Is gold worth its weight in Bitcoin?

15 Nov

A question for my American readers: have you ever been watching a British drama on PBS or BBC America and wondered what the difference is between a guinea and a pound sterling? I used to think that “guineas” was just a nickname for pounds, like “bucks” and dollars. Turns out that the difference between guineas and pounds provides an almost perfect real world demonstration of Gresham’s Law (the subject of my last post) in action.

During the colonial era in America, Great Britain defined the weight of the shilling as 86 troy grains of pure silver, and its legal tender law established this coin as the basis of the British monetary system. Twenty shillings made a “pound sterling”. Britain also minted the guinea, a gold coin weighing 129.4 grains of .9135 pure gold. The valuation of the guinea relative to the shilling was set by British law, but was adjusted from time to time as the relative market prices of gold and silver fluctuated; for the purposes of this tale, we will look at the 1717 guinea, which was set by statute at the value of 1 pound 1 shilling (21 shillings).

Doing the math, we see that 118.21 (129.4 x .9135) grains of gold was set equal to 1806 (86 x 21) grains of silver. Thus the price ratio of silver to gold was established by British law at 15.28/1. All well and good, but unfortunately, the actual ratio of the market prices of gold and silver in the foreign markets where British goods were traded was somewhat less than this figure, meaning that gold was overvalued in Britain (and in America). In turn, this meant that Britain’s trading partners wanted to be paid in silver, and wanted to pay for British exports in gold. The result, bad money (gold) drove good money (silver) away from British shores.

So what accounted for this mismatch in prices? After all, gold and silver coins issued by an imperial government both function in exactly the same way. They are equally recognizable, equally portable, equally exchangeable, equally storeable. You need more shillings than guineas to make the same purchase, but that factor exerts a negligible effect on the relative demand for the different coins. The fundamental driver of the ratio of the free market prices of gold and silver coins was the relative supply of the two elements. When the combined weight of all of the silver in the British sphere was less than 15.28 times the combined weight of all the gold, the result was a drain of silver coin from the British isles. As a result, the empire switched from silver to gold as the currency standard in the nineteenth century.

In the twentieth century, gold and silver coins were abandoned as circulating currency (i.e. as a medium of exchange) by the nations of the world in favor of fiat paper currencies and base metal coinage. Once the United States defaulted on its obligations under the Bretton Woods agreement and later changed the statutory definition of the dollar to remove all reference to a fixed weight of gold, neither gold nor silver served as the unit of account in any part of the global financial system. Of the three defining functions of money, this left only the storage of value. Because of its lower price, silver came to be valued more highly in industrial applications than as bullion, so that most silver coin and bullion has disappeared. Today, the only remaining monetary role for metal is gold as a store of wealth, either in central bank reserves or in private hands.

For this reason, the traditional the price relationship between gold and silver, based on the relative quantities of circulating coins, which had varied in a narrow range for centuries, has now completely broken down. Silver today would probably command a higher price than gold if the price ratio depended on relative quantities of bullion. Some interpret this fact to be extremely bullish for silver, assuming that the price ratio must inevitably move in the direction of alignment with the ratio of physical bullion, or at least with the traditional ratio of around 15 to 1. But since silver is no longer in demand in any monetary role, there is no clear basis for predicting any particular ratio between gold and silver.

Let me pause to recap a few facts. We know that the price of anything is a function of supply and demand. We know that prices can only be comparable against a unit of account. We know that historically, at least for most of the last 3 millenia, the ultimate means of balancing financial accounts was by the exchange of quantities of an easily measurable characteristic of a scarce commodity, usually the weight (mass) of a precious metal. We know that when a specified weight of one metal is used as the unit of account, the market price of an equal weight of any other metal used in coinage stays very close to the ratio of the total available weight of that metal to the total available weight of the reference metal. We know that when an attempt is made to constrain the price of one metal relative to another, for example, by statute, the metal that is undervalued will either be exported or saved and will cease to circulate (Gresham’s law).

We also know that the policies of central banks supported by states have overthrown this regime and replaced it with a system of accounts maintained on bank ledgers, using paper tokens exchanged by hand or digital tokens exchanged electronically in the place of metal specie. Each major state establishes its own unit of account and its units of currency are the primary means of exchange within its borders. These major currencies are freely traded on global markets, and so a fluctuating exchange rate exists between each pair of currencies. And finally, the US dollar is the de facto unit of exchange for most international trade, primarily due to the relative strength of the US economy and the relationship with the Saudi Kingdom establishing the dollar as the single currency used to settle international trades in petroleum.

What can we glean from these historical facts to guide us in predicting the future dollar price of bitcoin? Obviously, neither dollars nor bitcoin are metals. However, bitcoin simulates the properties that make metals useful as money to a far greater extent than dollars. The main difference is in the limited and predictable supply of bitcoin. In addition, although bitcoin is exceptionally well suited to provide all of the essential elements of monetary utility, (unit of account, medium of exchange, and store of value), its level of acceptance at this stage allows it to compete in only one area, that is as an incorruptible and indestructible store of value. This is because the dollar is far too ingrained as the unit of account in the world’s financial systems to be overthrown on any time scale less than decades. And bitcoin is severely undervalued, not due to government fiat, but due simply to the lack of widespread acceptance. This undervaluation is precisely what makes bitcoin problematic as a medium of exchange but almost unbelievably valuable as a store of wealth.

So we have the following situation: despite the replacement of precious metals as money, there remains a vestigial demand for gold bullion, and to a much smaller extent for silver, as a store of wealth. There are estimated to be around 3 billion troy ounces of gold in the form of bullion or coins. At today’s market price in dollars, this comes to a little less than $4 trillion of demand for the utility of gold as a store of wealth. I personally see no reason why this demand for a secure means of storing and protecting wealth for future needs cannot be met by bitcoin as readily as by gold. You can refer to my earlier post (here) for my explanation of why the basis of the value of bitcoin is exactly the same as the basis of the value of metal bullion.

Right now, I could buy all existing BTC for a little over $5 billion (well, I couldn’t, but there are a few folks who could). This reflects the fact that practically none of the 7 billion plus people on earth have even heard of bitcoin, and the majority of those who have think it is a scam, a bubble, a money laundering scheme, a hack waiting to happen, or else they are simply too busy or too dull to make the effort to understand what it actually is and to grasp its potential. However, the tiny fraction of humanity who have taken the time to study and really understand what bitcoin is all about are grabbing it with both hands as fast as they can.

As one of these people, I can unequivocally state that there is zero chance that any significant fraction of us will ever be persuaded that bitcoin’s value as a savings vehicle is likely to decline in the long term. These are people, for the most part, who not only have an understanding of bitcoin, but also have much greater than average understanding of the current financial system and its weaknesses, particularly the utter worthlessness of the fiat dollar, under current Fed policy, for savings. There is some finite positive probability, given bitcoin’s exponential explosion into the world’s consciousness, that some of those learning about it for the first time, or those currently rejecting it, will also come to embrace it. So the demand for bitcoin solely in the role of digital bullion can only stay at current levels or increase. Thus;

Worst case – the demand for bitcoin as digital bullion remains about where it is and its dollar value fluctuates in the range of $100 – $1000 (in 2013 dollars)

More likely case – bitcoin splits the demand for bullion with gold at some level near parity and trades between $50,000 and $500,000 (in 2013 dollars)

Best case – the continuing spectacular increase in the price of bitcoin ultimately leads to total acceptance, so that it splits or captures the demand not only for bullion but for a medium of exchange, and becomes the defacto global unit of account. At that point, the dollar price becomes meaningless. If this has occurred by 2040, when the supply of bitcoin will be stable at under 2,100,000,000,000,000 Satoshi, and world population is estimated to be around 9,000,000,000, the per capita share of BTC will be 233,000 Satoshi.

Today, anyone on earth can purchase that amount of BTC for a buck, but the price is going up. I’d get started if I were you.

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