Bitcoin and Deflation

Pundits frequently cite Bitcoin’s “deflationary nature” as one of the reasons why it will never succeed as a global, widely accepted currency.

But is bitcoin really deflationary? And is this actually a problem for the currency?

In the paragraphs to follow, I aim to address these concerns.

Bitcoin: Deflationary or Inflationary? #

We know that a currency is inflationary if its purchasing power decreases over time. Two percent inflation over 35 years means that if $10 originally bought you a 12-pack of beer, it can now only be used to purchase a 6-pack.

Conversely, a currency is deflationary if its purchasing power increases over time (you get more beer for your money if you wait to spend it).

So, how does purchasing power go up or down?

If the growth of the money supply outpaces the growth of the economy, inflation occurs, while if the economy grows faster than the currency supply, deflation occurs.

Today, the supply of Bitcoins is ever-increasing. However, the demand for capital in the Bitcoin economy is outpacing the supply. This is why we’re seeing the bitcoin price rise with respect to the dollar. Put another way, Bitcoin is experiencing deflation.

But… is deflation a necessary property of the Bitcoin economy? I’d argue that it’s not.

The total number of bitcoins is in fact capped - the protocol dictates that there will only ever be twenty one million bitcoins. Thus, it is safe to assume that if the bitcoin economy continues to grow while the supply of bitcoins remains fixed, deflation will persist.

However, everything in the Bitcoin protocol is subject to change. Small changes that are obvious to everyone can easily be pushed through and drastic updates to the protocol simply require 51% of the voting power to decide that they are necessary.

That means that the algorithm that controls the creation of bitcoin can be modified. The 21 million bitcoin cap is only a temporary feature, and we may see the community vote to increase that number eventually.

And… if the cap is increased to such an extent that the growth of supply outpaces the growth of the Bitcoin economy, then bitcoin holders will experience inflation rather than deflation.

Is monetary deflation even bad for the economy? #

Quite a few economists (probably a majority) hold the view that currency deflation is bad for the economy. And the rationale for that perspective goes something like this:

1. inflation incentivizes spending today over spending tomorrow (saving), while deflation encourages saving over spending
2. high spending/money velocity is good for the economy, while excessive saving can have a drag effect on the economy
3. if there exist benefits of encouraging saving over spending (such as a potential increase in upward mobility), those benefits are dwarfed by the downsides

Now, these premises may very well be correct. However, it is important to note that we don’t have very much evidence either way, so I’d say it’s premature to suppose that deflation is necessarily bad.

Further, gold bugs will point out that over most of human history we’ve had a deflationary currency system and we seemed to do quite fine.

Does it even matter whether Bitcoin is deflationary? #

The inflationary (or deflationary) state of the dollar matters mainly because:

1. prices are denominated in USD
2. Americans hold the bulk of their wealth in dollars and dollar-denominated assets

So, in the case of Bitcoin, the deflationary/inflationary state only really matters if one of the above becomes true with respect to Bitcoin. That is, if people set prices in bitcoins (BTC) and store most of their wealth in bitcoin and BTC-denominated assets.

And I’d surmise that even if we start making the majority of our purchases using bitcoins, we’ll still probably set prices in USD and we’ll still hold the bulk of our wealth in USD, converting it to bitcoins on an as needed basis.

In this scenario, spending will absolutely not be discouraged.

The Gist #

I definitely hear the concerns regarding Bitcoin’s deflationary tendencies. However, I’m skeptical that they will actually pose a problem.

For one, anything in the Bitcoin protocol is subject to change and so deflation might eventually be curbed.

Second, even if Bitcoin continues to experience deflation, there is no need to worry about a slowing effect on the economy, so long as prices are still denominated in USD and dollars remain the primary store of value for American citizens.

Last, even if Bitcoin becomes the dominant world currency and there is a slowing effect on the world economy, that effect might not be as big as we think, and the deflation might actually come bundled with benefits that exceed the drawbacks.

So you can quit having those deflation nightmares now.