3 Reasons Why Bitcoin Is Sound Money

bitcoin-sound-money

Last Updated on November 5, 2024

Bitcoin is the best form of sound money mankind has ever known.

Until very recently, gold held that title.

Then in 2009 some anonymous guy called Satoshi Nakamoto wrote some code, released a white paper and changed monetary history forever.

Bitcoin came into the world as digital money that was sounder, harder and superior to gold.

Sound money means money that effectively functions as a store of value, a medium of exchange and a unit of account over a long period of time.

To be sound, money needs to be hard. Money’s “hardness” refers to the difficulty of producing new monetary units.

For gold, this means extracting the metal out of the earth’s crust. For fiat, this means typing a few zeros on a keyboard. For Bitcoin, this means solving proof-of-work equations in a process known as mining.

Gold held the title of the hardest money for thousands of years because its unique chemical properties made it particularly suitable.

It is scarce, malleable, durable, portable and fungible.

The total amount of gold ever mined is estimated to be 205,238 tonnes. To put it into perspective, this is approximately a 22m3 cube. It’s really not a lot of gold.

Throughout the 20th and 21st centuries, the amount of new gold mined relative to the existing stock has been approximately 1.5% per annum, a small and reasonably predictable rate of inflation.

While this is a small amount of new stock, the amount of gold that humans can mine from the earth’s crust is practically limitless. So while gold is scarce, it is not finite.

Fiat, on the other hand, is “easy money.” It takes very little effort to create new units. Fiat doesn’t need to be dug up out of the ground. Every time a commercial bank makes a loan or a central bank buys a bond, new monetary units come into existence. The annual increase of fiat money far exceeds that of gold and there is no physical limitation on the rate of increase.

Bitcoin is harder money than gold because there is a fixed limit on its supply. There will only ever be 21 million bitcoin.

The block reward for mining new blocks is also programmed to diminish on a predetermined schedule. Over time there will be a smaller and smaller flow of new supply added to the existing stock until one day new supply will reach zero, forever.

Additionally, the mining of bitcoin gets harder and harder as more miners compete for a finite amount of bitcoin.

Normally when something becomes money the demand for it goes up, thus its price goes up. This incentivises more mining, which means more supply and thus a drop in price.

The key difference with Bitcoin is that no matter how much people are incentivised to mine, supply cannot be increased as the new rate of supply is fixed in the code.

The combination of the supply cap, the diminishing block reward and the increasing mining difficulty make Bitcoin the hardest money.

Let’s cover each of these aspects in more detail.

Why Bitcoin Is Sound Money

1. Bitcoin’s Supply is Limited to 21 million

The key reason why Bitcoin is sound money is that there is a fixed and unchanging supply cap.

There are only 21 million bitcoin and that’s all there will ever be.

No other form of money ever had a supply cap. With gold, you could always dig more out of the ground. But not with Bitcoin.

This cap makes Bitcoin different to every other form of money and any other asset. No authority can mine more Bitcoin, print more Bitcoin or dilute the stock of existing Bitcoin.

Saifedean Ammous, in The Bitcoin Standard, describes Bitcoin as having digital scarcity:

"With this technological design, Nakamoto was able to invent digital scarcity. Bitcoin is the first example of a digital good that is scarce and cannot be reproduced infinitely. While it is trivial to send a digital object from one location to another in a digital network, as is done with email, text messaging, or file downloads, it is more accurate to describe these processes as copying rather than sending, because the digital objects remain with the sender and can be reproduced infinitely. Bitcoin is the first example of a digital good whose transfer stops it from being owned by the sender. Beyond digital scarcity, Bitcoin is also the first example of absolute scarcity, the only liquid commodity (digital or physical) with a set fixed quantity that cannot conceivably be increased. Until the invention of Bitcoin, scarcity was always relative, never absolute."

Jason Williams, in Bitcoin: Hard Money You Can’t F*ck With puts it another way. He says that Bitcoin isn’t scarce, it’s finite:

“Gold is scarce, but bitcoin is finite. There’s a difference. We’ll almost certainly find more gold in the oceans one day. We might even mine gold on asteroids in the future. No-one truly knows how much gold actually exists. This can’t happen with bitcoin. We know its total supply is 21 million. It’s hard-coded. You can literally check the code and see it right there in front of you. 21 million bitcoin.”

Whichever way you describe it, Bitcoin’s hard cap of 21 million is the key reason it is the hardest form of money. It gets harder and harder to produce new units over time until we reach the 21st million bitcoin and then new supply falls to exactly 0.

While the number of 21 million is completely arbitrary and could have been anything, the fact that it is set in stone and unchanging is what makes Bitcoin sound money.

2. The Stock to Flow Ratio Increases Over Time

Bitcoin miners compete to successfully mine each block. A block is a bundle of Bitcoin transactions. Each block is added to a chain of previous blocks, hence the term blockchain. A new block is added to the chain approximately every 10 minutes.

A miner who successfully solves the Proof-of-Work problem and adds the next block in the chain receives a reward, known as the block reward.

At the start, Bitcoin’s block reward was 50 bitcoin per block. Every four years the block reward is cut in half, in a process known as the halving. In 2012 the block reward was reduced to 25. In 2016 it was reduced to 12.5. In 2020 it became 6.25 and in 2024 it will reduce again to 3.125 and so on.

What this means is that bitcoin’s stock to flow ratio increases over time.

Stock refers to the existing stock of bitcoin and flow refers to the new bitcoin being added to the supply.

Over time, as more and more bitcoin are mined and the rate of new supply falls due to the falling block reward, the stock to flow ratio will get higher. In other words, the percentage of new supply relative to the existing stock will get smaller.

The stock to flow ratio of gold is also commonly measured. But with gold the ratio fluctuates over time as the production rate of gold is fluid and is not fixed.

Bitcoin is very different. The code has been programmed so that a new block is added approximately every ten minutes. And there is a pre-determined schedule of new production that is diminishing over time.

This means both the stock and the flow of Bitcoin are known to market participants in advance. They know that Bitcoin is finite and that there is no chance of a new injection of supply.

Compare that to the discovery of silver in the Americas or the Californian and Victorian gold rush. The discovery of new precious metals stocks increased supply and lowered the value of existing stock.

Such an event is impossible with Bitcoin. There will only ever be 21 million and we know the exact schedule of the arrival of new supply.

Ten minute block and four year halvings were arbitrary decisions, like the 21 million cap. But the key is that this monetary policy cannot be adjusted or changed.

This is what makes it hard money.

3. Bitcoin Gets Harder To Mine With More Miners on the Network

In conjunction with the fixed supply and the falling block reward, the other key reason for Bitcoin’s hardness is that the mining difficulty is set according to the code, and it gets more difficult as more miners compete to mine Bitcoin.

Neither fiat nor gold have any adjustable difficulty when it comes to creating new units.

With gold, or any other commodity money, one of the critical flaws is that an increase in price leads to an incentive to increase production, which leads to more supply. For example, a significant rise in the price of gold will lead to more resources being dedicated to gold discovery and production and thus more ounces of gold extracted out of the ground.

With Bitcoin, a rise in price leads to an incentive for resources to be dedicated to mining Bitcoin. However, unlike gold or commodity money, this increase in resources does not lead to an increase in the quantity of Bitcoins mined. That’s because as more miners are attracted to the network, the difficulty of solving the mathematical problems required to mine each block increases, ensuring that each block takes about ten minutes to process.

No matter how many miners there are competing for Bitcoin, new blocks will be added to the chain approximately every 10 minutes and the block reward will be what is predetermined in the code.

Saifedean Ammous explains:

“The quantity of bitcoins created is preprogrammed and cannot be altered no matter how much effort and energy is expended on proof-of-work. This is achieved through a process called difficulty adjustment, which is perhaps the most ingenious aspect of Bitcoin’s design. As more people choose to hold Bitcoin, this drives up the market value of Bitcoin and makes mining new coins more profitable, which drives more miners to expend more resources on solving proof-of-work problems. More miners means more processing power, which would result in the solutions to the proof-of-work being arrived at faster, thus increasing the rate of issuance of new bitcoins. But as the processing power rises, Bitcoin will raise the difficulty of the mathematical problems needed to unlock the mining rewards to ensure blocks will continue to take around ten minutes to be produced. Difficulty adjustment is the most reliable technology for making hard money and limiting the stock-to-flow ratio from rising, and it makes Bitcoin fundamentally different from every other money. Whereas the rise in value of any money leads to more resources dedicated to its production and thus an increase in its supply, as Bitcoin’s value rises, more effort to produce bitcoins does not lead to the production of more bitcoins. Instead, it just leads to an increase in the processing power necessary to commit valid transactions to the Bitcoin network, which only serves to make the network more secure and difficult to compromise. Bitcoin is the hardest money ever invented: growth in its value cannot possibly increase its supply; it can only make the network more secure and immune to attack.”

Competitors Do Not Decrease Bitcoin’s Hardness

A common criticism of Bitcoin’s 21 million hard cap is that, while Bitcoin may be limited, there is no limit to the amount of other cryptocurrencies that can be created, and thus Bitcoin is not scarce.

This is an understandable position at first glance but does not stand up to scrutiny.

Firstly, it must be noted that most altcoins are not attempting to be competitors to Bitcoin. Most are attempting to offer some form of technological use case that is different to sound money.

However, some are attempting to be a better version of money than Bitcoin.

What they are up against is Bitcoin’s key value proposition – its immutability. The network is run on thousands of computers worldwide with no one person or organisation in charge. Nobody can change Bitcoin’s monetary policy.

Many competing coins have emerged, promising to be faster or cheaper than Bitcoin but none have been successful in dethroning it. While one could argue that it might be better to be faster and cheaper, the mere act of creating a new coin with new features would destroy immutability and put monetary policy in the hands of a centralised group of individuals.

Saifedean Ammous explains:

“Bitcoin’s advantages lie not in its speed, convenience, or friendly user experience. Bitcoin’s value comes from it having an immutable monetary policy precisely because nobody can easily change it. Any coin that begins with a group of individuals changing Bitcoin’s specification has with its creation lost arguably the only property that makes Bitcoin valuable in the first place. Bitcoin is straightforward to use, but virtually impossible to alter. Bitcoin is voluntary, so nobody has to use it, but those who want to use it have no choice but to play by its rules. Changing Bitcoin in any meaningful way is not really possible, and should it be attempted, will produce another pointless knock-off to be added to the thousands already out there.”

Bitcoin’s One Potential Limitation As Sound Money

I am, however, in the minority camp that sees one potential flaw in Bitcoin – the lack of privacy.

Since everything is recorded on the blockchain for all to see, Bitcoin has no privacy and thus its fungibility could be called into question.

In other words, 1 BTC may not equal 1 BTC since newly mined bitcoin could trade at a premium over old bitcoin that are tainted through criminal use or other uses the government deems unsanctioned.

That’s not to say I think this will happen. Just that it might.

Privacy coins like Monero offer an alternative. There is a scenario where a coin like Monero supersedes Bitcoin in use or exists alongside Bitcoin but as the smaller player.

However, even if this occurs it does not change Bitcoin’s hardness. The 21 million supply cap, the decreasing block reward and the increasing mining difficulty cannot and will not be changed.

Interestingly, Monero, as an example, does not have a supply cap. Unlike Bitcoin, block rewards will never fall to zero. Monero has a “tail emission” which means the block reward will always be a minimum of 0.6 XMR.

This means Monero is always going to be slightly inflationary. However, Monero’s inflation is set by the code and is always predictable. Relative to existing supply the rate of inflation will continuously fall.

Monero too is sound money but it is not as hard and will never be as hard as Bitcoin. Nor is it attempting to be so.

Conclusion

Bitcoin is sound money because it has a maximum supply of 21 million. In conjunction with the hard cap, Bitcoin is programmed to reduce the block reward from mining by 50% every four years.

Additionally, Bitcoin’s difficulty adjustment means new supply will arrive at a pre-determined schedule in the code, regardless of how many miners are in competition for rewards.

Market participants know exactly how many bitcoins have been mined, how many are still to be mined and the rate at which they will be mined.

Monetary hardness refers to the difficulty of creating new units. It is more difficult to create new Bitcoin than it is to create new units in any other form of money.

This combination of factors make Bitcoin unique as sound money. Gold was formerly the soundest money known to man but it has no maximum supply, variable rewards and no difficulty adjustment.

An increase in the price of gold would lead to any increase in mining activity and thus an increase in supply. New discoveries would dilute the value of existing stock.

These things are impossible with Bitcoin.


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Sources

Ammous, Saifedean. The Bitcoin Standard : The Decentralized Alternative to Central Banking Hoboken, New Jersey: John Wiley & Sons, Inc, 2018.

Williams, Jason. Bitcoin: Hard Money You Can’t Fck WIth. Going Parabolic, 2020.

Image Credits

Bitcoin by Thought Catalog on Unsplash

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