to do so and the latter provides money for lending. To make these high levels of debt sustainable, interest rates have to be kept even lower, which encourages more debt, creating a vicious cycle.
In this context, increasing interest rates or suspending QE programmes could lead to payment defaults and trigger a financial crisis by cascading effect — the kind of situation the Fed found itself in back in 2018 when it started increasing rates. It intended to do it again in 2019 but was forced to backtrack eventually.
Another potential side effect of QE is the risk of creating severe inflation.
Expanding the money supply means more money chases the same number of goods or even fewer goods in case of supply chain disruptions like we’re experiencing at the moment.
When the amount of circulating money increases faster than the number of available goods, prices mechanically increase — that’s inflation. While moderate inflation is deemed good for the economy, strong inflation can hurt it. Today, many developed countries experience the latter.
What do central banks do to fight inflation? They reduce the money supply. How? Mostly by increasing interest rates and reducing asset purchasing programmes (QE). As we’ve just seen, however, they can hardly do so without triggering an economic downturn.
Central banks are stuck in a trap they set for themselves.
Despite the current economic climate, the Bank of England was the first to increase interest rates in February 2022 to combat severe inflation in the UK. Soon after this move, the Fed followed suit and announced similar measures, causing markets to tumble. Several rate hikes are planned in the next few months — we’ll see how that goes.
Overall, central banks are stuck in a trap they set for themselves. After months of contending that inflation was transitory, it is now largely acknowledged that it will be around for a while. Tools to both stimulate the economy and fight inflation seem to have run their course.
Right now the focus is on high inflation and it looks like most countries will have to let it run for a while, for lack of recourse. The general economic outlook still isn’t great, however, and more economic stimulus will most likely be necessary down the line.
What will central banks do? Debt levels are historically high, and more QE would only make it worse. Interest rates are already very low, so it’s a lever that central banks can’t seem to use anymore.
But what’s preventing central banks from setting deeply negative rates anyway?
The reason is negative interest rates means savings accounts start costing savers money instead of earning them some. In other words, it becomes more expensive to keep your money with the bank than to keep it at home, in cash.
While doing so would come with storage and insurance costs, the risk is that most people would still prefer to hold cash at home at essentially zero interest over paying negative interest to the bank. This is why central banks can’t set deeply negative interest rates at the moment.
Is there anything that would allow them to do so?
Enter CBDCs
CBDC stands for Central Bank Digital Currency. We heard a lot about them back in 2019 when Facebook unveiled Libra (rebranded Diem in 2020, before they pretty much abandoned the project in 2022), a digital currency intended to be pegged to a basket of fiat currencies. As a response, many central banks announced they’d be working on their own CBDC.
What happens when cash goes away? So does the lower bound on interest rates.
While implementation varies from country to country, the goal for central banks is to leverage new monetary tools.
For instance, you may have heard about the stimulus cheques that the US government sent to some of its citizens to increase their purchasing power. These cheques, sometimes referred to as helicopter money, are a way to get cash to people more directly than by lowering interest rates to incentivise them to borrow from commercial banks, which is a slow process with no guarantee that the money will ever make it to households.
The idea of helicopter money is for individuals to spend it straight away and thus stimulate the economy more quickly. But while it allows for a faster monetary response indeed, it is still a rather cumbersome process.
A CBDC would essentially allow each citizen to have an account at the central bank. These accounts could then be credited some stimulus money directly, further reducing the monetary policy response time in case of an economic downturn.
But CBDCs have the potential for more — especially in a world without cash.
Depending on where you live, you may already rely very little on cash, especially since the COVID-19 pandemic. Payments are largely electronic nowadays, simplified by contactless technologies, phones and various applications.
What happens when cash goes away? So does the lower bound on interest rates.
Remember the reason why central banks can’t set negative interest rates? It’s because people would then rather withdraw their money to store it at home (in cash) instead of paying the bank to keep it.
In a world without cash, there’s nothing to physically withdraw and the only choices left are to pay interest to banks to keep your money for you, or to spend or invest it. No doubt that’d be a very efficient way to stimulate the economy.
Sound outlandish? The IMF, the international organisation that promotes global economic growth and financial stability, was already talking about it on its blog back in February 2019.
Justifications will be ease of use, price stability, and the fight against terrorism and money laundering.
Negative interest rates are also mentioned in various central bank discussion papers about CBDCs:
Note that this isn’t proof that it will be implemented. It just shows that it’s part of the conversation.
But it doesn’t stop there. China, which is currently running a pilot programme in a few cities for its CBDC called “DCEP”, is experimenting with features like expiration dates on money and transaction tracking and blocking.
From there, it’s easy to imagine how they could (and will) integrate it with other systems like their social credit score to exert ever greater control over the population.
And it’s not just authoritarian regimes — even in Western democracies, the temptation to resort to such means is already hard to resist. In February 2022 the Canadian government invoked its Emergencies Act for the first time in response to the “Freedom Convoys”, a protest against vaccine mandates. It led to the freezing of some of the participants’ bank accounts, which, however you feel about these people, sets a worrying precedent.
These are the sort of things CBDCs make possible or facilitate. Of course, they will be deployed to various degrees around the world. Some even argue that central bankers will think twice before going down that road because of the potential headaches.
But as we’ve seen, they currently have their backs against the wall. At the moment they want to appear reassuring, promising that phasing out cash and deeply negative interest rates are not on the cards. But not so long ago, QE and slightly negative interest rates were inconceivable, too.
It won’t happen overnight, either. CBDCs will be deployed gradually, first as a complement to cash. Justifications will be ease of use, price stability, and the fight against terrorism and money laundering. It will be in the name of convenience and welcomed as progress by many.
The point is that without alternatives, everything’s possible.
Even now there aren’t many options to preserve one’s wealth against inflation, assuming there is wealth to be preserved in the first place — many people are stuck with little savings whose value is being inflated away. Gold used to be considered one such safe haven, but in practice, it’s very inconvenient to hold and history has shown that when push comes to shove, its efficacy is limited.
Bank deposits aren’t immune to seizure, either. Customers of Cypriot banks found that out in a painful way in March 2013, in the wake of the Greek financial crisis.
So where does that leave us?
Ideally, there would be an asset outside the purview of the state, far from the influence of central bankers. It would be a store of value that is both accessible, easy to look after, and hard for governments to confiscate. An asset that would facilitate transactions, from anywhere, without limit.
Enter Bitcoin
Bitcoin is a decentralised cryptocurrency.
Decentralised means that no single entity controls it. Instead, it is run by thousands of nodes spread across the globe, each of them holding a record of all the transactions that ever happened.
Crypto refers to the fact that each account (or wallet) comes with a public key and a private key. As long as you keep your private key to yourself, no one can take your bitcoins. People usually store it in a safe place or memorise it.
Bitcoin’s monetary policy is controlled by maths, not people.
Bitcoin has a fixed supply and a predictable issuance rate. There will never be more than 21 million bitcoins, and the supply rate is halved every four years. New bitcoins will be issued until this upper limit is reached, estimated to be some time in 2140.
New bitcoins are issued as a reward to miners, which are special nodes recording Bitcoin transactions by creating new blocks, each referencing the previous one, thus forming a chain (the blockchain).
They do that by solving mathematical problems whose difficulty is regularly adjusted based on the number of miners operating on the network. This process is called “proof-of-work” and is a costly operation essential to the security of the network.
No country can ban Bitcoin entirely — it can only ban itself from the Bitcoin network. China did just that in 2021, which shouldn’t come as a surprise given the country’s CBDC agenda.
Before that, China was home to a large number of miners and this sudden crackdown was a source of concern for the Bitcoin network. What happened is the hash rate (the amount of available computing power) went down 50% and the mining difficulty automatically decreased accordingly.
Mining rigs moved their operations abroad, and six months later the hash rate had completely recovered, even reaching new all-time highs. The network’s security was never compromised.
In short, Bitcoin is a portable store of value that is:
- non-sovereign (not controlled by the state);
- censorship-resistant (transactions cannot be blocked);
- borderless (can be sent and received from anywhere on the planet);
- permissionless (there’s no vetting process);
- resilient (no single point of failure).
The value of your bitcoins cannot be inflated away by a central authority. The network’s monetary policy is controlled by maths, not people, and can’t be tampered with. It’s a neutral store of value that anyone can use — all you need is an internet connection.
Bitcoin’s value is volatile in the short term but tends to go up in the longer term. The reason is the number of participants increases faster than new bitcoins are issued, applying upward pressure to the price.
While most people initially join as speculators, many stick around and become long term holders once they better understand Bitcoin’s properties. This constantly raises Bitcoin’s price floor, the price under which holders with high conviction won’t sell.
They realise Bitcoin is a way to shelter their wealth from inflation and the uncertainty of monetary policies.
While the shortcomings of central banks are generally less apparent in advanced economies, many are starting to see the cracks and seek financial protection as a result.
Elsewhere, people already understand the importance of decentralisation. In many parts of the world (Palestine, Venezuela, Cuba, Lebanon, Argentina…), people are using Bitcoin as a tool against poorly managed currencies and oppressive regimes. Alex Gladstein, the CSO of the Human Rights Foundation and a strong Bitcoin advocate, writes extensively on the topic. I invite you to read his publications for Bitcoin Magazine for detailed use cases around the world.
Bitcoin and society
While the situation isn’t so dire in more privileged corners of the world, one also has to consider the effect of an inflation-driven economy on our societies.
How does mandatory eternal growth work in a world with finite resources?
In economics, time preference refers to delaying spending in exchange for a reward. An individual with a low time preference is more likely to save in order to earn some interest than to spend her money immediately. In psychology, this is also referred to as delayed gratification.
Inflation is an incentive to spend today rather than tomorrow — it increases people’s time preference. Another way to put it is that it makes today more valuable than tomorrow. How much does that influence our behaviour as individuals? What does that do to long-term planning?
How about larger-scale consequences? We’ve seen that, beyond driving economic growth, inflation is now a requirement to sustain high levels of debt. If the music stops, the system collapses. How does mandatory eternal growth work in a world with finite resources?
Politics is also subject to short cycles. To be reelected or reappointed, politicians and bureaucrats often favour immediate results over long-term thinking. How can we envisage a sustainable future when society as a whole is geared towards short-termism?
I don’t know to what extent our debt-based economies influence our apparent failure to tackle climate change, for instance. And I don’t know how much sound money principles could instil long-termism in our societies. But I do find this idea very compelling.
Bitcoin raises many more questions and this post is only a small part of the conversation. While I’m mostly making the case for it as a store of value here, there’s potential for more.
Could money become a shared resource whose preservation is the responsibility of all?
El Salvador made it legal tender in 2021, making it a medium of exchange. The network’s limited transaction throughput and high fees made this use case impractical for years, but layer-two solutions like the Lightning Network have now made it a reality, leaving volatility as the last impediment.
As an aside, this is why comparing Bitcoin to a network like Visa makes little sense — Bitcoin is a base layer offering final settlement, while Visa sits on top of several other layers. Nic Carter provides further details in a piece on the subject, should you be interested.
There are many more topics worth exploring. To mention a few:
- Can Bitcoin be a reserve asset, working as a backstop in case of global debt default?
- Should it replace fiat currencies, or live alongside them?
- Is inflation truly the alpha and the omega of the economy?
Another dimension of the debate I would like to see covered more is the place of Bitcoin in a world where the US isn’t the only dominant power anymore. As countries are increasingly working on ways to circumvent US sanctions and as the dollar’s share as a global reserve asset is dwindling, what will replace it?
Will it be another country’s currency, like China’s digital yuan, bolstered by the Digital Silk Road? Or will it be a basket of currencies, like the IMF’s Special Drawing Rights?
Or will the world embrace Bitcoin as a neutral monetary network that no single country can control, but to which all can participate through the development of mining operations? Could money, through Bitcoin, become part of the commons — a shared resource benefiting everyone and whose preservation is the responsibility of all?
On the other hand, some areas already have some answers. For example, if you’re still struggling with the energy debate, or think that anyone can replicate Bitcoin, Lyn Alden’s piece on the subject will, if not convince you, at least offer a different perspective.
Her explainer of the differences between proof-of-work and proof-of-stake (another blockchain consensus mechanism that doesn’t rely on solving mathematical problems) and why Bitcoin should not migrate from the former to the latter, is worth a read too.
When you’ve got an exit, you’ve got a voice
Central bankers are running out of options to manage the economy. The current monetary system is unsustainable, but instead of working to change it, their response is more of the same, which exacerbates the problem in the long run.
QE and low interest rates feed the debt spiral and contribute to high inflation, further increasing wealth concentration. CBDCs would allow central banks to push these monetary tools even further, all the while opening a path to a dystopian future.
The global fiat standard is unprecedented and only 50 years old. There’s no roadmap to follow — central bankers are making it up as they go. In this context, Bitcoin is an alternative store of value, an insurance policy against the consequences of adversarial monetary policies.
Bitcoin isn’t perfect. But the mere fact that it exists at all, that it appeared out of nowhere and grew to become this unstoppable network that no government can control is an incredible feat that is vastly under-appreciated. Perfect is the enemy of good, and Bitcoin is pretty darn good.
Bitcoin is a counter-power, a check on unelected officials who have tremendous control over our lives. Bitcoin is an alternative, an opt-out, an exit valve. And as Balaji Srinivasan often reminds us, in reference to Albert O. Hirschman — when you’ve got an exit, you’ve got a voice.
This post was originally published as a Twitter thread.
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