There's A Fatal Flaw In Bitcoin Which Means It Can Never Become A Real Currency

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Cryptocurrencies like bitcoin and ether will never become true currencies because of a series of “fatal” flaws, a senior economist at the Swiss banking giant UBS says.

At a roundtable discussion last Thursday, Paul Donovan, the global chief economist at UBS’s wealth management arm, tore into the argument that cryptocurrencies could eventually replace fiat currencies like the pound and the dollar.

“The problem that cryptocurrencies face is that they fail the two key metrics of what makes a currency a currency,” Donovan said. “A currency has to be a widely used medium of exchange. Cryptocurrencies are never going to achieve that. Period.”

One of the main reasons for this, Donovan said, has to do with taxation and the inability to use cryptocurrencies to settle tax liabilities.

“The reason I’m so definite about this is that if you look in the OECD, on average, 34% of all economic activity is taxed,” he said, using the abbreviation for the Organisation for Economic Co-operation and Development. “Governments are not likely to accept cryptocurrencies that they do not control” to settle taxes.

He continued: “Cryptocurrencies that they do not control will not be accepted by governments for tax payments. You are therefore removing one of the main sources of demand for a currency. One of the key issues, whenever we talk about monetary economics, is that the money supply should never, ever, ever be considered in isolation.

“Money supply needs to be considered against money demand. If you do not have the ability to use cryptocurrencies for the largest single transaction in the economy, then it will never be a majority medium of exchange.”

Using the example of the 1,000-year-old jiaozi – widely believed to be the first paper currency – Donovan pointed out what he saw as fatal flaws in the current crypto market.

“If you’re interested in historical parallels, the 10th- or 11th-century kingdom of Sichuan introduced a paper currency,” he said. “It was an enormous success initially because the kingdom of Sichuan insisted that people pay their taxes using paper currency. As a result, there was an enormous demand, and initially, the paper currency kept its value.

“Unfortunately, there weren’t any economists in the kingdom of Sichuan, and they just kept printing the stuff, and then money supply exceeded demand, and it all went horribly wrong.”

Bitcoin’s overall market capitalisation has surged this year.

Donovan thinks cryptocurrencies are almost certain to end up having huge imbalances in supply and demand because there is effectively an unlimited supply of them but a clear demand ceiling.

“The fatal issue for cryptocurrencies is that the supply of them can only ever go up,” he said. “There is unlimited upside to the supply of cryptocurrencies.”

He continued: “An individual cryptocurrency may have a ceiling on supply, but if were to introduce the Donovan cryptocurrency next week – which clearly would be superior to all existing cryptocurrencies – then what you would see would be a massive move out of existing cryptocurrencies and into the new, technically superior currency.

“And because you cannot reduce the supply of a cryptocurrency, that drop in demand would not be matched by a drop in supply, and, therefore, if demand goes down but supply does not, we all know what happens to value. It is basic economics.”

The increasing supply of cryptocurrencies can be seen in the recent boom in so-called initial coin offerings, in which startups issue digital coins or tokens in exchange for real money used to fund projects. Over $US3 billion has been raised using the method so far this year.

Without a central bank to regulate things like bitcoin, Donovan said, there is no way of controlling the supply.

“The Federal Reserve is reducing money supply in the USA at the rate of $US10 billion a month,” he said, because “demand for liquid dollars has dropped, and in order to preserve the value of the dollar – i.e., avoid inflation – the Fed is reducing money supply to match a reduction in demand.”

“That cannot happen with a cryptocurrency,” he said.

Furthermore, Donovan said, a key feature of a currency is that it acts as a store of value – meaning you can put your money into it and be reasonably sure that in normal circumstances its value will not fluctuate massively.

Cryptocurrencies cannot do that, he says.

“Bitcoin, in particular, has had, I think, three hyperinflation episodes this year,” he said. “That is to say its ability to purchase goods has dropped more than 25% in the course of a week. That is not a particularly stable store of value.

“Cryptocurrencies are, at the moment, universally treated as assets, not as currencies, for tax purposes.”

He added: “What that means is that if the price of bitcoin rises against the pound sterling and I cash in, I am liable to capital-gains tax on the appreciation of the currency. If the value of sterling rises 20% against the US dollar, then I am not liable to capital-gains tax on that appreciation.”


Comments

    The inflation side of it is what worries me. Nobody cares when inflation is pushing the value up, but it goes down as well. A month ago it went from about $7200 to $5700 in a week, then rebounded to over $8000. Great if you get them at that low point (note: its more than doubled since then), not so great if you got them a week before.

    Alternatively, the increase in value would also mean any periodic bills are increasing at the same rate. Rent, mortgage, even phone bill, expressed in bitcoins, would mean they would have doubled in the last month.

    It cuts both ways, and that makes it problematic. If you only look at the positives, you're only looking at half the equation.

    So he's crying foul because it needs to be taxed and thinks a Fiat-based currency, which is literally based on printing money with nothing to back it, is superior? The current system is going to fall flat on its face sooner or later and then we'll need something to replace it. My bet is Cryptocurrency, or something similar, will be that replacement. Also, most people exchange their cryptocurrency via legitimate dedicated banks, at least I do anyway and it is taxed.

      He didn't say it needed to be taxed - it was that no government agency will accept it to pay taxes. And taxes account for a large proportion of the general flow of money around the economy. So it's hard to keep an economy moving if your currency can't be used.

      Fiat isn't ideal either. But at least it's controllable. When the economy is stagnant, more money can be issued/printed. Conversely, then the inflation is too high, interest rates can be increased. So the "value" of the currency is more stable. Stability creates confidence ... one aspect of the Fiat (i.e. Latin for faith).

      The other aspect is of Fiat is that, at any time, we can convert our wealth into something shiny and tangible (exploiting human psychology). Paper money is also just a representation for the real thing: gold. UK banknotes did (perhaps still do) have on them "I promise to pay the bearer on demand the sum of ..." since they were originally receipts for depositing gold with the Bank of England.

        I still think our current Fiat-based economy is seriously flawed. You only have to look at the last economic break down to see how knife-edge balanced it is right now. Cryptocurrency or similar is the way forward.

        Does that not all depend on the specific economy in question? Fiat can get WAY out of control! Have a look at countries like Zimbabwe or Venezuela. Their stories of hyperinflation are frightening (There's lots more through history too).
        A colleague of mine was born and lived in Zim until his family moved to Aus to escape the troubles there. He said even when they used USD that got inflated. He said one day you would go to a store and pay $5USD for a box of cereal. The next day they would charge $50USD and there's nothing you could do about it.
        I guess my point is that any economy is highly complex and susceptible to volatility.

      Actually taxation and productivity back fiat based currency whereas bitcoin is an artificial return to the gold standard among other things.

    Technically there's nothing stopping governments issuing and controlling virtual currencies. In a manner of speaking they sort of already do. Most transactions these days (including those to and from the ATO) involve no transfer of physical currency whatsoever.

    And fiat currencies are hardly immune to hyperinflation. The crux is the availability of an escape such as pegging to a stable currency/gold standard, interest rate manipulation, and so on. In the absence of such a controlling mechanism, Bitcoin can be expected to have a hard crash at some point.

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