March 17, 2018 Reading Time: 3 minutes

The basic economics of gold mining are straightforward, but the process is volatile and unpredictable. When the resource costs associated with mining one ounce of gold (machinery, discovery, labor, payoffs to government officials, etc.) are sufficiently less than the value of one ounce of gold, there is an economic incentive to mine gold. Of course, gold mining is capital-intensive and requires a long-term commitment, both complicating the calculus. Specifically, what does the gold miner do if factor costs go up in terms of gold? Since the world no longer uses gold as a unit of account, what does the miner do if the exchange value of gold falls relative to the unit of account relevant for the company? These are just two of many issues that make gold-mining stocks some of the most volatile you can own.

Historically, because of the incentive cited above, new capital for gold mining followed a pattern of boom and bust. Capital flows in when new, lower-cost gold fields are discovered or when new mining technologies lower the cost of extraction. Contrary to popular belief, the amount of mining activity has little impact on the price of gold relative to everything else. This is because virtually all the gold ever mined is still accounted for in various central bank and private hoards. This in turn is why gold has been the ultimate store of value for 3,000 years. As economist Larry White explains, when the market demand for gold increases or decreases, gold goes in and out of storage to adjust to the changing need. The stability of gold’s value also means miners are price takers, with little impact on the market price of gold.

The basics of bitcoin mining are also straightforward, but they’re different from the basics of gold mining in many ways. Miners discover new bitcoins at a prescribed, increasing level of difficulty and increasing energy usage. As long as the market value of new bitcoins exceeds the cost of discovery, new bitcoins will come on line at the prescribed rate, but ultimately discovery will stop at 21 million. Citing Larry White again,

The most important difference between Bitcoin and gold lies in their contrasting supply and demand mechanisms, which give them very different degrees of purchasing power stability. The stock of gold above ground is slowly augmented each year by gold mines around the world, at a rate that responds to, and stabilizes, the purchasing power of gold. Commodity (non-monetary) demands also respond to the price of gold and dampen movements in its value. The rate of Bitcoin creation, by contrast, is entirely programmed. It does not respond to its purchasing power, and there are no commodity demands.

Price volatility due to a vertical long-run supply curve is one of many reasons why I and others think bitcoin is not suitable for use as sound money.

Here’s where it gets complicated. The bitcoin “miners” are also responsible for validating bitcoin transactions. So it is important to distinguish bitcoin the coin, which is a unique digital signature, from Bitcoin the blockchain system, which validates the ownership and transaction information. People who speculate about the ultimate market value of bitcoin often conflate the digital coin with the payment/validation system it runs on, thereby coming up with analogies to Visa or MasterCard. It is fair to question what will happen when bitcoin mining becomes uneconomical. Who will validate the transactions? What will happen to the valuation of bitcoin?

Many proponents of the Bitcoin system argue that ever-increasing computing technology will continue to make mining cheaper and solve the problem, but it’s hard to take such predictions of the future as certain. The above questions pose real challenges to Bitcoin as well as pointing out the critical differences between mining it and mining gold.

John R. Skar


John Skar is an actuary with more than 30 years of senior management experience in US and international life-insurance industries.

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