How Bitcoin attains the status of a good store of value

So it can be more demanded and eventually become a natural medium of exchange.

Can Bitcoin become a digital version of gold?

This is the third of a five-part series. Read here the first and second parts.

For Bitcoin to be perceived as a good SoV, the marketplace must understand and trust the soundness and resiliency of its value proposition as laid by the protocol’s core properties and rules. The immutability of its monetary policy (i.e., the hard cap of 21 million or 2.1 quadrillion satoshis) is a distinctive example of a protocol rule, along with its paramount (and paranoid) security and decentralization, all of which reinforce each other.

Solid protocol development means safeguarding these core properties through strict rule adherence. Developers, including core maintainers and other contributors, are part of this process and lead the technical implementation. However, developers alone do not, and should not, dictate the future of the protocol as users must play an essential role in molding and strengthening this ethos.

Strict rule adherence requires independent, dispersed, self-validating, and rule-enforcing nodes, which can only be guaranteed over the long run if the cost of running a full node remains modest. Compromising the ability to self-validate and enforce rules economically also compromises decentralization and, consequently, the principle of strict rule adherence.

Solid protocol development also means conservatism, including favoring backward compatibility and defending the doctrine of status quo primacy (e.g., in the face of a controversial change or contentious improvements, the status quo must remain). Adhering to this idea, Satoshi Nakamoto once wrote, “the nature of Bitcoin is such that once version 0.1 was released, the core design was set in stone for the rest of its lifetime.” The implications of this claim cannot be overstated, and it matches the premise of Bitcoin as first and foremost a SoV or digital gold.

For Bitcoin to attain the position of a good SoV, its core properties, especially its supply schedule and total cap, must be regarded as a law that is unbendable and eternally immutable, which is analogous to the laws that govern the supply and irreproducibility of gold. For if alchemists discovered a way to replicate the yellow metal and undermine its natural scarcity, then gold’s demand as a SoV would collapse with its status as a safe haven asset fading into oblivion.

The Alchymist, in Search of the Philosopher’s Stone (painting by Joseph Wright of Derby, 1771).

Considering gold, it is worthwhile to inquire why it has thus far withstood the test of time over millennia among distant and diverse societies? Why, still to this day, is gold desired by Central Banks around the globe comprising a significant portion of reserve assets while no currency in the world is officially backed by or redeemable in gold?

In the negative, it can be answered that it is not because it has lower transaction costs in the narrower sense than most media of exchange neither because it allows for unparalleled transaction capacity. It is definitely not because it is a better medium for effecting actual exchanges.

In the positive, no one is better qualified to answer it than Central Banks themselves. As published in a recent survey by the BullionStar blog:

“In their own words, the reasons central banks hold gold in large quantities are many fold. However, there are consistent themes in the central banks’ explanations. Many of the respondents cited gold’s ability to be mobilized in a crisis, that ‘gold holdings can be activated in an emergency,’ that gold is an ‘emergency reserve in a crisis,’ ‘a contingency against unforeseen events,’ a form of ‘insurance’ or, as the Bank of England says, ‘a war chest’ and the ‘ultimate asset to hold in an emergency.’ As such, nearly all central banks referred to gold as a safe haven asset.

Many central banks mentioned gold’s high liquidity, and some referred to the ability to use their gold to raise liquidity in a foreign currency, even for foreign exchange intervention.

Gold’s role as a hedge against inflation was cited in a number of the central bank answers, which explains why central banks look to the gold price as a barometer of inflation expectations.

Many of the banks also pointed out that because of the unique attributes of physical gold, such as limited supply and mined into existence, gold does not have any counterparty risk or credit risk, and because it is not issued by governments, it has no default risk.”

In summary, Central Banks around the world hold gold because it is a widely recognized SoV. All of gold’s other attributes follow from this assessment.

Historically, because gold was a good SoV and its scarcity could not be meddled with, it was demanded by individuals and commerce. As its liquidity increased, it gradually turned into a natural MoE until it achieved unsurpassed liquidity and was used as the UoA. But, due to its “un-scalability by design,” technology came to the rescue by providing different methods for paying with gold without having to move it around. Banks, bank notes (the forerunner to modern paper money, if we disregard the Great Khan experiment in the 12th century), deposit certificates, and payment networks through the banking system are all examples of carrying out transactions (off-chain) without physically handling the base money (on-chain).

Gold, thus, became the de facto monetary standard during various periods in history. Again, not because of lower transactions costs in the narrower sense, but because of its natural scarcity and its unforgeable costliness of production.

Bitcoin can only attain and sustain the status of a good SoV if it is governed with the same rigidity nature afforded gold, which requires base protocol properties to be as inflexible as gold. This might mean the protocol eventually ossifies in terms of non-backward compatible changes; this involves avoiding hard forks other than for critical or lethal emergencies. When the idea of SoV as the primary utility is embraced, hardening the protocol from contentious changes is seen as an improvement in itself.

Gresham’s Law and Bitcoin HODLers

When people have the choice of paying with good or bad money, people will always choose the bad money and hoard the good one. In other words, spend the overvalued money while holding on to the undervalued money. This idea is the gist of the famous Gresham’s Law that states, “bad money drives out good money.” However, this condition is only present when the values of each money are artificially fixed by law just as has happened throughout history with the prices of gold and silver.

“But, Gresham’s Law does not apply to competition between money of different denominations, the rate of exchange between which is currently determined by the market,” as economist Friedrich A. Hayek observed. “It is only when people have the choice of paying in either good or bad money that they will inevitably choose the bad one and keep the good one for other purposes.”

As a holder myself, I confess that spending Bitcoin is exciting, but it makes little economic sense today. (By the way, I tend to spend it much more when the price rises, contradicting the prediction of mainstream economists, but this is the source of another debate). Why would I get rid of a great SoV (according to my subjective evaluation) if I can spend the local depreciating fiat currency? Why would anyone spend an appreciating asset (or with good prospects to do so) instead of legal tender inflationary money?

Economists who suffer from apoplithorismosphobia would immediately reply that I am a living proof that a deflationary currency can never work as no one would ever spend it. However, this response misses a crucial aspect in voluntary exchanges: the choice of currency is not a unilateral decision. As long as one does not live in countries where forced legal tender laws are in place (such as my home country, Brazil, where it is a contravention to refuse payment in the local currency), then good money tends to drive out bad money because the seller has a say in an economic transaction. So, the seller may rightfully decline being paid in inferior money or insist on superior money. In nations with a track record of currency crises, citizens have historically resorted to good, old American dollars, especially in large transactions, such as real estate deals. In these cases, the seller would demand being paid in US dollars and nothing else. (Try to buy a piece of property in Uruguay with local pesos, if you don’t believe me).

For holders, the same economic reasoning applies. Today, if the seller is indifferent, then I won’t part with my coins; let him have local fiat money. But, if Bitcoin becomes increasingly viewed as a good SoV, i.e., as good money, then I won’t be as privileged and will spend my coins because the seller will not settle for a depreciating currency. In this sense, I argue that we need merchants to want to be paid in Bitcoin and not simply devise ways for them to accept it with no intention of ever holding.

Those urging incessantly for Bitcoin to be spent today seem to not understand sound money[1], legal tender or Gresham’s law.

Read the fourth part.


[1] For a great treatment of sound money and Bitcoin, see the book The Bitcoin Standard by Saifedean Ammous.