Tuesday, November 08, 2011

Bitcoin: Gold of the Future

Six months ago, while visiting San Francisco, I met a successful entrepreneur for dinner to discuss and trade Bitcoins.  He had recently sold his most-recent startup to one of the Big Four.  I assumed he viewed Bitcoin as a startup and wanted in on the ground floor.  It turns out, he was a goldbug whose main interest was Bitcoin as a "better gold."  It's one of the more productive analogies offering some insight into how Bitcoin might develop.

Viewing Bitcoin as digital gold is not a new idea.  Satoshi Nakamoto, who created Bitcoin, says it is partly an implementation of Nick Szabo's bit gold proposal.  Satoshi also uses gold analogies to describe the economics of Bitcoin mining and Bitcoin's adoption as a currency.  I'll draw some further parallels.

Why Gold?

Gold has been used as a currency and store of value for thousands of years, so it has history on its side. It's fungible, durable and easily recognizable.  The supply is moderately predictable and, because of relatively low industrial use, the demand is somewhat more predictable than other precious metals.  The supply grows slowly (about 2% annually).  Gold also has a high value density, being one of the most expensive commodities per weight.  When holding physical gold, there is no counter-party risk, unlike bonds and fiat currencies.

Why Not Gold?

Gold isn't perfect as a currency or store of value.  As a physical good, it must be conveyed with expensive, secure transportation.  Surprise discoveries can dramatically affect the supply.  For instance, 12 million ounces of gold entered the market during five years of the California Gold Rush (sea water contains another 15,000 tons of gold deposits).  Gold can also be destroyed in accidental fires or lost at sea.  Although industrial demand is lower than other commodities, roughly 60% of newly mined gold becomes jewelry.  Changes in jewelry demand can have substantial effects on gold prices.  Some argue that gold mining also has non-trivial environmental costs.

Why Bitcoin?

Bitcoin has nearly every strength that gold does.  Bitcoins are fungible.  They're easily recognizable (by Bitcoin software) and durable (with reasonable data backups).  The supply is almost perfectly predictable.  Bitcoin has no industrial or jewelry uses so demand is less affected by economic conditions.  It possesses almost arbitrary value density.  A single microSD card, weighing 1.5 grams, could hold millions of dollars worth of Bitcoins, if desired.  As a digital commodity, Bitcoin is also immune to counter-party risk.

Many of gold's weaknesses are Bitcoin's strengths.  As a digital good, Bitcoin can be transported securely and cheaply to nearly any location in the world instantly.  The Bitcoin network adapts rapidly to maintain predictable supply in the face of surprise mining advances.  Assuming good data backups, Bitcoins aren't destroyed in a fire and won't be "lost at sea."  Electricity used for Bitcoin mining offers a substantially lower environmental footprint than gold (a subject for another article).  Bitcoin's impact is low enough that an environmental group opposed to gold mining advocates Bitcoin as a replacement for gold.

Why Not Bitcoin (Now)?

If Bitcoin is so much better than gold, why aren't we all using it?  One of gold's major strengths is that it has stood the test of time.  Through thousands of years, it has shown itself a resilient store of value and a useful currency.  Bitcoin has less than three years under its belt.  If Bitcoin were gold, we'd still be in the early stone age carrying gold flecks in a leather pouch.  There aren't any assay offices, there aren't any minted coins, there aren't massive mining operations or liquid futures markets.  There are still doubters claiming they can one day turn lead into gold.  With real gold, those issues were settled long ago.  With Bitcoin, those issues are still to be settled and might never be settled at all.

Even if Bitcoin had a lengthy history to support its utility and resilience, the current inflation rate stands around 35% annually (similar to gold-rush-induced inflation in the 1850s).  In 2017, the inflation rate will drop below typical fiat currencies.  In 2021, it will finally drop below gold's production rate.  Unless you have a long time horizon and a high risk tolerance, right now is not the time to buy Bitcoin.

To date, the world has mined 5.3 billion troy ounces of gold.  Dividing the US M2 money supply by that number, gives a price for gold of $1,792 per oz, within a few cents of today's gold spot price.  To date, the network has mined 7.624 million Bitcoins.  A similar calculation yields a price of $1.24 million per Bitcoin. When all is said and done, there will be somewhat less than 21 million Bitcoins in existence (through carelessness, some have been lost along the way).  Even at that volume, the calculated price would be $452,000 per coin.

Like the '49ers of old, we began this discussion in San Francisco.  I'm not saying the parallels are exact, but having a few flecks in a leather pouch sounds like a reasonable idea to me.


Jon Matonis said...

I think the $1,792 might just be a coincidence. There are several methodologies for imputing gold price. Another calculation takes total central bank foreign exchange reserves divided by total gold holdings of said central banks, which implies a gold price of $11,000. See, http://www.beaconequity.com/smw/13754/Goldmoney-s-James-Turk-11-000-Gold-Price

Calle said...

The price of gold has nothing to do with dollars outstanding (a decade ago, gold was selling for under $300). Otherwise, I agree Bitcoin is an improved (digital) version of gold:

* http://cs702.wordpress.com/2011/09/28/a-brief-note-on-krugman-on-bitcoin/

* http://cs702.wordpress.com/2011/05/29/on-the-potential-adoption-and-price-appreciation-of-bitcoin-in-the-long-run/

Travis Hendricks said...

With no short term requirements on my end it seems like I picked a good time to get some Bitcoin. Let's hope it works out.

akreider said...

Bitcoin is open source. Anyone can create a new identical virtual currency (and many are trying). Supply of these virtual currencies (and thus the potential for inflation) is unlimited.

Bilbo Shwaggin's said...

Anyone could create as many Internet's at they want too.

Erik Voorhees said...

Bilbo +1

Matt said...

@akreider: Your argument is specious. If what you're asserting were true, then Russia could cause inflation in the U.S. Dollar by printing more Rubles. After all, by your logic, since any country can create massive new supplies of fiat currency, the global supply of fiat currencies (and thus the potential for inflation) is unlimited. Except it doesn't work that way. Each fiat currency is independent. If Russia were to print a trillion new Rubles, nothing would happen to the value of a U.S. Dollar, a Euro, a Yuan, etc. Similarly, if someone were to come along and "print" 20 million "BetterCoins," nothing would happen to the value of a BitCoin.

Jon said...

If you believe in bitcoin you can sell off your excess gold at Coinabul.com :)