Bitcoin, Inflation Risk, and Credit Risk

This is going to be a very quick post that grows out of something I tweeted earlier today. And it’s about Bitcoin, something I admittedly know little about. And it’s almost certainly something someone has already said, because it seems perfectly obvious.  But I was responding to a tweet about how one of the first BTC transactions involved someone paying 10,000 BTC for 2 pizzas in 2010. So if a pizza was say 20 dollars, that made the value of one Bitcoin back then 20/5000 USD or 4/10 of a cent.  The price is (as of this writing) 70K USD, which means an extraordinary appreciation of roughly 35 million times. So I guess I should have bought some instead of the Latin America ETF. Oh well.

But now imagine that I was someone who had borrowed BTC back then. I would be so screwed, even if I had gotten the loan interest free. But importantly, not only would I be so screwed, so would the person who had lent me the money, because there is no way I could repay the money today. Or maybe there is one way—I might be able to repay it be if I had borrowed the BTC to invest in equipment that mined BTC (but I would have energy and equipment costs etc.) Note that even the equivalent shovels —high performance semi-conductors —most likely would not have worked. If I had bought NVDA at 4.25 in 2010 (I did not), I would be up only about 220x, certainly not 35 million x. But if I had actually borrowed the BTC to invest in a pizza shop, or a machine that made pizza faster, or even one that conjured pizza out of thin air but with some energy costs (like a Star Trek replicator), it’s not clear to me that I would have generated a return in excess of 35 million times over less than 15 years.

My point here is that Bitcoin as designed is a numeraire that is intentionally deflationary. Taken at the word of its apostles, its claim to be an inflation hedge lies in the fact that its fixed supply means that the price of pretty much everything in the world will drop in terms of bitcoin. But while that might make it a good hedge against inflation (taken at its word), its very design  makes it extremely difficult to hedge against the default of pretty much anyone you ever lend your BTC to. You have to hang on to it rather than lend it, because the likelihood that anyone (other than the possible exception of a fantastically efficient BTC miner) that you lend it to will be able to return the BTC amount you lent them is extraordinarily low. It is like the gold standard on steroids, because that at least had the possibility of new supplies of gold being discovered —e.g., the Witwatersrand in the late 19th C. As designed, it is meant to be hoarded, because lending it creates immense exposure to credit risk, which is a risk inherent to  and inescapable from its design. This in turn, IMVHO, creates certain obstacles to its ever forming the basis of anything remotely like a broad-based monetary system.

Anyway, I’m sure someone has already said this. And I’m a rank amateur when it comes to Bitcoin—and as I noted, I don’t own it, but at least I don’t owe any either.  But it struck me that having spent more than a couple of decades thinking about the troubles of Emerging Markets and of the the Eurozone  this might be of some use, in the extremely unlikely event you haven’t encountered something like this already.

It struck me that it might be worth adding another point here. I have in the past said that the single most important aspect of currency internationalization lies not in its use as an “asset vehicle” but rather as a “liability vehicle.” This then leads eventually the provision of an international Lender of Last Resort* in that liability vehicle who can backstop the system from catastrophic cascading risks. Now, if Bitcoin’s deflationary tendencies make it ill-suited as a liability vehicle (as suggested above) and its decentralized and anonymous structure makes it much harder to provide an LoLR (I suppose in theory there might be 1907 Morgan of BTC, but I doubt it)**, that’s just another strike against it as broad-spectrum international money that fulfills all the functions we’ve come to think a money should have.

P.S.

The dad joke. So if I’m right that an all-Bitcoin economy would have a naturally persistent deflationary bias, that means its R* would be negative. Which then means that both lenders and borrowers in that economy would have to face up to the fact that “Default lies both in R*s and ourselves.”

*Excruciating footnote—Without a proper LOLR facility, a money is a second rate version of the real thing, much like those ill-starred places in America in the 1980s where the only place to get bagels was a supermarket that had Lenders of Last Resort.

** About that 1907 Morgan of BTC thing, I was both wrong and right. I was wrong in that the media did speculate about someone as the 1907 Morgan of Bitcoin. I was right in that the media thought it was going to be….. Sam Bankman-Fried!