Medium-term effect of low-inflation of Bitcoin money supply.

[rta]

I'm regularly reading articles about how deflation [sic]* will kill Bitcoin, and I'm just not getting it. I'm not an economist (as is true for many of those writing said articles), but let me put this in laymen terms with an example, and see if anyone can poke holes in it.

Some time in the not too far future:
Average Joe decides to put some of his money in bitcoins. Not only have they a tendency to increase in value measured against most fiat currencies, but they can also be used to buy a lot of stuff, especially online. The valuation is somewhat volatile, and he has been warned that bitcoins might be entirely worthless at some point, so he decides to limit his holding to, say, 10% of his savings, although he starts out with a lower amount, say 5%.

Since the of the value of bitcoins tend to go up, he ends up using dollars for most of his shopping and only use bitcoins when there is all but no choice. [Gresham's law; this is as far as I can tell, one of the main attacks mounted in articles worrying about the slow increase in bitcoin money supply]. He only uses bitcoins when there are large savings to be had, like when paying small amounts or at places like bitcoinstore, or when paying sites that are abroad or seem too shady to leave a credit card number at (Average Joe has a weakness for HD-porn).

Now, focusing on the monetary issues, one of two "bad" things could happen to Bitcoin:
1) The value of a bitcoin increases slowly over time. Mr. Joe is happy with his bitcoin holdings, but find that even though every coin becomes more valuable, his total holdings are shrinking. Since it has been a good investment so far, he replenishes his holdings to 5%, or maybe slightly more.
2) The value of a bitcoin increases rapidly. Mr. Joe is spending a fair amount, and still sees his holdings increase in value. Once his total Bitcoin holdings approach 10% of his savings, he start spending bitcoins for stuff he could equally well buy with fiat, or sell some of them. Over time he decide to increase his holdings above 10%, but only slowly, because economy experts on TV keep reminding him that the value will collapse one day.


Now, I'm aware that these two are not the only possible outcomes for Bitcoin, but they seem to be what economists worry about. So let's not discuss stuff like bitcoin value dropping, quantum computers breaking encryption or governments outlawing bitcoins here. As far as I can tell, Mr. Joe's behaviour in situation 1 will contribute to keep the Bitcoin economy stable and thriving, while his behaviour in situation 2 will contribute to move the Bitcoin economy towards situation 1. Can someone please point out for me what the big problem is, or where I have made a fault assumption?

* Bitcoin money supply is currently not deflating and will not for a long time. The word is often used to describe a decrease of prices, which is not it's original meaning.

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[cpunks]

As far as I understand, the scenario to be feared would happen, if the following chain of events happened:

1. bitcoin value can be foreseen to increase vastly
2. holding bitcoin is foreseeably more profitable than spending bitcoin
3. a point is reached where creation of new bitcoins has almost stopped
4. additionally, a point is reached where few transactions occur with bitcoins (holding is profitable, after all, so everyone expects their money's value to increase)
5. transaction fees are not sufficient for miners to make a profit
6. miners start requiring higher transaction fees
7. transactions become more expensive to make
8. fewer transactions are made
9. miners start leaving
10. with less miners, there is less security (easier to mount attacks)
11. attacks start succeeding

...and at this point, either value drops and it becomes reasonable to circulate bitcoin instead of holding it, or attacks succeed to such a degree that confidence in the Bitcoin system is lost.

In an ideal world, people realize the possibility of such a chain of events, and avoid holding unreasonably large amounts of non-circulating BTC. Circulating BTC is not harmful to network health, as it can be "taxed" by transaction fees and offers incentive for miners to secure the block chain. If the block chain is sufficiently secured, attacks will not sufficiently succeed, and confidence in the system is not lost.

P.S. As a sidenote, some bitcoin clones are trying to rule out the possibility of runaway deflation by implementing a demurrage fee (all holdings gradually leak away to miners, approximating inflation at a controlled rate). I actually consider this a safer bet than Satoshi's, but unfortunately the only credible project trying to do this (freicoin) is operated by a foundation which wants to control and distribute 80% of the initial money supply, and as an opponent of planned economy, I will keep my distance from their project until they've successfully done this or finished trying.

[nybble41]

Since the of the value of bitcoins tend to go up, he ends up using dollars for most of his shopping and only use bitcoins when there is all but no choice. [Gresham's law; this is as far as I can tell, one of the main attacks mounted in articles worrying about the slow increase in bitcoin money supply].

This is actually based on a misinterpretation of Gresham's law, commonly abbreviated "bad money drives good money out of circulation". If you look at the full form of the law it's actually referring to money which is overvalued and undervalued, respectively, when compared to the market price. For example, under bimetallism in the U.S. there was a legally-fixed exchange rate between gold and silver coins, while the actual market values of the two metals fluctuated. When the law caused gold coins to become undervalued, people hoarded them and spent their silver, and vise-versa. The coins were legal tender, so merchants had no choice but to accept them in payment of debts at the fixed exchange rate, even if the coins were currently worth less than their face values.

In the case of Bitcoin there is no fixed exchange rate; if the value is generally expected to increase over time, that will affect the net present value to the merchant as well as the buyer. The increase or decrease will not cause bitcoins to be under- or over-valued with respect to other free-market currencies. Gresham's law would only apply if there was a fixed exchange rate between bitcoins and fiat currency. For example, if the U.S. government declared that USD $1000 was equivalent to 1 BTC for the purposes of legal tender, when the actual exchange rate was $1100/BTC, people would have an incentive to settle their debts with the overvalued USD rather than the undervalued BTC.

[rta]

1. bitcoin value can be foreseen to increase vastly
2. holding bitcoin is foreseeably more profitable than spending bitcoin

The effect (and truthfulness) of that would be dampened by people finding bitcoins risky. After a vast increase in value, some speculators will take profits, and other, more modest investors, will find themselves with too much of their holdings in bitcoins (above 10% in my above example), and thus wanting do diversify out of it. This will dampen the increase in value, or might even reverse it.

I think we witnessed the effect of this when BTCUSD passed 200. We can hope that when Bitcoin matures, investors/speculators will react more quickly, reducing the volatility.

P.S. As a sidenote, some bitcoin clones are trying to rule out the possibility of runaway deflation by implementing a demurrage fee (all holdings gradually leak away to miners, approximating inflation at a controlled rate). I actually consider this a safer bet than Satoshi's, but unfortunately the only credible project trying to do this (freicoin) is operated by a foundation which wants to control and distribute 80% of the initial money supply, and as an opponent of planned economy, I will keep my distance from their project until they've successfully done this or finished trying.

I think many people like the idea that they can store value in the same commodity as they use for trade. With demurrage baked in, the currency will be less useful.

[rta]

This is actually based on a misinterpretation of Gresham's law, commonly abbreviated "bad money drives good money out of circulation". If you look at the full form of the law it's actually referring to money which is overvalued and undervalued, respectively, when compared to the market price. For example, under bimetallism in the U.S. there was a legally-fixed exchange rate between gold and silver coins, while the actual market values of the two metals fluctuated. When the law caused gold coins to become undervalued, people hoarded them and spent their silver, and vise-versa. The coins were legal tender, so merchants had no choice but to accept them in payment of debts at the fixed exchange rate, even if the coins were currently worth less than their face values.

In the case of Bitcoin there is no fixed exchange rate; if the value is generally expected to increase over time, that will affect the net present value to the merchant as well as the buyer. The increase or decrease will not cause bitcoins to be under- or over-valued with respect to other free-market currencies. Gresham's law would only apply if there was a fixed exchange rate between bitcoins and fiat currency. For example, if the U.S. government declared that USD $1000 was equivalent to 1 BTC for the purposes of legal tender, when the actual exchange rate was $1100/BTC, people would have an incentive to settle their debts with the overvalued USD rather than the undervalued BTC.

I think you are right, Gresham's law in its proper form might not apply to Bitcoin. Still there are people seeing bitcoins as undervalued, choosing to keep their bitcoins and pay with dollars. My point was that this is not a real issue for Bitcoin. As long as (enough) people behave remotely rationally, the economy will self-regulate:
Too much hoarding will reduce the perceived "fair" value of bitcoins, thus reducing the hoarding.
High circulation/usage will increase the perceived value, thus increasing hoarding/reducing circulation.

I think we will see oscillations in the valuation becoming more damped as more and more people, and maybe speculators in particular, enter the Bitcoin economy.