Deflation and Bitcoin, the last word on this forum

[JoelKatz]

Imagine we're gods and watch the entrepreneurs in our examples from above.
They don't know the future not the price deflation rate but we do.
My baker instead of not making his investment because of deflation, will make it. Because he doesn't know about the future deflation.
But we do, and we know that if he was right on everything else he will go bankrupt because of deflation.

I absolutely, 100% agree that uncertainty is bad. But be clear, he didn't go bankrupt because of deflation, he went bankrupt because he couldn't predict deflation. Any unpredictable change in the value of anything, including money, can cause a sensible plan to fail horribly. This is why hedging and similar techniques are so important.

Other than the fact that inflation acts as a tax when it's monetarily driven, inflation or deflation doesn't matter if it's predictable. If it's unpredictable or chaotic, both inflation and deflation are bad because people cannot reliably know what they should do. So long as it's predictable, it just gets priced in and it all cancels out.

[finway]

I absolutely, 100% agree that uncertainty is bad. But be clear, he didn't go bankrupt because of deflation, he went bankrupt because he couldn't predict deflation. Any unpredictable change in the value of anything, including money, can cause a sensible plan to fail horribly. This is why hedging and similar techniques are so important.

Other than the fact that inflation acts as a tax when it's monetarily driven, inflation or deflation doesn't matter if it's predictable. If it's unpredictable or chaotic, both inflation and deflation are bad because people cannot reliably know what they should do. So long as it's predictable, it just gets priced in and it all cancels out.

What about people hoarding bitcoins ,
this kind of deflation is unpredictable.

[jtimon]

Imagine we're gods and watch the entrepreneurs in our examples from above.
They don't know the future not the price deflation rate but we do.
My baker instead of not making his investment because of deflation, will make it. Because he doesn't know about the future deflation.
But we do, and we know that if he was right on everything else he will go bankrupt because of deflation.

I absolutely, 100% agree that uncertainty is bad. But be clear, he didn't go bankrupt because of deflation, he went bankrupt because he couldn't predict deflation. Any unpredictable change in the value of anything, including money, can cause a sensible plan to fail horribly. This is why hedging and similar techniques are so important.

But if he had predicted deflation he would have not make the investment. I insist, predictable or not, deflation hurts real capital in relation to money-capital. And that's really bad, because real capital is what we want.

Other than the fact that inflation acts as a tax when it's monetarily driven, inflation or deflation doesn't matter if it's predictable. If it's unpredictable or chaotic, both inflation and deflation are bad because people cannot reliably know what they should do. So long as it's predictable, it just gets priced in and it all cancels out.

That's the part they have in common. Changing prices caused by monetary events is inconvenient and mess with business plans.
As you say monetary inflation has another drawback which is being another tax, but somewhat hidden.
What I say is that deflation has also another drawback too, which is preventing investments.
I don't think the solution is government spending, but it's still a problem.
Monetary inflation is just a patch that doesn't solve anything: just postpones the deflation and makes it bigger, as it keeps the credit expansion going.
I'm more radical and I want to identify and prevent the causes, but first I would like that we agree it is a problem.
I've heard people in this forum saying that "deflation is good" and many others think "it doesn't have any special effect on the financial market". I want them to recognize, like Hayek, that deflation is a problem. That's all. I'm not keynesian and I don't want anybody to become one. I also think that his ideas on government spending and aggregate demand are condemned to die. Soon.

Maybe the causes of monetary cycles don't apply to bitcoin as 99percent says. We can discuss that too.

[lonelyminer (Peter Šurda)]

Jtimon,

JoelKatz and 99Percent made solid arguments, so I don't think I need to add much more. Just a bunch of minor things.

It is important to realise that Austrians use the term "deflation" to indicate a decrease in the quantity of money, rather than a decrease of the price level. While there are disagreements among some branches of the Austrian schools if all decreases in the quantity of money or just particular ones are "deflation", they all agree that they they do not mean a decrease in the price level. A decrease in the price level can be a consequence of deflation, but it can be a consequence of other things too, e.g. an increase in productivity.

Mises wrote that changes in the quantity of money are not socially beneficial. This includes a shrinking of the quantity of money, for example as a result of a prior credit expansion. A deflation is not a "fix" of inflation. The damage done by inflation is not reversed by a subsequent deflation, because the beneficiaries/victims of these two phenomena are unrelated groups. If Hayek says that deflation has negative effects, he's referring to the shrinking quantity, not to a falling price level. So Hayek's argument (if I got it right, I'm not a Hayek specialist, I only read two or three of his books) is that the central bank should have sustained the quantity of money rather than let it shrink (or, of course, expand it even further).

From the Austrian perspective, Bitcoin is not deflationary, as long as the amount of newly mined bitcoins is equal or greater to the amount of bitcoins lost.

You asked which sectors primarily benefit from deflation. It's a bit imprecise to look at it this way. It is more accurate to say that during the boom phase of the ABCT, production processes which expect to turn profitable at a more distant time in the future are preferred instead of those that are expected to turn profitable sooner. This does not necessarily mean any particular sector of the economy.

Also about the "intrinsic value", I don't know any Austrian economist subscribing to this point of view. There are a bunch of random guys on the internet argue along this way, but they are not actual economists. Robert Murphy in one of his recent lectures clearly pointed out that Mises opposed this concept with respect to money. The term "intrinsic value" mentioned once in Mises' Theory of Money and Credit comes from an unfortunate translation into English of his original German text and prone to misinterpretation.

[steelhouse]

Suppose the value of bitcoin at any given time in terms of wealth is x.   Deflation will happen if, the amount of wealth and services increase, the amount of saving increases, lost coins, or the population or number of users of bitcoin increases.

Suppose the total amount of bitcoin is the amount of water in the world, and it is the only currency in the world.   Thus you own a 40,000 gallon tank 3/4 full of bitcoin.  Thus you own 30,000 gallons of bitcoin.  Suppose your expenses are 100 gallons of bitcoin a day.  The point being you have some expenses.

Sum all the expense in society and you have total expenses and say that number is 107,303 gallons per day.  Now suppose the amount of savings or hoarding only allows 1,000 gallons to be spent.  What is going to happen is that hoarding will result in deflation, but there will be a point where spending will equal savings and deflation will stop.  The water of society will be flowing from tank to tank.

Yes over time, there might be 5% deflation a year from all 4 reasons above, but that is good for society because instead of people worrying about losing their money to inflation, buying gold, obtaining debt to counteract the inflation tax, they will just keep their money in the currency.

This is exactly what happened in the 19th century in the United States, where we became a small nation to one of the most economic powerhouses.  Instead of worrying about gold, people thought about capital and savings.

In summary Bitcoin is much better than liquidcoin or gold, where new coins will always be added.

[ribuck]

The key issue then is whether deflation would spiral out of control.

No society has ever experienced a deflationary spiral. It's not a realistic possibility. It's not something to fear.

But those who advocate inflating the monetary base just love for people to fear the fiction of the deflationary spiral.

[hashman]

OK I agree.  I finally figured out how bitcoin is deflationary. 

What it took for me was reading the current thread about "how many coins are lost" as well as the article about braincoins.  Braincoins are cool, but many are likely to go the route of their hosts.       

My problem was that I was short sited.  Bitcoins are inflating at 40% annually I thought, what is all this bs about a deflationary currency?  I'd like to congratulate the forethought of those worried about deflation already, and admit my mistake.  We should indeed describe a system with it's economic impact averaged over several generations.  While I might not live to see net monetary deflation of the coin, others will.   

[steelhouse]

OK I agree.  I finally figured out how bitcoin is deflationary.  

What it took for me was reading the current thread about "how many coins are lost" as well as the article about braincoins.  Braincoins are cool, but many are likely to go the route of their hosts.      

My problem was that I was short sited.  Bitcoins are inflating at 40% annually I thought, what is all this bs about a deflationary currency?  I'd like to congratulate the forethought of those worried about deflation already, and admit my mistake.  We should indeed describe a system with it's economic impact averaged over several generations.  While I might not live to see net monetary deflation of the coin, others will.    

Bitcoin will be a deflationary currency, in 20 years.  The inflation rate will drop to less than 10% in a couple years.  IOC, IXC, liquidcoin, and Solidcoin will have less inflation sooner.  

[JoelKatz]

What about people hoarding bitcoins ,
this kind of deflation is unpredictable.

It is predictable to some extent, and to that extent it is harmless. To the extent that it is unpredictable, yes, it is harmful. Anything unpredictable is very likely to do more harm than good.

[cunicula]

But that not only implies that predictable deflation is not possible in the long run, that implies that predictable deflation is not possible at all.

Not quite. These aren't quite logical proofs like the way you prove two plus two is four. The assumption behind the proof is that deflation is essentially perfectly predictable.

I'm jumping in the middle here, so I may have missed something. Deterministic deflation is completely possible. However, it is impossible for the deflation rate to exceed the real interest rate.

That if the annual real interest rate is 3%, then a currency can deflate by at most 3% per year.

(As an aside, deflation at a rate equal to the real interest rate is the socially optimal monetary policy in a wide class of deterministic monetary models. Not saying this applies to the real world, but interesting to note.).


Am I adding something here, or did you already cover this? If this adds something, would it help to post links to some key references on this subject?

I really think the concern with deflation is greatly overblown. It might not be the best idea to deflate, but there are other problems in bitcoin which seem obviously much more important (long-term security, motivation of initial adoption, short-term price stability). Why rattle away about this nonissue?

[JoelKatz]

Deterministic deflation is completely possible. However, it is impossible for the deflation rate to exceed the real interest rate.

That's correct. It just can't be currency-driven for anything remotely resembling a sensible currency. (Otherwise, among other things, speculators would buy up the currency today and build the future value into the current price.) It can be, for example, productivity-driven.

[cunicula]

Deterministic deflation is completely possible. However, it is impossible for the deflation rate to exceed the real interest rate.

That's correct. It just can't be currency-driven for anything remotely resembling a sensible currency. (Otherwise, among other things, speculators would buy up the currency today and build the future value into the current price.) It can be, for example, productivity-driven.

It is unclear how "correct" should be interpreted when it is accompanied by ambiguous phrases like "remotely resembling a sensible currency." I would not give your explanation full credit on an exam, though you do better than almost anyone else here.
Maybe this has made you a bit overconfident about your knowledge of monetary theory?

In the monetary models I refer to (called cash-in-advance models), there is no productivity growth involved, just discounting of future consumption. Discounting generates a positive real interest rate, call it r. The models have steady-state equilibria where output is constant each year (no productivity growth occurs). Deflation is then driven by withdrawal of currency from the money supply by the money issuing authority.

Under optimal deflation, the money supply evolves recursively as follows:

Money supply in year M(t) = m  (m is an arbitrary constant determined by how much money is printed in year 0)
Money supply in year M(t+1) = (1-r)M(t)

The price level evolves recursively as follows:

Price level in year P(t) = M(t)/Y
Price level in year P(t+1) = M(t+1)/Y

(Y is real output measured in constant prices. Y is the same for all t because there is no productivity growth in the economy and the equations are describing the steady state equilibrium.)

Substituting

P(t+1) = (1-r)M(t)/Y = (1-r)P(t)  , so we deflate at a rate equal to the real interest rate. In other words, prices fall each year at a rate r.

Speculators do not have a reason to invest in money to raise P(t) to P(t+1) during period t. The rate of return from investing in money is r. Speculators can obtain the same rate of return, r, from investing in other types of risk-free assets. Diverting investment funds to money does not make speculators better off. Therefore, there is no reason to expect P(t) to increase to P(t+1) in period t.
 
I do not want to go into any other details of the model here. This topic is a diversion from more important issues. However, I am happy to post references (or lecture notes if I can find them). Of course, if you want to pretend that you know what you are talking about...

[JoelKatz]

You are correct.

[cunicula]

You are correct.

Thanks. I apologize for being a smart, asshole guy, here. You seem like a smart, nice guy. That is clearly better.

[steelhouse]

As an analogy, everyone has a water tank and a spicket of water flow for cost of living, entertainment, and travel.  If you have a tank full of water and prices drop your tank effectively got fuller.  As result you will have more money to spend.  Thus, you can turn the spicket up more.  Nobody hoards in safe investments or currency for the fun of it.  They do so to buy something in the future or for emergencies.  Eventually the water flowing out of spickets of society equals the money flowing into savings accounts of society.  You have a balance or no deflation.  

Inflation does not cause people to invest, it makes people have less return on their cash and investments.  They go towards food stamps, teaching, militarism, and debt.

 

[cunicula]

Aka a fallacy of the Keynesian morons.

There is nothing remotely Keynesian in the model. It is derived from classical economic theory. Keynes plays no part. Your misunderstanding here is clearly due to extreme stupidity and ignorance.

Moreover, the model I outline is actually used to critique of Keynesianism. The model's optimal monetary policy is deflationary. Inflation in the model taxes people who are holding money, but not people who hold other assets. To avoid the inflation tax, people shift resources away from money and into other assets that yield higher returns. Under inflation, the society holds a smaller amount of money than is socially efficient for txn convenience. Under optimal deflation, people are indifferent between holding money and other assets as investments. The inflation tax disappears and the society holds the optimal amount of money.

Now, any further discussion with you is clearly beneath my dignity.

[jtimon]

Jtimon,

JoelKatz and 99Percent made solid arguments, so I don't think I need to add much more. Just a bunch of minor things.

Not sure what 99Percent thinks now because I thought I agreed with him and you and Joel didn't.
I'm not sure he means what I think when he said:

In order for investments to be worthwhile in a deflationary economy, profits would have to be much higher and with a quicker turnaround. 

Summarizing, my point was that...

1) Capital yields tend to equal the real interest rate.

2) The real interest gets greater with deflation (compared to nominal interest)

3) Nominal interest rate can't be under zero (at least with capital-money). So using the formula nominal interest = real interest + inflation premium, with nominal rate = 0 = real rate - deflation rate,  real rate = deflation rate. Which is what cunnicula is saying.

Now, we have a capital A and we consider its profitability.
In the first case (without deflation) the investment is profitable if its capital yield is above the real interest rate, which is equal to the nominal interest rate.
Say current average capital yields and the real interest rate are at say 5%.
Borrowing money at 5% to make that 5% yield capital investment seems right.
Now with deflation, say at 10%, the nominal interest on the loan should be -5% (which we have already stated is impossible) for the same capital investment to be equally attractive.   
Or in other words, in this deflationary context, the capital yield should be 10% to be as attractive as the 5% investment in the stable prices context.
According to cunnicula, this is impossible because of what I just said. But what's the mechanism that prevents that from happening?
Let's say we have a shrinking monetary base that would produce a 10% price deflation. How that 10% turns into a 5%?
What I think happens is that investments stop, driving capital yields and the real interest higher. That is, deflation creates an artificial scarcity on investments (we could say the same thing for the basic interest, but that, although related, is another discussion) that is product of the money-capital being temporally superior to real capitals because of deflation. Deflation, by slowing real capital investments, make their yields rise.
It's obviously more interesting to have a fountain when there's only two of them around than what it is when everybody have their own.   

Do we agree that deflation can make it harder for capital to be profitable?
What am I missing here and in my bakery example? What's wrong in my reasoning?

[JoelKatz]

Do we agree that deflation can make it harder for capital to be profitable?

Yes, but you have the cause and effect precisely backwards.

You're assuming you can hold the monetary system constant as you imagine various changes in economic productivity. But the monetary system responds to the economy. For example, Bitcoins can become scarce because of their built-in scarcity. But they can also become scarce because demand goes up due to economic productivity. And either way, the result will be in increased effective supply of Bitcoins in the form of things like demand notes, mortgages, or bonds circulating as currency.

What will happen, unless you imagine a coercive government mucking with the process (say by printing currency, borrowing endlessly, or strong arming interest rates), is that the economy will drive the currency to encourage sensible investment, or non-investment, as makes sense.

[highlevelminer]

I think the main point to recognize here is that without an official government or oganization backing every BTC it will always be open for unsavory behavior.

This type of monetary herding (or hoarding) causes dis faith and un trust amongst those who actively proport its finances.

To simply state that through developmental formulae and vissectomy the bitcoin has a secured future is naïve.

It needs to be actively and ethically supported just as much as it needs to be actively and ethically traded.

[lonelyminer (Peter Šurda)]

For example, Bitcoins can become scarce because of their built-in scarcity. But they can also become scarce because demand goes up due to economic productivity. And either way, the result will be in increased effective supply of Bitcoins in the form of things like demand notes, mortgages, or bonds circulating as currency.

I have a comment on this. I would not go as far as saying that this is incorrect, but it's definitely inadequate. The supply of Bitcoins denominated instruments will not increase merely because there is demand for more Bitcoins. This is especially true for instruments which are a medium of exchange. Anyone can issue a Bitcoin denominated instrument. They can do it right now. However, in order for this instrument to be treated as a substitute of Bitcoin, it needs to provide identical, or better utility. To achieve this with, say, gold or the monetary base of fiat money is pretty straightforward. Gold cannot be traded electronically, for example, so as long as people want to trade electronically, this creates a demand for gold-denominated instruments which can be traded electronically. Since Bitcoin is form-invariant, such stark contrast does not exist. There are situations where a Bitcoin-denominated instrument does have a specific advantage over Bitcoin, but they are rather limited in scope. It's even possible that their existence is temporary, until someone finds out how to implement the same (or better) featureset using Bitcoin directly. I am particularly skeptical whether the difference can be sufficient to give rise to a Bitcoin-denominated instrument as a medium of exchange.

I tried to think of a helpful analogy, but could only find a cumbersome one. Let's say that there is a high demand for iPhones. This demand probably cannot be satisfied by clay bricks cut into same dimensions as an iPhone. Merely because they have the same size, it does not follow that from economic point of view, they act as substitutes. Similarly, merely because a financial instrument is denominated in Bitcoins, it does not follow that its supply satisfies the demand for Bitcoins, because they are not necessarily substitutes from economic point of view.

Therefore, rather than an emergence and proliferation of substitutes, I think a more likely outcome of increased demand would be a rise of value of Bitcoin.