Reserve Currency Fallacy

There is a theory that Bitcoin will eventually be held by states as a reserve currency and that individuals will transact using state currencies "backed" by Bitcoin. The theory asserts that transaction volume is insufficient for its use as a consumer currency, but the ability to prevent monetary inflation makes Bitcoin an ideal reserve asset. Central banks and their authorized functionaries would issue negotiable promissory notes while holding Bitcoin in reserve. Given that Bitcoin cannot be inflated, the litany of problems produced by state control of money would be resolved, ushering in a new era of prosperity. Transaction fees would be low while transaction volume would be limitless.

Let us consider the scenario as it unfolds. Bitcoin becomes a fairly widely utilized currency but struggles with low transaction volume, high fees and long confirmation times. After purchasing or mining large amounts of bitcoin, state banks end up holding large amounts of bitcoin (BTC) and issue Bitcoin Certificates (BC) to facilitate trade. An auditing process is set up whereby people can verify that the issued BC never exceeds BTC reserves. Legal tender laws are created, requiring people to accept BC as payment for all debts. People purchase BC with BTC so that they can pay taxes and buy stuff from white market retailers. Eventually most BTC is held in reserve.

This scenario should sound familiar, as it is how states ended up with gold and people ended up with paper. The theory is invalid on multiple levels.

The ratio of issued BC to BTC in reserve cannot ever be effectively audited. Even if Bitcoin consensus rules somehow remain, there is no way to know how much BC has been issued, and there is no recourse if debasement is suspected. The member banks have to be trusted to account for their issues, and ultimately this means everyone trusts the central bank to not engage in easing. History demonstrates that this is unlikely, and nevertheless it is no improvement over current state moneys.

So why is it that a person cannot ever effectively audit (validate) BC, as had been possible with the BTC that it replaced? Because that would make BC indistinguishable from the BTC held in reserve. In other words the reason there is a difference between legal tender and reserve currency is to enable inflation of the currency in use (taxation) while holding a hard currency in reserve (savings). States hold hard currency because even other states cannot debase it and issue soft currency so that it can be debased.

Furthermore, for Bitcoin to be a hard money, there must be an actual decentralized Bitcoin economy. Without individuals validating BTC received in exchange, there is nobody to refuse invalid BTC as it comes to be redefined by the state. In this case arbitrary inflation can easily be introduced to BTC as well, invalidating the theory.

It is an error to conflate a reserve currency with a settlement layer. Layering preserves the key security aspect of decentralization, which works against debasement, while "backing" is full abandonment of this protection. It is very possible for Bitcoin to be held by state treasuries, but not for it to be predominantly a reserve currency. People must trade with it for it to be secure.