The millennial generation and later, as natives to the Internet, seem to register the utility of cryptocurrencies more than generations before them. As an inverse of this observation, older generations understand the utility of investing in and storing physical gold. The value of each investment derives first and foremost from its scarcity. In addition to scarcity, Bitcoin contains characteristics that liken it more to a payment network such as Visa and PayPal than a store of value asset. To add complexity, we now see borrowing and lending systems with Bitcoin collateral and the steady introduction of new regulations concerning its custody and classification. How do investors classify something with such unique and diverse qualities?
Although there is no straight answer, I offer a three-pronged solution to the question posed as the title of this chapter. First and foremost, Bitcoin is a decentralized payment network; or as Twitter CEO Jack Dorsey states, “the best manifestation” of a global currency native to the Internet.1 Due to its programmed scarcity in the face of fiat currency supply inflation, it also serves as a store of value. Any asset whose price appreciation outpaces the devaluation rate of the currency used to measure it can be said to sufficiently store value. Bitcoin, therefore, is also savings technology that allows you to store liquid dollars in a scarce protocol to avoid the Federal Reserve’s programmed 2 percent devaluation rate. Lastly, Bitcoin is software applied to the problem of money and can therefore be likened to a high-growth tech stock, though it cannot be valued as such.
Peer-to-Peer Cash
All online payments not on the Bitcoin network necessitate a trusted third party in the form of a bank or credit card company to process the transaction. These financial institutions verify these transactions and prevent fraud in a process that takes time and fees. The average cost for credit card processing is between 1.3 and 3.4 percent.2 Bitcoin, and blockchain technology in general, is revolutionary in that its decentralized nature eliminates rent-seeking behavior from those standing in the middle of value transactions. Bankers, lawyers, supply chain managers, and human resource representatives are all examples of professionals that will all be affected by this technology, whether they realize it yet or not.
The biggest issue with digital money has historically been double spending. This is where a fraudster spends the same digital token with multiple merchants. A trusted third party mediates transactions to prevent double spending of funds, but Bitcoin uses a distributed ledger system that records and confirms all transactions on the blockchain. While coins with digital signatures provide proof of ownership, a verifiable distributed ledger prevents the double spending fraud problem. Transactions are final once published on the blockchain, hence the cash aspect. Risks of a hack where an attacker owns over half of the nodes (a 51 percent attack) was a risk early in Bitcoin, but becomes less possible as its market capitalization reaches trillions of dollars. The more the network grows, the more secure it becomes. In addition to its near impossibility, hacking the Bitcoin network would undoubtedly crash its price. From a game theory perspective, the incentive structure of the network strongly discourages anyone from attacking it. All cases of Bitcoin fraud or hacks were really just phishing scams where the victim willingly gave up their private keys or sent funds to a fraudster. One is more likely to have his or her card information hacked from a company’s centralized database than from the Bitcoin network.
Lastly, traditional banking takes time in addition to incurring fees and third-party risk. While micropayments occur instantly, larger payments such as international wire transfers take between one and five business days to settle. It is faster to physically send large sums of cash via express mail than conduct digital transfers under the current system—a perplexing fact given the current state of technology caused by the fact that technology has never really challenged financial infrastructure. Bitcoin transactions occur instantly and the funds post in the several minutes it takes for blocks on the chain to approve the transaction. At its core, Bitcoin allows individuals to send value over the Internet without a bank or trusted third party. While technologically impressive, I admit that this itself does not serve as a large enough catalyst to create parabolic price action.
Bitcoin will not subvert the payments industry altogether anytime soon as the current system is not overly cumbersome. A rule of thumb is that adopting a new technology will usually require a 10× improvement on current technology. Most consumers are not likely to transfer their cash to the Bitcoin network to avoid time and fees because they do not regularly conduct large-scale, international wire transfers. However, understanding how scarcity dynamics in Bitcoin affects the price is the true selling point. Absolute scarcity versus an inflationary monetary system is undoubtedly a 10× improvement. The next section is likely the most important for understanding the current value proposition of Bitcoin.
Digital Gold
What drives value? The Austrian School of Economics contends that all things contain utility value, scarcity value, or a mixture thereof. The air we breathe has ultimate utility value in that we need it to survive; however, its abundance makes it worthless as a sold good. A market for air manifests itself once it becomes scarce. Take Delhi in India, the fifth worst polluted city in the world. Oxygen bars have popped up for customers to breathe pure air for 300 rupees, roughly 4 dollars, per 15 minutes.3
Gold is the quintessential scarce good. Roughly 190,000 tons of gold have been mined historically, while an average of 2,900 tons are introduced each year through mining. One will find slight differences in these figures depending on the source used. The stock of 190,000 divided by the annual flow of 2,900 gives gold a Stock-to-Flow (SF) ratio of 66. That is, in 66 years the current stock of gold will double. For comparison’s sake, silver has an SF of 22, platinum of 1.1, and palladium of 0.4. The obvious correlation is that the higher the SF ratio, the higher the market price due to a scarcity premium. Gold has served as a store of value for over 5,000 years because it has a limited supply and limited flows. It is the harder asset, with an inflation rate of 1.5 percent that is excellent compared to fiat currencies historically. The British pound, for example, has lost 99.5 percent of its value since its inception in 1209. A 13th-century British family could store their wealth in gold and still provide value to their relatives centuries later.
The argument in this section is as follows: if scarcity drives value, and scarcity can be measured by the SF ratio, a higher SF ratio means higher value (or price). Gold’s scarcity is unforgeable due to its chemical properties. Bitcoin’s scarcity is unforgeable due to its code. Bitcoin serves as a technologically enabled, perfectly scarce good. Except for the time we spend on this planet, perfect scarcity does not exist in the physical world.
To understand Bitcoin’s scarcity, we have to understand the mining process. A mining reward occurs roughly every 10 minutes, when a miner uses electricity and computational power to find the hash that satisfies a proof-of-work requirement. It is the equivalent to finding the solution to a complex puzzle. Instead of a gold mining operation with machinery and manpower, think warehouses filled with servers. The mining reward started with 50 Bitcoin and is halved every 210,000 blocks, or roughly four years. The mining reward at the time of this writing is 6.25 Bitcoin.
Price action tends to increase substantially following a halving event. Why? Because the incoming flow was cut in half, the SF ratio doubles. If demand remained the same and supply gets cut in half, price increases. If demand increases at the same time, which we have seen with Bitcoin’s adoption by CashApp, PayPal, Square, MicroStrategy, and retailers such as Microsoft, Whole Foods, and Starbucks, the price goes parabolic. Taking behavioral economics into account, increased price action also creates attention that attracts a growing investor and user base.
Bitcoin’s SF doubles every four years. Its current SF of 50 nears gold’s ratio of 66. Following the next halving event in 2024, Bitcoin will become more scarce than gold. The market capitalization of gold is roughly 9 trillion dollars. If investors own gold due its premium as a scarce store of value in the face of inflation or uncertainty, and Bitcoin will be more scarce than gold, it is possible that Bitcoin steals market capitalization away from precious metals. If Bitcoin attained a market capitalization of $9 trillion, the price per coin would be $500,000. In 2140, there will be no more Bitcoin to mine as the stock reaches 21 million. That means that Bitcoin will become the only asset in existence to achieve absolute scarcity. With an SF ratio of infinity, it will be the only investable asset as scarce as the time you spend on this planet. Its demand will increase as investors take note of its utility as a cheaper payment mechanism and a scarcer and more liquid store of value compared to physical gold, real estate, fine art, and so on. Programmed, decreasing supply couples with steadily increasing demand in what Bitcoiners refer to as “number go up” technology. Institutional finance is slowly catching on to the scarcity value proposition. However, retail investors have an opportunity to front-run the incoming wave of institutional money as regulations slowly become solidified.
Software Solves Money
This section delves into monetary history as well as the theoretical question of what is money. To begin with, the properties of money include divisibility, durability, portability, scarcity, and recognizability (its authenticity can be verified). Historically, the free market decided on the most acceptable money or form of payment based on these characteristics. Gold coins filled this function beginning with the Lydians in 700 BCE. Gold’s chemical properties make it durable and scarce. However, it lacked portability due to its weight and divisibility due to its requirement to be melted. Merchants would also have to confirm its recognizability with each purchase to avoid accepting gold alloyed with other metals. The divisibility problem led to the issuance of silver and copper coins as less scarce and therefore less valuable money. Meanwhile, paper money backed by gold, coupled with centralized gold custody at Central Banks, solved the portability problem.
Historically, governments entrusted with the custody of gold and issuance of currency have always violated that trust and funded wars or public deficits through issuing money in excess of their gold reserves. For governments, the alternatives to debasing the money supply include finding new forms of financing or simply limiting their expenditures. From 54 AD to 305 AD, the gold content of Roman coins was reduced by half.4 Centuries later in a similar tale, European powers left the gold standard in 1914 to finance World War I, and like Rome, lost their status as global hegemon soon thereafter. The story of the United States’ 1971 severance of gold for dollar convertibility is a tale as old as time.
The post-World War II Bretton Woods system pegged all currencies to the dollar while the dollar was pegged to gold. Up until 50 years ago, global economies agreed that gold is the best form of currency. As previously mentioned, in 1971, President Nixon severed the convertibility of paper notes into gold. Why? The United States had printed more money than they had gold reserves. In 1965, French President Charles de Gaulle sent the French Navy across the Atlantic to exchange France’s dollar reserves for physical gold. When Germany attempted to do the same, Nixon ended convertibility. This was in fact a default on the currency. The United States did not have the gold reserves to keep true to its promise of convertibility. This action compromised the scarcity of money. With no check on spending, deficits ballooned and inflation continuously eroded the value of money in circulation.
We currently straddle between two incomplete forms of money. Gold is durable and scarce, but not portable, divisible, or an accepted form of payment. It is a great store of value due to scarcity, but not an accepted medium of exchange. To test this theory, try paying for your groceries in gold coins. Dollars, or fiat currencies in general, are the recognized medium of exchange but a terrible store of value due to the ability of governments to print money without consequence—and print they do. By January 2021, twenty-two percent of all U.S. dollars in circulation were printed the previous year. The Federal Reserve prints money in order to avoid a deflationary collapse with the current amount of debt in the system. It also targets a 2 percent annual inflation rate. An achieved 2 percent inflation rate will lead to $1 becoming $2.59 in as little as 50 years. Chapter 3 will delve into why inflation targeting exists and why the present and future must involve more money printing than generations past. This inflation does not manifest itself equally among all goods and services. However, newly created paper money has no value. Instead, it takes value from the currency in circulation at the time, primarily hurting those with savings and fixed salaries.
Bitcoin is savings technology that solves the inflationary problem of fiat money. The current system punishes workers by continuously debasing their wages and grants exorbitant privilege to the government, banks, and corporations allowed to borrow at low or negative real rates. It rewards large debtors. Think of the interest rate as the cost of borrowing. The real interest rate is the nominal interest rate minus inflation. For example, if you took out a personal loan with no collateral at 9 percent interest, which is quite typical for the average borrower, a 2 percent inflation rate means your real rate is 7 percent. The biggest debtors of all are the U.S. government and large corporations. The U.S. government issues bonds to spend money it currently does not have and pays interest to the bondholder. The current rate on a 10-year treasury note is 0.93 percent. With a 2 percent target inflation rate, the real rate becomes 0.92 − 2= −1.07. That’s correct, inflation allows the government to continue its debt-based growth and spending patterns. In fact, they receive a premium when they issue debt. In Europe and Japan, the epitome of monetary policy run amuck, governments issue negative yielding bonds. The interest rate on AT&T’s 10-year corporate bond is 1.9 percent at the time of this writing, meaning AT&T and similar indebted corporations can also issue money for free. The toxic combination of low borrowing costs and inflation is essentially a tax on savers and employees with fixed wages to fund U.S. government and corporate spending.
Nominal yields may not remain at such subdued levels under conditions of a robust recovery or rising inflation fears. Additionally, the Federal Reserve does not directly dictate corporate bond yields. However, loose credit conditions set by the Fed reverberate through capital markets in their entirety. A policy set by the Federal Reserve of below free market level interest rates and above free market level inflation incentivizes the aforementioned dynamic of cheaply raising capital through debt issuances.
This system also rewards asset owners. Why would the price of stocks and real estate reach all-time highs in the middle of a pandemic, where millions of Americans cannot pay rent and small business are forced to close with a lack of cash flow? For one, the financial system needs inflation if it has any chance to service the debt and prevent a deflationary collapse brought about by higher debt service costs. It also needs appreciating asset prices because U.S. equity market capitalization is 160 percent of Gross Domestic Product and 200 percent of annual personal consumption expenditures derive from a combination of capital gains and taxable Individual Retirement Account distributions.5 Luke Gromen, Founder and President of the research provider Forest for the Trees, aptly states that in the United States, the stock market is the economy. If 65 percent of U.S. GDP is consumption, and consumption is inextricably linked to capital gains from a growing stock market, the Fed cannot afford for stock prices to go down without creating a recession in the real economy. Furthermore, the mechanism by which newly created money enters the economy means that it stays within the financial system and fuels asset appreciation first. A system that lifts asset prices while suppressing wages results in an ever-expanding wealth gap. Putting your savings in a scarce and liquid store of value allows you to opt out of the implicit savings tax imposed by economic central planners. That is why Bitcoin solves money.
Bitcoin also solves the exchangeability problem of physical gold. The list of merchants accepting it grows every year. Even if some major merchants never accept Bitcoin as a medium of exchange, its digital nature allows for a seamless transition to U.S. dollars, dollar-backed stablecoins, or whichever fiat currency the consumer needs. Contrast this to taking physical gold coins to a gold buyer in your local city or town, and one can see the benefits of digitization. Technological breakthroughs oftentimes solve a problem we did not know existed. With Amazon, we do not need to rely on physical retail locations to make purchases. With Google, we do not need to rely on books or encyclopedias to obtain information. With Apple iPhones, we do not need to rely on one device for calls and texts, one device for e-mails, and one device for music. With Bitcoin we do not need to rely on a dollar that will continually devalue as a matter of policy. Investors have a perfectly liquid market to store their dollars for future use. Though they currently have to convert it back to dollars for most transactions, this may not always be the case.
Conclusion
As readers can tell, the answer to the question posed at the beginning of the chapter is not a straightforward one. Bitcoin has qualities that liken it to a payment network, digital gold, and high-growth technology companies providing a valuable service. These qualities put together make it a valuable asset to have in the portfolio. As Chapter 4 will explore, we can use certain models to assign a numerical value. Bitcoin’s value proposition makes it an alternative asset whose rightful place belongs with gold, real estate, collectible art, technology stocks, and venture capital. It connects the age-old concepts of scarce money with 21st-century concepts of breakthrough technology. Once we see it as an asset worthy of our investment, the question arises as to how much to allocate. Again, the answer is nuanced and depends on an investor’s conviction and risk profile.