Part 1: Digital gold - Bitcoin’s inflation hedge potential
Preface: This is the beginning of a 3-part series of longer form content. The series will introduce the theoretical theses for Bitcoin and Ethereum to become institutionally adopted assets and then unpack the causes and effects of the bearish reality that cryptocurrencies face today. If you are completely new to crypto you can get started here.
Pandemics and printers
In early 2020 the pandemic brought with it a dual supply and demand shock to the real economy which threatened to plunge the world into a global recession. Central bankers responded to this threat by aggressively pumping new money into the system to finance stimulus, push down interest rates and ultimately prop up their respective economies.
M3 money supply in the US (2017–2022)
Source: OECD
The above graph shows the M3 money supply in the United States; in 2020 alone the money supply increased by 26% over a 12 month period. Understandably, this information drove many people to allocate some capital towards investments which benefit from a devaluation of the dollar. Many chose Bitcoin, fueling an incredible bull run which saw the asset almost 10x within 12 months.
Is Bitcoin “good money”
Understanding why Bitcoin benefits from inflation and has potential to behave as a haven asset like gold requires an understanding of what it takes for an asset to be considered ‘good money’. In my eyes for something to act as “good money” and serve as an alternative currency it needs to exhibit the following properties:
- Store of Value — Maintains its value over time, usually requires a fixed supply
- Medium of Exchange — Accepted as payment for goods and services
- Unit of Account — Convenient to price goods and services consistently using it
- Portable — Simple to carry and exchange, digital being ideal
- Secure — Easy to protect, store and maintain ownership
So how do fiat currencies, gold and Bitcoin stack up against these criteria?
Bitcoin’s capped total supply and ability to facilitate digital transactions without relying on intermediaries gives it a compelling case to potentially become a haven asset much like gold is today.
Some poorly thought-out arguments against Bitcoin
Even if Bitcoin does seem like ‘good money’; introducing a new currency may feel like a wildly farfetched concept that could never gain mainstream traction. To counter this, it is worth acknowledging that currencies in general are not rigid, immutable structures which never change.
In Australia, our currency was gold-backed until 1932. It was then pegged to the Great British Pound Sterling (which for a time was silver-backed) until 1967; then it became pegged to the US dollar. It was only in 1983 that the Hawke-Keating Government ‘floated’ the Australian dollar making it a fiat currency. What this history lesson tells us is that currencies can evolve — and digital assets could therefore have some role in the future.
The old, “if you can’t see it or hold it, it can’t be real” argument is perhaps the least clever one going around. If you believe that statement, then I regret to inform you 92% of your money doesn’t exist by your standards. That’s because only 8% of ‘money’ as we know it takes the form of physical notes and coins — the rest of it is just digitally stored on a computer with nothing backing its value other than social constructs and our faith in government.
If you are a Bitcoin bear then parts 2 and 3 of this series will give you some more robust rationale than either of the above arguments. That being said, no haven asset is truly perfect.
Gold isn’t perfect
Historically gold was considered a haven asset due to it attractive luster, scarcity, and the fact that it could be stored and transported without deteriorating or rusting. In the modern world, gold’s inability to facilitate swift digital transactions has exposed a small, yet long term detrimental, weakness.
To pay rents, employees, and interest expenses businesses simply need dollars. Perhaps employees, property managers or creditors would accept gold as payment if it wasn’t for its physicality making it an inconvenient form of money. Physical gold is costly to physically transport, trade, and store; and digital ownership or derivative positions cannot be transferred without either relying on third parties or exposing one to counter-party risks which are not immaterial during liquidity crunches. All these factors make gold difficult to protect and transact with, which is why during serious economic or financial shocks it is common for gold’s price to become volatile as cash-strapped businesses liquidate their gold exposure for dollars.
The gold price chart below shows a clear example of this in practice during the peak of the COVID liquidity crunch.
Gold price during 2020 liquidity crisis
Source: Trading Economics
This is not to say that gold doesn’t perform admirably as an inversely correlated asset, it clearly does, but the reasons why this is so seems to be largely due to behavioral finance rather than gold having genuine utility. Behavioral finance tells us that if enough people think gold is the right investment during turbulent times, then speculative demand will trigger a self-fulfilling prophecy which does indeed make it a great investment during downturns.
However, history is starting to show gold fails to act as a liquid medium of exchange and therefore becomes very volatile during genuine crises (albeit in the short run). How long then can we expect a speculative self-fulfilling prophecy to exist in relation to gold’s status as a haven asset?
Bitcoin would likely suffer a similar fate today if it was more often utilized as a haven asset given its adoption as an accepted medium of exchange is still low. The crucial difference is Bitcoin can provide digital payment infrastructure which is resistant to both civil and political crises. This gives it the ability to conquer the core shortcoming of gold.
The obvious counter argument is that gold is itself a useful commodity — implying a floor on its value. How could Bitcoin ever challenge gold if there is always natural demand for the commodity? To address this, let’s look at the demand drivers of gold.
Gold demand drivers (% of tonnage)
Source: World Gold Council
Depending on the year, bars and coins, exchange-traded funds (ETFs) and Central Banks — all different forms of speculative or investment driven demand, account for between 43–56% of gold’s demand. One could even argue that some of the 36–49% of gold’s demand which comes from manufacturing jewellery could also be considered partially speculative. After all, if you are going to hold some physical gold you may as well make it stylish.
The reality is gold derives a substantial amount of its valuation from speculation and hedging. If it’s image as a haven asset were to deteriorate gold’s demand could be slashed by 50%; but more importantly, if 50% of gold’s demand is a result of financial constructs — then it is not unreasonable to assume another assets valuation could be driven entirely by social acceptance.
Given that Bitcoin has such a compelling case to act as a haven asset, the disparity between gold and Bitcoin’s market caps either presents a flaw in this thesis (stay tuned for Part 3) or an outstanding opportunity.
Market cap. of Bitcoin and gold (trillions of USD)
Source: 8marketcap
Even if we just take the 50% of gold’s market capitalization which we can attribute to speculation and investment — its speculative market cap of 6T USD is still over 8 times as large as that of Bitcoins.
If you believe in the ‘digital gold’ thesis which is outlined above, then you’d expect that as more institutional money comes on board with the idea of Bitcoin acting as ‘digital gold’ there could be a substantial rotation from gold into Bitcoin. This is the most common justification used by research houses and investment banks when they spout their 6-figure price targets for Bitcoin.
But is Bitcoin the best digital asset out there?
Coming Soon
Part 2: Digital oil — Stay liquid with Ethereum
Part 3: Digital volatility — The harsh reality of the crypto casino
Disclaimer: None of what I write is intended as financial advice. All opinions represented are my own and are presented solely as an attempt to timestamp my own thinking or provide entertainment. Do not act on or interpret any of my content as financial advice.
Twitter: @isthatPatJaffe
Join Coinmonks Telegram Channel and Youtube Channel learn about crypto trading and investing
