Cathy Reisenwitz responds to an article on bitcoin’s “image problem.” The article she responds to pretty much argues that bitcoin users are a bunch of misogynistic nerds, and that people outside that narrow community see that as a reason not to invest in that asset. The fact that bitcoin is largely unregulated (and the bitcoin community’s aversion to regulation) is also used as a reason for mistrust that outsiders have in the asset, and why they might decide to not buy into it. I like Reisenwitz’ response; I particularly like this line from her piece, “…illegal narcotics make up about half a percent of bitcoin transactions” (strong proof that there’s more to bitcoin than black markets).
In any case, Reisenwitz’ article got me thinking about bitcoin and its scope for growth. I say growth, and what I have in mind are the opportunities for the demand for bitcoin to grow — for the number of people who hold it for transaction purposes to increase. I think, right now, these opportunities are limited, largely because the reasons to demand bitcoin are still relatively narrow. Allow me to explain what I mean.
Before I proceed, I should clarify that I am not opposed to bitcoin, nor do I have a specific interest in discrediting it. In fact, I support bitcoin and I see it as a natural consequence of government’s attempt to monopolize currency. Throughout history, we have seen people try to get around these legislated constraints. When note issue was restricted, banks focused on their deposit service. When interest on demand deposits was made illegal, the market responded with assets like mutual funds and eurodollars. Markets tend towards competition — not perfect competition, but still competition —, and that is what we are seeing in currency markets with bitcoin and other digital currencies. Will bitcoin succeed or fail? Who cares? The uncertainty of Amazon.com’s future doesn’t bring anybody to emphasize their opposition to its existence. Entrepreneurial projects sometimes fail and other times they succeed. But, this trial-and-error process is what allows our society to progress, for new ideas to implemented and tested, and for the good ideas to be rewarded.
Let’s come back to this article’s point.
Why is bitcoin demanded? There are probably various reasons. There is a significantly large libertarian community which distrusts government and any service provided by government, including the U.S. dollar. For years after the financial crisis, there was also a (most likely misguided) fear of runaway inflation. For libertarians with these preferences, especially if they have a service or goods they can provide in exchange, it’s sensible to be interested in a growing financial community which promotes the use of bitcoin for exchange. As the demand for bitcoin grows, it’s also reasonable to expect speculation. Many investors are going to put their money in bitcoin, because they expect its price to appreciate over some period of time — and the great thing is that bitcoin is relatively liquid.
According to Cato, 15 percent of Americans are libertarian (the Washington Post claims 22 percent). What induces the ~75 percent of other Americans (and other non-libertarians throughout the world) to demand bitcoin? The fact that there even many libertarians who haven’t invested in bitcoin is a strong signal that bitcoin is not necessarily a strong competitor to the U.S. dollar. Consumers differentiate between products, and right now the supermajority of people still prefer to hold U.S. dollars and other fiat currencies before bitcoin. This poses a serious limitation to the demand for bitcoin, and especially its demand for transactions. Increases in demand for transactions creates a network effect, because it increases the liquidity premium attached to bitcoin, but without other benefits the use of bitcoin might be restricted to people with certain ideological preferences.
Reisenwitz actually goes into some of the additional benefits to bitcoin,
- Smart property: I don’t know much about this, but Reisenwitz describes it as a credit market, where credit can be extended to the worst off (who don’t have access to credit from firms with stricter requirements).
- Remittances: She argues that remittances are easier and cheaper through bitcoin. I can’t verify, but if that’s true it’s a big advantage. Remittances are a big deal. According to the CBO, outward flow of remittances in the U.S., in 2009, totaled $48 billion. As the economy picks up, this flow will grow.
- Charity: innovative and effective charity programs might induce people to give through bitcoin, rather than through traditional means.
I wonder, though, if a strong demand for bitcoin will arise if sophisticated bitcoin-using financial markets develop. Bitcoin is an asset — a commodity, if you will —, like gold. If it becomes money (or if it already is), it will be as “outside money.” The supply if bitcoin is relatively inelastic. It’s growth function is asymptotic, to mimic the physical scarcity of other highly liquid commodities. If the value of the asset is stable, or the risk of loss in value is low enough, financial firms can use it as capital and they will borrow it from bitcoin holders through deposits. The firm will most likely pay interest on these deposits (if it’s legal), to compete with other firms who are seeking the same means and ends.
These are demand deposits and they are liabilities to the firm. The latter can issue notes in exchange, or the depositor can spend all or part of the deposit through some other system, such as a debit card. These would all be bitcoin-substitutes. But, if these services are competitive enough, it creates a proxy demand, in a sense, for bitcoin. Customers who are interested in the firm’s notes or their debit cards will demand them and, in turn, there is a derived demand for bitcoin.
This brings me to a more important point. Right now, when we think digital commodities (or currencies, if you prefer — I don’t want to debate on what is money) we think bitcoin, dogecoin, et cetera. When we think about where the industry is going, we think about competing brands. We should also be thinking about spontaneous orders, and how these competing brands will lead to competition in more sophisticated financial markets, using digital currencies as assets. If these services are superior to those provided by firms who still use “traditional” assets — and the legislated rules that constrain how these assets are used —, the demand for bitcoin (and digital currencies in general) will grow.
The question is, will digital currencies become a sufficiently stable asset for these purposes? What I mean by stable is not necessarily constant value, but where the expected path of changes corresponds to the mean expectation. And, if they do, will they be competitive enough to offer a product superior over those already existing? The “answer” to these questions is: we will have to wait and see. But, while there is clearly a lot of exciting scope for growth, there are also serious obstacles that digital currencies have to topple if they plan on becoming widely used transaction assets.