Bitcoin, Cookies and Gold: Why Scarcity matters
Developed countries in the world are looking to enter the second phase of the fight against the pandemic — the dance phase — and lockdowns are slowly lifted, yet, nothing seems like before. Numbers of unemployment are soaring and to finance all the government rescue packages, central banks have created more and more money.
One big fear that comes with all this money printing — even though we all agree that governments have to do something to help out their citizens — is high inflation. Most citizens of the Western World are familiar with small inflation and the rate that central banks aim to achieve is usually around 2%. This means that our money loses 2% of its value every year. This is not per se a bad thing for an economy, because it encourages investing and spending money better now than later.
However, when inflation rises to an unsustainable level, essential goods and services become unaffordable. Inflation also makes money an unsuitable store of value. If you want to save up for something far in the future then your best bet is to not keep it all in cash. Traditionally, investors have flocked to commodities like gold, oil or collectables like art to store value.
“What do antiques, time, and gold have in common? They are costly, due either to their original cost or the improbability of their history, and it is difficult to spoof this costliness. Precious metals and collectibles have an unforgeable scarcity due to the costliness of their creation. ” — Nick Szabo
As Nick Szabo rightly points out these commodities are expensive to create (or mine) which is why the supply annually created is limited. This scarcity is what makes them valuable. When something has a limited supply but is in high demand the price for that something increases. This is the invisible hand of the market.
Psychological effect of Scarcity
Scarcity also has an interesting psychological effect on us. In an experiment conducted in 1957 the researchers Worchel, Lee, and Adewole wanted to find out how the scarcity would influence which value participants would assign to a product.
In the experiment, participants were asked to value cookies in 2 different jars. In both jars the cookies were exactly the same — the only difference was the number of cookies. Some participants received a jar with just 2 cookies while other participants were given a jar with 10 cookies. It turned out that participants valued the cookies in the jar with just 2 cookies higher than the cookies in the jar with 10. Why’s that?
It seems that when something is more limited, it is more attractive to us. On top of that, context plays a huge role. What the jar with 2 cookies tells people is, that others have knowledge about these cookies that they don’t possess — e.g. these cookies are delicious and that’s why only 2 are left. I wonder if scarcity is one of the reasons why Mum’s cookies are always the most delicious.
Back to things that are better-suited stores of value than cookies.
Stock/Flow Ratio and Bitcoin
To put a numerical value on scarcity, economists utilize a ratio called Stock/Flow ratio. The stock/flow ratio is calculated by dividing the amount of a commodity held in inventories by the amount produced annually (the supply). It tells us how many years it would take at the current production rate to produce the supply currently held in storage. The higher the Stock/Flow ratio the more scarce is a commodity.
The commodity with the highest stock/flow ratio is gold with SF = 62 followed by silver with SF=22.
For a long time, gold has been the first choice for investors trying to store value over time. But now, we have Bitcoin. It’s not a coincidence that Bitcoin is often compared with gold.
Similarly to gold, Bitcoin has a limited supply of 21 Million Bitcoin once all of them are mined. This would barely be enough for every citizen in Burkina Faso to own one Bitcoin. To make matters worse (or better in terms of scarcity) more than 20% of Bitcoin supply is estimated to be lost forever due to traders losing their private keys or sending Bitcoin to wrong addresses.
“Lost coins only make everyone else’s coins worth slightly more. Think of it as a donation to everyone.” — Satoshi Nakamoto
Unlike gold, the amount of Bitcoin entering circulation each year is not steady, but steadily declining. In the first 4 years after the inception of the protocol miners still received 50 BTC for each block they created. Fast forward nearly 12 years later mining rewards are set to be cut down from 12,5 BTC to 6.25 BTC halving the supply entering circulation every year. While at a block reward of 12,5 BTC on average 657,000 BTC are mined every year, this will be dropping to 328,500 BTC. Consequently, the Stock/Flow ratio for Bitcoin will follow. It’ll increase from 25 to 50 which brings it closer to gold in those terms.
What will be particularly interesting for traders is, how this increase in Stock/Flow ratio impacts the price. As you can see on the chart below the bitcoin price (shown as colourful dots) seems to follow the S/F ratio in red.
Miners for one seem to be confident that the Bitcoin price will increase as their hoarding before the halving indicates.
Whichever side you’re on, if you think that the price will increase or decrease…or maybe you’re still convinced that Bitcoin is just a fad..For us to really know what the halving brings, we’ll have to wait and see. Anyone who tells you otherwise might as well start working as a fortuneteller.
And in the meantime, why don’t you have some scarce cookies? 🍪