December 2018 Commentary

May 4, 2020

Bitcoin continues to be in bear market, as the technology around it is improving at remarkable pace. Lighting is the second layer solution on Bitcoin base layer network for small payments. Twitter CEO, Jack Dorsey, recently announced that he is exploring the idea of enabling lightning payments in order to tip people when you like someone’s tweets. In the same interview, he announced that he has plans to integrate Square app also with lightning payments.

As I got more interested in bitcoin, starting from 2014, I kept thinking about lot of questions which never crossed my mind in my entire life. These questions are,

  • What is money?
  • What characteristics produce sound money?
  • How does money evolve in the human civilization?
  • What factors contribute to the development of sound money?
  • What role has government played with fiat money?
  • How does the free market choose any commodity as money?

Austrian economists like Ludwig Von Mises, Murry Rothbard, F.A.Hayek and Guido Hulsmann have written extensively about these topics. One of key ideas described by these economists is that having more cars, more wheat, more corn and more health services etc is good for the society. These are known as consumable goods. They don’t have any other purpose other than being consumed. These consumable goods are exchanged for monetary goods. Monetary goods are accepted by the society for its ability to carry the value of the consumable item across space and time. People use up consumable goods while they hoard monetary goods in order to exchange them for other goods or services over time. The society is more prosperous when it increases its consumable goods. Society does not get richer simply by making more of monetary goods, whose sole purpose to is to store value across time and space.

Before we had fiat currencies, soundness of the money is determined by the natural properties of the stuff we have used as money. The amount of gold on earth is limited by laws of physics.Over several millennia gold has beaten all other commodities to reign supremely as the monetary good of the human civilization. The commodity which has the highest stock-to-flow ratio (StFR) is alway chosen as the best form money by the free markets. This ratio is defined as follows.

Stock-to-flow ratio    = 

There is a clear difference between commodities, which can be explained by a consumption model (e.g. crude oil, copper, agricultural commodities) and goods that are bought in order to be held (gold, diamonds, works of art). While the economic utility of a consumable good is created when it is destroyed or used up, the utility of investment assets lies in their possession and later resale. Industrial commodities therefore have low stock-to-flow ratios, this is to say, inventories usually only cover consumption demand for a few months. If there were no inventories at all, supply would have to correspond exactly to production and demand exactly to consumption. However, if there are inventories, consumption can temporarily exceed production. Since inventories of consumable commodities are as a rule very low, prices will rise quickly in anticipation of a future supply shortage and bring consumption into balance with production.

Unlike consumable commodities, gold and silver exhibit a large discrepancy between annual production and the total available supply which is a high stock-to-flow ratio. The entire amount of gold ever mined totals approximately 190,000 tons. That is the stock or numerator in the equation. Annual production was about 3100 tons as of 2017. That is the flow. If one divides the two amounts, one arrives at the stock-to-flow ratio of currently 64 years. In other words, the inflation rate of gold is around 1.6393%, which is the inverse of 64.

Gold isn’t as valuable because it is so rare, but quite the opposite: Gold is valued so highly because annual production relative to the existing stock is so small. If someone stores their wealth in gold, it is difficult for someone to dilute its value no more than 1.6%. When various commodities compete to become a form of money in a society, the money which has the highest StFR ratio always wins. It is because it is not convenient to have multiple forms of money in a society and people will naturally tend towards the best store of value. Usually the best store of value, is one which inflates the slowest or highest StFR.

As we have seen through out human history that if humans control money supply and they will definitely print more of it. We have hundreds of examples of failed fiat currencies. We can observe one in real time, which is currently happening in Venezuela. Bitcoin does away with the temptation to print money in an ingenious way. Satoshi was aware of our greed and fallibility-this is why he chose something more reliable than human restraint: Mathematics.

In the formula above, as time passes, every 4 years, bitcoin supply becomes smaller and smaller.  Block reward started with 50 bitcoins for every block and halves after every 4 years. The next bitcoin halving is expected to happen in the first quarter of 2020. Since the supply of bitcoins continuously reduces leading to the denominator, ‘flow’ to reach close to zero. After the year 2140, this number makes the StFR ratio to be infinity.

Currently in the year 2019, this is ratio is close to 3.8%. Once the next bitcoin halving happens in 2020, this ratio suddenly drops down to 1.9% and over time it naturally becomes the hardest money ever invented, as no one can beat a fixed supply.

Rising stock-to-flow ratio of bitcoin when compared to Gold

In the initial years, the inflation rate of bitcoin is very high, even higher than some fiat currencies in the world. The world has never seen any fungible object as scarce as bitcoin, let alone a currency. There are 36 million millionaires in the world today, but only 17 million bitcoins. If every millionaire wants to own 1 bitcoin, there is not enough to go around. Once people realize how scarce this asset is, it becomes a natural store of value. It will gain market share from precious metals, fiat currencies, bonds, stocks, derivatives and even real estate. Crypto Assets will slowly grow to be an asset class that will compete with all other asset classes.

Managing Partner