Bitcoin, Gold, and the Quantity of Money

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 Lamarckism

[3] See my papers: The Theory of Interest and Prices in Paper Currency



Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals.  Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads.  Keith is a sought after speaker and regularly writes on economics.  He is an Objectivist, and has his PhD from the New Austrian School of Economics.  He lives with his wife near Phoenix, Arizona.





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5 Responses to “Bitcoin, Gold, and the Quantity of Money”

  • Keith Weiner:

    By the way, I wrote an article for Forbes that touches on this problem that you cannot measure the value of a currency in terms of prices (because real costs are in free fall, almost as fast as the dollar itself).

  • Keith Weiner:

    Thanks for your comments Jonas and Vess.

    Vess: I don’t say that falling prices are bad, and I do say “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.”

    The problem is if the currency itself (which cannot be measured in terms of consumer prices!) rises. Think of a business. You borrow money, which is worth X at the time. You invest in a business. The value of the money–which you owe–rises. What then? You might be forced into bankruptcy. A wealth-creating business could be destroyed by a change in the value of their unit of account. Similarly, a wealth-destroying business might appear to be profitable.

    Btw, falling prices are not necessarily bad for producers. Enormous wealth has been earned in high technology, an industry which has had falling prices for at least 5 or 6 decades.

    I don’t use the term “backed” because it means too many things to different people. I use the term “redeemable” because it’s much more specific. It means is there a contractual guarantee that each bitcoin can be turned in to receive the specified amount of gold. This is what the dollar was until 1933.

    Bitcoin is not hoarded at present. People hold it as a speculation. Their goal is not to hold bitcoin for its own sake, but to wait for its price in dollars to rise. They want profits, which means more dollars. This is not how gold behaved for thousands of years. That there are many who treat it this way today is part of the problem.

    • Vess:

      Hmmm… What is value? Despite what the gold bugs keep repeating, value is not something objective and it is not intrinsic to anything. Value is always in the eye of the beholder. One and the same thing can have different value depending on the person valuing it, on the time when it is valued and on the circumstances at that time. So, how can you say that the value of a currency rises or falls by itself, if you do not measure it relative to something else, like how many products it can buy? You can try to measure it in labor (i.e., how many work hours it takes to produce something) but that’s unreliable because productivity keeps increasing and the same amount of labor can produce things that people value differently. You can choose to measure it in gold – but that’s just as arbitrary as anything else. What if tomorrow a gold asteroid hits Earth in an easily accessible place? The “value” of gold would plummet in terms of what it can buy, because the supply has increased. This is precisely why there have been cases of severe inflation under a gold standard, like in Spain during the conquest of the Americas and in California during the gold rush.

      Also, as your said yourself, forget about the dollar. It was flawed even during the gold standard years. Even then it was money by government fiat. The proper way to have a gold standard is not to have gold coins with a nominal value engraved on them, not by having laws that say you could redeem some paper notes for gold coin and so on – the proper way is to have gold tokens (round or otherwise) with the *weight* of gold in them engraved on them. So, when you are paying, you know that you are paying, say, one gold gram and do not depend on somebody’s laws and so on. The unit of weight is standardized in terms of natural constants and then everybody knows what exactly money is – it’s a fixed amount of gold and not what somebody believes it is, what somebody forces you to accept it is, or whatever somebody promises to pay in gold for it. And I say “gold” here only as an example and because historically people have accepted it as money. But it can be anything the free market agrees on – provided that it is the thing itself and not some inscription that depends on laws and regulations to lead you to the real thing.

      What is the difference between hoarding and holding (for a long time) for speculation? You hoard money because you speculate that it will either buy you more in the future or that you will need it more in the future (but when you need it, you’ll need it immediately, so you can’t afford to have it invested). You don’t necessarily want profits (i.e., don’t plan to sell Bitcoin for more dollars) – maybe you just want to wait until it buys more products than today – either because its “value” rises or because the dollar falls.

      Nice discussion, BTW, thank you. It is refreshing to discuss this stuff with somebody who is both intelligent and knowledgeable *and* who is not hampered by ideology and fanaticism that you often encounter both in mainstream economics and on the gold bug forums. :D

  • Very nice article. It is the first criticism of bitcoin that I can agree with and I never looked at it this way.

  • Vess:

    While the basic premise of this article – that the lack of arbitrage is a fatal flaw of Bitcoin – has some value that deserves careful thought, there are several other things in the article that I disagree with.

    First of all, what is wrong with falling prices (because the money supply is fixed but the productivity and the population increase)? This was, in fact, the state of the US economy for decades while it was on a gold standard. Yes, it sucks if you are a producer and have to sell tomorrow your products for less than today. But they didn’t come out of nothing, did they? You buy labor, raw materials, etc., in order to produce these products. The prices of these things would keep falling too, so selling the product at a lower price shouldn’t be a big problem. And, of course, falling prices are great for the consumer.

    Second, the claim that Bitcoin isn’t “backed” by anything isn’t exactly correct. It is “backed” by the same thing that gold is – labor. In order to produce a new ounce of gold, you have to work hard in order to get it our of the ground and in a marketable state. In order to produce a new Bitcoin, you have to spend computing time calculating hashes and pay for the electricity your computer uses.

    Third, I fail to understand why Bitcoin isn’t suitable for hoarding. In fact, this is the main problem I have with Bitcoin – that you are motivated to hoard Bitcoins, instead of investing them. After all, their supply is fixed, while the demand grows as more and more businesses start accepting it as a medium of exchange – so it not only preserves value, its value keeps growing. This is, in my opinion, the main reason why Bitcoin is not suitable as a replacement of money – because you need capital investments in order to have a healthy economy and with Bitcoin you are not motivated to invest. You are motivated only to hoard them, spending them only when strictly necessary. (I am not talking about speculation here, that’s an entirely different area.)

    Of course, another reason (according to me) why Bitcoin will never become money is because it is too free for the taste of today’s totalitarian governments. They *will* squash/regulate/tax it at some point of time until it stops being free.

    I am also not convinced that Bitcoin does not allow for various forms of arbitrage, but I have to give this a careful thought before I can voice an argumented objection.

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