Unit 3 Lecture Notes

The most widely held prediction about how a bitcoin economy develops usually involves the entirety of the world economy collapsing into a heap of hyperinflationary misery similar to the one you see in Venezuela today. The dollar, euro, sterling, and all global currencies would collapse in value as all their holders drop them and choose to move to the superior store of value of bitcoin. Governments would collapse, banks would be destroyed, global trade supply lines would come crumbling down. The kind of imaginations reared on watching Hollywood movies can be relied on to run wild with the scenarios here. But there are several reasons to be optimistic that this may not be the case; The move to bitcoin could instead look more like an economic upgrade which replaces manual political central bank policy with ruthlessly efficient engines, and could in retrospect be an even better deal for humanity than the replacement of horses with engines, or phone line operators with computers.

The major problem with the hyperinflation scenario is that it misunderstands the nature of the current monetary system in a way that is unfortunately far too common among those familiar with Austrian economics, and whose conception of the current monetary system has failed to keep up with the developments of the past few decades. In particular here, I refer to the issue of money creation, and how the current shadow monetary system is responsible for an inordinately large amount of money creation, far more than the currency and the bank deposit loans that used to be responsible for most money creation in the past. The key issue to understand here is that the supply of money is not an outcome that can be precisely controlled by a lever at the central bank, since fractionally reserved banks don't necessarily have to exercise their money creation ability to its full capacity. Central banks can respond to market changes and affect the supply of their currency, up to a point, but the fractional reserve based monetary credit system itself, through its own movements and dynamics, can contract or expand the money supply. Demand for money can thus vary significantly, but the supply of money can also vary as the credit creation mechanisms contract as demand for borrowing drops.

The hyperinflationary scenario assumes that demand for the currency would collapse, leading to the value of the currency collapsing, regardless of what would happen with the supply. It assumes that even if the supply of fiat money is likely to remain constant or vary only slightly, the decline in demand will lead to the value of the currency collapsing. However (and this is the first important problem the hyperinflation scenario runs into), hyperinflation is always and everywhere a result of the drastic increase in the money supply, and not a sudden decline in demand.

Demand for Rai stones, glass beads, seashells, salt, and cattle, and various other monetary media discussed in The Bitcoin Standard and elsewhere did drop over time as harder alternatives were introduced, but that would likely have led only to a gradual decline of their value. The real decline of their value occurred due to the ease of overproduction. Every example of government hyperinflation has been the result of government manipulation of the money supply, much as governments would love to pretend otherwise. While the decline in value of a money is likely to put people off, taxes still need to be paid (and in whichever currency the government so chooses) to avoid going to jail, and as a result people will still use government money for everyday uses, even if its value does decrease consistently over time. Only as a result of government and central bank increases of the money supply can hyperinflation happen, as a close study of any and every modern hyperinflation would show. Looking at a place like Venezuela today where the local currency has dropped to less than a millionth of its value in just a few years, even if one knows nothing about Venezuelan monetary policy, one can dismiss the idea that the destruction of the Bolivar can be explained by a drop in demand. Venezuela the country is still there, its population at largely the same numbers as before the currency collapse, and still in need of money and demanding more of it. While there is no doubt that demand for holding the bolivar has dropped significantly, it could not possibly have dropped to a millionth of where it was simply due to steady decreases in purchasing power, as Venezuelans still need the currency to settle all their government-related business ( an ever-growing occurrence thanks to the demented socialization of the economy). The only way to understand the collapse in value is as a result of the rapid increase in supply, and any reduction in demand was rather an effect, not a cause, to that currency's value drop ping. Therefore, even if Bitcoin continues to increase its share of demand for money as a percentage of government demand, government moneys could avoid hyperinflationary collapse so long as they manage to avoid spiking the rate at which they expand their money supply.

Global central bank in the past 30 years have clearly been unable to centrally-plan their economies to achieve the economic outputs they seek, which no central planner could ever succeed in doing (since it is the very nature of central planning to fail, as excellently explained by Mises, Hayek, and Rothbard); what they've nonetheless developed enough competence to understand is the basic idea that accelerated creation of monetary instruments will bring the value of their currency crashing down. Despite all of their pseudoscientific macroeconomic voodoo rituals, they have nonetheless learned to find ways to keep credit creation from spiraling out of control to avoid severe hyperinflation. There will likely still be central banks making these mistakes, but don't expect the major ones that have managed their moneys' purchasing power at a slow decline for decades to start suddenly increasing their supply drastically any time soon. Central banks can fail at all their policy objectives but still maintain the slow pace of increase of the supply of their currencies over time.

The second and more important problem with the hyperinflation scenario lies in the fact that it ignores the second order effects that come with society's acceptance of bitcoin as a long-term store of value, particularly its influence on the supply of government money. This is a matter that I have not seen discussed anywhere else, and it was one of the prime motivations for me to start this research bulletin. I wanted to sit down, work through this, and quickly send it out to my intelligent and interested readers for feedback, rather than spending months toiling and looking for a platform with their own agendas and concerns.

How does the growth of Bitcoin affect the growth of a government's money supply, you ask? The key is to remember that the process of money creation in the current monetary system is driven by lending and credit creation, whether in the narrow banking system or the shadow banking system. As discussed in my Udemy class the narrow banking system creates new money whenever it generates a new loan. The shadow banking system creates money through the monetization of the endless shuffling of financial assets, or the rehypothecation process. In both cases, lower interest rates, relaxed lending criteria, and the central bank's readiness to intervene as a lender of last resort to save the financial institutions will all lead to increasing money supply. The reason that debt has continued to grow since the 1970s, of course, is that ever since money was completely decoupled from gold, there's significantly less restraint on capital markets' ability to create credit for consumers or investors. Governments have of course abused this privilege to allow themselves to buy their voters (and themselves, and their wives, and cousins, and cronies) several free lunches, each of which comes at the expense of the value stored for the future. As discussed above, low interest rates in the past used to come at the expense of the present in order to finance the future, while low interest rates in today's manipulated credit markets come at the expense of the future in order to finance the present. With artificially manipulated interest rates, it becomes harder and harder for people to save for the future, and thus more likely that they get into debt. Fractional reserve based credit creation does not just increase the money supply, the flip side of this coin is that money supply increases and lower interest rates drive demand for more credit creation.

So, again, how does this help us understand how widespread adoption of Bitcoin as a long-term store of value affects the growth of the supply of money? When the value of money is constantly dropping, and interest rates are artificially low, people will move from saving to borrowing. But when a new and completely decentralized, depoliticized, and automated hard new money enters into the economic calculations of the individual today, that individual's relationship with credit is likely to change. With the presence of a hard money that can appreciate in value over time, people's need for credit will likely decline. As those who move to Bitcoin witness its value appreciate, they find themselves able to pay off their debts sooner. As they become debt free with hard savings that nobody can inflate, they're likely to start living off of their savings and accumulating more, rather than continuing to borrow and pay interest.

Many bitcoin holders have already gone through this process, and many have been able to pay off all their debts thanks to the appreciation of bitcoin. When people have a healthy store of value that appreciates over time, they're less incentivized to borrow. If bitcoin continues to grow, and more people do this, then the demand for credit from the traditional financial system will likely decline.

Bitcoin not only destroys demand for government money, it also hampers the mechanisms for creating new supply.

As more people pay off their loans and fewer people demand new loans, the financial system's credit creation is contracted significantly, and as a result, the growth in the supply of money slows down, or possibly even reverses into a shrinking supply.

The availability of bitcoin as a hard store of value will seriously undermine the value proposition of going into debt that keeps the current monetary system able to create money. It is true that demand for government money would be reduced as people move to bitcoin, but the flipside of this process is that supply is also reduced, rather than expanded, as the appreciation in bitcoin's value makes individuals less likely to demand credit.

If governments in the advanced economies, which have done a semi-respectable job in managing their currencies over the past few decades, manage this process wisely, they would allow the credit and money contraction to happen naturally. If they try to react with inflation, they will likely witness quick reduction in the value of their currency. The wiser among them are likely to adopt strict monetary policy, and in that case, rather than go out on a whimper, the current global monetary system would just slowly and naturally get downsized into irrelevance as its currencies lose their value slowly next to Bitcoin, but the size of the people using the currency is also being reduced.

The current monetary system's history shows that its inflationary tendencies are likely to end with a collapse of the currency and economic disaster as people have no monetary alternative. But Bitcoin might fundamentally change this, by being the peaceful and intelligent way to unwind this monetary system by upgrading to a new one that frees people from being dependent on debt, which is what this current monetary system is dependent on. We can think of the significance of bitcoin as being a superior alternative system to the current modern system, which allows us to unwind the current system by simply depriving it of the oxygen it needs in the form of debt.

The third reason we can expect there to be no hyperinflationary collapse as a result of the rise of bitcoin is that hyperinflation happens when the entire monetary system of a society collapses, thus destroying the complex web of calculations and interactions that coordinate the activities of individuals across a large modern society. A modern society relies on money as the medium in which prices are expressed, and these prices are what coordinate economic activity and allow individuals to figure out what to produce and consume. No modern society, with its sophisticated infrastructure, is possible without a highly complex division of labor dependent on the price mechanism to coordinate economic activity. The collapse of money brings this network crashing down, and makes economic coordination impossible. Prices cannot be expressed in terms of barter, and there are no easy ways for people to calculate the true opportunity cost of their actions or the most efficient use of resources. The entirety of the division of labor of society collapses and life in the modern cities unravels into disaster. But all of this happens when the only monetary system of a society collapses, it isn't because the people lost their government's monetary system in particular. If people move to an alternative monetary system, then there would be no corresponding collapse in the economy and the division of labor. Anybody who moves from fiat to bitcoin is accessing a global network of buyers and sellers that they can interact with. Should bitcoin become widespread enough to destroy demand for government currencies, then these networks will be large enough to support an increasing amount of coordination, trade, and investment. Unlike in a hyperinflation scenario, a move to bitcoin that does not see a large increase in the supply of government money would not lead to a catastrophe; it would be a global upgrade - a peaceful technological upgrade of the monetary infrastructure of society. Anyone who wants to keep using government money can continue doing so, but as bitcoin undercuts both the demand and the supply of government money as discussed above, the government money bubble shrinks and withers away, while the bitcoin economy grows. To use an analogy, hyperinflation is like the sinking of a boat due to a leak in its hull. An upgrade to bitcoin looks more like people voluntarily leaving an old boat for a superior one. The old boat will slowly lose business and get decommissioned (and eventually destroyed), but nobody would be hurt by this upgrade, as nobody will be on the boat when it gets destroyed; it purely gets destroyed because it was abandoned. People can keep using central bank currencies if they want, but increasingly, it is difficult for governments to stop others from using bitcoin, or to stop bitcoin from appreciating in value. As more and more of the users of government currency move to bitcoin, the world economy upgrades to a better and more sound monetary standard.