At a Glance
- Bitcoin has grown 6 million percent since its launch
- The digital currency could still be undervalued
An inherent tension exists between the two major purposes of money. Currencies that are perceived as great stores of value, such as gold and bitcoin, make for poor mediums of exchange. By contrast, currencies that are effective mediums of exchange, such as fiat currencies used the world over, can make for dubious stores of value. Where a currency falls on the store of value versus medium of exchange spectrum influences its usefulness as a unit of account and a standard of deferred payment.
Supply Scarcity and Stores of Value
As stores of value, many investors perceive gold and, more recently, bitcoin as second to none. Since 1971, gold has appreciated from $35 per ounce to around $1,300 at the time of this writing, a gain of over 3,500 percent. Bitcoins have done even better. On July 19, 2010, a bitcoin was worth $0.08. At the time of this writing, it’s priced close to $5,300 per bitcoin, a gain of over 6,000,000 percent in seven years. Not bad!
Whether gold and bitcoin really are stores of value is not universally accepted. Viewed from a fiat currency perspective, such as that of the U.S. dollar, bitcoin and gold are, to say the least, not without risk. Over the past 12 months, the annualized standard deviation of gold has been 12 percent. Gold had a 70 percent drawdown between 1980 and 1998. Compared to bitcoin, the gold market looks sleepy. Bitcoin owners experienced a 60 percent annualized standard deviation over the past 12 months and in the past, it has achieved a mind-boggling 175 percent annualized risk. Moreover, in its short life, it has already had drawdowns of 93 percent and 84 percent.
Drawdowns of such magnitude do sound crazy yet investors still allocate funds to other markets which have experienced large drawdowns. The U.S. equity market, which experienced an 89 percent drawdown between 1929 and 1933, from which it took until 1954 to recover. Since then, it has experienced a 47 percent drawdown in 1973-74, a 50 percent drawdown in 2000-2002 and a 60 percent drawdown from October 2007 to March 2009. Crude oil prices are currently 67 percent off their 2008 highs. The difference being, of course, that few investors would argue that stocks and crude oil are stores of value. Rather, investors perceive them as being risky investments.
However volatile they may be, the reason why gold and bitcoin are perceived as stores of value is simple: their money supply doesn’t grow quickly and, in the case of bitcoin not at all, some days. Both gold and bitcoin money supply growth is determined by mining output. Over the past half century, new gold mining supply has added anywhere from 1.1 to 2.4 percent to the existing stock of previously mined gold and gold prices tend to vary inversely with the degree of mining supply coming on line. This is much slower growth than the money supply of the U.S. dollar and credit. Even during the 14 years prior to the 2008 financial crisis, the Federal Reserve’s balance sheet, one of many proxies for the amount of money in the system, grew by 5.6 percent per annum. Since the fall of 2008, it has expanded by nearly 20 percent per year.
Cryptocurrencies such as bitcoin have very specific processes for expanding their money supply – mining by technology with strict limits. For bitcoin, most of the “mining” activity happens in China. The strict money supply rules mean that if demand grows, as it has, the price can soar, which it has. Some observers, such as economist and Nobel laureate Robert Shiller, have suggested that the rapid rise in bitcoin prices resembled a financial bubble. Nevertheless, Shiller also notes that from his perspective, gold has been in 5,000-year bubble.
Bitcoin’s mining supply grew at an infinite pace in 2009 when the currency burst into existence. This year it will likely slow to around 4.2 percent and then drop to below 2 percent per year after 2020. Sometime around 2140, the last new bitcoin ever will be mined, bringing the total to 21 million. The bitcoin market anticipates this, hence the extraordinary bull market in the digital currency. This contrasts with gold, whose price has been depressed by 94 million new ounces coming onto the market each year.
While bitcoin has delivered its holders spectacular, if highly volatile returns, what’s most amazing is how little it’s worth, even at $5,800 per coin. If one assumes that there will be 21 million coins in existence by 2140, that means that their aggregate present value comes to $120 billion. While it is nothing to sneeze at, it pales in comparison to the outstanding value of the nearly 5 billion ounces of previously mined gold whose total worth is over $6 trillion at current prices. Moreover, the 94 million ounces that will come out of the world’s mines in 2017 have a value of nearly $120 billion at current market prices, about the same theoretical value of all the bitcoins that will ever come into existence. While there is no logical reason to suppose that bitcoin should have the same value as gold, if it did, each bitcoin should be worth approximately $285,000, 45 times the current market price. As such, one might wonder: is bitcoin still vastly undervalued even after a 6,000,000 percent rally?
The existence of other digital currencies could limit price upside for bitcoin. Ethereum, Zcash, dash, ripple, monero etc. compete with bitcoin just as silver, and to a lesser extent platinum and palladium, compete with gold. This might keep bitcoin’s value in check before it rises another 10 or 100-fold in value.
Indeed, just in the past two years, over 1,000 additional digital currencies have been launched. One could argue that they actually are limiting the rise in bitcoin, whose price appreciation actually has slowed, at least in percentage terms. Even bitcoin itself has split (“forked”) into bitcoin, bitcoin cash and bitcoin gold as disagreements within the user community create new iterations of the original currency.
That said, two things argue in favor of bitcoin’s continued success: network effects and government regulation. Just as Facebook, LinkedIn and a handful of other websites or apps dominate social networking, it is possible that the incumbent currencies like bitcoin and ethereum could continue to dominate cryptocurrencies as well for the simple reason that they have large networks of users who accept them. Google’s attempt to invade the social networking space with its Facebook equivalent, Google+, didn’t turn out so well because the user community was already on Facebook’s platform (although Google, by all appearances continues to prosper in other domains). Analogous network effects could work to bitcoin’s advantage. If a large community of users accept it, they will be loath to move elsewhere unless a new alternative is truly compelling and not a mere copycat.