Bitcoin’s vs FED’s Monetary Policy

In the book “The Bitcoin Standard” written by Saifedean Ammous in 2018, the author claims that Bitcoin is a better store of value than the US dollar because it’s a “harder” currency. The corollary of this claim is that, if you want to save money for the future, you better use a hard currency that’s most likely to preserve (or even increase) its purchasing power over time. According to the author a simple way to analyze the “hardness” of a currency is to calculate its “stock to flow ratio”.

The stock to flow ratio of a currency is a measure of the amount of currency existing at any given time (the stock) compared to how much new currency is issued in a given year (the flow). The higher the ratio, the harder the currency. Gold is a good example of a hard currency, it has been mined for thousands of years so we already have a significant stockpile of gold sitting in vaults or used as jewelry. Gold is still mined but because it’s scarce, the amount of gold mined every year accounts for only 2% of the total stock on average. This amount of new gold is small enough to not disturb the value of the current stock and instead, gold has been appreciating in value over time as shown in the chart below.

The author does a good job comparing the stock to flow ratio of Bitcoin, gold and the US dollar but his analysis is from 2018. A lot has happened this year and many of the global trends have accelerated dramatically during 2020 because of the global crisis caused by Covid-19. How does the stock to flow ratio compare today? Which one is the hardest currency? How much different is the monetary policy of Bitcoin versus the FED?

Let’s start with the most complicated one to analyze: the FED.

The FED’s Monetary Policy

The role of the Federal Bank, as for any other central bank, is to keep inflation within reasonable levels. They do this by controlling the money supply, expanding during slowdowns and contracting when overheating. A currency whose supply is controlled by a central bank is known as a FIAT currency. Virtually every national currency these days is a FIAT currency as the gold standard has come out of fashion a long time ago.

As mentioned before, the pandemic has massively accelerated some of the trends outlined in the book and it feels like we have lived a decade of unfolding events in just one year. A clear example of this acceleration of history can be seen in figure 2 depicting the amount of new money (US dollars) created by the FED over the years.

Before discussing figure 2 it’s important to note that the real amount of money injected in the economy is always bigger than the amount of money created by the FED due to the “fractional reserve banking”. The money created by the FED is known as “m0” and it enters the economy in the form of debt, either as direct loans to private institutions like banks or airlines, or as the purchase of bonds from public and private institutions in the stock market. Once this money gets to commercial banks, they are able to create even more money in the form of loans for their customers (mortgages, line of credits, etc.). The money created by the FED plus the money created by commercial banks through fractional reserve banking is known as “m1” or “m2” depending on how it’s calculated.

Here I’m pushing the limits of my knowledge on economics and I’m not going to try to calculate the size of the real amount of money injected into the economy (m1 or m2) so I’ll stick to the m0 money supply (money created by the FED) for my observations. If you want to learn more about how these values are calculated and how they relate to each other watch the video below.

As we can see on figure 2, the FED injected a massive amount of money during the 2008-2009 financial crisis and then again during the 2019-2020 period. How much? During the 2008 financial crisis the FED increased the m0 money supply 144% in just a few weeks. Since the start of the pandemic the FED has increased the m0 money supply 90% so far. This means that the stock to flow ratio of the US dollar is very low as a lot of money is created (the flow) compared to the existing money supply (the stock). According to the the author’s thesis, this situation makes the US dollar a weak currency that losses value over time. This “value” is measured by its purchasing power and it’s normally associated with inflation.

Bitcoin’s Monetary Policy

To understand Bitcoin’s economics we need to understand at a high level how new currency is created.

All Bitcoin’s transaction are grouped into blocks, these blocks are then “mined” through an expensive computational process known as “proof of work”. The miner then gets rewarded for the use of his computing power by the fees paid in every transaction and by a set amount of bitcoin known as the “block subsidy”.

The block subsidy is new money being created in the system that increases the money supply. It’s the “flow” and defines the inflation rate of bitcoin. Engraved into the source code, the block subsidy is set to halve every 4 years as seen in the chart below.

The last halving occurred on May 11th 2020 when the block subsidy went from 12.5 BTC to 6.25 BTC per block. The next halving will occur around 2024 when the subsidy will further decrease to 3.125 BTC per block. This means that eventually the block subsidy will come to 0 and the maximum amount of BTC ever to be in existence will be 21 million BTC. Bitcoin’s stock to flow ratio make it (or will make it) the hardest currency in circulation.

To drive the point home, while in the period of late 2019 and 2020 the FED increased the m0 money supply by 90%, Bitcoin only increased its money supply by 4%.

Conclusion

According to the flow to stock ratio measurement, Bitcoin is the hardest currency in circulation and it vastly outpaces the US dollar as a reliable store of value. This could explain in part why institutional investors are flocking to buy BTC as a hedge against a possible depreciation of the US dollar during 2021. This hardness of Bitcoin will only improve over time as the algorithm precisely and timely reduces the creation of new currency, preserving or improving its purchasing power.