Bitcoin is Deflationary, and That's OK

[andrewbadr]

New post at http://andrewbadr.com/log/19/bitcoin-is-deflationary-and-thats-ok/:

Despite the polarizing question of Bitcoin's future, we can say with certainty that particular arguments on the subject are good or bad ones. One bad argument that has been making the rounds lately says that the protocol's fixed, finite supply of coins makes the cryptocurrency useless as a medium of exchange, because it would induce a deflationary spiral.
The argument goes: suppose, for the sake of contradiction, that Bitcoin has become used as a medium of exchange. This usage would presumably be increasing over time, similar to how the world economy grows overall. Perpetually increasing usage, when the supply of Bitcoins is fixed, means the value of each Bitcoin must also be perpetually increasing. But if their value is perpetually increasing, no one will want to spend their Bitcoins, because they'd rather hold on to them and capture that appreciation. Therefore, they won't be spent after all, so Bitcoin cannot work as a medium of exchange.

First of all, the present value of a perpetually appreciating asset is not infinity. Consider real estate. Like Bitcoins, they aren't making any more of it. It has major instrinsic value, which is growing, since they are indeed making more people. Yet the present value of a piece of real estate is clearly finite. That's because money in the future is worth less than money now, and people intuitively (and economists, mathematically) model this when valuing something.

Second, there is a liquid market for Bitcoins. The existence of this market distinguishes Bitcoin from any of the supposedly relevant historical examples of deflationary spirals. And the existence of a market price shows that people value Bitcoins differently: for every buyer, there is a seller. And someone who sells a Bitcoin for X would have been equally happy to spend it on something they value at X.

Third, the marginal utility of money is diminishing. Put simply, as a person's wealth increases, they want to spend more. As someone's Bitcoin wealth becomes worth more, each part of it becomes worth less to them. This is especially true because Bitcoin is one asset among several that someone is likely to hold, with its own risk profile.

Those are the fundamental flaws in the deflationary argument. In practice, people make several more, such as ignoring the time-value of purchases, conflating volatility and market corrections with deflation, making claims from society's perspective instead of the individual's (e.g., saying inflation is a good kind of taxation), and of course, ignoring the empirical fact that people are spending their Bitcoins.

There are real flaws with the Bitcoin protocol that detractors could focus on. Deflation isn't one of them.

[Etlase2]

"Making the rounds lately"? This is an "argument" that has existed essentially since the dawn of bitcoin's economic discussion. I don't actually think anyone ever really argued it though, I think it was the Austrian school bitcoin propaganda defense to a general argument that already existed for the benefits of fiat over harder money (whether or not it is true), not bitcoins per se.

However, common sense would suggest a deflationary spiral is quite likely to never occur in bitcoin unless bitcoins are used up and down the line of production and salaries are commonly paid in bitcoin. Until then, fiat must implicitly exist alongside bitcoin. So, should a "spiral" start occurring at any point before ubiquity, people will simply switch back to fiat and stop the spiral. This is bitcoin's ultimate failing as a replacement for fiat.

"First of all, the present value of a perpetually appreciating asset is not infinity." - This is not related to the argument of a deflationary spiral.

"Second, there is a liquid market for Bitcoins." - This is under the assumption that bitcoin is not ubiquitous, and therefore has not replaced fiat and means that there is an option for people to use besides bitcoin to stop the spiral. "Economic problems in my bitcoin? Ok I'll use fiat again." It's not a particularly eloquent argument when you concede that if people prefer to use something else it will be ok.

"Third, the marginal utility of money is diminishing." - And this is essentially the Austrian argument, which is in some respects, defeated by history. The marginal utility of money may diminish, but that does not mean that money suddenly appears where it needs to be to prevent economic recession. Yes, the great depression is likely the result of some people controlling vast amounts of a limited supply of money and making mistakes. There is nothing that precludes such a thing from happening in bitcoin just because those people controlling the money supply are no longer necessarily influenced or directly controlled by governments.

[Impaler]

Good summary Etlase2, no one says that BTC can't be used in the way it's already been used, simply that it's economic model prevents it from ever scaling up to the size people want it too (irrespective of the inherent technical scaling issues that also rule that out), and that deflation has slowed to the adoption rate so far.

Deflationary spirals are a description of society wide collapses of real productivity brought about by monetary deflation and because BTC is just so small it has no ability to create such an effect.  Even a total collapse of BTC would just disperse people and productivity back into the wider economy, just as when a single bankruptcy disperses capacity back to the economy and dose not cause a crisis.

So all BTC can really do is suffer a slower or even stagnated rate of adoption because of deflation.  A negative rate of adoption (people leaving BTC) would naturally result in the value of BTC dropping, which is what happens when an alt-coin dies.  If a coin was devised that was much more stable it could probably grow much faster then BTC.

Also the 21 million coin cap is only one reason BTC is deflationary, and is actually not even a contributor now when supply is still growing.  The real deflationary 'ratchet' is the block-reward halving every 4 years.  Because mining hardware is a rather large investment that will have a narrow profit margin over the long-term do to difficulty adjustments, the sharp reward drop guarantees that miners will suddenly be unprofitable and miners will be forced to double their selling price to return to profitability.  A few miners may quit or shutdown but the hardware guarantees they keep mining and keep having largely the same total costs (capitol + electricity) and thus you get a doubling of price every 4 years even if the demand remains the same.  A gradually declining curve would encourage miners to gradually quit as the least efficient ones were squeezed out, thus difficulty would decline and their would be no sudden jumps in valuation and probably less deflation.