Posted on 17 December, 2020 by Rob Price for Sound Money Macro
“Do you believe bitcoin?” “Do you believe in gold?” This line of questioning makes it sound like there is something mystical or religious about these store of value assets. Yes, people talk about gold and bitcoin with religious fervor, but gold is precious for a reason and the same logic is applicable to bitcoin. The yellow metal was just so superior at storing value for thousands of years that we forgot the primary reasons. In this article I explain why assets with high stock-to-flow ratios, and strong network effects, store value. Store of value is a critical concept in your toolkit for understanding bitcoin – the store of value for the digital age – which will become the scarcest monetary asset in 2024.
Gold is Precious for a Reason
There’s a finite amount of gold on the earth. It’s difficult to find, expensive to mine, durable, divisible and it has developed powerful network effects*. These qualities created an asset that stores value over periods of time. Gold is too valuable to use for “useful” products like a car, or phone or laptop because the technology in these products goes out of date. It’s expensive to extract the gold from the phone when we upgrade so we don’t use gold for disposable products. Rather, we use gold for ornamental objects that won’t be “upgraded”. This allows us to store value in them through generations.
*Network effects is the only non-geological or intangible property. In the process of acting as a store of value, a trading network emerged for gold. The trading network is, in of itself, powerful. Its useful that you can take your jewelry to a pawn shop and they will want to buy it from you. This isn’t necessarily the case with other commodities. It’s difficult and time-consuming to find buyers for obscure commodities, even if they’re valuable (like artwork). Certain precious metals are rarer than gold, but they aren’t great stores of value because they don’t have the network effects.
Stores of Value have high Stock-to-Flow ratios
Gold is superior to other commodities as a store of value, which is displayed in its stock to flow ratio (thanks to Ronnie Stoeferle at Incrementum for the chart). We eat grain, we burn oil and we consume copper so the annual flow (or supply) is large relative to the amount of stock in the world. We can store these commodities but it’s expensive because they take up space and they may perish/corrode; hence they aren’t good stores of value. High stock-to-flow assets don’t corrode nor perish and their value cannot be inflated away by a large increase in new supply (flow). Gold miners cannot produce trillions of tones of gold in the next year, just because the price hit an all-time high in 2020. They have to find new deposits, build the mines, develop the infrastructure and will only start pulling new gold out of the ground in years to come. So, the influence of supply on the value of gold is low, which is a desirable characteristic for a store of value.
The graph is additionally insightful because silver or “poor man’s gold” has the closest monetary characteristics to gold. Silver functions in between gold and industrial metals. We use silver for some more “useful” goods like cutlery and crockery, but it also has an ornamental, store of value quality. We know silver retains its value better than stainless-steel cutlery and don’t use it every day as a result. We don’t use silver to create cars, phones and laptops but we use it for watches, everyday jewelry and some specialised equipment which we’ll hold onto for years to come. I.E. The higher the stock-to-flow, the more precious the commodity, the less incentive to use it for consumption purposes and the more incentive to store value in the object itself.
Bitcoin will become the scarcest monetary asset in 2024
Bitcoin is the store of value for the digital age. Its supply is entirely pre-determined and supply growth halves every 4 years so the stock-to-flow ratio increases over time. In 2024 bitcoin will have a higher stock-to-flow ratio than gold. Bitcoin will become the scarcest monetary asset at this point.
Bitcoin’s network effects are strong & growing
Looping back to network effects before we wrap up; high stock-to-flow isn’t the only store of value quality. Network effects are important, just like gold’s global network effects. There are crypto currencies with higher stock-to-flows than bitcoin, but they don’t offer network effects and thus aren’t valuable.
As of mid-Dec 2020, bitcoin has >$370bn worth of capital allocated onto the network. This is small relative to gold at $10tn but it’s fast growing into a deep and liquid financial market. Exchanges are active 24/7 in most countries around the world so you can buy or sell bitcoin at the click of a button in reasonably large quantities, which is a pretty powerful network effect.
In Proof of Work algorithm blockchains the computer processing power allocated to the network is an indication of the hashing power. Bitoin has about 134 million terra hashes per second (TH/s) worth of power committed to securing the network. State-of-the-art specialised mining equipment produces about 110TH/s and costs around $4000. From a rough back of the envelope calculation, that’s approximately $4.9bn worth of capital invested into securing the network.
So, while bitcoin is small enough to offer significant upside price potential, substantial network value already exists which boosts its store of value credentials.
Stock-to-flow combined with network effects, determine a commodities’ ability to store value. There is nothing mystical about gold’s ability to store value for thousands of years. You don’t need to ‘believe’ in the technology to invest in it, you just need to understand it. Gold stood alone as the world’s best store of value because of the highest stock to flow ratio and strong cultural network effects. Until bitcoin! In 4 years’ time, bitcoin will become the scarcest store of value network in the world. There are all sorts of critiques one can level at bitcoin and potential risks, but that is an impressive technological feat! For as long as bitcoin works in the way it has, it will compete as the world’s chosen store of value.
Banner photo by Anne Nygård on Unsplash
