Is Bitcoin a true replacement for Fiat currencies?

Upsetting the current monetary system would be a tall order

Image source: Gemini.com

I was on a Twitter Space on Tuesday talking about rising global inflation and that led to discussions about fiat and crypto. But can Bitcoin (it’s the crypto mostly put forward for that purpose) replace fiat currencies? Some people have suggested that countries should adopt Bitcoin. I do not think they are substitutes and I have a short experiment for people who believe otherwise much later in this article. Let us get into it. 

The thesis of crypto (read Bitcoin), as put forward by its strongest adherents, is that it would offer protection against the devastating effects of inflation caused by the actions of governments and central banks over the long-term. Many people make the case for Bitcoin based on this quote attributed to Satoshi:

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust”

That makes sense as human history is replete with these instances all across the world. This thesis is now extended to mean that Bitcoin would be a source of phenomenal wealth growth and more equitable distribution of wealth. 

There are many people betting on this future, but Michael Saylor — the founder, CEO and Chairman of MicroStrategy (controls 70% of company) —  stands out. The man or MicroStrategy started out buying Bitcoin as an alternative to holding cash. But how has a company that does not generate cash or hold enough do this? One word — debt. MicroStrategy is a technology company that is past its best days. And without cash, the company has aggressively borrowed  — not to fund new growth ideas — but entirely to buy Bitcoin ($3bn+ in holdings). I am not sure anyone saw that coming — that we need to deprioritise actual production of goods & services but instead buy bitcoin with leverage and wait! Another extreme case is in El Salvador where the President seems to be betting everything on Bitcoin. I love experiments so much, so let’s have it. 

Now imagine people who already believe that central banks cannot be trusted — because they debase the currency — living at a time when governments and central banks supported their economies with record fiscal and monetary stimulus. You don’t have to imagine, that happened in 2020 due to COVID-19. 

Now imagine that there was indeed rising inflation afterward —  that’s our present reality. This means the narrative has shifted firmly in their favour, and they have milked it. I think I have read more tweets about hyperinflation (inflation at 50%+ per month) in the past year than in my entire life. 

What the crowd misses about fiat — inflation is built in

Inflation is built into fiat currencies. And fiat is government issued currency that is not backed by a commodity such as gold but by trust in that central entity. The argument against this regime is that you cannot trust central banks and governments to be disciplined — they can print too much money and cause too much inflation. We have seen examples of such value destruction in cases of hyperinflation in Germany, Zimbabwe and Venezuela.

The money creation process is not necessarily enabled by outright money printing but through fractional reserve banking — a system where banks put only a fraction of their deposits in reserves to meet withdrawals and other funding needs. Practically, this means that if a bank accepts $100 in deposit and the central bank pegs the required reserve at 10%, the bank can use the $90 to create loans. The $90 loan becomes deposit, and another 10% is kept in reserves while the remaining $81 is loaned. The $81 extended goes on to become deposit again, and the cycle continues. That is a simplified view of how money is created. If Central Banks want to expand money supply, they can implement policies that enable banks to expand credit continuously.

But having a currency backed by “nothing” was not always the case. We had the gold standard, a period where money supply (cash in circulation and deposits) was tied to the supply of gold. I will not bore you with the details but the world left that system behind partly because it had many problems. It gave policymakers little flexibility to support the economy in a crisis.

The gold standard was also deflationary as prices were falling due to the finite nature of gold. In simple terms, this meant that money supply could not grow because gold is limited in quantity and not that accessible to all — this had negative implications for prices and economic activities which are driven by money and credit. The gold standard is somewhat related to the features of Bitcoin that proponents extol — finite, predictable supply  that is outside the control of a central authority. 

The limitations of the gold standard is partly why inflation is built into the present monetary system. However, it must be delicately managed because you want a level of inflation that would not destroy the purchasing power of consumers but still incentivise businesses to produce goods and services. In a deflationary environment, consumers delay spending, demand is weak and businesses do not invest. Nobody wants this, and certainly not Japan which has been stuck with this problem for some time.

In advanced economies, the inflation target is around 2%. This is believed to be optimal in the sense that it supports the growth and employment ambitions of the economy. However, we can also see why people worry about fiat currencies when you look at countries like Nigeria where inflation has been elevated at an average of 12% for the past decade. 

But the US is not Nigeria — the former creates wealth and manages inflation

The challenge with inflation in Nigeria is that it has been out of control for some time. When inflation is out of control, economic agents lose faith in the ability of the government/central bank to bring it under control. This is bad because individuals and businesses would then expect high inflation in the future and build it into their decision making process. In the US and most of the advanced world, this is not the case— it is also why they are very careful because of the recent rise in inflation.

There is also the problem that there are no avenues to grow wealth in Nigeria. Recall the argument about wealth creation via crypto because fiat is destructive. In most of the advanced world, wealth is in real estate and financial assets (including the pension system). And, guess what? Wealth has grown by a lot over time, enabled by fiat currencies. Bitcoin proponents talk about how the return on cash is low or negative in real terms (when adjusted for inflation) but who really keeps wealth in cash over the long-term? While one might argue the case of high wealth inequality, the truth remains that wealth has expanded overall for most groups. 

In Nigeria, the real estate and financial markets or the pension system are non-existent as a wealth creating tool. It is then obvious why Bitcoin can be attractive to people in countries like Nigeria - inflation is high and there are no opportunities for wealth creation. Whose fault is this?

Even though fiat currencies by design give room for abuse, this is more prominent when you have poor economic managers. And does that mean we should completely abandon fiat? No. 

What is hilarious is that the leading proponents of crypto in the US believe that the US FED will destroy their purchasing power through hyper inflation and Bitcoin paves the road to wealth creation and equitable distribution. hehe

Some experiments to consider on Fiat vs Bitcoin

Here comes the experiments. Consider these scenarios and tell me whether Bitcoin would or should replace fiat. 

Imagine a business or individual that has the option of borrowing $1,000 or 1,000BTC ($1 each) in 2010 to be repaid back in 2021. What would be the principal repayment by 2021? $1,000 is still $1,000 but 1,000BTC is now $57,000,000+. 

Can you run an economy with a currency like this? What would make this scenario meaningful? Easy answer — the borrower must find another asset or strategy that would outperform BTC over the long-run. Can you find this in real life where people make goods and services to sell? 

Now imagine a business that decides to pay staff in BTC instead of USD. I am using this example specifically because it is now very popular to hear “pay me in Bitcoin”. Well, can businesses truly pay people in Bitcoin?

If a staff earns 1BTC or $57k annually in 2021 and you decide to opt for the former payment method, when Bitcoin reaches $500k like it is expected to perform by 2025/26, how many businesses would be able to afford such a steep growth in wages if they are to pay $500k as salary?

The point is that people who talk about being paid in Bitcoin have their salaries pegged to fiat and not BTC. 

Or even imagine a vendor that quotes their prices in BTC. Would this make any sense over the long-term? 

Fiat, for all its faults, is the way it is for a reason. 

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