Bitcoin Value Knowledge
It is often puzzling that society has such confidence in the value of central bank fiat currencies, yet so little belief in bitcoin value. Granted, there are several factors that play into this line of thought, but a general lack of “financial literacy” is most likely the largest factor. Financial markets have become increasingly accessible to the “small investor” and consumer credit and mortgage borrowing has burgeoned. Alternative financial services like payday loans, pawn shops, auto title loans, tax refund loans, rent-to-own options, etc. are readily accessible and widely utilized. At the same time, responsibility for saving, investing, and retirement planning are increasingly thrust upon us – whereas, in the past, Social Security or employer-sponsored benefit pension plans were relied upon.
The ability to process economic information and make informed decisions when it comes to financial planning, wealth accumulation, debt, and pensions is considered “financial literacy” – and many are ill-prepared to endogenize financial knowledge. One has to think confidence in central bank fiat currency over bitcoin is one effect of financial illiteracy and wonder the cost of such financial ignorance for the future. Fully rational, well-informed individuals consume less than their income when earning is high, and save to support their needs when income decreases, as recently discussed in a previous post about “bitcoin time preference”. However, calculating and executing savings and spend-down plans takes more effort than in the past when such details were designed by employers and implemented by governments.
This begs the question can strong confidence in the value of fiat currencies vs. bitcoin be the result of fewer incentives to save, accumulate wealth, and invest in one’s financial literacy? To try and answer that question, let’s compare the properties of fiat currency, bitcoin, and gold to determine if bitcoin has become a viable option for a diverse portfolio.
Note: For simplicity, the reserve currency USD is used for fiat statistics in this post. A Reserve Currency is a one that is held in significant quantities by governments and institutions as part of their foreign exchange reserves. However, Bitcoin’s performance against all Reserve Currencies is important and it is a mistake to focus solely on BTC vs. USD.
Bitcoin Value Comparison
There are two major purposes of money; 1) store of value; 2) medium of exchange. Currencies that are a good store of value usually make poor mediums of exchange – good mediums of exchange are used globally but are questionable as stores of value. How a currency scores as a store of value vs. medium of exchange impacts its usefulness as a unit of account and standard of deferred payment.
Store of Value Properties
Fiat currency supply increases at the whim of the Federal Reserve, and there is nothing “scarce” about it when politicians can will more of it into existence. Bitcoin’s mining supply grew at an infinite pace in 2009 when the currency came into existence but has slowed and sometime around 2140, the last new bitcoin ever will be mined. The bitcoin market anticipates this, hence the extraordinary bull market in the digital currency. This contrasts with gold, whose price has been depressed by 94 million new ounces coming onto the market each year. Bitcoin is also impossible to counterfeit, as is gold – which can be authenticated even if melted down. But unlike cash or even a bar of gold, you can be certain the bitcoin you receive is real in a matter of seconds because it uses cryptography – the same branch of computer science and mathematics used to protect everything from electronic military communications to your bank’s online password.
Gold is limited, divisible, counterfeit-resistant and virtually indestructible by nature – whereas bitcoin has all those same properties and is also democratic, but by design. People who say Bitcoin is not a good store of value really would be more accurate to say it isn’t being adopted yet.
During the 14 years prior to the 2008 financial crisis, the Federal Reserve’s balance sheet grew by 5.6% per annum.
Money supply growth is determined by mining output, prices tend to vary inversely with degree of mining supply coming on line.
Money supply growth is determined by mining output, but the supply is limited to 21 million – and should be reached around 2140.
As with any commodity, physical Gold and bitcoin are subject to drastic price fluctuations. Market pressures drove the Gold price to historic highs between 2011 and 2013, exceeding $1,900 an ounce in September 2011. So Gold prices have responded to supply and demand, but fluctuations are less extreme than many other investment commodities, including bitcoin. However volatile, the reason gold and bitcoin are perceived as stores of value is simple: their money supply doesn’t grow quickly and, in the case of bitcoin around 2140 it will cease to grow at all. It’s worth putting aside some of bitcoin’s short-term volatility and liquidity concerns to compare them as long-term stores of value side by side. Future utility as a means of account, exchange and storing value suggest that bitcoin’s value, usefulness, and importance to society will only continue to grow as commerce becomes more digitized.
Gold is held in most portfolios as insurance because the value is generally stable most of the time, and can serve a specific purpose as needed – you buy it, hold it, and the value changes very little. Bitcoin, on the other hand, has large rises in price that can be highly profitable depending on the price at which it was acquired. By the same token, the price of bitcoin has fallen more than 10% in a single day dozens of times during the years it has actively been traded.
What many may not know is that Bitcoin was created in part as a reaction to the market panic and volatility of 2008 when investors saw fiat currencies pumped into the banking system to save those very banks that appeared to have caused the crisis. Bitcoin was created as a way to insulate savings from the political class and directly mimic the best properties of gold – without the downsides that make gold impractical to use in today’s digital world.
As for stability – it occurs (if it happens at all) only when everyone learns the favorable properties and knows that everyone else has learned those properties. Currently, people are only just starting to learn Bitcoin’s properties but are still very much confused about what other people know or believe about those properties. Therefore, fear and volatility remain. But whether you view Bitcoin as a legitimate currency, long-term investment, short-term trading asset, or a pure novelty – there are ways to profit from its current volatility. Simply exercising bitcoin cost averaging – buying small amounts daily, weekly or monthly – can help investors take advantage of price swings by smoothing out the average. Making gains then pulling out the initial money invested is a good way to stop worrying about daily bitcoin value. In any case, the volatility isn’t going to go away soon – and there are many who will profit greatly until it does.
Unit of Account
People do not generally take the term unit of account literally, but rather interpret it to mean having the ability to reliably measure wealth. In reality, prices change all the time so any unit of account can only be compared to other alternatives over a same period of time. If a unit of account is something profitable to acquire, but unprofitable to lose – it is a worthwhile asset. Liquid goods are used as a unit of account because it keeps people from having to think too far into the future. If you have a large amount of cash, you feel you’re in good shape for some time regardless of what happens. Without highly liquid assets, people have to think ahead so they can access profits and losses for the future.
If the currency used as a unit of account starts changing in value – an individual has to select a different medium of exchange to use. If you have an expectation that Bitcoin will be a liquid medium of exchange in the future it would make sense to be acquiring as much of it as possible now.
Medium of Exchange
“Currency is a medium of exchange, a unit of account. It is portable, durable, divisible and something called fungible. Fungible means that each unit is the same as the next unit. A dollar in my pocket buys the same amount as a dollar in your pocket. Money is all of those things plus a store of value over a long period of time.” ~ Mike Maloney
Gold is most certainly money and has been used as a medium of exchange and a store of value for millennia. But the world’s governments abolished the gold standard, a move that made the price of currency solely a function of politician’s ability to tax people in the future to pay back the money they borrowed today – by the stroke of the pen, or by “fiat”. Therefore, all currencies today are “fiat” and are eroded of value each year when the amount of it is inflated. This process taxes those who save by constantly subtracting value.
Fiat currency is anything but scarce and is issued by a central bank with the main purpose being a medium of exchange. But this is not the primary function of money – it should also be a store of value. In order to have value, there must be those who want bitcoins and want to store them. Clearly, there are such individuals because if everyone were spending their bitcoins the price would be driven down. Since the bitcoin value is going up, there are people who want to store them. Thus, the higher the bitcoin value, the more liquid bitcoins become and the more trade they enable.
Gold and bitcoin offer individuals options with controlled and predictable supply increases. Using bitcoin as a medium of exchange means individuals don’t have to wait for funds to be converted from one currency to another and therefore no money is lost to conversion fees. That said, given changes in bitcoin value mean purchase prices change, it is challenging to use it as a medium of exchange currently. It is too early to tell if Bitcoin will be a good medium of exchange because of the purchasing power has been so volatile. In reality, counting on any form of money is a gamble, so it may be wise to place multiple bets.
What assets to trust?
It is safe to say that the see-saw rise of Bitcoin tells us people are losing their trust in money and other traditional measures of wealth. Our current monetary system would crash if everybody attempted to withdraw money supposedly “easy to convert into cash” as the stock of physical money is insufficient to cover such withdrawals. Paper money is not backed by anything tangible like gold or silver and has not been for decades. Little wonder that trust has declined and more people seek to acquire and hold some amount of gold or silver.
If bitcoin is considered digital gold, then bitcoin as a global currency would be a move back toward the gold standard – a digital one. An important benefit of bitcoin as a global currency would be that it removes the need for faith in a central intermediary (government), and sets aside fears of future sovereign debt crises. In addition, the electronic transferability and divisibility of bitcoin make it a prime candidate for digital cash. However, there are large variations of possible outcomes and value, making bitcoin currently a speculative asset. Reasonably, it should be a small part of a well-diversified portfolio – one should not hold ONLY gold, fiat currency or bitcoin.
Financially, it makes sense to add a small number of crypto assets to your portfolio and rebalance regularly to improve risk-adjusted returns. Bitcoin has combined high returns with low correlations to other asset classes – making for a good combination in portfolio construction. It is potentially a good alternative to hedge traditional stock and bond portfolios, but should not be treated as part of a cash, currency or income generating portfolio because of the volatility. Volatility will be tempered by education, knowledge, technology, and mainstream-access solutions – but that will take time. Bitcoin has the required properties to become a reserve currency, and the more the world comes to understand this, the more stable it will become.
Gold and Bitcoin can be used to diversity and complement holdings of wealth. Historically gold does well when other currencies and markets weaken and is a good complement to the gains an investor can realize from Bitcoin. Now, imagine a gold coin with every gold transaction in human history written on it, and guaranteed to be 100% confirmed and unable to be changed. That is what determines bitcoin value – it is digital ownership with a transaction record back to the first transaction. If you buy a portion of a bitcoin in Italy from a seller in Canada, the private key for that portion is sent to the person in Italy for an agreed upon price. No third party is required for such a transfer, it is completely voluntary, and that all-important private key cannot be taken away from the buyer. Yes, the private key can be lost if the buyer exercises poor security measures – but that’s a topic for another post.
Banks, the military, businesses, and governments all use cryptography to secure money and information. With Bitcoin, cryptography is used to encrypt a wallet, make it impossible to use someone else’s wallet, or corrupt the blockchain with malicious transactions. Confirmations – about six, actually, that are mathematically impossible to reverse – are required to ensure transactions are recorded on the blockchain. The blockchain is a historical record that no one can change or rewrite. Just as it took centuries for people to accept paper over metals, decades to accept plastic over paper, it will take a few more years for digital to be accepted over metals, paper or plastic. If you believe that will happen, then you are part of what gives bitcoin value.