Deflation and Bitcoin, the last word on this forum

[jtimon]

But does that observation invalidate my other calculations?

You've calculated the consequences of a set of conflicting assumptions. That's kind of like figuring out what happens if both "X=3" and "x>5" are both true. Even if you do the calculations correctly, it's hard to figure out what your results apply to.

What are the conflicting assumptions?

[JoelKatz]

What are the conflicting assumptions?

All of them as a set conflict. Which one you change so that they don't conflict is up to you.

For example, you cannot assume that I can get a 10% rate of return by doing nothing but would be willing to settle for a 5% rate of return on an investment. Those are conflicting assumptions. It is very unlikely you will ever see both of those conditions in the same world and the same time, and if you do, obviously very strange things will happen.

If you wish to assume that 1 bitcoin will be worth 5% more real value in a year than it is worth now, you cannot also assume that the present value of that greater future value is more than 1 bitcoin now. (How can something have a net present value of more than 1 bitcoin if anyone who wants to can buy it now for 1 bitcoin? That makes no sense.) Otherwise, you are assuming an economy that is concurrently experience both predictable long-term inflation and predictable long-term deflation.

[jtimon]

What are the conflicting assumptions?

All of them as a set conflict. Which one you change so that they don't conflict is up to you.

For example, you cannot assume that I can get a 10% rate of return by doing nothing but would be willing to settle for a 5% rate of return on an investment. Those are conflicting assumptions. It is very unlikely you will ever see both of those conditions in the same world and the same time, and if you do, obviously very strange things will happen.

Exactly, that's the reason why I think less people will settle for a investment.
Prior to the deflation, you could get 3% either making an investment or lending the money. With deflation, you get more by lending than what you get from investing so the interest rates must get lower, but they cannot go below zero. And real capital yields need to rise to yield as much as money lending. Let's say interest rates go from 3% to 1%. Now investments need to rise their yield to 6% or they won't be funded. Some investments that were viable without deflation are no loger viable because of it.
I wanted to keep the example simple, but I'm going to rewrite it.

If you wish to assume that 1 bitcoin will be worth 5% more real value in a year than it is worth now, you cannot also assume that the present value of that greater future value is more than 1 bitcoin now. (How can something have a net present value of more than 1 bitcoin if anyone who wants to can buy it now for 1 bitcoin? That makes no sense.) Otherwise, you are assuming an economy that is concurrently experience both predictable long-term inflation and predictable long-term deflation.

No, but the present value of 1 btc now (1 rc) must be greater than the present value of 1 btc later (1.05 rc) because of interest. And the financial and investments market have to adjust to meet that condition.
You say loans aren't affected by deflation, because it only affects the current price of btc (1 btc = 1 rc). But when you told me how to factor deflation and interest in the current bitcoin price we got reductio ad absurdum.

[JoelKatz]

Let's say interest rates go from 3% to 1%. Now investments need to rise their yield to 6% or they won't be funded. Some investments that were viable without deflation are no loger viable because of it.
I wanted to keep the example simple, but I'm going to rewrite it.

That's not correct. You are forgetting that those investments would have a higher return as well because a deflationary currency changes the time value of money.

No, but the present value of 1 btc now (1 rc) must be greater than the present value of 1 btc later (1.05 rc) because of interest.

That's correct. So the assumption that 1 btc is worth 1 rc now but will be worth 1.05 rc in a year changes the time value of money dramatically -- it means that 1 rc today must be worth more than 1.05 rc next year.

And the financial and investments market have to adjust to meet that condition.

They already will have. Otherwise, that condition wouldn't exist. You can't change one assumption while keeping all the others the same, the world doesn't work that way.

You say loans aren't affected by deflation, because it only affects the current price of btc (1 btc = 1 rc). But when you told me how to factor deflation and interest in the current bitcoin price we got reductio ad absurdum.

You got a reductio ad absurdum because you assumed both inflation and deflation at the same time.

Deflation simply means that more of the present value of money comes from its expected future value. But it is still worth precisely what it is worth, and that includes the present values of its future value. A borrower is borrowing the present values of those greater future values and gets to spend them, providing the notional surplus that compensates for the deflation.

Say I borrow 1 bitcoin for a year. I pay back 1 bitcoin plus some interest. You're thinking "I only borrowed 1 rc and I have to pay back 1.05 rc and that's before the interest -- unfair". But it is just as valid to think "I borrowed a bit more than the right to have 1.05 rc in a year, and I pay back precisely 1.05 rc in a year, before interest -- more than fair". I am paying back almost precisely the same thing I borrowed, plus interest of course.

And you'll note how perfectly balanced it is. The thing I'm borrowing more than I'm paying back, before interest, is the extra opportunity value of having that 1->1.05 rc for a year. And that is always precisely what the lender contributes and the thing for which he is paid interest.

[jtimon]

Let's say interest rates go from 3% to 1%. Now investments need to rise their yield to 6% or they won't be funded. Some investments that were viable without deflation are no loger viable because of it.
I wanted to keep the example simple, but I'm going to rewrite it.

That's not correct. You are forgetting that those investments would have a higher return as well because a deflationary currency changes the time value of money.

What's not correct? Interest rates go down or yields have to rise?
How real capitals increase their real yield through deflation?
Deflation reduces the nominal income, so you have to reduce the proportional yield or devalue the investment.
On the other hand, proportional yields will tend to rise as competing bakeries close down due to insolvency.

And the financial and investments market have to adjust to meet that condition.

They already will have. Otherwise, that condition wouldn't exist. You can't change one assumption while keeping all the others the same, the world doesn't work that way.

I guess the tricky thing is "from one day to another you has a 5% deflation period". The destruction deflation causes, makes the remaining real capital more profitable again, allowing money to market its time value.
There won't be more investments as long as money can't profit from its time value, that evil is the nature of interest. Capital yields tend to zero by competition, but when they try to push down the interest to zero, money (demanding a minimum tax on investments) stops further competition.
Deflation would cause the scarcity that would end with itself, so I don't think that a 10 year 5% deflation period is possible within a free market.  

You say loans aren't affected by deflation, because it only affects the current price of btc (1 btc = 1 rc). But when you told me how to factor deflation and interest in the current bitcoin price we got reductio ad absurdum.

You got a reductio ad absurdum because you assumed both inflation and deflation at the same time.

Deflation simply means that more of the present value of money comes from its expected future value. But it is still worth precisely what it is worth, and that includes the present values of its future value. A borrower is borrowing the present values of those greater future values and gets to spend them, providing the notional surplus that compensates for the deflation.

Say I borrow 1 bitcoin for a year. I pay back 1 bitcoin plus some interest. You're thinking "I only borrowed 1 rc and I have to pay back 1.05 rc and that's before the interest -- unfair". But it is just as valid to think "I borrowed a bit more than the right to have 1.05 rc in a year, and I pay back precisely 1.05 rc in a year, before interest -- more than fair". I am paying back almost precisely the same thing I borrowed, plus interest of course.

And you'll note how perfectly balanced it is. The thing I'm borrowing more than I'm paying back, before interest, is the extra opportunity value of having that 1->1.05 rc for a year. And that is always precisely what the lender contributes and the thing for which he is paid interest.

I'm not saying it's unfair, just that discourages real capital accumulation.
The fact that when you borrow 1 btc it includes the right to have 1.05 rc next year, doesn't change the fact that if you invest that 1 rc today, you need to gain 1.05 rc plus interest in a year to pay back the loan.
Without deflation if you invest 1 rc now, you need to gain 1 rc plus interest in a year, which is easier.

[JoelKatz]

I'm not saying it's unfair, just that discourages real capital accumulation.
The fact that when you borrow 1 btc it includes the right to have 1.05 rc next year, doesn't change the fact that if you invest that 1 rc today, you need to gain 1.05 rc plus interest in a year to pay back the loan.
Without deflation if you invest 1 rc now, you need to gain 1 rc plus interest in a year, which is easier.

In the deflation case, you borrow the right to 1.05 rc next year, and can invest/trade/whatever precisely that amount of value. You pay back 1.05 rc next year plus interest. You pay back precisely the same real value you borrowed, plus interest. It is no harder or easier.

You can only have this kind of deflation in a world where 1 rc today is worth very slightly more than 1.05 rc next year. So you are borrowing very slightly more than you are paying back. The difference is precisely the opportunity value of having the money sooner.

[jtimon]

I'm not saying it's unfair, just that discourages real capital accumulation.
The fact that when you borrow 1 btc it includes the right to have 1.05 rc next year, doesn't change the fact that if you invest that 1 rc today, you need to gain 1.05 rc plus interest in a year to pay back the loan.
Without deflation if you invest 1 rc now, you need to gain 1 rc plus interest in a year, which is easier.

In the deflation case, you borrow the right to 1.05 rc next year, and can invest/trade/whatever precisely that amount of value. You pay back 1.05 rc next year plus interest. You pay back precisely the same real value you borrowed, plus interest. It is no harder or easier.

But if the productions costs of a capital good you invest in today is 1 rc =1 btc, you don't care about 1 btc = 1.05 rc next year, because you no longer have the btc. With deflation you have to gain 0.05 rc more using the same capital good. Yes, it's harder.

You can only have this kind of deflation in a world where 1 rc today is worth very slightly more than 1.05 rc next year. So you are borrowing very slightly more than you are paying back. The difference is precisely the opportunity value of having the money sooner.

You're saying that the borrower is paying interest for the right to have 1 btc = 1.05 rc next year, but that's not true, he wants to invest it right now at 1 btc = 1rc. No one borrows money to hoard it. The opportunity value of having the money sooner will be more expensive with 5% deflation, even if interest rates drop from 3% to 1%.

If we were talking about inflation, it would all be much simpler. The inflation would be added to the nominal interest.
The borrower is happy to pay back the same 1 rc plus interest.
The lender would not lend at 3% interest with 5%, he would ask for 8% or would prefer invest it himself in something that just keeps its value and yields that 3%. The same cannt be applied to deflation because interest cannot go below zero.

[JoelKatz]

If we were talking about inflation, it would all be much simpler. The inflation would be added to the nominal interest.

The inflation wouldn't be added to the nominal interest. There is usually no way the lender can pass off the cost of inflation to the borrower. Inflation is like a "storage fee" on money. Since the lender is providing the money, he would have to pay the fee if he doesn't loan the money out. So how can he pass it on to the borrower?

For example, suppose I want to borrow your car for a month. And suppose we decide that $200 is a fair price for the wear and tear I'll place on your car and any liability you might have in case I damage the car, injure someone, get tickets, or the like. Now imagine we add something to the mix -- if you don't let me borrow your car for a month, you'll have to pay a $50 storage fee. Well logically now I should be able to negotiate a lower price. You can't pass on the $50 storage fee to me. This lower price I can now negotiate because you avoid the cost of holding the money perfectly balances the reduced value of the money I pay you back -- again, making the loan currency neutral.

The lender compares loaning the money to anything else he might do with the money. If sprocket futures are going up and reliably expected to continue to go up, he'll buy sprockets instead of loaning the money unless the borrower can pay more. A borrower must compete with everything a lender can do with his money -- the entire economy.

It's not whether the currency itself is inflationary or deflationary because the borrower or the lender could easily just change the money to a more favorable currency if that was the case. If some currency properties favored the lender, he'd just convert his money into that currency before lending it. And if some currency properties favored the borrower, he'd just seek loans denominated in those currencies.

[jtimon]

If we were talking about inflation, it would all be much simpler. The inflation would be added to the nominal interest.

The inflation wouldn't be added to the nominal interest. There is usually no way the lender can pass off the cost of inflation to the borrower. Inflation is like a "storage fee" on money. Since the lender is providing the money, he would have to pay the fee if he doesn't loan the money out. So how can he pass it on to the borrower?

No. Demurrage is like an storage fee, but with inflation, if the borrower doesn't want to pay the inflation premium, he can just take it by acquiring a real capital.

For example, suppose I want to borrow your car for a month. And suppose we decide that $200 is a fair price for the wear and tear I'll place on your car and any liability you might have in case I damage the car, injure someone, get tickets, or the like. Now imagine we add something to the mix -- if you don't let me borrow your car for a month, you'll have to pay a $50 storage fee. Well logically now I should be able to negotiate a lower price. You can't pass on the $50 storage fee to me. This lower price I can now negotiate because you avoid the cost of holding the money perfectly balances the reduced value of the money I pay you back -- again, making the loan currency neutral.

This is demurrage, not inflation.

The lender compares loaning the money to anything else he might do with the money. If sprocket futures are going up and reliably expected to continue to go up, he'll buy sprockets instead of loaning the money unless the borrower can pay more. A borrower must compete with everything a lender can do with his money -- the entire economy.

Exactly, that's why the lender would prefer to buy the bakery, rent it (taking the basic interest) and then sell it after 10 years for its new inflated price (inflation premium + principal sum).
From the wikipedia:

"Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate (approximately). For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate. As the rate of inflation decreases, this has the opposite (negative) effect on borrowers."

It's not whether the currency itself is inflationary or deflationary because the borrower or the lender could easily just change the money to a more favorable currency if that was the case. If some currency properties favored the lender, he'd just convert his money into that currency before lending it. And if some currency properties favored the borrower, he'd just seek loans denominated in those currencies.

I agree, that's why everyone would prefer to borrow freicoins instead of bitcoins.

[Boussac]

Since another thread got started today on the same subject and got locked, I feel compelled to reply here.

The emerging bitcoin economy cannot fall in a deflationary spriral IMHO for the following reasons:

1/Even if there is hoarding, the value of bitcoins will eventually stabilize to some equilibrium price or equilibrium deflation rate.
In fact, the wild fluctuations we have witnessed in a recent past look more or less like the growing pains of a small cap stock.
A continuous but steady deflation rate is not a problem since bitcoins are infinitely divisible.

2/ Bitcoins then can be used as a meta-currency: the bitcoin network will act as a transaction processor for money transfers in just any currency.
If I send dollars overseas using a bitcoin Forex, I am in fact sending my bitcoins to this Forex.
If I wish to maintain my stock of bitcoins at the same level, I can just buy them back from that same Forex.
The seller is the recipient that billed me in dollars.
The Forex makes a living out of transaction fees that are more competitive than existing money transfer services.

3/Hoarding can last only as long as one does not need to liquidate.

Therefore, I see no need for demurrage nor for other artefact to stimulate bitcoin trading.

[jtimon]

I'm not saying deflation will destroy bitcoin. I'm just saying that deflation discourages investments and therefore capital accumulation.
I make an example with a bakery previously in this thread.

[Ten98]

I'm not saying deflation will destroy bitcoin. I'm just saying that deflation discourages investments and therefore capital accumulation.
I make an example with a bakery previously in this thread.

Deflation does not discourage investment. This is a myth perpetuated by holders of Fiat currency.

[JohnDoe]

Deflation does not discourage investment.

This is a myth perpetuated by holders of Bitcoin.

[Ten98]

Ridiculous. Most holders of Bitcoin don't really understand deflation past the point of "if I hold on to this it'll probably be worth more some day". More to the point they've only really existed in any significant number for less than a year they haven't had time to perpetuate a myth.


I invest in a company and give them 50BTC, they do well and my return on investment is 75BTC over the course of a year.

DEFLATION SCENARIO
During that same year, heavy deflation means that the relative value of a Bitcoin has gone up by 10%
If I did not invest, I would have made 10%
If I did invest, I would have made 65%
Difference = 55%

INFLATION SCENARIO
During that same year, heavy inflation means that the relative value of a Bitcoin has gone down by 10%
If I did not invest, I would have lost -10%
If I did invest, I would have made 35%
Difference = 45%

For the same amount of risk, in a deflation scenario I stand to make more profit. Why am I discouraged from investing again?

In any case, Bitcoin is only deflationary *in theory*.

In practice it seems to be hyper-inflationary, as the value is dropping day by day.

[netrin]

Monetarily, bitcoin is far from deflationary and won't be monetarily stable for years. The fact that prior to this northern summer, the demand outpaced the supply does not imply that bitcoin is or will be inherently deflationary, only that bitcoin were appreciating against most other currencies in the past. Electronics are deflationary because the good actually loses value as newer, faster, smaller, better, cheaper electronics come on the market. Unless owners are hoarding the majority of their wealth in bitcoin, bitcoin appreciation should not detract from investment in bitcoin projects. Is the converse true, that with rapid bitcoin devaluation over the last few months, investment is surging?

[jtimon]

@ten98
You're using big profits in your example, with those profits, sure people will invest despite of deflation. Also I don't get why the inflationary investment yields 35% and the deflationary 65%.
Anyway, here's my example explaining why deflation discourages investment. I'm not advocating for inflation so I don't compare deflation with it, only with stable prices.

Although it may decrease interest rates (negative inflation premium), deflation can never take them below zero.

I still think deflation makes borrowing to invest less desirable.
Say we have a potential secure investment that yields 5% of its value annually and interest rates are at 5%.
Our baker starts his bakery (and discounting its own wage and other costs) profits a 5% of the investment that goes to pay interest. After twenty years, the baker sells his bakery at the same price and pays back the full loan.
With stable prices, the investment covers its financial costs and therefore is economically viable.
With deflation, you also have to cover the gains of money from deflation to get the loan.
Say we have 5% annual deflation.
That same investment won't get the loan.
Producing exactly the same and selling the products at lower price each day, the baker can lower his wage to compensate deflation and will buy its supplies at a lower price, but he cannot lower the interest. Even if the loan is made in a way that the monthly payment of interest for the whole period takes deflation into account, the borrower will not be able to pay the loan after that period.
We have assumed a constant revenue of 5% and assuming there's no changes in the competition, there's no reason to expect it to go down.
But the nominal revenue has decreased. What has happened is that the capital (the bakery) has devalued. In our case to 0.95^20 = 0.358485922 % of its original price.

The business should have grown at a 5% rate too to compensate deflation. The interest paid monthly could be nominally constant in this case. Only the very best investments will get funded with deflation.

Edit: this example is also discussed here.

[supermine]

The question is what will you do when it reaches 0.1 BTC/$ in a few days ?

[MoonShadow]

I'll buy everything you have for twice that right now.

[JohnDoe]

Ridiculous. Most holders of Bitcoin don't really understand deflation past the point of "if I hold on to this it'll probably be worth more some day". More to the point they've only really existed in any significant number for less than a year they haven't had time to perpetuate a myth.


I invest in a company and give them 50BTC, they do well and my return on investment is 75BTC over the course of a year.

DEFLATION SCENARIO
During that same year, heavy deflation means that the relative value of a Bitcoin has gone up by 10%
If I did not invest, I would have made 10%
If I did invest, I would have made 65%
Difference = 55%

INFLATION SCENARIO
During that same year, heavy inflation means that the relative value of a Bitcoin has gone down by 10%
If I did not invest, I would have lost -10%
If I did invest, I would have made 35%
Difference = 45%

For the same amount of risk, in a deflation scenario I stand to make more profit. Why am I discouraged from investing again?

Because realistically you will never get that return on your investment in a deflationary currency. You seem to miss the part where the company's revenue continuously shrinks and tends to 0 in the long run as deflation forces either a drop in prices or keep the prices at the expense of less demand. To be able to even try to pay its investors, all the company's profits have to go out as dividends, so it can never grow beyond its initial investment. Not that it has an incentive to grow anyway, as the value of all its assets will go down too. In fact there's no reason to even create a company in the first place other than to scam other people because just holding your money will in most cases net equal or more profit than running the company, with the added bonuses of being risk-free and work-free.

You can see this exact predicament in a real world company that you own shares of, SkepsiDyne Integrated Node.

"As of July 11, we've sold 2,029 shares, and sold the BTC raised for over $15,000.

We currently have 13 rigs producing ~12.8 Ghash/sec.

To date we have made 4 dividend payments totaling 211.6 BTC."

Shares were being sold at 0.75 by Tawsix so that makes the investment 1521.75 BTC, but the return has only been 211.6 BTC so far (old data from July I know, but OP hasn't been updated yet). Luckily the value of BTC is going down and the difficulty with it, but if we had continuous deflation there would be no way for the profits to reach the initial investment. I just skimmed through the latest updates but it doesn't look that the ROI will reach 0% even with the current favorable climate, judging by posts like this:

Dividends are paid!  The miniscule amount is because this was the week I switched the meter cycle to Wednesdays from Sundays, so we're paying for a week and a half of usage with one week of production.  Next week will be back to normal.  Also, got one rig up today, the others should be up before tomorrow is over, then we'll be back up to full capacity.  The electric bill was $230.74, and total mined BTC was 28.21.

So the cost of electricity was 28.84 BTC (using 8 $ per BTC) and revenue was 28.21 BTC. Not only there's a net loss making dividends impossible, there's no money left to reinvest in the company, which will further exacerbate the problem and eventually make the company go bankrupt. This same scenario will happen to every company in a deflationary economy, except for the net loss, that's just bad management.

[netrin]

Say we have 5% annual deflation.

A 0% interest loan in a 5% deflationary economy is equivalent to a 7% loan in a modern fiat 'stable' 2% inflationary economy. The difference is that members of the inflationary economy are encouraged compelled to spend, whereas a deflationary economy encourages savings. That is not to say that people will save 100% nor spend 100% in either environment, but during great inflationary times, spending becomes rampant (velocity) until the economy loses all value.