Bitcoin a Port in the Storm

Monetary policy is a more general instrument, rather than a specific tool. It is conducted in an environment of uncertainty where policy decisions are taken based on theory. In this sense, it is an experiment. Perhaps this would be of less concern to many of us if theories and policies that seemed effective in the past worked today. However, it seems that despite the significant effort of established institutions to stabilise the global economy post the 2008 global financial crisis, the tools that have been used in the past by developed economies have not had their anticipated affect – or at the very least recovery has been slow and it has been seen as necessary to use unconventional monetary policy tools including quantitative easing (QE). Perhaps when optimism returns and subdued spending increase this will bring with it inflation. While some might argue a case that QE prevented deflation – it can easily be argued in contrast that there is also no basis from which anyone can predict the future, especially in consideration of the unconventional path adopted.

The point here is not to predict or argue the potential affect of QE, but to highlight the environment of uncertainty by which decisions are taken, and the inherent possibility of uncertainty in the impact of these decisions. QE and the potential for inflation when consumer optimism returns is just one example. Inflation in Argentina is another recent example. As is the deflation felt by countries in southern Europe who have had their currencies fixed to the Euro. The US also felt the impact of inflation after they broke from the gold standards in the 70s. It should be evident therefore that there is no way to operate monetary policy with certainty on its affect, and that from time-to-time these monetary tools fail to maintain the stability of a currency. Most credible central banks in this respect will try to target an inflation rate of 2-3% to ensure currencies remain attractive and stable – and monetary policy is the instrument used to control the supply of money to achieve this rate. We could consider that monetary policy fails when inflation does not operate within this range.

To understand how bitcoin the currency might offer relief from failed monetary policy a little more needs to be understood about the supply of money and its relationship with price inflation and deflation. The quantity theory of money proposes that the exchange value of money is determined like any other good, with supply and demand. For example, if we increase the supply of money then there is more money per economic unit of activity – and prices rise. The same is true the other way around. Monetary policy seeks to control money supply(and hence price) through buying and selling bonds, adjusting base interest rates and setting reserve requirements for banks. And QE – for completion in this context – is an unconventional policy conducted outside of these typical instruments.

Bitcoin by contrast has a fixed and transparent supply of money driven by consensus. Here the supply of money is fixed and regulated by the protocol (21 million BTC, with a declining issuance currently at 12.5 BTC every ten minutes). The important point here is that the value of bitcoin as a currency increases over time. This is exactly the opposite of fiat currency that by design decreases in value overtime (i.e. it is inflationary). Therefore bitcoin the currency could be an alternative to currency to move into during instability or crisis. indeed we have seen an increase of people move into bitcoin during these events. For example, demand for bitcoin increased post Cyprus bailout in 2013; and likewise we saw an increase in demand for bitcoin upon Indian Prime Minister Narendra Modi’s decision to demonetize 500 and 1000 rupee notes.

It is therefore plausible to argue that we will likely see a further increase in the demand for bitcoin the currency in times of currency instability or crisis. It is worth understanding at this point also how value is created in Bitcoin. With a fixed money supply price is driven by demand, and demand is driven by use cases – i.e. as more uses are found for Bitcoin demand will increase. Therefore bitcoin price will increase. This creates a virtuous circle of increasing value being driven into the network and increasing acceptance. As usages compound, the viability of bitcoin as an alternative currency increases. Perhaps if inflation results from QE we could see people flock to bitcoin as a safe-haven, providing a store of value, and acting as a stable medium of exchange. In theory, there is a tipping point at which the network affect benefit tips in favour of bitcoin, and there is less need to convert bitcoin back to base currency because more people accept it. This network affect is analogous to the example of the telephone. The more people that join, the more value there is in owning a telephone.

In summary, there is an increasing tide of dissatisfaction with the effectiveness of current monetary controls. This has arguably created a driver for the adoption of Bitcoin since the 2008 global financial crisis, and it is likely that future currency instability and crisis will position bitcoin more increasingly as a viable alternative. This compounds. As more people believe in it, network effects take hold and the value in bitcoin the currency increases to a tipping point.

James Kyd has spent fifteen years as a management consultant and has extensive experience advising to public and private enterprises on the role of emerging technology and the application of innovation.