Bitcoin: A Protocol for Quality (Part 2 of 2)

How decision-makers can utilize Bitcoin as digital capital to improve Quality in their organizations.

“Bitcoin is Not Money”

Some economists quibble that Bitcoin is not currently a “commonly used medium of exchange (MoE),” and therefore cannot be considered money. That may be true right now, but it has all of the characteristics necessary to become a MoE that is utilized throughout the global economy (i.e., commonly used). Additionally, there is a chicken-and-egg debate about the primacy of the MoE and store-of-value (SoV) characteristics. It is not entirely clear how something becomes a commonly used MoE in the first place. It is possible that something must first develop trust across its user-base by proving itself as a SoV before being adopted as a commonly used MoE.

Either way, it is fair to say that Bitcoin is not currently money, which means that businesses still need to operate in an abstract economy. In an abstract economy, one can think of money as segmented into two sub-groups based on use case: currency and capital. Currency having more of the qualities of a MoE, and capital having more of the qualities of a SoV. As long as currency is decoupled from capital, we will continue to live, to some extent, in an abstract economy. The adoption of Bitcoin as money will offer our civilization a permanent exit strategy from the abstract economy, but in the meantime, we do not need to wait for its adoption as money to start taking advantage of its utility. Right now, Bitcoin has the characteristics of an apex SoV. Bitcoin may not be money until tomorrow, but it is capital today, specifically digital capital.

“Bitcoin is Too Volatile”

Based on the volatility of Bitcoin’s price, as measured in USD, critics object to the characterization of Bitcoin as a SoV. It is true that when measured against the USD, Bitcoin appears to be volatile, but it is important to understand why.

The volatility in Bitcoin’s price can be broken down into two categories: real and abstract. The real volatility comes from it being in the infancy of its adoption. During the early stages of adoption of a monetary technology, you would expect to see short-term volatility with a long-term upward trend in price. That is exactly what we see with Bitcoin. As the adoption progresses, this type of volatility will necessarily decrease.

The abstract volatility comes from being measured in USD, which is used in the economy as a unit of account (UoA). This role means everything else in the economy is measured against USD, which makes it appear stable (i.e., zero volatility). To circumvent this bias, it is useful to compare their relative supplies. The Bitcoin protocol has a stable and algorithmic stock-to-flow ratio that means the supply increases by a small amount every 10 minutes until it is capped at a total of 21 million. The stock-to-flow ratio of the USD is a function of the US federal government’s spending, which makes it inconsistent. In principle, its supply could grow to infinity, and there is no concrete way of predicting the fluctuations.

This is more apparent when looking at price inflation of goods and services measured in USD. It generally isn’t the egg supply that is volatile, it is the total amount of USD circulating in the economy. An increase in the supply of money does not increase the quantity of goods and services available for exchange. We just end up with more money chasing the same amount of goods and services, which is reflected in price inflation. The same is true for the relationship between Bitcoin and the USD.

Bitcoin has a steadily increasing stock-to-flow ratio that is slowly approaching infinity, or in other words, a finite supply. These fundamental characteristics are what make it an apex SoV. Even with the volatility, these characteristics have resulted in its price (measured in USD) never going down over a four-year period. Regardless of the price action, the nature of the characteristics would remain true. The price measured in USD will continue to be volatile in the short-term for both real and abstract reasons, but if planning to hold it for a minimum of four years, we can have confidence in Bitcoin as a SoV. As adoption increases, both real and abstract volatility will decrease, and it can be reliably used as digital capital over shorter timespans.

The Value Proposition of Digital Capital

Capital is accumulated through generating value in excess of consumption (i.e., profit). Generally speaking, capital is accumulated through taking Quality actions. When an individual accumulates capital, they have two options: invest or save. The equation is the same for a business, but they have the additional option to decapitalize (i.e., return the profit to their shareholders).

Generally, a business’s start-up capital is deployed in productive assets with some in reserve for operating costs. When a business starts generating a profit, they have a decision to make with the newly accumulated capital. They need to decide if they should invest it, save it, or return the profit to their shareholders. If they decide to invest it, they need to decide how. Unfortunately, in an abstract economy, most businesses are accumulating capital with an inflationary money. This immediately puts the decision-makers on a timer. Holding an inflationary money on your balance sheet is like holding a melting ice cube. The purchasing power will be less tomorrow than it is today, so decision-makers are forced to act quickly.

If a business can identify a productive venture that will return value to its shareholders, decision-makers may decide to invest the newly accumulated capital. The psychological pressure from the melting ice cube generally reduces the time spent on due diligence and increases the likelihood of malinvestment. In a real economy, malinvestment is an investment that either does not generate a profit or one that realizes a loss. In other words, it is the destruction of capital.

In addition, decision-makers are required to evaluate return-on-investment (ROI) in an abstract economy. It is unclear how quickly the ice cube is melting. This lens distorts their perspective and often leads to malinvestment. In an abstract economy, malinvestment should be thought of as any investment that does not beat inflation (and not the CPI, inflation measured by the government, but real inflation). If the ROI is 5% year-over-year (YoY), but inflation is 8% YoY, that cannot be considered a Quality investment. Ammous makes this point in his Principles of Economics as well, saying that in a real economy, “the only investments that would make sense would be ones that offer positive real rates of return,” but in an abstract one, or one distorted by inflationary money, “investments that offer positive nominal returns, but negative real returns can be undertaken, leading to capital destruction in real terms.”

If there isn’t immediately a new Quality idea to invest in, and they manage to avoid malinvestment, businesses are left with options of saving or decapitalizing.

Saving provides a business the flexibility to take advantage of opportunities that are not immediately actionable. Saving makes businesses more robust and resilient to market downturns which may arise from simple supply-demand shifts or for macroeconomic reasons out of the business’s control. If a business could save with good money, it would likely be done more often and would have the effect of lengthening its time horizons. Despite its inherent flaws, businesses still decide to save with inflationary money, but they are subjecting their shareholders to slow and steady capital destruction, simply to retain some flexibility. Shareholders in an abstract economy rarely have a tolerance for saving.

That leaves decapitalization. If a business cannot identify a productive venture (and cannot save), they have a fiduciary responsibility to return capital to the shareholders. This is done through financial mechanisms like issuing dividends or performing share buybacks. Decapitalization has the inverse impact on a business as saving. It makes a business inflexible and reduces their ability to take advantage of market opportunities. It makes them less robust and more susceptible to market downturns. A well-capitalized business can withstand many years of unprofitability without existential threat, but a decapitalized business risks bankruptcy at any given downturn in the market. Once the value is returned to the shareholder, the individual is then faced with the same problem. They cannot save, so they are either forced to reinvest quickly (and often blindly), or they can consume what they otherwise wouldn’t have and destroy the capital for good.

In the absence of an alternative, to maintain flexibility, some businesses still choose to hold USD (or equivalents) as a reserve asset on their balance sheet, but the psychological pressure from the melting ice cube causes them to make decisions that decrease Quality, often unknowingly. The emergence of Bitcoin as digital capital turns the table around for businesses seeking to make Quality decisions. Digital capital has comparable liquidity to money, and any business holding it would maintain comparable flexibility. Instead of it being rationale to decapitalize or consume, it becomes rationale to retain and save profits. The single best thing a business can do to improve Quality is to adopt Bitcoin as its treasury reserve asset. Doing so will allow the business to recalibrate their investment decisions and operate as if they were in a real economy. Eventually, adopting Bitcoin as a monetary system will return our civilization to a real economy, but in the meantime, utilizing it as digital capital can help de-abstract the decision-making process and assist businesses in making Quality decisions. Adopting Bitcoin as its treasury reserve asset will increase a business’s time preference and incentivize decision-makers to delay gratification and improve Quality.