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An inherent tension exists between the two major purposes of money. Currencies that are perceived as great stores of value, such as gold and bitcoin, make for poor mediums of exchange. By contrast, currencies that are effective mediums of exchange, such as fiat currencies used the world over, can make for dubious stores of value. Where a currency falls on the store of value versus medium of exchange spectrum influences its usefulness as a unit of account and a standard of deferred payment.

Supply Scarcity and Stores of Value

As stores of value, many investors perceive gold and, more recently, bitcoin as second to none. Since 1971, gold has appreciated from $35 per ounce to around $1,300 at the time of this writing, a gain of over 3,500%. Bitcoins have done even better. On July 19, 2010, a bitcoin was worth $0.08. At the time of this writing, it’s priced close to $5,300 per bitcoin, a gain of over 6,000,000% in seven years. Not bad!

Whether gold and bitcoin really are stores of value is not universally accepted. Viewed from a fiat currency perspective, such as that of the U.S. dollar, bitcoin and gold are, to say the least, not without risk. Over the past 12 months, the annualized standard deviation of gold has been 12%. Gold had a 70% drawdown between 1980 and 1998. Compared to bitcoin, the gold market looks sleepy. Bitcoin owners experienced a 60% annualized standard deviation over the past 12 months and in the past, it has achieved a mind boggling 175% annualized risk (Figure 2). Moreover, in its short life, it has already had drawdowns of 93% and 84% (Figure 3).

Drawdowns of such magnitude do sound crazy yet investors still allocate funds to other markets which have experienced large drawdowns. The U.S. equity market, which experienced an 89% drawdown between 1929 and 1933, from which it took until 1954 to recover. Since then, it has experienced a 47% drawdown in 1973-74, a 50% drawdown in 2000-2002 and a 60% drawdown from October 2007 to March 2009. Crude oil prices are currently 67% off their 2008 highs. The difference being, of course, that few investors would argue that stocks and crude oil are stores of value. Rather, investors perceive them as being risky investments.

However volatile they may be, the reason why gold and bitcoin are perceived as stores of value is simple: their money supply doesn’t grow quickly and, in the case of bitcoin not at all, some day. Bothgold and bitcoin money supply growth is determined by mining output. Over the past half century, new gold mining supply has added anywhere from 1.1% to 2.4% to the existing stock of previously mined gold (Figure 4) and gold prices tend to vary inversely with the degree of mining supply coming on line. This is much slower growth than the money supply of the U.S. dollar and credit. Even during the 14 years prior to the 2008 financial crisis, the Federal Reserve’s balance sheet, one of many proxies for the amount of money in the system, grew by 5.6% per annum. Since the fall of 2008, it has expanded by nearly 20% per year.

Cryptocurrencies such as bitcoin have very specific processes for expanding their money supply – mining by technology with strict limits. For bitcoin, most of the “mining” activity happens in China. The strict money supply rules mean that if demand grows, as it has, the price can soar, which it has. Some observers, such as economist and Nobel laureate Robert Shiller, have suggested that the rapid rise in bitcoin prices resembled a financial bubble. Nevertheless, Shiller also notes that from his perspective, gold has been in 5,000-year bubble.

Bitcoin’s mining supply grew at an infinite pace in 2009 when the currency burst into existence. This year it will likely slow to around 4.2% and then drop to below 2% per year after 2020. Sometime around 2140, the last new bitcoin ever will be mined, bringing the total to 21 million (Figure 5). The bitcoin market anticipates this, hence the extraordinary bull market in the digital currency. This contrasts with gold, whose price has been depressed by 94 million new ounces coming onto the market each year.

While bitcoin has delivered its holders spectacular, if highly volatile returns, what’s most amazing is how little it’s worth, even at $5,800 per coin. If one assumes that there will be 21 million coins in existence by 2140, that means that their aggregate present value comes to $120 billion. While it is nothing to sneeze at, it pales in comparison to the outstanding value of the nearly 5 billion ounces of previously mined gold whose total worth is over $6 trillion at current prices. Moreover, the 94 million ounces that will come out of the world’s mines in 2017 have a value of nearly $120 billion at current market prices, about the same theoretical value of all the bitcoins that will ever come into existence. While there is no logical reason to suppose that bitcoin should have the same value as gold, if it did, each bitcoin should be worth approximately $285,000, 45 times the current market price. As such, one might wonder: is bitcoin still vastly undervalued even after a 6,000,000% rally?

Bitcoin, Gold and Fiat Currencies Demand and Regulation

While gold and bitcoin supply comes from miners, what drives demand is another story. Gold’s demand side is mainly as jewelry and as an alternative currency that get stored in vaults, albeit one that pays no interest. As such, when interest rate expectations increase, gold prices tend to fall and vice versa.

By contrast, demand for bitcoin has a reputation of being used for money laundering, tax evasion and avoidance of regulated cross-border money flows. The motivation is that the transactions are extremely hard to trace, yet they offer considerable security. Proponents of bitcoin and cryptocurrencies would argue that the reputation of cryptocurrencies being used for criminal purposes may not be entirely fair. After all, fiat currency cash is used by criminal organizations and tax evaders the world over.

A little historical background may be informative. When the euro was introduced at the end of the 1990s, illegal drug and money laundering transactions in Europe, including Eastern Europe, were often conducted in large denomination Deutsche Mark (DM) paper currency. The advent of the euro meant that the DM cash notes had to be turned in and exchanged for euros, and the unintended consequence was that large denomination U.S. dollar paper currency filled the void left by the DM. This switch from DM to U.S. dollars actually helped push the euro lower against the U.S. dollar around the time of the transition.

It is also worth noting that of the $1 trillion or so of U.S. paper currency outstanding, about 50% resides outside the United States. Unfortunately for drug dealers and money launderers, the digital revolution is rapidly eliminating the need for paper currency and even the ability to use it secretly and discreetly. Bars, restaurants, and dry cleaners are no long bastions of cash transactions. This has created a market opportunity, so to speak, for cryptocurrencies that can facilitate secure, yet difficult to trace transactions.

Regulators, tax collectors, central banks, etc., around the world can be expected to act aggressively to combat illegal uses of digital currencies, especially as they gain traction in the global economy. U.S. regulators are beginning to act. The Securities and Exchange Commission (SEC) has launched fraud cases. China has started to rein in the use of cryptocurrencies for moving money out of the country.

Regulators are also moving to bring cryptocurrency platforms into the mainstream. For example, in July 2017, the Commodities Futures Trading Commission (CFTC) approved a new Derivatives Clearing Organization (DCO) which was also granted an order of registration as a Swap Execution Facility (SEF). Under the order, the new DCO will be authorized to provide clearing services for fully-collateralized digital currency swaps (i.e., Bitcoins, etc.). Several other countries are also onboard with encouraging cryptocurrencies for legal commerce, including Japan and South Korea.

Some of the cryptocurrency platforms are starting to perform active user due diligence in terms of Know Your Client (KYC) and Anti-Money Laundering (AML), putting them in a position to successfully meet a variety of regulatory tests and become more mainstream with their business models.

And, one should recognize that regulation does not mean the demise of cryptocurrencies – only that the motivating uses will eventually have to be dominated by legal activities. For now, the regulatory landscape for cryptocurrencies is very much a moving target around the world.

Medium of Exchange and the Benefits of Inflation

While gold has proven to be a great, if volatile, store of value, essentially nobody still uses gold as a medium of exchange. When was the last time that you heard of somebody buying groceries, clothing, a new house or a new car with gold coins? The problem for gold as a medium of exchange is simple: why would you part company with it now if you think that it might be worth more in the future? This problem applied doubly (or exponentially) for bitcoin and other cryptocurrencies. Wouldn’t you have regretted paying 20 bitcoins for a $40,000 car in June 2017 only to see the same 20 bitcoins valued at nearly $100,000 by October of the same year?

Basically, the overwhelming majority of transactions are in fiat currencies created by central banks. These currencies tend to lose their value over time, not just against gold and bitcoin as we have seen, but also against the baskets of goods included in consumer price indices. Some fiat currencies lose their value slowly, others do so quickly. That loss of value is precisely what makes them useful. Without the fear of inflation, holders of currency tend to hoard rather than spend it. Hoarding currency depresses economic growth and creates financial instability. The Japanese yen, the one fiat currency that has experienced deflation over the past few decades, is a case in point. Far from being a virtuous store of value, the Japanese deflation produced a depressed, underperforming economy.

Likewise, both gold and silver were extensively used as currencies in the past and both produced less than desirable economic outcomes. Despite the rosy history of the gold standard written by gold bugs, economic reality under the gold standard was harsh. While laboring under the gold standard, the United States experienced high economic volatility (Figure 6) and repeated economic depressions: 1873-79, 1884, 1893-98, 1907, 1920 and the Great Depression of the 1930s. Between 1877 and 1933, when then President Franklin Roosevelt confiscated the nation’s gold and devalued the U.S. dollar to $35 per ounce from $21, per capita GDP rose by just 1% per annum despite tremendous technological progress.

The New Deal was a success. Between 1933 and 1939, real per capita GDP grew by 6.8% per year and that growth accelerated to over 10% per year during the massive, fiat-currency financed, government spending program known as World War Two, which was basically the New Deal on steroids. Post-war, under the Bretton Woods system of fixed exchange rates tied to gold, real per capita GDP expanded by 1.3% between 1945 and 1971 when President Nixon abandoned gold entirely and floated the U.S. dollar. Floating currencies proved a difficult adjustment but despite the volatility of the 1970s and the Great Recession in 2008, U.S. real per capita GDP expanded by 1.7% per year, on average, since Nixon dropped gold and floated the dollar (Figure 7).

Unit of Account and Method of Deferred Payment

It’s difficult to use money as a unit of account if it is excessively volatile. While the U.S. dollar loses value versus consumer goods and services over time, it has the virtue of losing that value at a steady rate. By contrast, consumer prices viewed from a gold or bitcoin perspective are excessively volatile making using either currency as a unit of account difficult (Figure 8). Moreover, using either currency as a method of deferred payment would be extremely risky.

In addition to being volatile, consumer prices tend to be in a strong deflation from both a gold and bitcoin perspective. Since December 1999, consumer prices have risen by 44% in U.S. dollar terms but have fallen 64% in gold terms. From a bitcoin perspective, prices have fallen by 99.98% since the end of 2010. Imagine the economic disaster that would have resulted had people borrowed money in gold or in bitcoins. Paying back loans would be a near impossibility. As such, given the inadequate growth in money supply, and the persistence of long-term deflation, there is little possibility that either bitcoin or gold could be used for deferred payments.

This is the beauty of fiat currencies. Central banks can create as much money as they deem necessary. Moreover, fiat currencies pay interest, and long-term interest rates allow investors to discount future cash flows into the present, creating liquidity, facilitating trade and greasing the wheels of commerce. Essentially, fiat money inflation is the lubricant of the economic engine. This isn’t to suggest that either fiat currencies or the central banks that create them are above reproach. They can create too little credit growth (the U.S. during the early 1930s or Japan during the 1990s), too much inflation (the U.S. and Europe during the 1970s), or hyperinflation (Germany in 1923 or in Venezuela or Zimbabwe today). Unlike the gold standard and bitcoin, which depend upon mining supply, central banks can at least attempt to create the right amount of money to keep the economy growing.

Moreover, holders of fiat currency don’t necessarily lose their value if they put their currency to work in the banking system and bond markets, which pay interest, or the in the equity market, which tends to increase over time. Although interest rates can be below the rate of inflation, as they were frequently during the 1970s and have been since 2008, for the most part, depositors hold their own against inflation. Over the long term, fiat currencies only lose value if they are kept under the mattress, in cash, in checking or in other non-interest-bearing accounts.

The ability to use a currency as a method deferred payment explains why even under precious metals standards there tends to be so much inflation. Yes, you read that correctly, inflation. Far from preventing inflation, gold and silver standards require currency debasement in order for the economic system to function. For example, under Julius and Augustus Caesar, the Roman denarius contained four ounces of silver. 250 years later, by the late third century, that same coin contained only 2% as much silver as before, implying that it was worth about 1/50th as much. That sounds like a dramatic depreciation but it amounts to an average annual inflation rate of about 1.6%, not far from what central banks target today. Rome’s metal-based monetary system functioned only with debasement.

The Roman experience of precious metal currency debasement was just a precursor to future European currency debasement. Essentially every single country in Europe did exactly what Franklin Roosevelt would do in 1933: they resolved financial crises by debasing their currencies (Figure 9). Sometimes the only way to pay off debts, public or private, is to do so with money that is worth less than what it was worth at the time the loans were secured. This is the Achilles heel of gold and bitcoins as currencies. They are stores of value. Stores of value are deflationary and deflation is destabilizing.

The Future of Bitcoin

So, will bitcoin rally another 5,000% or more until the outstanding value of the digital currency equals the outstanding value of the world’s gold? The short answer is that we don’t know. Something is worth what somebody else is willing to pay for it, and how much people in the future will be willing to pay to hold bitcoins is difficult to know. That said, precious metals do hold a potential insight into one factor that might limit bitcoin’s future upside.

Just as gold isn’t the only precious metal, bitcoin isn’t the only digital currency. As we discussed earlier, gold responds negatively to increases in gold mining production. It also responds negatively to increases in silver mining production. Thus, a boom in silver production can contain price rises in gold and vice versa (Figure 10).

Likewise, the existence of other digital currencies could limit price upside for bitcoin. Ethereum, Zcash, dash, ripple, monero etc. compete with bitcoin just as silver, and to a lesser extent platinum and palladium, compete with gold. This might keep bitcoin’s value in check before it rises another 10 or 100-fold in value.

Indeed, just in the past two years, over 1,000 additional digital currencies have been launched. One could argue that they actually are limiting the rise in bitcoin, whose price appreciation actually has slowed, at least in percentage terms. Even bitcoin itself has split (“forked”) into bitcoin, bitcoin cash and bitcoin gold as disagreements within the user community create new iterations of the original currency.

That said, two things argue in favor of bitcoin’s continued success: network effects and government regulation. Just as Facebook, LinkedIn and a handful of other websites or apps dominate social networking, it is possible that the incumbent currencies like bitcoin and ethereum could continue to dominate cryptocurrencies as well for the simple reason that they have large networks of users who accept them. Google’s attempt to invade the social networking space with its Facebook equivalent, Google+, didn’t turn out so well because the user community was already on Facebook’s platform (although Google, by all appearances continues to prosper in other domains). Analogous network effects could work to bitcoin’s advantage. If a large community of users accept it, they will be loath to move elsewhere unless a new alternative is truly completing and not a mere copycat.

Isn’t the U.S. dollar a bit the same? What makes USD the world’s reserve currency isn’t just the size of the United States (4% of the world’s population and about one fifth of the world economy) and its military might, it’s also a network effect: people the world over denominate their foreign transactions in USD. Once enough people agreed to use USD, it began to dominate the world’s liquidity and became the primary global reserve currency.

Recently, governments have begun to crackdown on digital currency exchanges in the case of China or at least regulate initial currency offerings ( ICOs ) in a manner similar to their regulation of initial public offerings (IPOs) of equities. To the extent that ICO regulation limits the creation of new currencies, one unintended by-product could be to restrict competition and to enhance the market position of incumbent currencies like bitcoin and ethereum. Libertarians often rightly accuse government regulation of protecting incumbents by raising barriers to entry. There is no reason to think that cryptocurrencies will be an exception to this rule.

On the other hand, regulation could also give rise to, and bestow legitimacy upon, new cryptocurrencies that lack bitcoin’s main attribute and flaw: an asymptotically fixed money supply. A digital currency that replaces fiat currencies as a medium exchange cannot have a fixed supply. In fact, central banks, like the Federal Reserve, might even create their own cryptocurrencies but ones that are designed to optimize economic growth. It will probably need to have constant money supply growth and preferably money supply growth that matches economic needs and not some algorithm’s hard, mathematical constraint. In the meantime, bitcoin could continue its role as a sort of purely electronic crypto-gold: a perceived store of value given to great but, perhaps, slowly decreasing volatility.

Bluford “Blu” Putnam has served as Managing Director and Chief Economist of CME Group since May 2011.

Erik Norland is Executive Director and Senior Economist of CME Group.

The opinions and reports contained in Wall Street’s Best Minds and Asia’s Best Minds are those of the economists, strategists, analysts and other market experts who have authored the reports or commentaries. Their opinions do not represent those of Barron’s or Dow Jones & Co., Inc. Some of the reports’ issuers have provided, or hope to provide, investment-banking or other services to the companies being analyzed.