The unusual incentives built into the bitcoin network mean that the cryptocurrency inverts the laws of economics: the more people buy bitcoin, the more its price goes down.
That’s the conclusion of Bank of England economist Peter Zimmerman in a blog published on the Bank Underground website, a forum for Bank staff to share views that may challenge conventional central bank thinking.
According to Zimmerman, bitcoin behaves in a counterintuitive way because of the interplay between short-term speculative forces and the network’s potential long-term value as a payment mechanism.
“Blockchain technology limits how quickly transactions can be settled,” says Zimmerman, citing the well-known capacity constraints of the bitcoin network.
“This is contrary to the usual laws of economics!”
But this leads to unique behaviour by the cryptocurrency, he suggests.
“This constraint creates competition for priority between different users. The more speculative activity there is, the longer it takes to make a payment. But the future value of cryptocurrency depends on its usefulness as a means of payment. Speculation therefore affects price formation through a channel that does not exist for other asset classes,” Zimmerman says.
Zimmerman theorizes that speculative activity, by increasing transaction fees, also delays the future point at which bitcoin might become widely adopted and used as a medium of exchange.
“People speculate on cryptocurrency because they expect it to be adopted as a means of payment, or because they expect to sell it to someone who believes adoption will occur,” Zimmerman says.
“But the act of speculation makes it harder for adoption to happen. All else equal, an increase in the number of speculators drives the price down, even if they are buying. This is contrary to the usual laws of economics! Normally, we would expect more buy-side trading to increase the price of an asset.”
Zimmerman suggests that these conflicting forces help explain the high price volatility of cryptocurrencies and the relatively low adoption rate so far for bitcoin.
However, while other central bankers, including Zimmerman’s previous boss, have written bitcoin off, with one labelling it as a ‘a combination of a bubble, a Ponzi scheme and an environmental disaster’, Zimmerman is more open-minded about the cryptocurrency’s eventual chances of success.
the impact of technological innovations are often overestimated in the short-term and underestimated in the long-term
He suggests that bitcoin could pass through two phases of development: an initial hype phase, with high volatility, little adoption and lots of speculative activity; and a subsequent adoption phase, where the cryptocurrency begins to be adopted widely as a payments instrument and prices stabilise at a high level.
Existing capacity constraints in the bitcoin blockchain, which can only handle a maximum of seven transactions per second, could be relieved by the availability of other means of speculation that don’t require blockchain usage, such as the cash-settled bitcoin futures market, suggests Zimmerman.
Another way of bringing forward bitcoin’s future adoption phase could be the further development of a payments layer that’s built on top of the blockchain, such as the Lightning network, the author says.
The cryptocurrency may even be a special case of Amara’s law, which states that the impact of technological innovations are often overestimated in the short-term and underestimated in the long-term, says Zimmerman.
But estimating when that long-term future might arrive is a thankless job because of bitcoin’s feedback effects, he argues.
“For blockchain technology, overestimation today pushes that long-term horizon further out into the future,” Zimmerman says.
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