Bitcoin, Gold, and the Quantity of Mone

The popular view today is based on the linear Quantity Theory of Money. It seems to be common sense. If more units of a currency are issued, then the value of each unit should fall. Many people may not think of it in explicit terms, but the idea is that the value of one unit of a currency is 1/N, where N is the total money supply. If you double the money supply, then you halve the value of each currency unit.

Inflation, according to this view, is either the cause—the increase in the money supply itself. Or it’s the effect—rising prices. The Keynesians hold that inflation is good, and the Monetarists basically agree, though they quibble that the rate should be limited. The Austrians universally think inflation is bad.

The Quantity Theory is not based in reality. One should think of this theory like the Lamarckian theory of evolution.[1] Lamarck asserted that changes to an animal’s body—e.g. its tail is cut off—can be passed on to its offspring. At the time, this theory may have seemed only common sense, and it was very convenient, if not tempting. The same is true with the Quantity Theory of Money. It is convenient, seems like common sense, tempting—and wrong.

The Fed has been inflicting Quantitative Easing on us for five years. There are many negative effects, but rising prices, today, is at best debatable. Certainly, even where prices have risen, the increase is not nearly proportional to the increase in the money supply. Advocates of the theory explain this by saying that the money hasn’t entered the economy, it’s sitting on bank balance sheets. However, money is always on bank balance sheets in a debt-based system, so this answer is not satisfying.

Enter, bitcoin, a cryptography-based currency and technology developed by someone with the pseudonym Satoshi Nakamoto. It has been designed to have a limited rate of growth in the total quantity of currency, up to a predefined cap. There can never be more than 21M bitcoins. The Quantity Theory says that this will make prices of goods measured in bitcoins stable.

One problem with this theory is that the real costs in terms of land, capital, and labor to produce things is steadily falling. Every productive enterprise is constantly seeking to drive cost out of production. If a currency had a constant value, then prices in terms of this currency would be falling.

As we shall see below, the value of bitcoin will be anything but constant. Without a mechanism for responding to increased market demand by creating more currency, there is a fatal flaw.

In the real world, when prices appear to be stable it is not because anything is static or unmoving. It is because there is constant arbitrage. Arbitrage is the act of straddling a spread. If one thing becomes more valuable relative to something else, then someone will take the arbitrage. For example, if the price of eggs in a city downtown rises relative to the price of eggs in a farm town 50 miles away, then someone will buy eggs in the farm town and sell them in the city. This will lift the price in the farm town and depress the price in the city center, until there is not much of a gap any more.

To continue with the analogy on to another point, what happens if the price of eggs in the farm town is higher than the price in the city? This arbitrage is one-way. Distributors can only buy in the farm town and sell in the city; they do not distribute in the other direction.

There must be another arbitrage or arbitrages, if the farm-city egg spread is to remains stable. Indeed, there is. If the price of eggs gets cheap in the city, then consumers will prefer eggs to other foods.

In the body of a vertebrate, every joint is stabilized by a pair of muscles. Consider the upper arm. The biceps flexes it, and the triceps extends it. Muscles can only pull, but not push. There must be a second, opposing, muscle to move the joint in the opposite direction. This is analogous to arbitrage, as each arbitrage can only pull a spread tighter in one direction, but not push in the other.

No market is more important than the markets for money and credit.

So what happens when the price of money itself rises? In thinking about this question and the answer, you should not look at the dollar. The dollar is defective by design and does not work the way proper money ought to. The dollar is the product of fiat, not of a market. Everything about it is driven by forced wielded by the government.

It is more instructive to consider gold. Gold is produced by gold miners. They buy labor, oil, truck tires, machine parts, and they sell gold. As we saw above, they bid up these inputs and gold metal onto the market. The gap between the value of gold and the value of this broad swath across the major factors in the real economy is thus closed by the arbitrage of gold mining companies. This keeps the value of gold from becoming too high, or in other words allows gold to be produced in response to market demand.

What happens if market demand for gold drops? One reaction is that the jeweler and the artisan increase their activities. They tend to bid up gold metal, and sell jewelry and objets d’art onto the market. There is another kind of arbitrage, which is outside the scope of this article[2] but it’s worth mentioning. If the demand for gold metal drops, then the owners of gold, otherwise known as savers, can lend gold for interest. This tends to press down the bid on the rate of interest.

Now consider bitcoin. Bitcoin is not a fiat currency. No government forces anyone in any way to use it. However, bitcoin is irredeemable. That is, there is no agreement by anyone to redeem bitcoin in exchange for a defined quantity of gold, silver, or any real good. With its fixed quantity, there are no arbitrages regarding the value of bitcoin. So what does this mean? What will happen?

The value of bitcoin will be set entirely by speculators. In gold, there are numerous forces in reality—i.e. numerous arbitrages—that will keep the value of gold tied to the values of every other thing in the economic universe. The value of gold in a free market is the exact opposite of untethered and arbitrary. The value of gold cannot crash and it cannot shoot the moon.

Satoshi Nakamoto ignored these forces, and his design does not provide for them. The value of bitcoin is not tethered by the value of labor and capital. It was assumed to be sufficient that its quantity is fixed. It is the exact opposite of sufficient—a fatal flaw based on the Quantity Theory of Money, which is flawed to its core.

The speculators will use bitcoin as a toy to generate profits (as they already do). When the value of bitcoin is rising, it will be obvious. Everyone has a chart, and they can pile on. The value can rise much farther than anyone would expect. Eventually, the chart will show a topping pattern. Momentum will dry up. The speculators can see this too, and thus will begin a collapsing wave of bitcoin.

If a giant speculative spike occurred in food, the consequence is that poor people starve. When the price crashes, the consequence is that food producers will go bankrupt. As bad as this is, the consequences when the value of money spikes and crashes are incalculably worse. This is because every business, including food growers, depends on a stable currency.

To understand this, let’s ask the following question. If you take two bushels of corn and feed it to raise one chicken from egg to market, did you create or destroy wealth? Which has greater value, two bushels or one chicken? To answer, we use the common denominator of money. If Two bushels cost ½ ounce of silver and a chicken is 2 ounces of silver, then feeding the corn to the chick creates value.

Simple cases like this can be (and were, in the ancient world) resolved without money. Complex cases cannot be. If you borrow money to buy land, erect a building, buy machines and inventory, then hire people to manufacture computer chips, did you create or destroy wealth? This question cannot be answered without a stable unit of measure. It would not have been possible to answer it in the ancient world.

Businesses keep books to measure profit and loss. The very principle of bookkeeping depends on a constant value of the unit of account, the numeraire. When the value of the numeraire spikes and crashes, then business which produce wealth go can bankrupt. At the same time others, which destroy wealth, can grow larger, employing more people and more capital to scale up their wealth-destroying activities. This is occurring today on a massive scale.

Bitcoin may make a great speculation today, because its unique combination of technologies enables many transactions that would otherwise be impossible (due to government fiat). If you live in a country that does not recognize your right to freedom of speech, you can trade your local currency for bitcoin, pay WordPress, and have your blog hosted safely outside your regime. There are many other kinds of legitimate transactions that are made possible by bitcoin.

Bitcoin would not work as the exclusive currency. Its unstable value is not suited to being used as the numeraire. For the same reason, it is not suitable for hoarding by wage earners. As I explain in In a Gold Standard, How are Interest Rates Set? it is the arbitrage between hoarding and saving (i.e. lending) that sets the floor under the rate of interest. If bitcoin is unsuitable for hoarding, then either it will not develop a lending market, or the lending market will not have a stable interest rate. A destabilized interest rate is the root cause of the ongoing global financial crisis.[3]

Bitcoin works well as a foil to fiat currencies. It makes it possible for people to conduct business that would otherwise be impossible. If enough people participate, then it becomes more difficult and more unpopular for governments to act to squelch those activities. It’s a pointed object lesson, showing people what is possible in a less-unfree market. Hopefully it will motivate them to clamor for more freedom.

Only gold serves as the objective measure of value necessary to act as the numeraire. It is no coincidence that the quantity of monetary gold is not fixed, but has elegant mechanisms to expand and contract in response to changing market demand.


[1] See the Wikipedia entry on Lamarckis

[2] See my paper In a Gold Standard, How are Interest Rates Set?

12 replies
  1. matus says:

    Hi Ken, excellent piece but have you consider into your argumentation creation of other crypto currencies? actually a lot of them exists and compete with BTC. they could serve as a supply side similar to gold, are not they? and all of them could have intrinsic value I presume because they are many possibilities to use them not only as “money”…

  2. Dennis says:

    Interesting piece, but I can’t see where you explained your view that increasing the quantity of fiat doesn’t cause inflation. If inflation is defined as an increase in the money supply, then the fact that it sits on bank balance sheets is irrelevant. This is monetary inflation, but not price inflation. When that money enters the broader economy and drives up the value of goods and services, then we experience price inflation. The Fed’s gamble is to react appropriately as velocity of money increases to remove money from the economy (disinflate) to keep prices stable.

    A more interesting article might be how this process exacerbates income inequality by providing below market interest rates to TBTF banks for speculation and bailouts when their speculations go bust, while leaving savers to struggle in a ZIRP environment.

  3. kaplan_cpa says:

    Your comment on the unit of account in bookkeeping is quite prescient. There is a dilemma in current accounting with the state of balance sheets. On one hand you have the traditional approach which leaves Property Plant and Equipment at its historical cost and on the other you have the concept of “Fair Value” which allows one to mark the assets to the “highest and best use”. One challenge arrives of course in marking these assets down once the overvaluation becomes obvious and the loss has to be passed through the income statement. Recently an Asian rating agency suggested that HSBC’s balance sheet was overvalued by 70 billion. Again the dilemma pits the conservative tenant against the finance fantasy. When an asset on the balance sheet can be turned into a revenue stream based on increased valuations of the asset, which are a direct product of lower interest rates, you have the ultimate loop for producing management bonuses on Wall Street.

  4. bgoldman says:

    Very interesting article. I appreciate the amount of thoughtful intellect and rational experience you have shared here! I don’t quite understand why you think there is no arbitrage in BTC mining activity. Isn’t it similar to gold mining, in that an arbitrage opportunity results in more BTC mining, and BTC mining actually does have a cost anchored in real values for CPU resources, networking, electricity, cooling?

  5. Keith Weiner says:

    Thanks for the great comments everyone.

    matus: it’s not clear to me if adding keithcoin to the market does the same things as mining more gold. Regarding the quantity of gold resources, I don’t think there is ever a firm idea of how much total there is. Only how much is known to be profitably recoverably with today’s mining technology and at today’s gold price.

    Dennis: Footnote 3, it is a series of papers. Inflation should not be defined as increasing the money supply, but as counterfeit credit (

    kaplan: an odd coincidence that it somehow works out to “bigger bonuses”. 🙂

    bgoldman: at the moment, there is just simply a gold rush to mine out the 21M possible btc. In a certain sense, I agree you can call it an arbitrage but it’s not a closely balanced system (or buffered solution of chemistry/biology students). It’s tilted so far to one direction. My comment refers to the design of btc that caps it at 21M bitcoins.

  6. mossmoon says:

    As an early adopter to bitcoin and mere layperson, I find it very interesting and rather gratifying to watch learned minds of monetary science perspire to debunk bitcoin. And then debunk it again. And then debunk it again.

    This particular debunking has a glaring oversight. The author doesn’t seem to understand the simple fact that because bitcoin fractionalizes to the right of the decimal its supply can expand and contract with demand. In other words, bitcoin’s supply is finite but you can never run out of it. (This really is Adam Smith’s Real Bills on steroids. You would think then that as a student of Fekete Weiner would embrace it.)

    But this effort really falls short because of the simple-minded view of bitcoin as nothing but a speculation and therefore ignorant of what truly keeps a bid under it: its UTILITY. Bitcoin is a protocol and ‘money’ is only its first application. Think the TCP/IP of money. A protocol that will allow for trustless contracts, microtransactions and multiparty escrows, the possibilities of which are endless, and in so doing unlocks hundreds of billions of dollars of waste trapped behind a corrupt and inefficient financial system is just an idle speculation. Right.

    • Greg Jaxon says:

      Keith isn’t “debunking” bitcoin. He is adding a (new) Austrian analysis to the mix of opinions about bitcoin. He may be debunking a few illusions people hold about the subject (including your early-adopter bias that you are not a speculator). But for example, he is not attacking the foundations or the functional protocols of bitcoin to show that they are other than advertised. The utility of a TCP/IP-like protocol for international money transfer without the high costs of compliance with capital controls is obvious – and to that Keith adds the hope that BTC and things like it will continue to erode the little tyrannies that make that key market-service so inefficient.

      Mossmoon, your comparison of BTC to Adam Smith’s real bills is fundamentally flawed. Although BTC transactions clear quickly they do not yet have a spread so small as US T-bills or even as small as spot gold on the major exchanges. Furthermore, BTC does not claim to be credit in any form: neither self-liquidating, nor short-term. Unlike real bills the total quantity in “circulation” will not be proportional to the changing GDP of its underlying economy.

      Isn’t it enough that bitcoin pretends to be the “new gold”? Now you want to tell us that it’s also the “new bill”! I find this debate extremely healthy for all Austrians: in analyzing bitcoin we have a perfect academic vehicle to reveal the Structure of Money.

      BTW, Keith: The website truncated the word “Money” in the article title… looks sloppy.

      • mossmoon says:

        The thrust of this piece is:

        “Without a mechanism for responding to increased market demand by creating more currency, there is a fatal flaw.”

        I consider an article that misunderstands bitcoin at such a simple level just more FUD. I don’t understand why, but there it is. Quantity DOES expand. Keith is a brilliant guy so I look on this comment with suspicion. Sorry.

        I understand Real Bills as Fekete describes them, as 90-day letters of exchange used to purchase seasonal goods (basically). This prevents the scourge of double spending. There is a direct, qualitative analogy to bitcoin (as far as it goes) as they cannot be double spent. Tight spreads are just a matter of time. Biticoin credit is just a matter of time.

        • Greg Jaxon says:

          The Original claim behind bitcoin – its play for the hearts of QTM enthusiasts – was that there could only, ever, be 21M BTC, a total it will approach asymptotically. But Mossmoon is sure that its “quantity does expand”. Expansion up to the 21M limit is on its own monotonic schedule. Fekete’s point about real bills is not that their supply “expands” – rather that it must expand and contract in strict synchrony with the trade in core economic goods, a claim which bitcoin has never made AFAIK.

          The definition of real bills does not prevent “double spending” – it’s more the other way around: over-leveraged credit will fail to circulate. Bitcoin is an admirable system for online trading – its spreads make it more efficient than many of the officially sanctioned alternatives. But it isn’t yet operating in the realm where ordinary monies function, though it is remarkably close.

          Come the day when transaction-clearing can no longer yield freshly mined bitcoin, when the block chain has grown to immense proportions, why would you say that spreads for bitcoin would continually tighten? They are currently subsidized by the system itself and the participants still demand entry and exit premiums no better than the best mutual fund loads! Absent the mining subsidy, I foresee spreads being not much better than they are now.

  7. runeks says:

    It shouldn’t be too hard to mimic the arbitrage done by gold miners in a crypto-currency.

    In Bitcoin there is a concept of “difficulty”, which basically measures how much effort is being put forth towards mining. The higher the difficulty, the more numbers are crunched per second, to find the solution that creates a pre-determined amount of bitcoins, based on how many bitcoins have been created before this.

    If one were to create a crypto-currency where the amount of currency generated is not fixed, and not derived from how many units of this currency are in existence already, but where the amount is proportional to the difficulty, it would have the same effect as gold mining in the gold market, as far as I can see.

    If the value of this crypto-currency rises rapidly, mining will become very profitable (just as with Bitcoin), but as opposed to Bitcoin, this will cause the rate of money creation to increase (because the difficulty increases), just as when gold mining becomes profitable, and more mined gold metal is sold on the market which compresses the bid on gold.

    The effect of this is that the final number of currency units will be unlimited, as well as the rate of creation (currency units per hour/day).

    It would be interesting to discuss the pros and cons of such a design with some experts in the field.

    So Keith, if such a crypto-currency was created, would you say that it has the potential to become an exclusive currency, a *numeraire*, as opposed to Bitcoin? Would savers want to hoard this crypto-currency?

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