In the Bitcoin white paper, BTC was compared to physical gold for the first time.
Both investment assets have both been touted as potential inflation hedges for diversified portfolios.
However, this status has been challenged as both assets have experienced a sell-off amid the recent inflationary environment.
We look at a brief history of gold and Bitcoin, compare Bitcoin vs gold, and consider whether these investment assets can still fulfill their promise of being a hedge against inflation.
The question has been asked many times: Is Bitcoin the digital equivalent of gold?
Few asset classes are as controversial as gold and Bitcoin. Some advocates trust nothing else, while others cannot understand why they have any value at all. Both are treated as alternative currencies and have promised to be a hedge against inflation and a safe haven in turbulent markets.
However, against the backdrop of the recent market downturn and rising inflation, Bitcoin has been highly correlated with tech stocks and risk assets. Meanwhile, the gold price has been stuck in the same range since June 2020.
Can gold and Bitcoin still fulfill their promise of acting as an inflation hedge? Let's take a deep dive into their history, qualities, and use cases to investigate whether these investment assets can play a similar role in investors' portfolios.
A brief history of gold
Gold has always attracted people and is part of almost all cultures in the world. Found in Bulgaria between 4600 and 4200 BC, the gold artifacts of Varna are often called the oldest in the world.
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Due to its attractiveness to people all over the world, the monetary use of gold caught on early and it became a globally accepted medium of exchange. The first known gold-bearing coins were minted in Lydia (Asia Minor) around 600 BC.
Introducing the Gold Standard
At the end of the 19th century, after the precious metal had proven its monetary properties in many countries for thousands of years, the Gold Standard was introduced in major economies such as England and Germany. The Gold Standard was a monetary system in which a standard unit of account such as the German mark or the pound sterling was based on a fixed amount of gold.
The Gold Standard was introduced primarily to improve the ability of money to be exchanged. People could exchange their paper claims (money) at a bank for gold. Most industrialized nations followed suit by 1900, but some countries abandoned the Gold Standard again during World War I in order to fund their military spending, which unfortunately lead to hyperinflation.
In the midst of the Great Depression, as some countries were still recovering from World War I, gold hoarding and bank runs became common as people lost confidence in their paper money. Raising interest rates was supposed to incentive people to keep their bank deposits. However, it also caused increased funding costs for businesses to such an extent that some countries, including the United Kingdom, abandoned the Gold Standard altogether in the early 1930s.
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Abolishing the Gold Standard
The United States took a different approach to prevent gold hoarding and maintain the Gold Standard. Citizens were not allowed to exchange their paper money for gold, and the Gold Reserve Act finally banned private ownership of gold in 1934 altogether.
Some 37 years later, on 15 August 1971, President Nixon would finally abolish the Gold Standard, clearing the way for today's common fiat monetary system, which allows the government to issue currency that is not backed by a commodity.
The Great Inflation
The chart below shows the consumer price index (CPI) over the last 100 years. It rose from 16,900 in January 1922 to 42,100 in September 1971, a 249% increase in about 50 years.
In contrast, since the US moved to the fiat system, it has risen to 296,311, an increase of 704% over a 51-year period.
US inflation since 1922
Source: https://fred.stlouisfed.org
Under this new regime in the 1970s, also known as the Great Inflation, inflation reached double-digits and gold, now being available to the public, became a popular vehicle to protect one's wealth against the loss of purchasing power. Gold rose from $35 to $850, a 24-fold increase over the course of a decade. After this enormous bull market, it took more than 25 years for gold to reach its previous highs.
A brief history of Bitcoin
While gold has been around for thousands of years, Bitcoin entered the world less than 15 years ago. In 2008, Satoshi Nakamoto created a successful concept of digital scarcity that was incorporated into his vision of a “peer-to-peer electronic cash system”.
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In technical and simplistic terms, Bitcoin is an open-source, decentralized public ledger with a built-in incentive mechanism for miners to verify transactions in exchange for fees. As a reward for the network's security, miners receive newly issued bitcoin every 10 minutes.
Users of the network use public and private keys to send and receive the network's currency, BTC. With their private keys, they can conduct transactions without a central third party being involved in the process.
This is the basic idea of the Bitcoin network. It is a ledger that holds the values assigned to different addresses (users) and allows its users to access their money under their own authority. This idea has been extremely successful and popular, with Bitcoin reaching 100 million users faster than the Internet since it is accessible to anyone with Internet access.
Is Bitcoin digital gold?
The first time Bitcoin was compared to gold was in the Bitcoin whitepaper itself, which states that “the steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended."
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And in fact, there are similarities between the mining of gold and Bitcoin, as both assets are finite – less and less of both assets remain to be mined.
The Bitcoin halving
Approximately every four years, the number of new coins that Bitcoin miners receive as a reward for securing the network halves. This feature is called the Bitcoin halving cycle.
Currently, a miner earns 6.25 BTC per block mined. As fewer and fewer new Bitcoins are distributed, the scarcity of the asset will continue to increase.
So far, each halving cycle has been followed by a rapid price increase. However, since 19 million of the maximum 21 million Bitcoins have already been mined, this effect will probably play a smaller and smaller role in the future.
Gold vs Bitcoin remaining supply
While it has taken just over ten years to mine 19 million Bitcoin, it is estimated that the remaining 2 million Bitcoin will not be mined until 2140.
Compared to Bitcoin, only approximately 79.5% of all gold reserves have been mined. It remains unclear when the increasing difficulty of gold mining will finally make mining operations unsustainable.
BTC: Self-custody and means of payment
There are remarkably few financial assets that do not require a central counterparty to be held. Real estate is one of them, but it is not transferable, liquid, or fungible. The same applies to transactions and payments, for which we usually need a central third party to execute and verify them. This leaves cash, gold and digital assets.
Because Bitcoin is a native digital asset, it can be transacted online, across borders, and in real time without a third party and thus remains in proprietary custody.
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Like fiat currencies, and unlike gold, each individual BTC or fraction thereof has no use apart from its properties as a means of payment and store of value. Although the digital currency was designed as a peer-to-peer payment network, it is too volatile to be used for everyday payments and has long made a name for itself as a hedge against inflation, mostly due to its limited supply.
BTC vs gold: The inflation narrative
Physical cash loses value over time as the amount of existing fiat currency increases. Fueled by the 2008 financial crisis and more recently by the Covid-19 pandemic, the money supply (M2) in the US has skyrocketed over the past two decades, from $4.6 trillion in 2000 to $19.5 trillion in 2021.
Over the last century, the US dollar has lost over 96% of its value (the average currency has lost far more). A visualization by Visual Capitalist shows the impact of this in a powerful graphic.
How the purchasing power of the US dollar has changed
Cash is therefore a useful medium of exchange that remains relatively stable in the short to medium term in most countries. However, it is less useful as a store of value.
As the global money supply continues to grow upward without a hard cap, gold and Bitcoin have been touted as excellent hedges against inflation due to their fixed, limited supply. However, this status has been challenged as the two assets (but most notably Bitcoin) have experienced a sell-off amid the recent inflationary environment.
Is Bitcoin an inflation hedge?
Although Bitcoin was touted as an inflation hedge, it has never had to prove itself in an inflationary environment until now. With inflation on the rise and monetary conditions tightening as a result, Bitcoin's price performance disappointed many as it experienced a 59% sell-off from $46,209 to $18,965 from its highest to its lowest point in 2022. Could Bitcoin fail to deliver on its promise to be an inflation hedge?
It is true that Bitcoin has not shown any positive correlation with inflation figures during the recent market sell-off. Instead, the chart below shows how Bitcoin declined sharply as M2 (broad money) growth declined in the US.
Bitcoin price vs US M2 money supply
Source: https://ycharts.com
As a far less volatile asset, gold has temporarily lost around 7% in value since the beginning of the year. In relation to other investments such as technology stocks and digital assets, the precious metal has outperformed under extreme conditions, despite the negative returns.
Which is a better inflation hedge?
However, while gold has only lost 7% of its nominal value, this does not take the rising inflation into account. Inflation is a lagging indicator, meaning that inflationary pressures have already materialized by the time inflation numbers are being released.
While the short-term price performance does not necessarily disqualify gold or bitcoin as an inflation hedge, it only works as such before the inflationary pressures materialize. Once they materialize, liquid assets such as cash become a better investment option. This is because rising prices put pressure on monetary policy, which drives asset prices.
With that in mind, let’s take a look at the performance of gold and Bitcoin over the last decade.
Gold vs Bitcoin over the last decade
Comparing the performance of gold and BTC is difficult as it depends heavily on a variety of factors such as local currencies, different inflation rates and the time horizon.
For simplicity, we will look at inflation-adjusted returns in the US over a 10-year period. The historical data below shows how these investment assets would have increased or decreased from 1 January on the year of allocation to 1 January 2022.
Gold vs Bitcoin inflation-adjusted returns
Investors who opted for buying gold when it traded at $1,565 on 1 January 2012, $263 lower than 10 years later in 2022, would have earned a return of 16.81%. However, when inflation is taken into account, the investor's purchasing power actually dropped by 6.01%.
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Gold and the Global Financial Crisis
Following the Global Financial Crisis in 2008 and amid simultaneous fears of inflation and a banking crisis, the price of gold rose to $1,881 per ounce in 2011. However, as Europe recovered from the crisis, gold entered a one-year bear market, and it took almost nine years for gold to regain its pre-cycle high in 2020. Nevertheless, shortly after its bull market high, the yellow metal would have proven to be a store of value until early 2022.
In contrast, Bitcoin would have consistently increased the purchasing power of the investor. It remains to be seen whether this trend will continue in the future. As digital assets are extremely volatile, it can be concluded that they offer no short-term protection against inflation.
However, even based on today's Bitcoin price ($23,250 on 8 August 2022), only an allocation in 2021 would have delivered a negative return of -23.43%.
Key takeaways
A millennia-old store of value or nascent technology? Gold and Bitcoin are among the few assets with limited supply that can be held in self-custody and used as a means of payment. However, despite the similarities, they react very differently to market conditions. As such, both could be used by investors as part of a diversified portfolio.
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Historic inflation-adjusted returns show that both gold and Bitcoin can be utilized as inflation hedges before higher inflation hits. Once inflation takes its toll on monetary conditions, however, these hedges may not be able to withstand the withdrawal of liquidity.
Furthermore, gold is valued as a pure store of value over the long term. Meanwhile, equities and Bitcoin tend to be more attractive to investors in times when the economy, businesses, and global liquidity are abundant.
As such, Bitcoin and gold may actually prove to be complementary investment assets that can be used as a portfolio diversifier. However, due to the volatility of digital assets, investors must first ascertain if an investment in Bitcoin fits with their risk tolerance.
IMPORTANT NOTICE: This blog does not constitute investment advice and is for informational purposes only. The price of digital assets can go down as well as up and you may lose all of your capital. Investors should consult a professional advisor before making any investment decisions.
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DISCLAIMER: The content of this article does not constitute financial advice and is for informational purposes only. The price of digital assets can go down as well as up, and you may lose all of your capital. Investors should consult a professional advisor before making any investment decisions.
