Towards the Moon? Five Microeconomic Lessons From Bitcoin

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Bitcoin can be complex and confusing, and little academic work has been done on it. Although the technology is still new, Bitcoin can be understood in traditional economic terms. Ironically, the report suggests that currency is a bad store of value

Cryptocurrency has been around for twelve years, and despite continued reports of its imminent demise, its use is growing in popularity. El Salvador is preparing to accept Bitcoin as legal tender (and plans to mine it using energy from the country’s volcanoes). Many large companies accept some sort of cryptocurrency as a form of payment, and even Communist Cuba is preparing to recognize and regulate the coins.

However, the technology and systems in which these parts operate are still quite new. Most of the talk about the coin economy was not academic in nature and often featured on blogs. Now more rigorous analyzes are available.

In an upcoming article in the Journal of Economic Literature that summarizes the research of the past decade, an international team of researchers is examining the microeconomics of Bitcoin and laying the groundwork for future research. At the same time, they help make sense of something often considered obscure.

What exactly is Bitcoin?

Bitcoin, the original cryptocurrency, is a completely digital form of money. Designed by Satoshi Nakamoto, a pseudonym for one or more unknown people, it is based on technology that dates back to at least the 1990s. Those who hold Bitcoins can conduct business transactions with people around the world without the involvement of third parties and with a high degree of anonymity.

Bitcoin is based on blockchain technology. When a person engages in a transaction using Bitcoins, they are actually sending instructions regarding that transaction to a decentralized network of ledgers. The people in charge of these registers, called minors, are in constant communication to maintain the coherence of the registers. As new information is added in blocks to the old records, also known as the chain, the records grow longer and provide a complete view of all the transactions that have taken place on the network since its inception.

For their troubles, miners are paid with transaction fees and freshly minted Bitcoins, although only those who are able to do the job the fastest and most accurately get the new coins. Bitcoin supply is capped at 21 million, the last of which is expected to be minted in 2140. This value is dictated by the code itself and not decided by the coin holders.

Five Microeconomic Lessons From Bitcoin

The paper offers some notes on how the traditional elements of supply, demand, competition, etc. all interact in this strange new marketplace.

Lesson # 1: Procurement. The supply of bitcoin worldwide is capped at 21 million and currently around 18.7 million has been mined. The production of new coins is slowed down every four years or so, with the number of coins struck at the end of a block being cut in half each time.

The limited supply is one of the things that makes Bitcoin attractive to many people. Decentralization means that it is unlikely that any person or group could take control of the ledgers or enough of the currency to manipulate its value (although this has been disputed by Giovanna Massarotto, professor at the University of Pennsylvania. ).

The fixed supply and the way it is created, however, can cause problems later. The authors point out that the incentive for miners to continue processing and recording transactions will be severely limited by future keystroke reductions, as the benefits from transaction fees alone will be far less than possible. get by getting new coins and transaction fees. However, this shouldn’t happen for some time.

Lesson 2: demand. On the other side of the equation is demand, and the demand for Bitcoin has changed dramatically over the years. While early adoption was limited by technical difficulties and legal gray areas, the growing number of uses and public awareness increased demand.

Additionally, an increasing number of items, from cars to burgers, can be purchased with Bitcoin. The number of places accepting them has increased in recent years and is expected to increase alongside institutional acceptance of the currency. As the utility of Bitcoin increases, so does the demand, especially when access to banking services is limited.

On the downside, much of the demand for the coin continues to come from speculators who buy the coin in the hope that its value will rise. In addition, much of the demand relates to questionable activities. While the idea that only criminals use Bitcoin or cryptocurrency in general is greatly exaggerated, it is real. It is believed that a fifth of all Bitcoin transactions are linked to criminal activity and gambling, although these represent only a paltry four percent of the value of all transactions. As a global proportion of transactions, the trend of illegal activities is decreasing.

Lesson # 3: Competition. Bitcoin isn’t the only game in town. Countless other cryptocurrencies have entered the market. Although it remains the dominant coin, Bitcoin’s market share increased from 94% in 2013 to 64% in March 2020. Other major cryptocurrencies have different uses, but they often overlap with possible uses. of Bitcoin.

Overall, Bitcoin benefits from network effects, i.e. it becomes more valuable as more and more people use it. Bitcoin still remains the foundation for much of the crypto market, which evolves in tandem with it. Thus, Bitcoin is unlikely to disappear.

Lesson # 4: Put the eggs in the same basket. One of the most popular uses of Bitcoin is as a long-term, gold-like store of value. Many cryptocurrency fans are passionate about protecting their wealth from inflation and see the controlled supply and decentralized nature of Bitcoin as a reason to put their money there for later.

Claims that Bitcoin could one day be valued at $ 100,000 per coin are based on this idea of ​​the coin as “digital gold.” The authors point out that this would be the coin’s value if all of the money currently invested in gold was suddenly used to buy Bitcoin. It also means that the current price reflects the confidence people have in the coin replacing gold at some point in the future.

However, a number of studies have suggested that Bitcoin is a rather poor store of value, being subject to a fair amount of speculation and volatility and lacking the reassurance that other commodities have against theft. or system failure. Despite this, the authors argue that the primary use of Bitcoin is speculative in nature, suggesting that there is some confidence in the coin’s ability to hold and gain value.

Lesson 5: Volatility has causes, maybe. Many studies of Bitcoin’s early years, which concluded that money was a bubble, were based on the idea that the market was already mature and that all participants had the information necessary to make rational decisions. We now know that this is not the case.

A graph showing the overall volatility of bitcoin by year over time. As you can see, while volatility remains high, it has declined significantly since its inception. By Ladislav Mecir – Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=83137319

While Bitcoin is still subject to fluctuations that would be striking in other markets, the authors conclude that it is an asset that does not behave quite like other, more traditional ones. As a result, its price volatility, which has fallen in recent years, may not be a sign of the coin’s impending collapse, but rather a feature of digital currencies.

Or, it could be something else entirely. It is still too new to find an agreement on how to study things. The authors say it’s unclear how Bitcoin will engage with the rest of the economy, although this can be understood in traditional terms within its own markets.

Now if anyone could just explain how to get rich from this that would be great.

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