The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics. Click here to get Hedgeye's Market Brief, a free weekly newsletter featuring the top 5 trending insights on Hedgeye.com.
I wrote an essay titled Are Virtual “Currencies” Likely to Succeed? shortly before retiring from the Federal Reserve Bank of St. Louis in 2014. Interest in virtual currencies has intensified recently perhaps because on August 31, 2017, a single Bitcoin sold for $4,683. Consequently, I decided to revisit this topic. I read what I wrote in 2014 and I decided that everything I said then was true today. However, I do have some new thoughts about the role of virtual “currencies,” which I share in this essay. I urge you to read my short Fed essay before you read this one.
The major point I made is “the continued use of a currency depends on the stability of its value and the existence of alternatives for achieving final settlement.” This is the starting point of this essay, so that is why you should read my Fed essay first. The critical question is: Is Bitcoin a currency? So far, the answer is a resounding NO. This essay explains why Bitcoin is not a currency, what it is, and why it is almost certain that the answer to this question will to continue to be NO.
For an asset to be a currency, that is, money, two conditions must be satisfied. First, it must be generally accepted as payment for goods and services. It appears that Bitcoin does not yet meet this criterion. There is a long list of business that will accept Bitcoin (list here) and there are between 200,000 and 300,000 confirmed daily transactions on Bitcoin (here). However, it is not clear how many of these transactions were to buy goods and services. The fact that there is no strong positive trend in the number of transactions, as one would expect if Bitcoins were increasingly used to purchase goods and services, suggests most of these transactions were with dealers who make a market for Bitcoins and other virtual “currencies.” However, even if all of the transactions were used to exchange goods, the number of transactions is miniscule relative to the number of transactions worldwide.
The second requirement to be a currency is that the asset must be acceptable for final settlement. That is, people must be willing to hold it to make their next transaction and not want to convert it to something else. While the analogy is not perfect, consider the use of credit cards to make purchases. Like a lot of people, by dollar amount, I make about 90% of my purchases with my credit card. Firms willingly accept my credit card because they know the credit card company will settle the account with dollars. The credit card company is nothing more than an intermediary that facilitates my purchases. It is not a currency. The dollar is used for final settlement—the dollar is the currency.
Purchases made with Bitcoin are likely to be similar. The merchant accepts Bitcoins because it knows it can sell the Bitcoins for dollars. Consequently, the dollar, not Bitcoin is the asset that provides final settlement. If the merchant is willing to simply hold the Bitcoins and use the Bitcoins to make additional transactions, Bitcoin would serve as final settlement. This is unlikely because the dollar-price of Bitcoin has been extremely volatile (here). It’s more likely that the merchant sells Bitcoins quickly for dollars. In this case, it is the dollar that provides final settlement and Bitcoin purchases are analogous to credit card purchases.
“So what’s Bitcoin?” It’s an asset.
Given the mining analogy that its proponents have used, think of gold. Gold is a mineral that has a number of qualities that make it desirable. It is also relatively scarce and is costly to recover. There is a strong incentive to mine gold so long as its value exceeds the cost of mining it. The same is true of Bitcoin. Historically, gold was used as money. However, it had a number of characteristics that made it less useful as money. Among these were the ease of debasing gold coins, fluctuations in total supply, and the variability of its price. Governments attempted to neutralize the effect of these factors by issuing gold certificates with a fixed price in gold (read more at Gold certificate). The gold certificates would be the currency.
But this didn’t solve the problem. Because the gold certificates could be redeemed for gold, the certificates would be redeemed whenever the price of gold rose above the fixed price. Consequently, the amount of currency (gold certificates) in circulation would shrink. Governments fixed the problem by making the certificates unredeemable: The good news is that your certificate is worth x-ounces of gold. The bad news is that you can’t get the gold!
Bitcoin is an asset similar to gold. Like gold, all of the large rewards go to the successful miners. If we are talking about printing money, the reward is called seigniorage—the difference between the currency’s value in exchange and its cost of production. In the case of the production of gold or Bitcoins, the reward would best be called profit (a million coins were mined by Bitcoin creator Satoshi Nakamoto, read here).
I have no idea of what is involved in mining Bitcoins and, consequently, the costs of “mining” them. But at a price of $4,000 or more per coin, I assume there is a strong incentive to mine Bitcoins. Of course, this statement is contingent on the probability of successfully mining a coin. Technically, the cost of production must be less than the expected value of mining a coin (the price of the coin times the probability of mining it). When the cost is higher than the expected value, mining ceases.
Bitcoins provide security that makes merchants willing to accept them as payment. But here is where competition comes in. Credit cards provide the same function and security for the merchant and are much easier to obtain and use.
When considering whether Bitcoin will ever serve as a currency, it is important to note that the total supply of Bitcoins increases very slowly and is capped at 21 million coins, of which about 16.5 million have already been “mined.” This means that the price of Bitcoins will likely continue to be volitile. This fact alone makes it less likely that Bitcoin will ever provide final settlement, at least as long as there is an alternative asset whose price is more stable—e.g., the dollar, the euro, the pound, etc.
Consequently, I believe I am safe in predicting that Bitcoin will never serve as a currency—a generally accepted and widely used medium of exchange. It appears there are other reasons to doubt whether Bitcoin will ever be widely used to purchase goods and services (for example, high transactions fees and slow settlement (see transactions fees). But, if Bitcoin is not used this way, I don’t see another reason for it to exist. Unlike gold, it has no other use. Unlike stocks, it provides no ownership of income generating assets. Consequently, the long-term future of Bitcoin is cloudy.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
