Stock to Flow Fallacy

Stock-to-Flow historically describes the relationship between capital and income, allowing a future capital level to be estimated from an expected income level. Later this elemental concept was applied to money supply generally.

The ratio of stock to flow is a measure of time. Given a higher ratio, stock will increase more slowly. There is a theory that money with a higher inherent stock-to-flow ratio will suffer less proportional monetary inflation than a money with a lower ratio. The theory holds that the higher ratio implies a “harder” money, defined as inherently more resistant to the effects of monetary inflation.

In the case of commodity monies, the theory fails to consider the source of flow rates. It necessarily assumes that the rate of production is simply a property of the commodity. But production of anything occurs when the anticipated price makes production profitable. A greater profit potential results in more competition, accelerating supply increase. More people digging for gold increases its flow.

In other words, commodity flow is a function of demand for the commodity. An anticipated loss results in no production whatsoever. This lack of any flow is not inherent in the substance but a consequence of lack of demand. Given that both supply and demand determine commodity flow, the theory is invalid for monies without predictable supply. This error is not an aspect of the elemental stock-to-flow concept, but a misapplication of it.

Stock-to-flow does not imply anything about future commodity flow. It can be used to analyze historical relations, and to calculate future stock based on assumed future flow, but it cannot be used to predict future flow. Any statement that a speculation is better or worse than another based on historical stock-to-flow ratios is an error.

Furthermore, in the case of two monies where the flow of each is predictable (e.g. two Bitcoins), it is necessarily incorporated into price, thus having no effect on relative speculative returns. Ratio differences have no bearing on the relative “hardness” of two predictable supply monies. While neither money suffers the effects of monetary inflation, return remains a function of demand. Given that predictable flow has no effect on speculative returns, the theory is invalid for predictable supply monies as well.