Since its inception in 2009, Bitcoin's controversy has raged. Its libertarian proponents see the digital currency as the killer of central banks everywhere. Its detractors have labeled it a binary bubble - calling it the most elaborate Ponzi scheme of all time. Most often, the latter arguments center on the misplaced belief that anything of value must be "backed" by something else - whether a stream of earnings, a commodity (like gold or oil), or the full faith and credit of a government.
Regardless of which camp you subscribe to, if you are reading this article, you too are undoubtedly curious about this question: what does make a digital currency (or anything else for that matter) valuable? And how does the "bitcoin vs. gold" analysis stack up?
Typically, when we value any asset or going concern (like a company's stock, or a piece of revenue-generating real estate), we observe the rate at which it creates cash flow, and we then discount that value to its appropriate present form. This helps us estimate what the company might be worth now - based on what it will earn in the future. But when you think of things like commodities - especially commodities like diamonds or silver, which have relatively little industrial or practical use - there is no way to evaluate a revenue stream. They don't have one!
Then of course, we come back to Bitcoin, which doesn't even enjoy physical status in the universe! A Bitcoin is merely digital ones and zeros! What sort of rational human being would invest cold hard cash into a currency you can't even touch and feel? From whence does it derive its value?
The logical answer to that question is to point out that many things of value in this world cannot be physically held. Bank account balances cannot be physically held, nor can credit transactions. Services, in general, have no tangible physical qualities, per se. So, let us dispense early with the notion that value must be derived physically.
Bitcoin Vs Gold
Nonetheless, to address the question of Bitcoin's value, we must go deeper. To do that, we must visit some simple economic concepts - namely scarcity, supply, and demand. For this article, we are going to use gold as a metric - mainly because everyone is familiar with gold. But before we get started, let's revisit the notion that gold is just one example of many commodities which serve as a store of value - commodities like copper, rubies, and palladium. We could use any of them for this investigation, but gold is simply the oldest, most universal, and most popular. Its value is also less bound to industrial and consumptive application than other commodities (like oil, wheat, or corn, for instance), which makes it more useful as a model.
Since the dawn of time, gold's value has remained almost exclusively defined by its status as a store of wealth and a medium of exchange. It does not, on its own, generate any form or revenue, or profit (earnings). It is merely valuable because it is scarce, and because human beings place value on that scarcity.
Gold is a finite, rare resource, whose supply is not likely to increase unpredictably. And because supply is relatively fixed, it is somewhat easy, over the long-term, for markets to gauge how much supply can, and should react to demand - relative to other assets (the most obvious of which are currencies). In other words, when we speak of gold, we usually speak of it in terms of yen, dollars, francs, or euros, because it is easy to follow in those terms.
Of course, prices are often imprecise, being driven by the whimsical notions of collective human "wisdom." But over long periods of time, markets tend to represent a reasonably accurate view of the supply and demand of a given good or service. This is why many investors, economists, and even philosophers agree that gold's long term movements are probably reasonable representations of the growth or destruction of other relative values - again, like currencies.
Gold is Heavy. Everyone Wants to Steal It...
No doubt, gold has been a major factor in the development of human history, and yet for all its grandeur and status, gold has become inefficient. Many of its previous uses have been abandoned in recent centuries. As a means of exchange, gold has almost universally been supplanted by fiat currencies - money created and issued by governments, and backed by decree.
There are good reasons not to use gold as an every day currency: it is difficult (and expensive) to store, transport, and protect. As metals go, it is exceedingly heavy; it is much easier to carry cash, checks, or credit and debit cards around in a wallet than it is to carry gold, for example. So, for the most part, gold now sits in government and institutional coffers, guarded by the only entities who can effectively stand to bear the expense associated with its storage and protection.
Please don't misunderstand: the purpose of this article is not to imply that gold is going to lose its appeal any time soon. As long as human beings exist, gold will be coveted because of all the positive qualities mentioned above. But that doesn't preclude it from being extremely inefficient when it comes to portability, nor does it relieve the impracticality of using gold as a means of exchange. It simply doesn't make sense to carry and spend gold.
Governments switched to fiat, for two primary reasons. The first was a response to a clear demand for flexible, more divisible, and lighter methods of exchange. The second was that, by issuing fiat, governments could control the supply of money - and by extension economies. By creating a moderate amount of inflation (printing money), governments could convince users that the assets they purchased were increasing in value.
This was an elaborate illusion, but most people accepted it, and since there were no legal or viable competitors - other than other sovereign currencies - the illusion was allowed to stand, facilitated by the collaboration of governments, themselves. If everyone agrees to be the only game in town, you wind up with a global oligopoly. That can be very profitable for the central banks who control the money supply.
The New Kid
In 2009, a new experiment appeared - Bitcoin. For the first time in history, the world has a currency that is not controlled by any single entity. Here is a store of value that has all the same advantages as gold, but also has the advantages of fiat money! At the same time, it carries none of the disadvantages that have plagued both. Bitcoin has a limited supply, which makes it scarce. It is driven by supply and demand. It is as portable as any sovereign currency. It costs almost nothing to store.
What could be better? It seems like the digital age has finally created the perfect form of wealth storage and transfer! But there is only one problem: nobody seems to be able to agree on how it should be valued!
That brings us to the crux of this article - namely that if you're going to try to value something like Bitcoin, why not look first at its tried and true grandfather... gold? Since they share so many of the same qualities, wouldn't that be the best place to start?
The Back of the Envelope: Gold Price vs. Bitcoin Price
First, a few facts about Bitcoin:
The total number of Bitcoins that can ever exist is limited to 21 million. Let's be as clear as possible about this: there can never be more than 21,000,000 Bitcoins in this universe.
There are currently around 10 million Bitcoins in circulation. These are Bitcoins that have been "mined," and are "outstanding" - meaning they're available to be acquired or spent. ("Mining" is the term used for bringing Bitcoins into existence. If you want to know more about the process, it's worth a Google or two.)
Bitcoins can be (and have been) lost. This occurs when people inadvertently overwrite them on their computers, or simply lose the media on which they are stored (like a crashed hard drive, for instance). There is no way to calculate how many unrecoverable Bitcoins there are, but suffice it to say, when all 21 million have been mined, there will be fewer than 21 million in circulation. For our calculations, however, we will stick with 21 million.
And that brings us to our final point: we are using the total number of eventual Bitcoins because it's more conservative and dilutive. We want to account for the valuation that will likely occur as new Bitcoins appear. We could use complex calculus to predict the rate at which the supply of Bitcoins will change, relative to the price of gold. Likewise, this article could become a book. For brevity, we are going to go with the simpler approach.
According to credible estimates, the total market value of gold today is approximately $8.5 trillion. More precisely, that is $8,500,000,000,000.
Next, we should determine the total market value of Bitcoins. Using 21,000,000 as the number of (eventual) Bitcoins in the world, and assuming a market price of $450, that gives us a total market value of $9,450,000,000 - or $9.45 Billion.
Please take note of the difference between billions and trillions in the values above!
What does all this mean? Simply, all the gold in the world is currently worth $8.5 trillion. And all the (existing and eventual) Bitcoins in the world are currently worth $9.45 billion.
Let's break it down. If the theory is correct, and Bitcoins possess all of the positive aspects of gold, plus all the positive aspects of sovereign fiat currencies, we could make a strong argument that Bitcoin will attract a significant amount of capital away from sovereign currencies. But for the sake of simplicity, let's just assume that won't happen. Let's just assume that all the capital flowing into Bitcoins will only come from gold - and no other source. This sounds absurd, but it is also extremely conservative, and should give you some idea of how undervalued Bitcoin really is at this moment.
Back to our equations:
All the gold in the world: $8.5 trillion
All the Bitcoins in the world: $9.45 billion
At what price would Bitcoin be at par value with gold? Essentially, Bitcoin would have to go from its current total market value of $9.45 billion ($450 per Bitcoin) to a market value of $8.5 trillion. So how much would each Bitcoin be worth if that were to happen? Divide $8.5 trillion by the total number of Bitcoins outstanding (21 million).
That gives you a price of $404,762, per Bitcoin.
Our assumption is that Bitcoins will at least attract some of the capital currently residing in gold. How much? Above, we calculated a 1:1 ratio, which is probably unrealistic - it's doubtful that anything approaching 100% of the capital in gold would flow to Bitcoins... at least not today. And yet it is realistic to think that, as Bitcoin establishes itself, it could attract a great deal of wealth away from gold. But again, how much?
It stands to reason that Bitcoin's ease of storage and portability would attract a huge amount of capital away from gold. But let's maintain our conservative posture - let's assume Bitcoin will only take 20% of the capital currently being held in gold around the world.
$404,762 X .20 = $80,952 (per Bitcoin)
And That's Just Gold. Try To Imagine Everything Else
We should again mention that this does not take into account capital flows from other assets - such as sovereign currencies, oil, real estate, or stocks. We are simply speculating on what the price of Bitcoin might be if it attracted just 20% of the wealth currently held in gold.
For a moment, try to imagine what could happen to the price of a single Bitcoin if we were to consider capital flows away from every other asset class in the world? Such an influx could have staggering ramifications on its value.
So, when we talk about Bitcoin vs Gold - considering their current market values - do you really think Bitcoin is a bubble?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long Bitcoin and gold.