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  • Benjamin de Waal

A Response to CME’s “In-Depth Look at the Economics of Bitcoin”

Updated: Dec 27, 2020

This was written by request of a colleague as a response to this article published by the CME group in April of 2018 so that he could get a better understanding of my criticisms. It is intended to address the most salient and important points but does skip some detail where it wasn’t necessary for the original requestor.


Section 1: Economics of Supply Inelasticity

“The supply inelasticity explains in large part why bitcoin is so volatile.”

Disagree: The supply inelasticity certainly influences and exacerbates volatility, but the primary cause of the amount of volatility is the size of the market. The total market is very small compared to other markets and shows a similar level of volatility to other markets.

This is somewhat self-evident in that the volatility of Bitcoin can be seen to decrease over time as the market has grown. If supply inelasticity were to be considered a primary explanation of the volatility, the significant decrease in volatility as the market grows would not be expected as the supply inelasticity itself has not changed.

“Meanwhile, consumers will find ways to use them more efficiently in response to higher prices. This is not the case for bitcoin directly, although rising prices might increase the probability of “forks” that split bitcoin into the original and a spinout currency such as Bitcoin Cash (August 1, 2017), Bitcoin Gold (October 24, 2017), and Bitcoin Private (February 28, 2018).”

I agree but consider this irrelevant.  I don’t see why this statement is being made and it’s not elaborated on further.  If they’re trying to argue that it’s a kind of supply inflation, I vehemently disagree (that’s like saying the billions of new Venezuelan Bolivars that were printed massively devalued the US Dollar and the Euro, which is just absurd) but I won’t necessarily assume they did mean that since they didn’t say it specifically.

“Bitcoin’s limited supply and soaring price make it difficult to be used as a medium of exchange outside of the crypto currency space. Imagine one’s regret if one uses bitcoin to purchase a mundane item such as a cup of coffee only to find that the bitcoin spent on a cup of coffee would have been worth millions of dollars a few years later. As such, investors treat bitcoin as a highly unreliable store of value – a bit like gold on steroids.”

Disagree: There is no difference between deciding to spend €2.50 on a cup of coffee or an equivalent amount of Bitcoin on that cup of coffee if you are able to easily exchange between euro and bitcoin. By spending the €2.50, the person willingly chose to buy coffee instead of storing the value in Bitcoin. In other words, they had a preference for the coffee over the opportunity cost of the Bitcoin.

“Bitcoin’s price is too volatile to compete as a store of value”

Disagree: As Bitcoin’s usage grows, its volatility should decrease (as we’ve already seen, and I described above).

“Bitcoin’s transaction costs are too high and too variable for it to be used as a medium of exchange.”

Strongly Disagree: “Transactions” on Bitcoin’s blockchain can represent any number of transactions from zero to millions/billions. The on-chain “transaction” costs do not say anything about the costs paid per real transaction conducted. It just happens that in these very early days of bitcoin, most on-chain transactions represent only one or a very few real transactions. This will change.

“Most importantly, for an asset to function economically as a medium of exchange, it must depreciate slowly over time – something that is impossible with a fixed supply.”

This is just a standard Keynesian economic argument made without any evidence provided to back it up. To use a quote from Christopher Hitchens: “That which can be asserted without evidence, can be dismissed without evidence.

“Without the fear of inflation, holders of currency tend to hoard rather than spend it.”

What Keynesian economists call “hoarding”, Austrian economists (and really anyone that remembers their childhood) call “saving”.


Section 2: A Deep Dive into Bitcoin Supply through a Study of the Economics of Commodities

“Bitcoin is “mined” by computers solving cryptographic math problems. In exchange for solving the problems, miners receive bitcoin. Those math problems grow in difficulty over time, increasing the required computational power required to solve them. This in turn drives up the equipment and especially the electricity cost of producing bitcoins. One needs more and more computers and to make them run at peak speeds, they must be kept cool.”

This whole description is wrong and based on false understandings of the technology.

Bitcoin is mined by computers performing a simple cryptographic mathematical calculation many times over, looking for a specific result that cannot be predetermined and is thus random chance. When the specific is found, a “block” is generated which contains the result, showing that the necessary work must have been put in to find it. The specific result being looked for depends on the current network difficulty, which in turn depends on how quickly the most recent blocks were generated. Thus, the more computing power put in to finding the results, the faster new blocks are generated. This in turn results in a higher network difficulty, slowing block generation down again. The network difficulty adjustment is designed to produce an average of 10 minutes per block regardless of how much computing power is added to the network.

If blocks are generated more slowly than 10 minutes, the network difficult reduces, meaning that a constant increase in energy expenditure is not expected (computing power may increase, but primarily through improvement of technology rather than increase in energy expenditure; in theory, this would also eventually cease, but likely not for many people’s lifetimes).

Since miners are rewarded with a known amount of new bitcoin per block (plus variable transaction fees), it is reasonably easy to determine whether it is economically viable to participate in mining.

This means that rather than a constant increase in energy expenditure, an equilibrium is found whereby it is economically valuable to add more computing power to the network based on the energy cost of adding it.

As the entire rest of this section is based on the false assumptions made above, there doesn’t seem to be much need to answer it. However, it is worth saying that their statements about “the difficulty not dropping” is wrong (it did, it just lagged behind because there were still plenty of profits to be had despite the price drop), and the comparison to physical mining is taken too far since they make the incorrect assumption that the mining difficulty relates to the remaining supply (which it does with physical mining, but not with Bitcoin).


Section 3: Demand Drivers are Not So Transparent

I don’t have a lot to say about this section.  They’re generally right, but I don’t see the issue.  I do take issue with their idea of “transactions” as mentioned in section 1, but when talking about historical data it’s quite acceptable.  It won’t be for the future though.


Section 4: Incentives, Bitcoin Forks and Alternative Cryptocurrencies

“When one thinks of incentives and reward structures, one might want to analyze some parallels with how shareholder value is created.”

One might want to, but one would be wrong to do so…

“Miners and transaction validators receive rewards in bitcoin. One can see a corporation’s shares as an internal currency used to compensate and motivate employees, aligning their interests with those of the organization. To that end, the number of bitcoins in existence is comparable to the “float” of a corporation – the number of shares issued to the public.”

Producers of fiat currencies (central banks) receive rewards in those fiat currencies. Why not compare to that instead of to shares? I don’t get how this analogy is supposed to make sense at all.

“A quick diversion back to supply is useful here. The existence of forks in bitcoin serves to modify some of our intuitions on supply. That is, while bitcoin’s supply is fixed, the supply of cryptocurrencies is not.”

Oh dear, they actually said it. See above in my second answer to section 1…


Section 5: Economic Destiny of Bitcoin

“One possible result of the development of cryptocurrencies is that central banks may one day decide to issue their own distributed ledger currencies as Venezuela is struggling to attempt to do today with the launch of the “petro.””

This is – or at the very least should be and will be in the longer term – completely irrelevant. Centralised “private blockchains” aren’t even the same kind of thing as Bitcoin no matter how much people try to lump them together. It doesn’t matter if it’s created by a state actor/government or by a 15-year-old in his mother’s basement: it’s still a shitcoin!

“Blockchain technology has the potential to allow policy makers to issue their own cryptocurrencies that will give them real time information on inflation, nominal and real GDP. It will not allow them to peer through the front windshield into the future but at least they can look into the rearview mirror with much greater clarity and see out the side windows of the monetary policy vehicle. This could allow them to create the amount of money and credit necessary to keep the economy growing at a smooth pace more easily than they do today.”

I consider this very short-sighted and a “waste” of the technology. Yes, I can see how a private shitcoin would have these advantages over fiat, but as long as the money-creation and so on are still human decisions based on gut-feeling and badly designed analysis techniques, it will still suffer every significant issue that fiat currencies have. Slightly greater transparency isn’t all that helpful when it’s transparency on a fundamentally broken design.

“Switching off the gold standard vastly reduced economic volatility and improved per capita economic growth.”

To quote Wikipedia: [citation needed]

In other words: I don’t believe this at all. Economic volatility in purely fiat currencies has been greater and more damaging than on gold-backed currencies (prior to the “cheating” of not really having it backed but saying it was). Also, per capita economic growth needs to be defined and measured in something other than the fiat currency you’re trying to evaluate. I don’t believe for a second that real per capita economic growth has happened on average (the rich got richer, the poor got poorer, and the standard middle-class family now have two working-parents instead of just one).

Switching away from the gold standard was practical because gold is hard to physically store and move and has divisibility issues. Gold has good properties, and poor ones. Bitcoin has the same good properties, less of the poor ones, and several more good ones that weren’t even in question/consideration before it existed.

“Moving to blockchain-enhanced fiat currencies could further reduce economic volatility and, ironically, enable further leveraging of the already highly indebted global economy as people find ways to use capital more efficiently.”

“could” is a weasel-word. Sure… it could, but I don’t see any reason to expect it would. The article doesn’t even try to defend or argue this point of view.

“Investors who are buying bitcoin are presumably hoping to find someone to sell to at a higher price.”

Some might be. There are however plenty who aren’t: because it’s a currency, not only an investment vehicle.

“As more people bid up the price, the difficulty of solving bitcoin’s cryptographic algorithms increases. This in turn is driving up investment in more powerful and faster computing technology of both a traditional integrated circuit and non-traditional variety. Indeed, solving cryptographic problems may be one of the first tests facing quantum computers. The problem is that investors in bitcoin and its peers are mainly out to make profits and not to finance or subsidize the development of distributed ledgers nor more powerful computers.”

This is again treating Bitcoin as an investment vehicle, not a currency. Of course, no one is interested in Bitcoin solely to subsidise the development of distributed ledgers or more powerful computers. The presentation of this as the only alternative to being interested in Bitcoin for “making profits” is a classic “Black or White” logical fallacy.

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