Currency, Carry and Entropy

Things ain’t what they used to be

or

How currencies are not stores of value.

One of the standard attributes that money is claimed to have is that it acts as a store of value.

“Store of value” tells you that it is the current holder’s intent to keep the currency for a while before exchanging it and that during that time before the exchange, the currency is expected to hold its purchasing power. Money, however, has a “particular requirement “that is the proverbial fly in the ointment. That characteristic has interesting and not so often mentioned consequences on how to view the “store of value “attribute of money.

Gold bugs like to mention how gold has maintained its value over time and how that value has never gone to zero or completely disappeared, like many fiat currencies have done. This may be true, but it is a grossly incomplete statement of affairs. What is always missing in that observation is the storage cost, the negative carry, that come along with holding gold and how it impacts holdings both on a micro and macro level.

Gold – Micro

Logically, if you really believe that gold is a currency, and not just an asset, it is used in your transactions as well. With that assumption in place the ultimate value of your gold holdings will be zero.

The reason why your holdings will be reduced to nothing is because you will pay for the storage of your gold asset in gold – your currency. Even if you don’t physically scrape a few grams off your good delivery bar (no more), to make your annual payment to the safe-keeper, in effect that is what you do.

If you start with 100oz of gold and you pay 1oz in storage costs per year, (1% of your holdings, not an abnormally high storage charge) after 30 years you are left with 70% of your hoard. After 100 years your heirs have literally nothing – It has all gone to storage costs / negative carry. You may be using gold that you earned doing something else – salary or whatever – but you are still using gold to protect your gold and using gold that flows into your pocket rather than from your stock of gold to pay for storage costs is simply a matter of how you choose to account for your expenditure.

Back to your gold bar that you are holding on to. If your heirs decide to keep the gold bar after you have lived a long 100 years and have died, they are quite literally throwing good money after bad. Your heirs would have been better off had you tossed your gold bar into the river.

Bulkier precious metals like silver are worse. They are physically larger and therefore more expensive to store. Additionally, silver specifically, corrodes slowly but surely so your pile will melt away at an even higher rate.

So much for gold / Precious metals as store of value – on an individual / micro level at least.

Gold has 2 primary reasons for safeguarding. Entropy and humans. Gold bars as we know them are not pure gold on purpose – the 100% variety is too soft. They are alloyed with other metals to give them more rigidity.

Gold is a very soft metal and when you see how much a quarter (a copper core coated in nickel) can wear down you can imagine that if gold coins were handled by people all the time they would literally wear away into very fine gold dust. Although technically the gold would still exist, it would be in a form that is for all practical purposes unobtainable and can be considered lost.

The second, vastly more pressing reason, is humans. Humans steal. Humans lose things. Humans die without telling their heirs where the gold is buried. Humans with either poor sailing skills or bad luck in choosing weather sometimes sink galleons.

The more gold gets handled the greater the chances of loss. There is a reason why even central banks prefer to keep their gold in one place, even if it is in another country that they are not exactly friends with, and just sign over the title rather than physically ship it.

Some lost gold will be found – think of coins that are dug up or scooped out of the ocean, but some won’t. The latter losses are essentially lost to the system.

If you own gold as a store of value, not just as jewelry, when was the last time you put it in your backpack and took it for a walk?  Something that for all intents and purposes is not something you want to have with you has limited use as a store of value.

Gold, which is supposedly so transportable and anonymous, in reality isn’t. Even the chemical signature of gold can tell quite a story – it is a whole lot more traceable than commonly is thought[i].

Gold – Macro

When you pay your safe-keeper in gold s/he now has that ounce you paid. Gold was transferred away from you, but not lost to the system. Your gold guardian however had to expend time and resources on keeping your stash safe. In order to do all of that s/he takes a bunch of the gold you paid as storage fees and in turn swaps it to other people for various goods and services. So that gold too gets dispersed more and more widely (remember, gold is the currency and is used to settle debts).

So in a macro sense the physical gold does not disappear but resources are spent to keep it that way and resources are in turn also spent to safeguard that gold. As more gold is spread around the globe for payments the more gets lost/stolen and the amount of goods and services (energy really) dedicated to just maintaining it are significant. The bigger the aggregate hoard of gold you have, the more society spends on keeping other people from having it. And that is not exactly the most productive use of labor and resources….

The more gold that has been dug up and concentrated, the more that can, and will be lost because large hoards are more attractive to steal – Goldfinger wasn’t trying to rob a jeweler who had a couple of ounces lying around – so the effective loss rate will increase over time unless more and more resources are consumed to protect the hoard. The presence of gold then increases entropy in the system without any corresponding increase in productivity – the opposite really because society will spend more resources on protecting what should be a medium of exchange, something which enables transactions between productive goods, but instead more and more resources are devoted to keeping the medium of exchange secure.

Fiat currency – Micro

Fiat currency comes in 2 forms.

The first kind comes in the form of the physical bills and coins that you can put in your pocket. Those can get lost or destroyed. Your average 20-dollar bill lasts about 8 years before it is shredded and a new one must be printed to replace it ^[ii]. Coins last longer but quite a few of them get lost^[iii] (but who knows how many are found). So physical fiat currency has negative carry for sure – it wears out and needs to be replaced every so often.

Once you own currency you can lose it – it can drop out of our pocket, your kid can steal it, and so you need to protect it. And buy a coin sorter to put on top of your safe while you’re at it.

The plus side of physical currency is that it creates value as it is made – for some of it at least. Although it costs 2.41c to make one penny ^[iv] it costs 19.6c to make a $100 bill[v]. In 2020 5.1bn notes (226.3bn of value was printed [vi] at a cost of 877.2mm so if you want to choose to ignore inflation you can argue that printing money creates value. Inflation in 2020 was estimated to be 1.4% so for a 21.48T economy that would be around 300bn – a number that is pretty close to the 226.3bn of new currency created. That is likely a coincidence though. The physical money stock is a significant portion of the total. As of January 2021, there was 2.04T worth of federal reserve notes floating around ^[vii] vs 6T in M1 ^[viii]

The electronic form also requires inputs – you need to check/transfer your stash of digits and so you need a device like a computer or phone to do that. To use the digits you have accumulated you need a distribution device like a credit card. That too has all kinds of digits associated with it that you need to keep track of. You will need binders or computers and hard drives etc. to keep track of those numbers, and they need to be fed electricity and periodically replaced. Just to keep the stash of both physical currency as well as electronic currency functional a continuous stream of inputs is required. The machinery required to process transactions needs feeding too.

Fiat currency – Macro

After the digits leave your domain they still require constant feeding by others to keep them alive. Banks have / are huge administrative machines to keep track of all those numbers. Those numbers are also checked by regulators, auditors and the like. Then they send you statements so you, the owner of the number, can see the number on a piece of paper. We are continually burning fossil fuels and hacking down trees to keep track of the digits which are yours. And the digits by themselves don’t keep you warm or feed you. You need to get somebody else to want those digits and give you a loaf of bread in return.

As long as the digits are in existence the digit-processing apparatus needs to be fed labor and inputs to keep them in existence.

An advantage that fiat currency has – the digital form at least –is that its creation requires virtually no resources. Unlike gold it doesn’t have to be dug out a hole in the ground because it is made as required. Also, the quantity of fiat currency can vary with need – it is not fixed – so the mismatch between supply and demand can be greatly reduced if one chooses to do so.

Bitcoin – Micro

There are 2 ways to get your hands on a bitcoin – “mine” it or exchange it for fiat currency (or gold if you would like) – i.e. buy it.

When you mine bitcoin you’re using energy with various portions of embedded fossil fuels to run calculations that eventually will give you a bitcoin. Mining is an appropriate word because you are releasing something that is already in existence. Of course, it could just be released on some kind of timing mechanism, randomly on a wait list for eager participants but the computing that miners do validates and records bitcoin transactions. The miner provides a service and in return will eventually get a bitcoin.as compensation.

As long as you own a bitcoin there is a chance greater than zero that you will lose it. Once you lose it, it is highly unlikely that you can recover it. It is estimated that around 20% of all bitcoins (so that is quite a bit more than zero) that exist have been irretrievably lost.^[ix] Losing bitcoins is different from losing gold or currency. Unless you lose the physical key (written down) and somebody else picks it up from the street, once a bitcoin is lost it won’t be found by somebody else. There is an asymmetry that gold and fiat don’t have. Your stolen gold or currency are still in existence but simply owned by a different party. If you want to keep your private BTC key safe you will need either an off-line computer, store it on a disk and put that in a safe, or some kind of secure place. In a way you end up in a similar situation to owning gold – a physical object that needs to be safeguarded.^[x] If you truly believe that BTC is a (the) currency, logically the safekeepers and the infrastructure providers will end up owning all bitcoin because that is the currency in which you pay them. Your computer, electric bill will all be paid in BTC. Also keep in mind that the concept of BTC rising or falling in price simply doesn’t apply because bitcoin IS the currency.

So unless you have an external source of BTC your stash will slowly but surely get smaller because of negative carry.

Bitcoin – Macro

Bitcoin and bitcoin transactions depend on computer networks that continuously consume energy and over time need to be upgraded and replaced. Like the gold example, if you truly believe that bitcoin is a currency and your electric bills were paid in bitcoin the electric utilities would eventually own all bitcoin^[xi]. The utilities would be using the bitcoin to pay their bills, thereby circulating BTC through society and put it in the hands of other people who then in turn will want to keep it safe and accessible. All of this activity has a significant environmental footprint which is indicative of entropy. ^[xii]

Once all bitcoins are mined and there no longer is a reward for people to dedicate computer resources to verify transactions, society somehow must muster the resources to do this on an involuntary basis – either charge for bitcoin ownership or usage or some type of taxation. And that charge would be levied in – of course – bitcoin.

Let’s see if we can draw some preliminary conclusions.

Both gold and BTC are supply limited, one by nature, one by decree / design and that produces the problem of either a static or very slow growing currency supply in a dynamic economy. Fiat currency is not supply constrained which also has certain consequences.

All these 3 options for currency have negative carry which makes it so  that none of them are or ever can be a store of value because they consume themselves. Both gold and BTC, if held long enough, will lead to a 100% loss. This loss is baked into the cake although it may not be that obvious to any given holder in the chain of ownership largely because gold and BTC are in effect externally subsidized and siphon off resources from outside (bitcoin) the system in order to exist.

Fiat currency has a different destiny. It feeds on itself and creates itself.

The loss is ultimately caused by entropy – to maintain anything requires inputs and if that which you are trying to maintain is the same thing that is required for maintenance, you end up consuming that which you treasure and are trying to maintain, at least on a micro level.

On a macro level, things are somewhat different. Gold will be what it is but as long as people are around you will use up resources keeping it out of “their” hands i.e.  you are consuming resources to just keep it.

The entropy issue is more acute for both fiat currency as well as bitcoin because both require continuous inputs to remain functionally “alive”. If there were some kind of global issue where power went out for a prolonged time it would be highly likely that a number of the digits – the ones to describe fiat currency as well as the digits to describe BTC, would be lost or scrambled. Transacting in any meaningful way would be impossible. Physical cash would still be around though (until it is worn out and needs to be replaced).

Fiat currency is differentiated by the fact that is created when needed (a loan is made) and extinguished when the need for it has disappeared (the loan is repaid) so at least the stuff won’t be around forever and in theory one should be able to minimize the amount of money in the system.

The underlying problem for all currencies as stores of value is that they are not productive assets.

All three that were discussed exist in systems where slowly but surely the value erodes for several reasons touched on above. All need external inputs to keep existing, or to remain in your possession.

Money then is not and cannot be a store of value in any economic system as long as that same money is used to make payments (to safeguard the hoard). Entropy makes the combination of being a store of value and a medium of exchange incompatible. The more of it that you have sloshing around the less efficient your economy is because a greater part of the productive part of the economy needs to be directed to safeguard and manage the hoard.

The only role money – whichever flavor you prefer – is as a unit of account and as a way to settle transactions between economic players like producers and consumers. The only real question then becomes which currency requires the least external inputs to exist.

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[i] https://www.sciencedirect.com/science/article/abs/pii/S0883292708000176

[ii] https://en.wikipedia.org/wiki/United_States_twenty-dollar_bill

[iii] https://money.howstuffworks.com/how-much-money-accidentally-throw-away.htm

[iv] https://www.thepricer.org/how-much-does-it-cost-to-make-a-penny/

[v] https://www.federalreserve.gov/faqs/currency_12771.htm

[vi] https://www.federalreserve.gov/paymentsystems/coin_currency_orders.htm

[vii] https://www.federalreserve.gov/faqs/currency_12773.htm

[viii] https://alfred.stlouisfed.org/series?seid=M1&utm_source=series_page&utm_medium=related_content&utm_term=related_resources&utm_campaign=alfred

[ix] https://www.investopedia.com/news/20-all-btc-lost-unrecoverable-study-shows/

[x] https://coinsutra.com/store-private-keys-seed-key/

[xi] https://digiconomist.net/bitcoin-energy-consumption

[xii] https://www.bloomberg.com/opinion/articles/2021-01-26/is-bitcoin-mining-worth-the-environmental-cost?srnd=premium&sref=hEO85HQm