Macroeconomics Of Mined Cryptocurrencies

The "mining" in some cryptos is meant to evoke traditional mineral-extraction mining: digging valuable materials out of the earth.  It is of course not identical but in broad strokes similar models should apply.  Macroeconomics has a lot to say about these sorts of industries.  Let's apply the basics here.

We are not trying to make predictions about the future here.  Instead this is the beginning of a basic framework within which to analyse prices and explore ways in which crypto mining is not like traditional mining.

The Bitcoin Difficulty Adjustment

The Bitcoin blockchain, and many others, incorporates a "difficulty" measure to keep block times consistent.  Roughly: the network adjusts the difficulty of mining new coins to keep new block issuance on a steady schedule.

Every 2016 blocks the network the network checks how long it took to generate the last 2016 blocks and adjusts difficulty up or down to maintain a 10 minute per block target.  A more detailed explanation is here and many other places.

If you go out and spend a bunch of money on mining hardware you will have excess profits until the next difficulty calculation.  But after that the network adjusts and your profits disappear.  Yes you may earn a larger fraction of the coins on offer but, in the long run, you cannot speed up the production of coins no matter what you spend.

Regular old physical mining does not work this way!  This is like trying to build a gold mine where spending more money pushes the gold deposit further underground.

Note that it might be possible to game the system by massively increasing computational power after each 2016-block segment finishes.  But the production of mining hardware is an industrial process that grows in a linear fashion.  And there is no evidence for a cartel in the market hoarding ASICs and GPUs only to release them when the difficulty is low.  Check any chart of historical Bitcoin difficulty and it looks "natural."  Rather we see the price of mining hardware tracking the coins -- evidence for a normal, functioning, secondary market.

Basic Macro

We call the "market clearing price" the level where supply equals demand.  In traditional macro the two sides are known as  "aggregate demand" and "aggregate supply."  And the market clears when they are equal.  The standard diagram is:

Demand, in number of units, goes down as price goes up.  And supply, in number of units, goes up as price goes up.  This pair of upward and downward sloping curves tends to yield stable markets.  Suffice it to say there is more detail out there.  This post is not going to try to review all of macroeconomics -- you have Google for that.

Mining

Now let's build a toy model where supply comes only from mining.  This is not entirely dissimilar from real-world precious metals mining.  Thus the term.  So let's consider a world in which miners sell off their production and something like the Bitcoin difficultly adjustment is in play.  We get:

The difficulty adjustment is essential here.  It means you cannot buy more production for money.  We find a fixed quantity coin supply independent of price.

In econ terms "the aggregate supply curve is vertical" or "supply is inelastic."  That AD curve is also a bit simple.  Let's say the market receives a constant amount of inflows every day.  That means: inflow = price * quantity.  This gives us:

As mining gets more difficult the quantity on offer drops.  We can see the impact on price -- again given a fixed cash inflow -- from changing the quantity supplied easily:

This model is not entirely different from the well-known "stock to flow model."  Simply rearranging the equations we get roughly: price = inflow / mining.  Note that mining and inflow need to be measured over the same time period (i.e. daily, weekly, whatever).

Uneven Flows & Smarter Miners

It is unreasonable to expect the exact same inflow every day.  In practice we will see a range of demand curves for different levels of inflow:

The assumption that miners sell their entire production immediately is also too simplistic.  What if instead miners sell enough of their production to cover the cash costs of mining and hold the rest.  This looks a lot like the demand curve: cost = price * quantity.  Recall that a higher price does not lead to more productive mining!  The supply of mined coins is fixed because of the difficultly adjustment.

There is also some variation in the cost and quantum of production.  So we have a range of supply curves:

Under this pair of regimes volatility will be sky-high!  Find the intersections:

In standard macro the curves are pointing in opposite directions.  But in a market where supply comes from miners who must raise cash but are unable to increase their own inventories and demand from buyers injecting a fixed amount of cash there is no obvious equilibrium.  The intersection of the curves is chaotic.

This sort of behaviour is consistent with high volatility, high sensitivity to mining production and high sensitivity to the size of inflows.  With a difficulty adjustment the market does not "clear" in the traditional sense.