Why Bitcoin Will Not Replace the Dollar

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Some will rightfully say I am a glutton for punishment. My previous articles on bitcoin and cryptocurrencies have been met with boos and hisses (to be kind) from laser-eyed crypto crusaders. Despite what many of my critics think, I am agnostic about cryptocurrency. However, I am willing to shed light on details that most crypto supporters refuse to discuss or even acknowledge.

I recently wrote a piece titled “Where Does Money Come From?” The article describes how money comes into being. Since publishing it, I have received quite a few reactions. Some of these claim that bitcoin is money and should replace the dollar. I’ll explain why I think that is incredibly unlikely.

Bitcoin is money

Bitcoin is money. I bet you didn't think I would lead with that fact.

However, salt and copper are also money. Tea, gold, and cows are money as well. Almost anything can be defined as money. Money is any item someone is willing to accept for the payment of goods and services.

Bitcoin has been used in many transactions. In fact, a few sports stars and Hollywood celebrities have been paid with bitcoin. While bitcoin, tea, and anything else used to satisfy transactions is money, none of them is lawful money.

The U.S. dollar is the only lawful money in the United States. While some think bitcoin can supplant the dollar, they fail to acknowledge that it has significant flaws, which I believe are critical to understanding why bitcoin should not be lawful money.

Money supply growth is vital

Before recent financial history, gold, silver, salt, wampum, and other items have been used as a primary source of money and/or lawful money worldwide. For example, the graphic below, courtesy of the Atlanta Fed, highlights that some Asian economies used tea bricks as money.

These various commodity monies served their purpose for many years, decades — and centuries, in some cases. They all made the exchange of goods and services easier. When defined and broadly accepted, money is more practical than barter. However, the monies we mentioned, and many others, have fatal failings.

For example, cows are hard to transport and difficult to subdivide. Salt dissolves but can also be discovered in vast quantities. Even though gold is hard to subdivide and can be cumbersome and difficult to store, it has been among the most popular forms of money throughout history. Many countries have issued legal tender backed by gold to work around its physical constraints.

The primary problem, however, with gold and other historical types of money is that their supply is not aligned with economic growth and activity. For instance, a massive gold discovery would instantly depreciate the value of gold versus the goods and services it can be used to purchase. Such an event would create inflation, as more gold would be required to buy goods and services than it had before. Conversely, if gold becomes more difficult to find, its supply may not keep up with its demand for money, causing it to appreciate. In that case, it would be deflationary, meaning the same amount of gold could be used to buy more goods and services than before.

The key point in both examples is that noneconomic or monetary events can dictate inflation rates. I think it's irrefutable that the money supply must be regulated to support sustainable economic growth. What's debatable is whether such regulation is the job of the free market or the government.

Bitcoin: Limited supply

Per the bitcoin construct, there will only be 21 million coins. The halving process ensures that creating new bitcoin is increasingly more complex, time-consuming, and expensive. Due to exponentially decreasing rewards for mining bitcoin, we doubt anyone will mine the 21-millionth coin.

As new bitcoin production inevitably slows and some coins are lost, its value should increase. That assumes enough people are still willing and able to hold and trade bitcoin.

Hypothetically, if bitcoin were lawful money, its limited supply would not be sufficient for a growing economy. Thus, the value of bitcoin would rise, and by default, the prices of goods and services in the aggregate would decline. Some may argue that deflation is a good thing. And yes, while we like cheaper things, ask yourself who would buy them.

If you like a new house that costs $500,000 today, why would you buy it if you think it will be cheaper tomorrow? Similarly, why would businesses expand today if they could do so at a lower price tomorrow? The bottom line, and likely not- a popular opinion, is that economic growth needs inflation.

I think the limited supply of bitcoin disqualifies it as lawful or even effective money.

Crypto: Unlimited supply

While the supply of bitcoin is limited, making it a suboptimal candidate for money, the supply of other cryptocurrencies is unlimited.

Therefore, if people think bitcoin and other cryptocurrencies can become lawful money, their supply will likely increase well beyond the sustainable economic growth rate. Why not "print" digital cash for free and sell it?

Contrary to the bitcoin supply problem, an unlimited supply of a currency(s) met with limited demand is inflationary.

The constitutional problem

In 2017, we wrote a primer on bitcoin. The following paragraph from the article explains why the government is not likely to allow bitcoin or any cryptocurrency to be lawful money.

The preamble to the US Constitution states the purpose of the Federal government is to: "form a more perfect union, establish justice, insure domestic tranquility, provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity." In other words, the government's role is to protect the freedoms and liberties of its citizens. If the government has no ability to fund itself and is unable to provide defense and law enforcement it cannot uphold the Constitution. More precisely - the sovereignty of any nation, regardless of its form of government, rests upon the strength and integrity of its currency.

Volatility kills

Another problem, at least today, is the volatility of bitcoin and other cryptocurrencies. The graph below shows the value of a $500,000 house priced in bitcoin. The blue line is based on the daily high, while the orange line is the daily low.

Between January 13 and January 20, the house value would have been as low as $470,000 and as high as $575,000. The green bars and their average (black dotted line) show the daily average price variance of our house is over $21,000. Buying or selling a home, or any good or service, in such a volatile currency environment is nearly impossible.

Summary

Like it or not, there is no viable alternative to U.S. dollars. The government and the Federal Reserve have an indirect but consequential influence on the money supply, thus allowing them to try to regulate economic activity. The free market, via financial institutions and borrowers, also dramatically impacts the money supply. Both the free market and government alter the supply and demand for money, with inflationary or deflationary consequences.

While we can easily point out the government and the Fed's poor stewardship of the money supply, alongside unproductive motivations of the free market, it sure beats a system in which the money supply is entirely independent of the economic growth rate.

Can you imagine a deflationary spiral, like the early 1930s, occurring solely because no one was mining bitcoin? Or an inflationary outburst due to ramped-up mining of bitcoin?

Michael Lebowitz is a portfolio manager with RIA Avisors and author for Real Investment Advice. For more information, contact him at [email protected] or 301.466.1204.

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