Bitcoin’s Role in Times of Economic Uncertainty

As global markets are facing a downturn, it is imperative to analyse several implications of this reiterative occurrence. In order to do so, a look into the current status quo is necessary as well as the understanding of macro trends and their significance for the individual.

The Standard & Poor 500 (SPX) is a capitalisation-weighted index that is supposed to reflect the state of the US American economy by tracking the performance of 500 stocks of companies based in the US from all major industries. The year 2019 has seen stark developments. The SPX started the year by recovering from a sell-off that took place between September and December of 2018, registering losses of almost 20 percent.

It took until late April to reach the previous year’s level of about 2930 again. While the SPX is seen as a solid long-term investment with strong returns in the last decade, the aforementioned and the so-called “lost decade” from 2000 to 2010, where no net returns were registered for long-term investors, indicate that the market can regularly be in a fragile condition.

Where this fragility comes from is a pressing question. The economic system we experience and shape is highly complex: institutions and agents are deeply interconnected, which can be understood at least twofold. On the one hand, institutions determine the playground and the rules for behavior, and agents, such as a carpenter, a politician, a trader etc., again have the capability to change those institutions to a certain extent.

On the other hand, with size comes interdependency: our economies’ produce is heavily influenced by their respective comparative advantages, which means entire economies often do not produce based on their own demand but aim to become competitive by creating goods more efficiently than other nations. Naturally, this creates dependencies and possibly static roles for countries as it is difficult to escape this non-self determined way of living.

It is purely a reaction to already existing trade structures, such as trade corridors or novel agreements that have to be considered and can hinder future economic mobility. Because of these constraints, however, domestic stability is highly volatile. If this is the case, systems are prone not necessarily to change, but certainly to shocks.

What exacerbates this state of affairs, is the current speed of money supply and the implications thereof. Loose monetary policies, where an economy’s Central Bank lowers interest rates in order to cheaply provide money to an expanding market, that we are experiencing at least in the US and in Europe, are proactively changing the markets, and are not the intended authority for corrective measures to improve them.

This has altered markets rather drastically. From a finance perspective, a bank will be hesitant in lending capital to smaller companies or individuals since the potential revenue as determined by the agreed-on interest rates is low – relative to the income derived from lending a lot to a larger entity.

The initial intuitive euphoria stemming from cheap money from banks therefore has to be treated with caution. Entrepreneurs or small companies cannot rely on these means to finance their businesses the same way large companies can, as banks will not consider them for the aforementioned reason as well as because of short-sighted and fallacious risk assessments.

By focusing on larger businesses, banks attempt to avoid payment defaults from start-ups or family businesses, without taking into consideration that, during times of economic recession, defaults from large market participants will pose systemic risks and be a stark threat to banks. This comes as a consequence of the deep level of interconnectedness of large businesses with the economy that central and commercial banks themselves have created by making money so cheap and mostly giving it to large firms.

Those are using it to acquire start-ups, thus incorporating risk coming from small firms that are yet to prove themselves and cannot fulfill their function as challengers or disruptors of a market, important and isolated risk-takers. Risk stemming from entrepreneurs not paying back their loans is not higher-order risk such as the one from interconnected institutions. If banks are at risk, partially caused by their own lending practices, a geography’s stability is in harm’s way.

According to the October 2019 Global Financial Stability Report of the International Monetary Fund (IMF), this corporate debt has exceeded £15tn – almost 40 percent of which in eight of the world’s leading economies, US, China, Germany, Britain, France, Italy, and Spain. It is explained that in case of “[…] a downturn half as serious as that of a decade ago” it would be impossible to service this debt. “Medium-term risks to global growth and financial stability are still firmly skewed to the downside”, as per the report.

Bitcoin, however, the world’s first cryptocurrency has been developed on different principles. A digital asset, its scarcity has been predetermined, meaning it will have a predictable supply of 21 mn coins by the time it will have been fully diluted. The inflation ratio is predictable, as computers verifying transactions on the bitcoin blockchain are rewarded with newly issued coins. This reward is halved approximately every four years, implying that the last bitcoin will enter circulation in about 120 years.

As opposed to current fiat money, such as Us dollars or the euro, bitcoins are not someone’s liability, first and foremost because there is no formal issuer.

The bitcoin blockchain is censorship resistant by diffusing the data that is stored in it globally in computer servers that also verify every single bitcoin transaction multiple times. In order to facilitate effective communication in absence of a central authority, a conflict resolution mechanism, called “proof-of-work mining”, has been developed that takes care of deciding which of two valid data blocks will get processed. These blocks of validated data give the blockchain concept its name.

At a size of about US$75tn and some US$90tn respectively, the global stock market and all money in existence show that the US$242bn invested in cryptocurrencies may certainly grow another 1000 or 10,000 percent in times of economic uncertainty. Investors want to know their liquid assets unaffected by politics, which is possible using a synthetic commodity money as bitcoin because it is an example of pure capitalism, as it gives the individual the possibility to be responsible for themselves, without a higher-order political dogma which creates dependencies.

Implications thereof will be presented in coming articles for The Future Citizen Institute.

Author: Patrick Lehner