Monetary policy, Bitcoin, supply, and demandJanuary 19, 2021
One of Bitcoin’s many claims to fame is the fact that it provides a strong defense against inflation, with a supply mechanism that caps the total number of coins in circulation and controls the rate at which new money is created. This, in fact, points to how Bitcoin favors deflation, which incentivizes saving and allows us to clearly see progress in reduction of prices of the goods and services we consume.
The mainstream view is that a small amount of inflation is good, and that by targeting 2% year over year increases the economy runs just hot enough to keep consumption at a healthy level and avoid liquidity traps. This idea is enshrined in the United States Federal Reserve’s dual mandate, which states as the institution’s goal to keep unemployment low and prices stable. Other central banks around the world have equivalent objectives, and they all try to achieve that target by performing open market operations (i.e., buying and selling securities) that affect the amount of money in circulation, and by controlling the interest rate at which they lend to private banks, which ends up regulating the amount of private lending in the market.
With the 2008 crisis, the Fed started growing its balance sheet at an unprecedented rate to dampen the impact of the recession. The COVID pandemic caused a similar but even more pronounced reaction. In the chart below we can see the growth of assets owned by the Fed:
Data from FRED, WALCL
This, of course, is also related to the amount of money circulating in the economy. There are many different ways to approximate this, but if we want to focus on the most liquid money forms, we can use M1 as a measure, and count all the cash and assets that can be quickly be converted to cash:
Data from FRED, M1
The value of the bills in your wallet depend on the actions of your country’s central bank. Additionally, regardless of where you live, the value of your currency is also subject to the monetary policies of all other major economies, and if you’re not under the Fed, or the ECB, or another major bank’s umbrella, their influence will be significant. In theory, these entities make decisions for the benefit of their population, but ultimately they don’t have your best interest in mind. If you have a large chunk of unpaid student loans, you’re probably better off with higher levels of inflation, while the issuer of that loan would likely think otherwise. Similarly, if you have money in a savings account, you can think of yourself as a lender to the bank, and rising inflation would cause the value of your money to decrease over time. Now, what if you could shield your assets from the whims of these central authorities, who have such outsized impact on the value of your assets?
Enter Bitcoin and its decentralized network with a predictable, mathematically defined supply mechanism. The desire to protect yourself from central bank actions would lead one to think that the increasing supply of dollars is a large driver of demand for Bitcoin, as my friend Stephen Pimentel points out. Clearly, something changed in 2018:
Data from FRED, M1; Yahoo Finance, BTC-USD
Stephen posits an exogenous relation between the supply of dollars and the price of Bitcoin. If this is true, when the number of dollars circulating in the economy goes up, the demand for bitcoin (using its price as a proxy) should also go up. Again, looking at the data, there’s something to that story. In the scatterplot below, each point corresponds to a weekly pair of BTC/USD price and M1 values, while the red line is a simple linear regression of the two, showing they are indeed correlated.
Data from FRED, M1; Yahoo Finance, BTC-USD
I’m not an economist, nor a statistician, and this is a complex system, so likely there are some more nuanced aspects to consider here. For one, I believe the influx of institutional money into the crypto sector is part of the story, and perhaps controlling for that in the regression above would be helpful, but I don’t have a good metric to reflect that. Perhaps something like HHI within the Bitcoin ecosystem could do the trick.
Next, I am planning on aggregating narrow money measures across large central banks beyond the US, but assembling the dataset seems tricky. If you have pointers to data sources, or ideas of how to further this analysis, please share.
Thanks to Hannah Doherty, Max Faingezicht, and Stephen Pimentel for their feedback on early drafts of this post.
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