Dilemma

To Central Banks or Bust
By Steven J. Grisafi, PhD.

Nobody alive today will live to see the last Bitcoin mined. Those who purchase Bitcoin now, for the purpose of selling later to a greater fool, need not fear the inevitable consequences that will result as the total number of Bitcoins reaches its maximum. But unless Bitcoin either undertakes a significant modification to its business plan, or becomes adopted by central banks throughout the world, its demise is certain. Proponents of Bitcoin like to emphasize that it has a maximum quantity of 21 million. They suggest that this feature assures avoidance of inflationary depreciation of the value of Bitcoin. Such arguments are complete nonsense since economists are unsure about how exactly inflation comes to be. Previously, before having been debunked, such an argument would have been considered valid for a currency. But Bitcoin has failed to become adopted for use as a medium of exchange. Its proponents have suggested its use as a store of value, such as the precious metals. However, that argument ignores the fact rarity is not the only reason why gold became of store of value. The value of gold and silver came about from their usefulness in crafting tools and utensils before they became used for personal adornment by the wealthy. Bitcoin has no such uses.

What Bitcoin needed was to be adopted for use as a medium of exchange, a currency. Unless it becomes adopted by central banks, Bitcoin will most likely never be adopted for use as a currency and is certain to end with a valuation of zero. While economists have generally taken an unfavorable view of Bitcoin, Wall Street and its finance professionals, love it. Since the last Bitcoin will not be mined until the year 2140, finance professionals can dismiss the inevitable demise of Bitcoin valuation and use it was they would any other financial derivative. Yet, this financial derivative is not merely based upon worthless commercial paper or mortgages, but upon nothing at all. Its value comes from the willingness of people to buy Bitcoin with the expectation of selling it to a greater fool at a later date after its price has appreciated. That opportunity persists solely because the time horizon for Bitcoin’s demise lies far in the future and Wall Street professionals are able to convince uninformed investors that Bitcoin’s lack of intrinsic value is similar to that of sovereign fiat currencies such as the US dollar. That argument is false. They are not similar.

Sovereign currencies have value because their use is compulsory by citizens of the sovereign nations that issue them. Nobody is compelled to accept Bitcoin as a means of payment. Until people become compelled to accept a cryptocurrency as payment in exchange for goods or services, those cryptocurrencies built upon the model of Bitcoin, having a finite number of coins produced through the Proof of Work mechanism, are certain to result in their demise with a valuation of zero. Those cryptocurrencies that utilize a different mechanism of production, such as Proof of Stake, or have abandoned the use of a maximum number of coins, such as Dogecoin, might not confront the same fate as Bitcoin. Bitcoin’s algorithm reduces the amount of coins rewarded for successful completion of a block on the chain by half every four years. As the reward for successful mining grows smaller few operators see the mining of Bitcoin as profitable. Some of those operators terminate their efforts, which then reduces the difficulty required to complete a block every ten minutes for the remaining operators. This helps to keep the activity ongoing. Those of us who have conducted research on cryptocurrencies since their inception, such as myself, have seen this development unfold before. Mining becomes easier and easier even though fewer a fewer coins are received as the reward for successful completion of a block. What eventually happens is that each block successfully completed becomes more and more difficult to be confirmed by other operators of mining equipment. Extraneous forks within the blockchain occur more frequently. Frustration builds amongst the operators when they find that their equipment has been building upon an invalid fork, costing them money through the use of electricity, but rewarding them nothing. Mining activity will still continue but only those operators with the lowest costs will find in profitable.

In the case of Bitcoin, when fewer and fewer operators continue their mining activity as the rewards for mining grows smaller and smaller, eventually the motivation for mining must transfer from receiving the reward of coins based upon block completion to the transaction fees accumulated within the formation of the block. But why would there be any transactions? Nobody uses Bitcoin as a medium of exchange. People buy it to horde it for a few years hoping to sell it to a greater fool later. As this process develops traders will notice that the few transactions they do undertake would require exorbitant fees. The number of transactions would drop even further when traders realize that they must make fewer transactions to assure themselves of a profit. Operators of mining equipment would respond to this by ceasing their activity as their costs outweigh their profits. Eventually everyone loses interest in Bitcoin, the miners, the traders and the investors. The only silver lining in this scenario is that it will be a long slow process providing the proponents ample time to explore modification of the Bitcoin algorithm.

Although I, and all who read this, will be long dead before Bitcoin enters its death spiral, we should not ignore that modification must occur. I recognize the promise of usefulness for cryptocurrencies. But realize the imperative for their adoption by central banks throughout the world. As I see it, the crucial task is to persuade those who resist the adoption of cryptocurrency by central banks because of the misperception of harm doing so would cause to commercial banks. As I see it, commercial banks would play an important role regarding the implementation of a cryptocurrency as the virtual form of a sovereign currency complementing its physical form. Critics question the need that cryptocurrencies are meant to serve. Those critics appear not to recognize enhancement as sufficient motivation for the adoption of new technology. The world ought not heed the Luddites.

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