How a Bitcoin System is Like and Unlike a Gold Standard

Bitcoin standard, gold standard, bitcoin, gold, synthetic commodity money

Bitcoin standard, gold standard, bitcoin, gold, synthetic commodity moneyMany commentators have compared Bitcoin to gold as an investment asset. “Can Bitcoin Be Gold 2.0?,” asks a portfolio analyst. “Bitcoin is increasingly set to replace gold as a hedge against uncertainty,” suggests a Cointelegraph reporter.

Economists, by contrast, are more interested in considering how a monetary system based on Bitcoin compares to a gold-standard monetary system. In a noteworthy journal article published in 2015, George Selgin characterized Bitcoin as a “synthetic commodity money.” Monetary historian Warren Weber in 2016 released an interesting Bank of Canada working paper entitled “A Bitcoin Standard: Lessons from the Gold Standard,” which analyzes a hypothetical international Bitcoin-based monetary system on the supposition that “the Bitcoin standard would closely resemble the gold standard” of the pre-WWI era. More recently, University of Chicago economist John Cochrane in a blog post has characterized Bitcoin as “an electronic version of gold.”

In what important respects are the Bitcoin system and a gold standard similar? In what other important respects are they different?

Bitcoin is similar to a gold standard in at least two ways. (1) Both Bitcoin and gold are stateless, so either can provide an international base money that is not the creature of any national central bank or finance ministry. (2) Both provide a base money that is reliably limited in quantity (this is the grounding for Selgin’s characterization), unlike a fiat money that a central bank can create in any quantity it likes, “out of thin air.”

Bitcoin and the gold standard are obviously different in other ways. Gold is a tangible physical commodity; bitcoin is a purely digital asset. This difference is not important for the customer’s experience in paying them out, as ownership of (or a claim to) either asset can be transferred online, or in person by phone app or card. The “front ends” of payments are basically the same nowadays. The “back ends” can be different. Gold payments can go peer to peer without third-party involvement only when a physical coin or bar is handed over. Electronic gold payments require a trusted vault-keeping intermediary. Bitcoin payments operate on a distributed ledger and can go peer-to-peer electronically without the help of a financial institution. In practice, however, many Bitcoin transactions use the services of commercial storage and exchange providers like Coinbase.

The most important difference between Bitcoin and gold lies in their contrasting supply and demand mechanisms, which give them very different degrees of purchasing power stability. The stock of gold above ground is slowly augmented each year by gold mines around the world, at a rate that responds to, and stabilizes, the purchasing power of gold. Commodity (non-monetary) demands also respond to the price of gold and dampen movements in its value. The rate of Bitcoin creation, by contrast, is entirely programmed. It does not respond to its purchasing power, and there are no commodity demands.

Let’s consider supply in more detail. Secularly, annual production of gold has been a small percentage (typically 1% to 4%) of the existing stock but not zero. Because the absorption of gold by non-monetary uses from which it is not recoverable (like tooth fillings that will go into graves and stay there, but unlike jewelry) is small, the total stock of gold grows over time. Historically this has produced a near-zero secular rate of inflation in gold standard countries. The number of BTC in circulation was programmed to expand at 4.0 percent in 2017, but the expansion rate is programmed to fall progressively in the future and to reach zero in 2140. At that point, assuming that real demand to hold BTC grows merely at the same rate as real GDP, Bitcoin would exhibit mild secular growth in its purchasing power, or equivalently we would see mild deflation in BTC-denominated prices of goods and services. (Warren Weber’s paper similarly derives this result.) This kind of growth-driven deflation is benign, but the difference is small in real economic welfare consequences between a money stock that steadily grows 3% per year and one that grows 0%.

The key difference in the supply mechanisms is in the induced variation in the rate of production of monetary gold in response to its purchasing power, by contrast to the non-variation in BTC. A rise in the purchasing power of BTC does not provoke any change in the quantity of BTC in the short run or in the long run. In Econ 101 language, the supply curve for BTC is always vertical. (The supply curve is, however, programmed to shift to the right over time, ever more slowly, until it stops at 21 million units). By contrast, a non-transitory rise in the purchasing power of gold brings about some small increase in the quantity of monetary gold in the short run by incentivizing owners of non-monetary gold items (jewelry and candlesticks) to melt some of them down and monetize them (assuming open mints) in response to the rising opportunity cost of holding them and to the owners’ increased wealth. The short-run supply curve is not vertical. Still more importantly, the rise will bring about a much larger increase in the longer run by incentivizing owners of gold mines to increase their output. The “long-run stock supply curve” for monetary gold is fairly flat. (I walk through the stock-flow supply dynamics in greater detail in chapter 2 of my monetary theory text.) The purchasing power of gold is mean-reverting over the long run, a pattern seen clearly in the historical record.

Because its quantity is pre-programmed, the stock of BTC is free from supply shocks, unlike that of monetary gold. Supply shocks from gold discoveries under the gold standard were historically small, however. The largest on record was the joint impact of the California and Australian gold rushes, which (according to Hugh Rockoff) together created only 6.39 percent annual growth in the world stock of gold during the decade 1849-59, resulting in less than 1.5 percent annual inflation in gold-standard countries over that decade. For reference, the average of decade-averaged annual growth rates over 1839-1919 was about 2.9 percent.

As a result of the long-run price-elasticity of gold supply combined with the smallness and infrequency of supply shocks, the purchasing power of gold under the classical gold standard was more predictable, especially over 10+ year horizons, than the purchasing power of the post-WWII fiat dollar has been under the Federal Reserve. As I have written previously: “Under a gold standard, the price level can be trusted not to wander far over the next 30 years because it is constrained by impersonal market forces. Any sizable price level increase (fall in the purchasing power of gold) caused by a reduced demand to hold gold would reduce the quantity of gold mined, thereby reversing the price level movement. Conversely, any sizable price level decrease (rise in the purchasing power of gold) caused by an increased demand to hold gold would increase the quantity mined, thereby reversing that price level movement.” Bitcoin lacks any such supply response. There is no mean-reversion to be expected in the purchasing power of BTC, and thus its purchasing power is much harder to predict at any horizon.

Describing gold supply, Warren Weber writes: “Changes in the world stock of gold were determined by gold discoveries and the invention of new techniques for extracting gold from gold-bearing ores.” This is not well put. Changes in the world stock of monetary gold come about every year from normal mining. Gold strikes and technical improvements in extraction brought about changes in the growth rate (not the level) of the stock. Historically, the changes in the growth rate were not dramatic by comparison to changes in the postwar growth rates of fiat monies. As often as not, the changes in gold stock growth rates were equilibrating, speeding the return of the purchasing power of gold to trend from above trend. As Rockoff noted, some important gold strikes (like the Klondike in the 1890s) and some important technical breakthroughs (like the cyanide process of 1887) were induced by the high purchasing power of gold at the time, which gave added incentive for prospecting and research.

The phrase from John Cochrane quoted above is part of a sentence that reads in its entirety: “It's an electronic version of gold, and the price variation should be a warning to economists who long for a return to gold.” From the consideration of the mean reverting character of the purchasing power of gold, by contrast to Bitcoin’s lack of such a character, we can see that the second half of Cochrane’s statement is incorrect. The inelastic supply mechanism that produces price variation in Bitcoin should give pause to those who predict that Bitcoin will become a commonly accepted medium of exchange. It says nothing about the purchasing power of gold under a gold standard.

  • John Hall

    We already see articles about people regretting spending their bitcoins like 2-4 years ago. People don't want to spend deflating currencies.

    • M. Camp


      A few points.

      1. Bitcoin isn't a currency to any significant extent, so the fact that people wish they had held their bitcoin isn't relevant to the general question of whether or not people want to spend deflating moneys.

      2. Most of those who wish they had held it are exactly like people who wish they had left their chips on the table for a few more rolls when they see after the fact that the roller stayed on a roll after they cashed in. They acquired bitcoin as a gamble that it would increase in value, not for monetary reasons, and they wish now that they had gambled longer. Those same people, if they hold on to bitcoin the next time it crashes (as it did 5 times in 2017 alone) will "regret that they had HELD it".

      3. Those who wish they had held their bitcoin did not, for the most part, SPEND it, as you imply. They traded it for accepted moneys like USD, renminbi, won, Euro, and yen.

      3. BTW, people actually DO spend steadily deflating moneys. Demand for REAL (inflation-adjusted) money balances doesn't go away simply because the expected inflation is negative. To oversimplify, if you are a person who desires to have a 90 day supply of money, on average, given current income and expenses, you will keep a 90 day supply of money regardless of whether you expect inflation to be 2%, 0%, or -2%. There's a lot more to it, but just thinking about your own case in this way exposes the fallacy of "people don't spend if there is deflation".

    • Relative to consumer electronics, the USD had been deflationary. And yet, consumers have been very eager to repeatedly buy the latest electronic goods as opposed to eternally waiting for prices to stop falling. Here the correlation is opposite to what you suggest.

  • M. Camp

    Great article! Very informative.

    I've one quibble, with this:

    "The inelastic supply mechanism that produces price variation in Bitcoin
    should give pause to those who predict that Bitcoin will become a
    commonly accepted medium of exchange."

    Inelastic supply "produces" its instability only in the sense that if supply responded to its "purchasing power" (actually, exchange rate relative to world moneys) today it would be more stable.

    But inelastic supply doesn't produce instability in a MONEY, like gold before fiat moneys. Bitcoin isn't to any great extent a money, and that is why human goal-seeking is able to cause instability.

    Bitcoin-money exchange rates are unstable because they are driven largely by speculation, not by monetary transactions. If bitcoin becomes a money then it will be stable (ultimately, with slow price deflation, as you point out) for the same reasons gold was.

  • Mattheus von Guttenberg

    Great article. I was hoping to hear your opinion on the economics of mining and difficulty adjustments given that BTC miners cannot increase the rate of stock growth.

    One question/quibble as well: Why did you not include the discovery of New World gold reserves in Mexico, Hispaniola, Florida, etc. after Columbus' visit as a major inflationary event? As I understand, the new massive gold reserves that went into Spain directly contributed to the inflation and general price volatility for the next 50 or more years. Perhaps my history is wrong, though.

    There is also the case of Mansa Musa generating incredible inflation in Egypt when he donated unbelievable amounts of gold on route to Mecca as part of his pilgrimage in the 14th century. That is not an absolute increase in gold reserves, but a relative change – still, it is worth considering when discussing gold's stability as a currency in certain places.

    • Milton_Hayek

      The Spanish inflation last about 100 years and affected most of Europe eventually. But that was at a time when economic understanding was very crude, and holding gold and silver were equated with holding wealth. Spain bore the brunt of that inflation as surrounding trading partners raised their prices….

    • Andrew_FL

      As George Selgin has pointed out before the "Price Revolution" after Spanish gold & silver importation from the New World amount to an annual inflation rate of around one to one and a half percent. Not much of an event at all.
      At any rate while historically interesting, pre-globalization cases of large amounts of gold money suddenly becoming available to the world market as a result of first cultural contact is unlikely to be a significant phenomenon in the present or future.

      • Andrew_FL

        And actually, as George has also pointed out, the Price Revolution wasn't even all due to New World metal. A lot of it began with debasement by European monarchies, even before significant gold inflows from the New World.

  • Jason White

    Doesn't the cost of the electricity to mine Bitcoin provide the feedback mechanism to help stabilize it's value?

    • Milton_Hayek

      No. The supply increase restrictions built into BTC software protocol vs market demand dwarf production costs. Worse, electricity costs for most of the "mining" countries are government subsidized…

      • bvee

        if the computing power used to mine decreases, won't coins be found at a slower rate?

        • Milton_Hayek

          Mined, not found. Yes but that wasn't his question.

          • bvee

            i guess i don't understand the difference between mined and found

          • Milton_Hayek

            "found" presumes prior existence and subsequent discovery, as does "mined" in the traditional sense – "mining for gold".

            BTC creation for better or worse has been tagged with "mined" to describe the process for which massive computing power is used to maintain the block-chain, process related transactions etc and after which a certain amount of that sort of "work" is done, per the relevant protocols a single bitcoin is earned & brought forth by the software…

  • Milton_Hayek

    Great article. I've tried to explain in my own crude way the stabilizing effects on the gold supply of production costs and market price vs. BTC price volatility and fiat currency inflations, but I'll just link to this far superior exposition in the future…

  • Szabaka

    Perhaps someone has started this, please fill me in if true:

    The solution for the ease of use of a digital mechanism for transfer of value (i.e. money) with a known value (that is known with market fluctuations) is to have a blockchain attachment to ETF that are defined with ownership of metals (e.g. IAU, GLD, etc).

    The cost of holding and insuring the physical asset is thus already contained (the monthly extraction as presently done by these ETFs).

    Some mechanism would need to fund the blockchain network support (which could be a transactional cost in and out of the ETFs).

    This then pins the supply of that blockchain "currency" (effectively shares in the pinned ETF).

  • Michael Kendall

    Good discussion. The difference between gold and bitcoin is that gold acts as a monetary standard of referenced based upon its thousands year history of stability of value. There is no real demand for gold as a transactional currency, though it can act as one. This is how gold standards, when properly implemented, had a 300 year record of monetary stability without inflation or deflation–and would continue that record today if the world returned to a gold standard.

    Bitcoin is touted to become a universal, borderless, digital transactional currency. Meaning unlike gold, its demand will theoretically increase almost unlimited. And this is supposed to happen against a fixed bitcoin supply that is already about 80% mined. This is highly deflationary and completely unworkable. When has there ever been a fixed supply currency, or even discussion of one, in the history of economics?

    Regardless of what you think of Craig Wright and his history as Satoshi Nakamoto, his monetary views, coincidentally, are the foundation for all cryptocurrency. I examined Wright's monetary theory. It is seriously flawed, I would say bizarre, insuring that the initial experiment in cryptocurrency will fail.

  • bvee

    "The rate of Bitcoin creation, by contrast, is entirely programmed."

    i don't think that is true. the cost of mining is electricity – if the price goes down, fewer mine it.

    • When fewer mine, the proof of work challenge simplifies to keep the rate of bitcoin production constant. The only way bitcoin growth can deviate from its predicted course, is if nobody mines it.

  • What is currently seen is that as bitcoin valuation and network demand has soared, people expand their holdings into other cryptoassets. This effect is one mechanism whereby the price of bitcoin could stabilize, but those other assets trade independently of bitcoin and so result in several different units of account (if cryptos were ever to become actual currencies).

    But, off chain technologies permit variable expansion and contraction of a *single* unit of account. Like historic banknote issue when the unit of account was gold. And like banknotes, off chain technologies in, say, bitcoin can be competitive and beyond any authority in the development or digital networking of bitcoin. Unlike banknotes, off chain technologies can be fee-based rather than debt-based.

    For those of us who have been absorbed in crypto thought for the past months or years, we sometimes lose track of just how young the technology is, and like much technology, we get impatient for further advances. It is not even 10 years old yet, so we should consider it impossible to imagine what the crypto market will produce in the next 10.

    However, it is not hard to imagine decentralized solutions to current and future problems, including crypto base money rigidity.

    Bigger than any technical or economic challenge, is the legislative challenge. Any alternative currency in most of the world today is treated as a simple asset requiring documentation of gains and payment of taxes for each transaction, and in many cases obtaining the SSN/TIN of those you transact with. This may be an insurmountable burden for any protocurrency without widespread civil disobedience.