Unit 3 Lecture Notes

On the first question, if a majority of holders had been speculating on buying bitcoin as a highly-speculative high-risk instrument for a quick return, you would expect its price to crash, as these people face financial pressure of recession. Bitcoin holders who witness their stock market portfolio suffer, job getting terminated, or salary being reduced will almost certainly react by reducing their bitcoin holdings in order to have more liquid and safe assets like cash and gold tide them through these tough periods. If this effect dominates, expect Bitcoin to crash considerably during the next financial crisis.

If, on the other hand, the majority of Bitcoin holders hold it as a long-term store of value, for the sake of its global liquidity and ability to settle payments quickly, as these people begin to suffer from financial pressures, they are likely to dump riskier assets and increase their holdings of bitcoin. This would also likely be the effect if the recession is combined with increased risk to commercial banks and threats to national currencies around the world, which would force people to look for alternatives to checking accounts and cash as a safe haven, bitcoin being an obvious one due to the difficulty of confiscating it and its global liquidity.

Should the financial crisis be triggered with shortages of liquidity that affect the lower levels of the current Exter pyramid, in other words, with collapses in the value of government money, government bonds, and other low risk bonds, or through restrictions in the operation of bank accounts for liquid money, this would induce large increases in demand for bitcoin. Should the next major collapses come in economic sectors like real estate, stock markets, and the more speculative sectors of tech, it would likely hit people who use bitcoin more as a speculative asset and who would be likely to sell bitcoin, bringing the price down.

In other words, we are yet to see where Bitcoin currently lies in Exter's pyramid, and whether a financial crisis would cause it to fall like a high-risk asset, or rise like a safe haven asset. I do not suppose I could know the motivation of the millions of bitcoin holders, and billions of potential holders, and so would not hazard a guess as to which effect would dominate in the next financial crisis. But I would be far more comfortable about predicting what would happen on predicting the outcome after a few financial crisis have exposed the nature of Bitcoin to many more people worldwide.

would not dare hazard a guess as to how bitcoin will behave in the case of the next financial crisis, as it is not possible to guess the financial motivations of every bitcoin holder out there, and what they will want to do with their bitcoins. Given how new bitcoin is, it is hard to estimate what kind of demand dominates. I would not be surprised to see bitcoin behave in either way in its first financial crisis. I would expect that after one or two financial crises, more and more people will appreciate the scarcity element of bitcoin, and bitcoin would likely drop lower in Exter's pyramid.

For its first financial crisis, the judgment and action of most bitcoin holders is going to be hard to guess, but the most important thing to understand here is that as time goes on, and more financial crises happen, bitcoin distinguishes itself from every other asset in Exter's pyramid in one distinct way: its supply cannot increase. Whereas in these early days as Bitcoin goes into its first crisis, the subjective opinions of various bitcoin holders are likely to determine the course of action, with each extra recessions bitcoin's fundamental economic quality, its strict scarcity, ensures its supply increases the least. This quality also shines through more as time goes on because bitcoin's stock-to-flow ratio, discussed extensively in the early chapters of The Bitcoin Standard, continues to drop significantly, making mining output a progressively smaller part of the new supply, and thus making bitcoin more and more of a pure monetary good.

It is worth remembering that for its first ten years so far, bitcoin has been quite inflationary. Its supply has grown at very high rates initially, and is still close to 4% annual supply growth, still more than double that of gold. When one considers that around 2-4 million bitcoins are likely lost, the actual supply growth rate is likely to be higher, possibly exceeding 5 % this year. Taking into account these lost coins would lead us to revise the following growth rates numbers which were produced in the analysis of The Bitcoin Standard.

This means that a larger new amount of bitcoins is being produced every day and added onto the market supply than these numbers indicate. There is no accurate way of assessing the number of lost coins, and when writing The Bitcoin Standard I preferred to not speculate too much in the data so assumed all coins that were mined were still available for their holders to sell.

But if I were to revise estimates of these growth rates in order to account for bitcoin's lost coins, this is likely a high estimate of the growth rate that we have experienced in the last five years, and the coming years.

I do not pretend these are in any way an accurate estimate, but I think they give a better idea of the real bitcoin supply growth rate considering only the coins whose owners can sell. A Satoshi Nakamoto himself said:

"Those coins can never be recovered, and the total circulation is less. Since the effective circulation is reduced, all the remaining coins are worth slightly more. It's the opposite of when a government prints money and the value of existing money goes down".

As bitcoin had an effective supply growth rate around 9% in 2016, 6% in 2017, and 5% in 2018, it is still a relatively fast-growing monetary asset. It is growing at multiples of gold's supply, closer to the numbers of national currencies with the better monetary policy. The way to understand this supply is that every day, bitcoin mining is producing new coins to the market which are depressing prices. Only with increasing demand can the price rise. At current daily mining output (1,800 new coins per day) and price ($6,500), daily new bitcoin supply is worth around $11.7 million. This is not an inconsiderable sum, and as long as new demand is not found to match it, the price will drop. Bitcoin's supply is still so small that the growth in adoption has more than compensated for mining output throughout most of its life, leading to long term value rise.

If a new financial crisis is around the corner, bitcoin will distinguish itself from other assets with the fact that its supply is likely to not increase a lot. Former JP Morgan head of global macro explained this eloquently in a blogpost last year:

This trading pattern has so far been only exhibited during Bitcoin's own bubbles, but we have yet to see it during the context of a global financial crisis. It may not happen with the first crisis, because the supply growth rate is still not very low, the number of holders is still very little and so they are quite price sensitive. For its first crisis, bitcoin may drop significantly, but no matter how much it drops, it is likely to eventually stabilize around some level due to the scarcity of its new supply. This is the key difference between bitcoin and all other assets, except arguably gold. Whenever money flows to an asset in Exter's pyramid, there is a large supply response. When people flow to the US dollar, the Federal Reserve is likely to resort to more inflation of the supply. When people resort to homes as a store of value, their supply increases as builders build more, eventually depressing the price. When people resort to mortgage-backed securities, these securities themselves proliferate quickly, as do the houses backing them, bringing the price down. But as more and more money flows to Bitcoin, there can be no supply response, and therefore it behaves similar to precious metals, as Gurevich ob serves.

An expected stability, especially in light of the extraordinary rise of the previous few years is likely to give bitcoin some credibility as a hedge and store of value. Given that bitcoin will continue to operate, and will maintain some value, even a significant drop would likely only set it back temporarily before new users begin to recognize its value proposition.
It might not happen with the first or second recession, but over time, as the supply growth rate continues, and perhaps after several financial crises had raised bitcoin's profile as an alternative asset one would expect that bitcoin as an asset will find its way down Exter's pyramid in a similar way to gold. Its wide salability across the world, and its scarcity and volatility, will ultimately make people more interested in holding it as a long-term store of value, rather than as a short-term speculative bet. This would in effect be the transition described in the second scenario for bitcoin monetization discussed above.

The longer that bitcoin continues surviving, and if it eventually gains the status of a safe haven in financial crises, it would start rivaling gold for being the base of the pyramid. Hypothetically, a bitcoin-based Exter triangle would be likely to be more stable than a gold based one for all the reasons discussed in last month's bulletin on the difficulty of performing fractional reserve banking on top of bitcoin. A bitcoin Exter pyramid would grow very little beyond the creation of productive assets, and contain very few unsustainable expansions through fractional reserve banking, rehypothecation, and maturity mismatching.