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Relative Scarcity and Bubble Dynamics

There is widespread awareness about the relative scarcity of BTC compared to the ever-expanding fiat money supply, but it seems to us that the dynamics underlying their relationship are largely ignored. The scarcity argument underpins a lot of speculative activity in BTC and other cryptocurrencies – hence ignoring the related dynamics is probably not a very good idea.

One of the features of bitcoin people find enticing– by no means the only one to be sure – is the fact that its supply is strictly limited (well, sort of – see our comment on “forks” further below). We have highlighted the currently circulating and the eventual total supply above. Keep in mind that the “free float” of BTC is even smaller: there are a number of very large wallets which apparently never trade, and quite few BTC have been lost forever – we are pretty sure that the UK resident who famously threw away an old hard disk drive that held his BTC wallet is not the only person who has disposed of his bitcoin in such a decidedly painful and unprofessional manner.

BTC is not a general medium of exchange, or putting it differently, regardless of whether it has the potential to become money (and it presumably tends to be purchased by people who believe in this potential), it is not money right now. This is something it has on common with gold at this juncture: it is a financial asset with various monetary characteristics, a “money in waiting”, so to speak (of course gold no longer needs to prove to us that it can be money; we are aware of the differences).

As such it is valued in terms of currently widely used media of exchange, i.e., the above-mentioned fiat currencies, and its valuation obviously does not develop independently from the latter. Take a look at the following chart of the broad true US money supply TMS-2. We would posit that the rally in BTC vs. the USD had a lot to do with the madcap expansion in TMS-2 that happened concurrently.

The true US money supply has grown enormously since BTC was created. Since January 2008 it is up by roughly 147%.

Obviously, a 147% increase in the broad money supply since 2008 is quite a lot and it has had far-reaching effects, particularly on asset prices. However, the important thing is not just the amount of new money that has piled up, but the manner in which it percolates through the markets and the economy, as well as its growth rate. The chart of the cumulative money stock shown above doesn’t convey how volatile said growth rate actually is.

Leads and Lags

Below is a chart showing year-on-year TMS-2 growth rates over the past three, or rather 2.5 business cycles (the current cycle is only half cycle, as the bust is still to come). We have drawn two horizontal lines on it that indicate roughly the levels of money supply growth associated with bubbles and where roughly the “danger zone” begins – when the growth rate falls below this threshold after an asset bubble has expanded for an extended time period, the air is getting thin.

What is also obvious is that there are very sizable leads and lags, the duration of which cannot be determined with precision in advance. Nevertheless, certain patterns emerge which are consistent with both theory and experience. After peaks in money supply growth rates are reached, it takes quite some time for the new money to spread out and exert its full effect on prices. When the growth rate slows down to the danger zone, it again takes a while for the effects to fully express themselves – contingent circumstances are apt to either slow down or speed up the process.

Peaks and lows in y/y TMS-2 growth. We have picked the two threshold levels based on the past few cycles. Following a peak, asset prices will tend to expand even while money supply growth begins to slow down; it is only after the slowdown has become very pronounced that asset bubbles begin to run into difficulties.

What is inter alia noteworthy here, is that all it took for the last two asset bubbles to burst (pre-bitcoin era) was a slowdown in the growth of money and credit (the two are intertwined most of the time). It was not necessary for the money supply growth rate to turn negative. To illustrate the lead-lag relationship discussed above a bit better, we have made an overlay chart that shows the TMS-2 growth rate together with the Wilshire total market index.

Wilshire total market index and TMS-2 y/y growth rate

Since BTC only exists since 2009 we have not yet seen how it will fare over a complete cycle and whether its behavior will be similar. We cannot even be certain that its cycle peak has been put in already – perhaps that is yet to come. Mind, the probability seems low to us, but we want to keep an open mind about this, not least due to the fact that a truly gigantic amount of new money has been poured into the economy in the current cycle (note the three distinct growth peaks in TMS-2 since 2008).

Scarcity Revisited

When discussing the relative scarcity of bitcoin, it is hard to ignore “forks” which can be used to create daughter currencies and are apparently fairly easy to implement. These new currencies use the same blockchain and hashing algorithm, and as far as we can tell, they essentially differ only in terms of certain technical details from BTC*.

Perhaps we are not assigning enough importance to said differences, but to us it looks almost as if the supply of BTC can simply be doubled overnight, almost on a whim. As we understand it, market participants have to provide some degree of support for a fork to succeed – users, miners and exchanges all need to play along to some extent –but why wouldn’t they? Superficially it is like getting an unexpected dividend after all, a.k.a. “free money”.

Moreover, the barriers to entry for creating other cryptocurrencies based on blockchain technology are evidently very low. Maintaining the BTC valuation premium may eventually become challenging in view of this, but obviously that remains open to question – the first mover advantage and name recognition effect were so far sufficient for BTC to maintain its top spot.

Actually, there is more to it than just that; we plan to revisit this issue when we post our views on bitcoin and monetary theory. For now we mainly want to note that it has to be expected that similar to other investment assets, the valuation of cryptocurrencies in terms of fiat money will definitely partly depend on money supply growth rates.

Incrementum Cryptocurrency Report

Lastly, our good friends at the Incrementum Fund, Ronald Stoeferle and Mark Valek, who our readers know as the authors the annual “In Gold We Trust” report, have released the inaugural issue of their new Crypto Research Report this December in cooperation with Demelza Kelso Hays and several other contributors.

We offer it a bit belatedly for download, but want to assure our readers that it remains an extremely interesting read despite the delay. The report is going to be published on a quarterly basis from now on (see the accompanying press release for details, which can be downloaded below as well), so if this report is to your liking, there will be a lot more interesting research to look forward to.

As the report inter alia notes, while the 2017 run-up in BTC had all the hallmarks of a major bubble and big setbacks have to be expected, in many other ways we are witnessing an experiment that is only at its very beginning and will offer a great many opportunities. We definitely agree with this sentiment.

Download 1: Incrementum Press Release on the new Crypto Research Report (pdf)

Download 2: Crypto Research Report Issue 1, Dec. 2017 (pdf)

Footnote:

* one of the “post-fork” currencies alluded to above, Bitcoin Cash (BCH-X), seems actually superior to BTC, as its transaction costs are much lower and its transfer speed is much faster – and yet, it trades approximately at an 80% to 85% discount to BTC. This makes absolutely no sense to us.

Charts by: coinmarketcap.com, St. Louis Fed