Critique of BitCoin and the Search of a Perfect Monetary System

Are algorithmic digital currencies the inevitable future of monetary systems? Despite their many advantages over traditional forms of monetization, digital currencies like BitCoin and DogeCoin have yet a series of limitations that they will have to overcome.

The strength of digital currencies is largely attributed to its universal potential. 1) BitCoins can be used in any country and 2) no governments can easily manipulate it. These two points come hand-in-hand, and the universality of bit coins relies on its lack of regulation. However, its strength is also its weakness. Monetary policy, monetary regulations, is economic policy. Without the ability to control money supply and flow, governments do not have an effective means to regulate their economy.

In an ideal monetary policy, there would be no need for government regulations. There would be no need for governments to adjust the “inflow” of money supply into the economy. To put it simply: 1) countries will only use BitCoins, if 2) it does not require regulation. And it will only not require regulations or adjustment to money supply, if 3) its inflow algorithms are ideal or perfect. However, I argue that these algorithms are not ideal or perfect. In which case, adjustments and regulations to the money supply will have to be made in the future, undermining the whole point of BitCoins.

Monetary policies by federal banks are coordinated with targeted inflation rates. Money is either taken out or put into the economy until the target inflation rate is reached. The strength of currency relies on its reliability to keep a fixed “worth”. Inflation is the rising of price levels, or in other words, the degradation of your dollar bill. If inflation rates are too high or too low, your dollar bill fails to hold a fixed “worth”; in other words, your currency fails to be useful. The gold standard is a highly ineffective monetary policy because of the inability of gold to hold a fixed value.

The money supply of BitCoins is determined not by a targeted inflation rate but by an algorithm, which is certainly a revolutionary way of thinking about money supply. However, to my understanding, the algorithm is in no way related to an inflation rate or anything economical. The principle of BitCoin’s algorithm relies on diminishing marginal returns. BitCoins are generated by computers, which “mine” for bit coins. However the rate at which computers can produce coins diminishes. In other words, it becomes harder and harder to “mine” for bit coins. Mathematically put, the amount of bit coins entering the market decreases at an increasing rate with time. An estimation of this idea is represented in fig 1.

Fig 1. Bit

As bit coins become harder and harder to mine, the more computation is required. This is why this algorithm has 2 major deficiencies: 1) it concentrates the production of wealth to those with great computational capacity (people who possess the capital to afford it), which will in itself contribute to an increasing wealth gap and 2) it is very unreliable in its ability to hold a fixed worth or inflation rate.

To abstract on the second part: The Money Supply and Wealth Disparity Theorem, states that in order for currencies to hold a fixed “worth”, the money supply must increase at the same rate as the rate of wealth. For an example, if your economy consists of $10 and 20 identical bananas. Each banana is going to hold a worth of $0.50, and each dollar is going to be worth 2 bananas. If 20 additional identical bananas are added to the market, each banana will now be worth $0.25 and your dollar is going to be worth 4 bananas (fig below).

Screen shot 2014-06-06 at 9.21.35 PM

Your dollar just gained value, and you have just experienced deflation. The only way to keep the worth of a dollar constant is to add the same ratio of dollars into the economy, in other words, to add $10 to the economy with the 20 bananas (fig below).

Screen shot 2014-06-06 at 9.23.03 PM

The models above are quite a simplification of reality. In the real world, the dollar does not represent the amount of bananas in the market; the dollar represents the amount of wealth in the market. However, the simplifications helps to illustrate that the disparity between how much of a currency enters the market and how much wealth enters a market leads to unstable price levels. We already know the amount of bitcoins entering the market is becoming slower and slower (fig 1). A constant price level can only be held if the amount of wealth (bananas) entering the market is the decreasing at the same rate. We represent this idea with the fig below.

Fig 3. Bit

where p* (the difference between the rate of bitcoins and bananas entering the market) represents price levels. However, data suggests otherwise to the model above. The rate of production has actually been increasing at a decreasing rate with the increase in efficiency in technology and the greater participation of developing countries. In reality our model looks like this:

Fig 2. Bit

as we can tell price levels change at an increasing rate with this model. It is important to note that BitCoin can be divided infinitely. For example, you can transact 0.000000001 BitCoins. However, precision in accounting does not matter if the prices of goods are changing rapidly; you still don’t know how much 0.00000001 BitCoins is worth or is going to be worth tomorrow.

In order to keep price levels constant, we must keep monetary inflow and wealth inflow the same. How do we determine wealth? The strength of digital currencies come from their decentralized nature. Allowing centralized entities or governments to determine what wealth is can be both dangerous and counterproductive to the nature of digital currency.

Our only hope for determining a perfect algorithm for money supply can come from defining wealth in an objective and a decentralized manner. To do so we must first explore where wealth or value is produced. Wealth or value in a product is first produced with “harvest-ation”, the extraction of natural resources from the earth. This is what we will call the “natural value” of a product. Wealth is also created when the natural resources are then through labor constructed or produced into more complex products. This is what we will call the ” value of manufacture”. Wealth is then created through transportation, retail, and marketing. All of these make up the final value of the products we buy. In other words, every time a product is passed on “value” is added onto a product (fig below).

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But how do we determine the amount of wealth that is produced with each step? Again there are certain dangers in allowing a centralized force in determining these numbers. To truly decentralize the calculations, we can simply take in to account the prices at which these products were bought/sold. Mathematically we can calculate how much value was added in a step by considering the difference in original value in which it was bought and the retail value at which it was then sold. If 100 pounds of iron ore are extracted from the earth and is bought by an smelting company for $7 then $7 dollars worth of wealth is added into the market. If the smelting company then smelts and refines the iron ore into 50 pounds of iron and sells this at $10 then $3 of wealth is essentially added into the economy (10-7 or the total value minus the natural value). If it were possible to calculate all the aggregate transaction in the economy, we are one step closer to creating an algorithm of money supply that is independent of centralized entities.

There is however one last problem to our method. Wealth has a tendency to degrade. If we have 20 bananas and $10 dollars in an economy… (we already know what this model looks like: $1 = 2 bananas). Instead of adding 20 bananas, what happens if 10 bananas are eaten or simply goes bad? $1 is now worth 1 banana. In other words, our algorithm will also have to be able to compensate for the amount of wealth that degrades over time. Just as we do not stay the same over time, no product stays the same over time. A new building today worth $1mil today can be worth $9k in a year due to wear and tear. In the same way all new wealth must be accounted for, the algorithm must also take into account all products that are destroyed or thrown out and all drops in price value. Such a monetary system would only be possible at the expense of an automated “super- infrastructure”, which would be able to keep track of all transaction without the interference of centralized forces. Altho science fiction today, such a system may be the possible future of our monetary systems.

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