To understand if Bitcoin is a currency, it is important to first define what makes something a currency, and secondly explain how Bitcoin correlates with traditional mediums of exchange. In this article, we will use economic fundamentals like the stock-to-flow ratio to understand how mediums of exchange become universally accepted as a store of value.
Put simply, currency is a medium of exchange for goods and services. For a currency to be accepted by others as medium of exchange, it must have the ability to maintain its value across time. Businesses and consumers are not willing to trade or accept mediums of exchange that quickly depreciate in value. If the currency can be easily replicated, or if large supplies compared to the existing quantity can be brought into the market, then the currency will lose all or most of its value. This can be best understood using the stock-to-flow ratio.
The stock-to-flow ratio describes a commodity’s (such as gold, livestock, fiat currency, etc.) years of inventory relative to annual supply. Put another way, how much of an item exists through being saved up over many years, compared to how much of this item is created, produced, extracted, or mined on an annual basis. You can expect items that are consumed frequently and lose value over time to have a low stock-to-flow ratio. For example, copper is used in manufacturing production, and can tarnish or turn green overtime. Businesses keep low inventory of copper, just enough to fulfill orders from copper manufacturers, because the value of copper as an asset does not typically increase over time, the functionality of copper diminishes over time, and there are costs associated with storing copper in warehouses. Therefore, it does not make sense to stockpile copper and keep large quantities of it, giving copper a low stock-to-flow ratio.
On the other hand, gold has a high stock-to-flow ratio. Gold does not tend to tarnish or rust, it is not used in manufacturing (apart from jewelry, and a select few other industries), and it is accepted as a safe store of wealth by society, so the value tends to appreciate overtime. For hundreds of years, humans have been stockpiling and saving gold as a store of value, rather than consuming it like we do with copper. This has created large reserves of gold throughout society. Also, gold is difficult to mine. As we deplete more of the earth’s gold reserves, it becomes harder to add more gold to the existing gold reserves (annual supply). For these reasons, gold has a high stock-to-flow ratio making it a more stable store of value.
Now, let’s look at today’s most commonly accepted currency: the government issued fiat bill. Since ending the gold standard in 1971, the US Dollar is not backed to any global asset. The United States Treasury Department determines how much supply of the Dollar will exist in the market. This government agency determines how much paper money to print each year (the annual supply). Printing additional money weakens the value of the dollar, and is the root cause of inflation. By printing more money every year, the buying power, or inherent value, of the dollar decreases. This is the reason people could purchase more items for $20 “back in the day.”
Society places a high level of faith and trust in the United States Treasury Department to be responsible stewards of our money. We hope that they will not increase the volume of newly printed dollars (annual supply), as that diminishes the value of the money that we have saved (years of inventory). The more money the government prints, the less our saved cash asset is worth. Typically, the USD inflation rate, or annual loss of value, is about 2% each year. This is a high enough number where people savvy in finance know to invest much of their cash in other assets such as stocks or real estate to help prevent against loss of value, but low enough where we can use the USD as a currency or exchange of value.
What would happen if the United States Treasury Department decided to double, or even quadruple, the annual supply of newly printed dollars?
Since a number of foreign governments have made this mistake before, we know exactly what would happen. The annual supply of new money would increase, lowering the stock-to-flow ratio. This would cause inflation to rise, leaving citizens with a dollar that has less buying power and inherent value. The money in your savings account that you have been adding to for the last twenty years from thousands of hours of hard work would immediately be worth less.
We have seen a history of governments acting fiscally irresponsible over the course of hundreds of years. From the devaluation of Roman Empire’s minted silver and gold coins by decreasing it’s purity back in 200 AD, to the hyperinflation of the German Papiermark in the 1920s, to the most recent collapse of the Venezuelan Bolívar that destroyed their economy, we see proof that governments have not learned from the negligent actions of those before them. While we can all hope this does not happen to us, we cannot prevent it.
BITCOIN IS A HEDGE AGAINST GOVERNMENT IRRESPONSIBILITY.
Now that we understand the traits of currency, let’s discuss Bitcoin’s role as a medium of currency. Bitcoin is a digital currency that operates on a decentralized peer-to-peer blockchain network. This means that Bitcoin is not issued through a bank, business, or government agency, but rather it exists and operates independently of any one organization. While the United States Treasury Department has the power to print as many US Dollars as they like, they have no control of how many Bitcoins are added to the market. In fact, no organization or individual can alter how many Bitcoins will be added into the market. While the intricacies of the system can be a bit technical, it is important to understand that there will never be more than 21 million Bitcoins in the market. For that to be possible, the number of Bitcoins introduced into the market overtime decreases through a process called the Bitcoin Halvening. Think of the Halvening as “reverse inflation.” Fewer Bitcoins are supplied to the market, rather than more. The key takeaway here is that there is an absolute finite limit to the number of Bitcoins that will ever exist in the market, and that the “annual supply” of new Bitcoin introduced is guaranteed to be reduced overtime.
Bitcoin is capped at a known supply of 21 million Bitcoins. This makes the asset truly unique, as the total supply for traditional currency mediums (gold, livestock, fiat) is not known. No other universally accepted currency has a known scarcity level like Bitcoin does.
While we can expect new supplies of gold to be generally consistent across time, we are not able guarantee a specified level of scarcity. For example, new technologies might make gold mining more efficient, therefore increasing the global supply of gold and decreasing the cost to extract gold from the earth. Or perhaps new areas rich in gold are discovered, and mining companies extract much higher than average quantities of gold, once again dimensioning the value of the precious metal. We could even experience a combination of new technology and better areas to mine. This might allow us to mine large gold reservoirs found underneath the ocean floor, or even on gold-rich asteroids found in space.
Government issued currencies are even more susceptible to fall victim to decreases in scarcity, and therefore value, than gold is. In order for gold to lose a considerable amount of value there has to be an event such as a technological mining innovation that is not likely to occur in the near future. Government issued currency is more vulnerable to an attack on the control of supply. With the ruling from just a handful of government officials, your savings are at an immediate risk of value due to overprinting and thus inflation.
Unfortunately, the majority of us store our value in the riskier government issued currencies (cash, savings account, etc), than we do in gold and other commodities with a high stock-to-flow ratio. We do this for different reasons, but one of the most common is that it is easy. When you purchase gold, you either need to store and secure the precious metal yourself, or pay a third party to do so. There are costs and risks associated with each, but this is a restraint that prevents many people from diversifying their investment portfolio into a globally backed store of value like gold.
Bitcoin has utilized technology to provide solutions for the risks and restraints that come with the more traditional stores of value. Bitcoin has a known quantity, making this finite resource uniquely scarce. With a limit of 21MM Bitcoins, this digital store of value has an extremely high stock-to-flow ratio. It will soon be higher than historical resources like gold, and it is much higher than government issued currencies. Bitcoin lives on a decentralized system, so no government or third party has the ability to increase the supply. Bitcoin can easily be stored, and is incredibly inexpensive to transfer to individuals all across the globe. Innovations with Bitcoin have taken our fundamental understanding about proper stores of value, and developed a more effective medium for storing value than what currently existed with precious metals, government bills, and other mediums of exchange.
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The MyCryptoCanvas Team
MyCryptoCanvas is not providing financial or investment advice. Consult a professional before making investments.