Bitcoin, Gold and Value Protocols


Note: This is an opinion piece.

Well, I say Bitcoin, but this article applies to any hypothetical decentralized value protocol modeled after something resembling gold in most of its properties. The analysis will indeed explore the noble metal as it exists today, its total valuation and what parallels can be drawn between it and Bitcoin. Recommended reading for a deeper understanding of how Bitcoin, Gold and money relates: Nick Szabo's fantastic Shelling Out - The Origins of Money, and Prof. Saifedean Ammous' book The Bitcoin Standard.

What driving factors have made humans assign value to Bitcoin specifically are explored also in my earlier article on the subject. Below I will outline descriptively why Bitcoin is suitably compared to gold. The article reflects not only on why Bitcoin has value but what value it can have. And to be clear, it is a hard game of estimation; valuing equity is in a sense straightforward because one has to mainly figure out expected future dividends as well as discount factors, which is practically hard but not conceptually complicated. The value of Bitcoin has gone from 0 to over USD 100B in less than a decade, and this is what makes people confused. How can anybody know the true value of non-physical tokens not assigned any dividend payout property? How do we even start to value it when no such models have been taught in university economics classes? It does require some critical thinking on own behalf, and I have found the whole thing easiest to gripe with after first mapping the value of, you guessed it, gold.

Bitcoin is a creature of the internet and is therefore global, just like gold is a globally sought after metal used for storing value. They are in a sense remarkably similar and counter roughly the same type of threats to wealth storage. The fiat to Bitcoin on-ramp infrastructure differs drastically around the globe and is constantly shifting for better or worse, but the general trend is a growing access to cryptocurrencies for the global population, just as gold is globally easy to obtain from traders. Here a valuation origo starts to solidify; the wealth earned and saved by individuals, families, companies, institutions, communities and even countries, over centuries even, is constantly looking for a value protocol that not mitigates but at least minimizes the risk of supply inflation, authoritarian confiscation, usability restrictions, theft, fraud etc. Human beings simply want to store accrued wealth - tokens of delayed reciprocal altruism - over space and time. The reason that crude value protocols initially formed was that they could act as a safety mechanism against future dangers like starvation. For many people they are now a practical solution to varying consumption time preferences. Let's try to understand one simple, specific threat to such value storage - a threat that has shown its ugly face time and time again in human history.

Store of Value and the Stock-to-Flow Ratio

The concept of stock-to-flow is well explained in Saifedean Ammous' book The Bitcoin Standard. The ratio is used to map what can be considered hard and easy money. Hard money is when the difficulty in producing new monetary units is high. On the contrary, easy money is easily produced. In other words, the stock-to-flow describes a mechanism where the total supply, or total stock, of any money is diluted by the continues flow of newly produced monetary units. Central bank money is one example where it is theoretically and sometimes practically easy to increase flow, hence it can be seen as easy money. Ammous terms the constant lure among authorities to assign themselves more money the easy money trap; what money can be mass produced will eventually be mass produced - a sort of Keynesian twist on Murphy's Law. The key word here is 'eventually'. Obviously some central banks keep a high stock-to-flow ratio for their managed national currencies, but we have all seen what happens when they are willing, ordered or pressured to disrupt that ratio.

Calico - A long abandoned Californian silver mining community. Its population scattered as the price of silver crashed in the mid-1890's. 

Gold is an example of hard money, as the mining companies have an extremely hard time achieving an annual flow as low as 2-3% of total stock. This stock is virtually indestructible due to the physical properties of gold, hence it is slowly building over time and any added flow tonnage is less and less in proportion to total stock. The stock-to-flow ratio of gold is more or less independent from the needs and wants of greedy authorities. It should come as no surprise then that gold became a global store of value mainly because of this high stock-to-flow ratio. Wealth is stored on this protocol because it has never been easy to inflate the total gold stock. A quick comparison to silver makes the picture even more comprehensive. Silver is more bountiful under Earth's crust, and parts of its stock is destroyed in industrial use. Firstly, this puts a downward pressure on the total silver stock. Secondly, the relatively easiness in which silver is found in mines puts an upward pressure on possible flow. A hypothetical price increase of silver results in a high future flow as miners immediately start digging for more, while the stock to begin with has been kept small due to usage. The stock-to-flow ratio diminishes and wealth stored on the silver protocol of value is promptly destroyed.

Nick Szabo lists multiple historical occurrences when the ease of producing money destroyed multi-generational wealth.

Clams were found only at the ocean, but wampum traded far inland. Sea-shell money of a variety of types could be found in tribes across the American continent. The Iriquois managed to collect the largest wampum treasure of any tribe, without venturing anywhere near the clam's habitat. Only a handful of tribes, such as the Narragansetts, specialized in manufacturing wampum, while hundreds of other tribes, many of them hunter-gatherers, used it. Wampum pendants came in a variety of lengths, with the number of beads proportional to the length. Pendants could be cut or joined to form a pendant of length equal to the price paid.
Once they got over their hangup about what constitutes real money, the colonists went wild trading for and with wampum. Clams entered the American vernacular as another way to say "money". The Dutch governor of New Amsterdram (now New York) took out a large loan from an English-American bank - in wampum. After a while the British authorities were forced to go along. So between 1637 and 1661, wampum became legal tender in New England. Colonists now had a liquid medium of exchange, and trade in the colonies flourished.

As soon as the Europeans refined techniques to mass produce and harvest wampum clams, unavoidable inflation hit and it was phased out as money. The sudden low stock-to-flow ratio destroyed wealth hoarded by many Indian tribes. Another similar example is glass beads (mass)produced in 16th and 17th century Europe that was used by Europeans to achieve valuable goals in West Africa where such beads had a much higher market value among the native population.

Wampum beads forming a necklace. 

Now, let's explore Bitcoin's stock-to-flow ratio. We know with certainty that only 21 million units will ever be produced. Around 17 million units exist already and the last 4 million units are released over the next 120 years or so. A deeper discussion may be had about the possibility of a supply increase, but not here. I will just state that it is extremely improbable, if not simply impossible. Anyone advocating a supply increase will have to convince millions of users that it is prudent, and most of them will end that conversation short with less than polite words. What we end up with is an indestructible, capped stock as well as a diminishing flow; new bitcoins are minted within the network through mining rewards - the neutral incentive mechanism put in place to make sure someone confirms transactions in the form of blocks and propagates those blocks to all that runs a full node. This flow is to the tune of around 4% of current stock and will decrease to that of gold in about two years.

Curiously, the flow dynamics of Bitcoin differs slightly from those of gold. A price increase of Bitcoin has virtually no bearing on more or quicker mining outputs as the network's difficulty adjustment algorithm makes sure that new blocks are found every ten minutes on average, no matter the number of miners and the power of their hardware. With gold on the other hand, a price increase will, as hard as it is, immediately encourage more and deeper searches for the metal, resulting in a higher future output within a given time frame. Gold output is thus constrained by a slightly more lenient physical 'difficulty adjustment algorithm' - a natural result of chemical processes occurring during the formation of our planet. If gold behaved liked Bitcoin, the richer veins would like living things burrow themselves deeper and deeper as more mining resources were put to the task of digging them up. Bitcoin is harder money in this sense.

A Bitcoin Standard

It is easy to see then how a hypothetical Bitcoin standard resembles a gold standard on steroids; gold will for sure be found in centuries to come, while the hard-mined digital Bitcoin vein depletes earlier than that. I am not in a position to judge the feasibility of such a standard for modern, industrialized societies, but in the end our opinions on the subject don't really matter. Feasible or not, it may very well be the case that global wealth will move without permission towards this new, digital harder money as a kind of game theoretic equilibrium, despite deflation warnings from mainstream economists. As they can't shut down the new protocol itself and block this possible 'Prisoner's dilemma' of savers, what may unfold in front of their eyes is an slow, uncoordinated stampede away from inflationary fiat money, where protesting voices are simply drowned out. For the convinced keynesians or inflationists out there, just picture a new-found green pasture commons and distrusting sheep herders, a small forest commons and envious wood cutters, a lake commons and fishermen from warring tribes. Sometimes, the coordination that would ensure a long term, beneficial common solution - a global optimum if you will - simply breaks down. This is worth remembering when you read all the economists that conflate the future success or failure of Bitcoin with how they think the monetary system ought to operate.

Ashdown Forest - A Commons initially utilized by Saxon and Jutish populations. Even during medieval times, lords saw fit to regulate how it could be used by commoners because they understood the danger of over exploitation. 

How come the whole industrializing or industrialized world, with some exceptions, operated on a gold standard during the 19th century and parts of the 20th century? Gold not only has a high stock-to-flow ratio as we have explored, but also a few other peculiar properties. As mentioned, gold is not destroyed when worked with; some of the gold that gathers dust in vaults today was mined centuries ago in countries that no longer exist. The metal is also highly divisible and hard to forge. As it is found on all continents, no specific company or country has full control over the production of new supply. It is in this sense a decentralized value protocol under control of no-one. All these properties, combined with a long history that validates them, made empires tie their national currencies to the metal as they saw the advantages with such a scheme. That is also why in today's fiat currency world, central banks still hold large reserves of gold. It is estimated that all gold in the world is valued to around USD 8 000 billion, which is around 8% of global M3 or global GDP.

A bitcoin can't really be destroyed either, meaning total supply is well known and quite similarly restricted in the same way as gold. It is also highly divisible, and no one has full control over the mining process as different mining inputs such as electricity, hardware and human capital has geographically and jurisdictionally shifting comparative advantage equilibria. Bitcoins ability to be transferred seamlessly and without permission is unprecedented in history. It is also impossible to forge. All in all, I tend to subscribe to Satoshi's allegorical description of Bitcoin as something akin to physical gold that can magically be transported over the internet. Its stock-to-flow ratio will in time move to above that of gold, which is probably something that needs to happen for the world's wealthy to even consider shifting much wealth to it. A harder money, a safer money, a more transportable money - these are the magnets that pull wealth in silence. When such a shift occurs with serious volumes, people will properly understand the sheer size difference between the two protocols; a mere 2% wealth shift from gold would in terms of USD be the same as more than a 100% Bitcoin value appreciation. A mere 0.2% shift of global broad money would have an even larger effect. Bitcoin is small.

Protocol Competition

What Bitcoin does have that gold doesn't is invisible semi-antagonists in the form of other cryptocurrency protocols that in a similar way can mimic digital scarcity. Gold's protocol competition was formed by natural laws and we know well that other similar metals are easier to mine, or they fall short in other important physical properties like indestructibility. Bitcoin on the other hand has to compete in the area of decentralization - meaning anti-fragility - and it does it of course well. Bitcoin is the most decentralized digital currency there is and ever has been, and because of this, a network effect is organically built around this property.

This competition is interesting to speak about as it gives rise to protests and absolutist claims before a sentence is even finished. But as this analysis tries to map reality and is oblivious to hurt feelings, altcoins will be briefly discussed as well. What 'maximalists' of any blockchain fail to account for are both knowable idiosyncratic risks and unknowable black swan events. Some are absolutely right to be both on guard and vehemently tired of the ridiculous claims by teams developing some newer public chains. These claims often take the form of snake oil jargon like 'blockchain 2.0', 'blockchain 3.0' (I think I have even seen a 4.0 somewhere), 'the new Bitcoin' etc. No cryptocurrency is currently as good store of value as Bitcoin, and the fact that the market prices Bitcoin so high confirms that notion. The rationale for not putting all wealth allocated to cryptocurrencies on the Bitcoin-chain only, is that other more centralized blockchains may 'de-centralize', even though human nature usually runs contrary to such steps. Proof-of-Work might in the future not be as well functioning as it is today and Proof-of-Stake might not be the perpetual motion machine it is sometimes mockingly described as. Different utilized hashing algorithms might have different security implications. And the list goes on.

No one is yet an expert on all different factors that affect what decentralized cryptocurrency will ultimately end up as the main value protocol, but from what we know today, Bitcoin is by far the most likely contender. What is being built around Bitcoin today in terms of scaling is incredible and confirms this verdict. Diversifying a cryptocurrency portfolio, extremely selectively mind you and absolutely not pro-rata over a market cap index, is still the logical choice. It is the conclusion from two very simple reflections: the fact that sometimes bad, random and unlikely stuff happen, and the fact that diversification does not mean 50/50.