One of the often-touted benefits of Bitcoin is that unlike conventional currencies, it supposedly offers its holders some insulation against inflation.
In times of crisis and associated economic downturns like a global-pandemic (if you can imagine such a thing), governments resort to printing new money to stimulate spending and to meet the additional costs of propping up businesses and citizens alike — a process known as quantitative easing.
The short-term effects can be positive, increasing the flow of money through the economy. But the long-term consequences are potentially catastrophic. The purchasing power of money already in circulation is weakened and the supposed value stored in existing banknotes is lessened. Inflation threatens to push up prices as the knock-on effects of the newly minted money work their way through supply-chains.
As I’ve educated myself on all things Bitcoin, I couldn’t help but notice that the supply of Bitcoin too is increasing daily — Bitcoin mining, the process by which new digital coins are notionally minted continues at a rate of approximately one every ten minutes. Even with a supposed limit of 21 million total Bitcoin built into the protocol, and 18.6 million of them in circulation today it still strikes me that Bitcoin doesn’t seem that different to conventional currency?
How could Bitcoin genuinely offer a hedge against inflation caused by (or at least exacerbated by) quantitative easing if its own supply is growing steadily too?
The only way of satisfying my curiosity seemed to be to understand the associated processes in more depth. I’ve outlined below what I learned about Bitcoin mining and quantitative easing in as simple terms as I can manage. I’ve thrown gold mining in for good measure too, since Bitcoin is often described as digital gold. I wondered if the comparisons with mining and creation of gold might share similarities with Bitcoin mining too?
There will only ever be a total of 21 million Bitcoin in existence. This limit is designed into the protocol and will never be increased.
With that set in stone, Bitcoin mining — the process by which new Bitcoins are created — is still ongoing. There are 18.6million Bitcoins in circulation today and this will grow until around 2140 when the total of 21 million is scheduled to be reached.
With the price of a single Bitcoin having reached $40,000 in early 2021 there’s still quite a lot of new value to be created through newly minted Bitcoin, even if the price were to drop radically.
Bitcoin Mining refers to the creation of new Bitcoins.
To understand the process demands a basic understanding of the technology of Bitcoin. I’‘ve describe this as simply as I can manage. Should you wish to learn more, check out a more detailed description such as this one from Investopedia or read Chapter 8 of the book ‘The Bitcoin Standard’ — it’s essential reading for anyone looking to learn about Bitcoin and money more generally.
Bitcoin itself is synonymous with the interconnected network of computers around the world (known as nodes or miners). Each hosts and maintains an identical copy of the Bitcoin ledger of transactions (the blockchain). The network allows transactions between Bitcoin holders to be completed and recorded in the blockchain. Without the network there is no Bitcoin.
Bitcoins themselves reside on this network or on offline storage devices (known as hardware wallets) but in essence Bitcoin only ‘lives’ on the network.
Transactions are processed constantly by the nodes as Bitcoin are bought and sold on exchanges or sent from one user to another. The nodes constantly process these transactions and compete with each other to verify and authenticate the transactions before they are written to the blockchain and replicated across all other ledgers.
The first node (or miner) that successfully validates 1Mb of transactions (also known as a block) AND which successfully resolves a complex numerical code (a hash problem) is awarded a sum of Bitcoin, known as a Block Subsidy.
The first miner to validate 1Mb of transactions and resolve the hash problem receives a miners reward (in Bitcoin)
The potential award of new Bitcoins to the miner that meets these criteria the quickest, is what incentivises them to host and run the nodes. The process of validating transactions is essential too — all ledgers are kept in sync with each other, avoiding the need for oversight or regulation and guaranteeing security and integrity.
The pace of mining of new Bitcoin remains broadly in line with the built-in schedule, and the miners reward is halved each time an additional 210,000 Bitcoin have been mined, approximately every four years.
In May 2020 the reward was halved to a reward of 6.25 Bitcoin per block. In 2009 this started out at 50 Bitcoins per block (and has now halved three times since). This too is built as an immutable rule in the protocol of Bitcoin.
The pace of minting is further controlled by varying the complexity of the hash problem upwards or downwards in difficulty depending on how quickly new coins are being mined. This variation is also managed within the Bitcoin protocol.
The net effect of all these inbuilt parameters is that a new coin is minted approximately every 10 minutes, taking the issued total ever closer to 21 million.
Around the year 2140 once all coins have been mined the nodes will be rewarded purely through transaction fees in recompense for their role in maintaining the Bitcoin network and ledger.
At this point it’s likely that the transactional nature of Bitcoin as a currency and means of exchange of value will have become its primary use-case. But as that’s 120 years in the future, I’m speculating.
What’s crucial in the context of inflation is that this schedule cannot be altered — to that extent, the number of coins in circulation is essentially fixed and conforms to a schedule of gradual and measured growth. It certainly can’t be altered on a whim of government or a centralised controlling body — no such thing exists with Bitcoin.
Bitcoin Minting in Summary
- The number of Bitcoin in circulation is tending towards a maximum that will NEVER increase.
- As of today around 89% of all Bitcoin that will ever exist have been mined (including those that we read of in the news that have been lost on hardware wallets or where the password to wallets have been lost)
- Nobody has the ability, freedom or authority to devalue those in circulation by choosing to create more — new ones that are mined, are awarded to those who incur the costs of maintaining the network and these then get gradually released into the wider Bitcoin ecosystem through trade.
- The incentives awarded for mining it are an essential part of keeping the Bitcoin network itself alive. It also ensures that the transactions carried out using Bitcoin are accurately recorded and secure.
I wanted to understand gold-mining to make a better comparison between gold and Bitcoin — a so-called digital gold.
Gold is extracted from the earth by mining the ore, and various mechanical and chemical processes extract and refine the base metal.
At every stage in the gold production process difficulties exist that contribute to its relative scarcity and its innate value. According to the World Gold Council, fewer than 0.1% of gold deposits that are detected in the world will lead to a productive gold mine. The costs and complexity of establishing a mine and processing facility are such that fewer than 10% of global deposits warrant mining and extraction. Building a mine takes years to complete once a suitable site is identified.
In short gold-mining is costly, complex and time-consuming from the very beginning.
That said it’s also important to note that in the 102 years from 1912 to 2014, annual global gold production increased from 705 metric tons per year to 2860 metric tons per year as a result of technological advances in mining and processing. Its relative scarcity then may be as much a result of commitments and agreements to limit the supply within the industry, as it is a result of physical scarcity of it in the earth’s crust.
Once refined and processed gold has utility as a store of value (in bullion form or when minted as coins, or traded securities backed by physical gold) but also in industry — for electronics and for making jewellery.
While new gold is being produced all the time and industrialisation has made it easier to mine gold at scale, the rate of extraction is constantly balanced against the relative price of gold and demand for it. Like any commodity, excessive supply will merely drive down price.
It isn’t in gold mining companies’ interests to mine endless amounts of it (even if that were possible) since it would serve to lessen the value of gold in circulation today.
Gold Mining in Summary
As a natural resource that’s inherently scarce and restricted in supply, it’s easy to see why gold has been used as a symbolic store of value for centuries.
- The value of gold is in part derived from its relative scarcity and the cost associated with locating it, extracting it and processing it.
- Its value is also due to innate properties associated with its uses in electronics and for jewellery.
- Crucially, its value is also maintained by conscious decisions and agreements made between mining companies and governing bodies to manage and restrict the supply and protect the value of gold in circulation. The steady increase in volumes mined over the last century indicates that more could feasibly be mined and made available to humanity — that it hasn’t been mined more aggressively seems like a conscious and deliberate move to protect the price.
When governments need to stimulate the economy, fund unforeseen expenditures (like the costs of war or the bailout of citizens and businesses affected by a pandemic) the most readily available option is to create new money out of thin air and to inject it into the economy via its financial system.
In response to COVID-19, the US Government announced quantitative easing of $700 Billion as a means of increasing money supply and stimulating the flow of money in the economy. The additional banknotes represent further government debt and are tied to long-term bonds or other forms of borrowing from other nations and central banks.
It’s hard to contemplate that debts of such magnitude would ever realistically be paid off, and what conditions would have to arise for governments to be in a position to pay it back. It’s almost impossible to think of such debt in the same way as we average citizens view our mortgage, student loan or credit card.
Quantitative easing is a relatively short-term solution with long-term consequences.
Consider first of all that most bank notes issued by most countries are no longer backed by gold or any other standard that might endow them with genuine value. They really are just bits of paper or polymer that we collectively agree have notional value.
The effect of flooding the economy with more money, either by issuing citizens with stimulus cheques or encouraging banks to lend money to citizens more freely is to make the money that already existed have less innate value.
That, in essence is inflation in action.
Inflation reduces the purchasing power of existing money, effectively diluting its worth. Furthermore it eventually pushes up the price of goods and services as the effects of inflation work their way through supply chains.
As there’s literally no limit to the number of new banknotes that governments can print and no innate value to them anyway, the printing of new cash is not really the same as mining of new gold or Bitcoin — there’s no new value creation associated with printing new notes, any more than there’s innate value associated with those in circulation.
Money Printing in Summary
- Quantitative easing isn’t used flippantly by governments and is an extreme tool used in response to extreme measures. But it is easy for governments to generate more cash at will as a means of stimulating economies and as a short-term stimulus to help nations through times of hardship.
- Through doing so, the value of existing currency already in circulation is diminished, as is the value that citizens believe they have stored in their savings and investments.
- Newly printed currency is backed by debt too, which must be paid back in the long-term. Such debt may be better viewed as a tax upon future generations who will be required to pay it back through future economic measures when nations seek to recover their financial strength.
With the relative similarities and differences between currencies and the processes associated with their creation now clear, there are certain conclusions that become apparent.
Right now, the global economy needs all the financial instruments that currently exist and each plays a number of important roles.
Cash is still required for day-to-day transactions although it’s gradually becoming less and less relevant or necessary as electronic payments proliferate.
Gold will remain valuable and relevant both as an investment vehicle and as a store of value, as well as for its many other uses in society and industry. But it’s clear that its innate value and preservation of such isn’t solely down to its genuine scarcity. Instead, it seems as though there’s an element of collusion and price-fixing or price-protecting between those who mine it and those who govern its supply to economies. This preserves its innate value, and protects it as a universally accepted store of value.
Bitcoin will continue to earn its place as a means of electronic exchange that facilitates digital transactions without intermediaries, but only when its price is less volatile — something that may occur as it becomes more established and universally accepted.
It may also gain status as a trusted store of value, in which people invest their money as an asset class but again this will only emerge when its price starts showing less volatility.
Most fundamentally in the context of this piece, it seems clear that Bitcoin in itself does offer inherent protection and insulation from inflation and may be used as a harbour for long term growth as an investment vehicle. The gradual and metered growth in its supply is restricted, controlled and understood by all who invest in it. I don’t think that even the most hardened of investors in gold can share such certainty about the future supply of gold, can they?
Both gold and Bitcoin are well-insulated from losing value and suffering from government-induced inflation since neither can have its supply increased so easily on demand. But for Bitcoin, this restriction is absolute. No amount of mining can alter or weaken this facet.
Note: This article is for informational purposes only. It should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.
