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https://bitflate.org/post/2021/05/21/inflation-and-security.htmlThe Bitcoin bull market is here again. Everything is up like, Bitcoin’s price, the total network hash rate. As usual, the amount of criticism has also gone up. The energy FUD around Bitcoin gets louder. Bitcoin’s price directly impacts the amount of energy used in mining. The energy debate is black and white. Supporters argue that Bitcoin is an efficient monetary system, likely the most efficient. Critics argue that energy usage is wasteful. The existing system is way more efficient.
How much energy?We know that any system consumes some amount of energy. The question is how much energy is efficient. It’s hard to compare Bitcoin and the existing monetary system. Bitcoin bull, Michael Saylor, recently discussed the topic on Twitter. Saylor claimed that the cost of securing the Bitcoin network is 1%. Future efficiency improvement can bring that cost to 0.1%. If Bitcoin is a 100 trillion dollar asset class, the security cost would be $100 billion at 0.1% and $1 trillion at 1%. Comparing this to running the banking system, military, Bitcoin would be more efficient at 0.1%. But it’s hard to decide when the cost is 1%. The difference is significant. A group of crypto researchers (Hasu, James Prestwich, Brandon Curtis) also published a model which recommends 1% inflation for security. Here’s the paper.
Bitcoin reward system is disinflationary. It inflates less and less. And eventually, Bitcoin’s supply has zero inflation. At that point, the incentive for miners transitions to a fee market. Miners no longer have block rewards. They collect transaction fees to pay for mining costs. At 0.1%, the fees may be too low to sustain miners. At 1%, the fees may be too high for Bitcoin users. The difference between 0.1% and 1% is significant. We don’t know the answer. The real cost of running a global monetary system may be higher. It could be 2%, 3%, or 4%. Anything higher than 1% is probably going to make Bitcoin too expensive and too inefficient.
Perpetual money machineBitcoin is a perpetual monetary system. It is a Ponzi scheme. It is self-contained and self-sustained. It relies on its rewards and fees to operate. There’s little external influence. That is good for decentralization. But we don’t have a good way to assess the price and the costs of running the network. If the price remains purely speculative, it could go up as high as people can imagine. The cost of mining would also go up as high as we can afford. It’s the Bitcoin Price Paradox. Bitcoin’s critics make a good point. Unfettered speculation can lead to disastrous energy spend.
Inflation and securityBitcoin is an interesting money experiment. It seems to show that there’s a relationship between inflation and security. A self-contained monetary system needs some inflation to secure itself. It’s a perpetual motion machine. It needs to produce new rewards. As it grows, the amount of reward needs to increase. Otherwise, the system will deflate and collapse. The amount of inflation needed is related to the cost of securing the system. Gold has a 1.5% inflation rate. It didn’t work very well as money. The cost of mining and securing gold is more than the reward. Gold is net deflationary. One can argue that Bitcoin is digital. It’s more efficient than gold. So it needs less inflation. But Bitcoin will eventually have zero inflation.
The US Fed has an inflation target of 2%. This rate may work if the US dollar is a self-contained monetary system. But it is a global reserve currency. The 2% target rate may be too low. It creates to trade imbalance as countries are willing to trade goods for currencies. Trade imbalance leads to a distorted economy and political issues in the US. The long-term M2 average growth rate is 7%. Here’s the data. That seems to be the real inflation rate. One can argue that the USD system is inefficient. It requires a large bureaucracy, a banking system, and a military for security. So the rate of 7% includes high overhead costs. An efficient rate should be lower. If the system becomes more efficient, we can bring the rate down to 4-5%.
We can also model inflation based on the human population growth rate. If the population grows between 1.5% to 2% with 1.5% to 2% as the overhead cost, the long-term average money inflation would be somewhere between 3% and 4%. Bitcoin supporters are likely too optimistic. The system may not rely on less than 1% to sustain itself. Critics may be wrong about energy usage. A monetary system needs 3% to 4% inflation to sustain itself. Bitcoin’s energy usage within or below that range (1.5% to 2%) should be acceptable.
