March 18, 2024 | Read Online

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"Unless it becomes a widely used medium of exchange, bitcoin should eventually implode. The alternative is that all I learned from monetary theory about how currencies acquire value is meaningless."

- Eugene Fama

Does Bitcoin Need to Become a Medium of Exchange?

In the 15 years since Satoshi wrote his white paper, the Federal Reserve has printed roughly $12 trillion — far more than even the most fervent bitcoiner could have feared, hoped or imagined.

And yet, the US dollar is stronger than ever — all 12 trillion of those dollars have found a willing holder at surprisingly robust levels.

Perhaps counterintuitively, Bitcoin is stronger than ever, too.

This is not because bitcoin is challenging the dollar as a medium of exchange — when was the last time you paid for something with bitcoin? (No, NodeMonkes don't count, sorry.)

Bitcoin's success can therefore only be attributed to rising demand for an alternative store of value.

But the timing seems odd.

Bitcoin's rise to new highs comes at a time when the Fed is not printing money (as hard-money types so fear), but unprinting it.

The Fed is also paying two percentage points above inflation on dollars deposited with them on reserve, which makes dollars held in money market funds an appreciating asset.

Logically, that should make this the worst-possible environment for bitcoin — who needs an alternative to the dollar when dollars are getting more scarce and more valuable?

But it also comes at a time of rapidly rising deficit spending — spending which makes it feel like money is being printed, even when (like now) it's only being borrowed.

The fear (or, if you have enough bitcoin, hope) is that money borrowed now will turn into money printed later.

With the US government now borrowing over a trillion dollars a year (while the economy is good!) it seems inevitable that lenders will eventually stop lending, forcing the Fed to turn the money printers back on.

That would be a good time to be long bitcoin, of course.

But it might not be anytime soon.

To understand why, consider that every dollar the US government spends creates a dollar of demand for the debt they sell to spend it.

This circular logic might be why trillions of dollars of money printing has so far failed to scare people away from lending to the US.

If so, it might also be why the big payoff for bitcoin holders may be further out than we seem to expect.

The Hotel California Economy

With the exception of physical cash, US dollars cannot leave the US banking system.

Eurodollars, for example, are not dollars held outside the US, as they are popularly understood to be — dollars can only be transferred to and from banks that have a master account with the Fed and the Fed only gives master accounts to US banks (which includes onshore branches of foreign banks).

So, dollars can never leave the US.

(Eurodollars are, instead, credit denominated in dollars. When it's time to settle that credit, real US dollars have to be exchanged by US banks in the US banking system.)

The US dollar is a closed system, and that means that every dollar spent by the US government ultimately becomes a dollar of demand for some form of US government debt.

After circulating for a time, newly printed US dollars inevitably come to rest with either a saver seeking a risk-free return, or a person who for whatever (often illicit) reason prefers to hold physical cash (also a government debt instrument).

In each of those cases, the new dollars ultimately end up back with the government that issued them.

Viewed from this (highly oversimplified) perspective, US deficit spending is self-funding.

There are presumably limits.

Mostly, people assume there is a limit to how many dollars non-US entities are willing to hold, and that beyond that limit awaits de facto default via hyperinflation.

There is so far no sign that we're anywhere near that slippery slope — foreigners seem as happy as ever to hold the dollars we send them in return for the stuff they make.

We pay for that stuff by sending dollars to US bank accounts (because that's the only place they can be sent) where the foreign owners of those accounts have (collectively) chosen to hold those dollars, mostly in the form of US debt.

We think that can't possibly go on forever, but it may well be that foreign holders of dollars will continue to hold US debt right up until the balance of global trade reverses direction.

Dollars earned by exporting things to the US might continue to be held in Treasurys until they're needed to pay for things imported from the US.

That's not likely to happen any time soon, but the current, seemingly precarious equilibrium of supply and demand for US dollars might persist for a sufficiently long time, long enough that it gets peacefully unwound by a shift in global consumption patterns.

So, if your bull case for bitcoin is really just a bear case for the US dollar, you should be prepared to wait — the US dollar is likely to remain the world's medium of exchange for the foreseeable future.

But (contra Fama), we don't need to start paying for things in bitcoin for bitcoin to do well while we wait.

Nor do we need the dollar to lose its status as the world's medium of exchange — we only need people to increasingly worry that the US dollar might lose it.

Bitcoin at new highs probably just means that people are increasingly worried it will.

― Byron Gilliam

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