The deflationary spiral question ...

[Tom]

Hello,


There seems to be lots of interesting thoughts on whether BitCoins could experience a deflationary spiral. There's even a wiki page on the subject. The general consensus of the site seems to be that it couldn't happen, but I'm still not convinced

This is of course all assuming that BitCoins become really big and replace world currencies and such like.

So a deflationary spiral seems quite possible to me. Here's my logic:

1. Once there is essentially no more BitCoin creation then BitCoins could be slightly deflationary, particularly in an expanding economy.

2. Since BitCoin is now a world currency, and a non increasing one there will certainly be a large market in BitCoin lending. People will lend out BitCoins, at interest.

3. Deflation generally discourages lending. People think "Why lend my money out and risk it not being repaid, when I can just sit on it and wait for it to gain value?".

4. This essentially means that instead of lending BitCoins for investment, people are hoarding BitCoins for speculation. Hoarding coins (temporarily) takes those coins out of the functioning economy. This effectively reduces the money supply.

5. A reduction in the money supply leads to a further reduction in prices.

6. Now we have a positive feedback. More deflation further encourages hoarding, which leads to more deflation, more hoarding and so on.

Thoughts?

[1713982012]

1713982012

[1713982012]

1713982012

[kiba]

Please search the forum for this topic. It had already been debated ad absurdum.

[FreeMoney]

 

1. Once there is essentially no more BitCoin creation then BitCoins could be slightly deflationary, particularly in an expanding economy.

Yes

2. Since BitCoin is now a world currency, and a non increasing one there will certainly be a large market in BitCoin lending. People will lend out BitCoins, at interest.

Yes

3. Deflation generally discourages lending. People think "Why lend my money out and risk it not being repaid, when I can just sit on it and wait for it to gain value?".

People who make loans already ask themselves this question. Is the risk worth it is not a different type of question when you are looking at 100 units of value turning to 90 if you do nothing and getting 110 if you lend and 100 turning to 110 if you do nothing and getting 130 if you lend. You always have to balance risk and reward according to your preferences and knowledge.

 
4. This essentially means that instead of lending BitCoins for investment, people are hoarding BitCoins for speculation. Hoarding coins (temporarily) takes those coins out of the functioning economy. This effectively reduces the money supply.

I don't know the difference between hoarding and saving, but yes, every coin is always saved by someone. I kind of see what you mean by reducing the money supply, but that's not a helpful way to think about this. Is there a difference at a global level whether I am still saving a coin or if my hooker is saving it now? All coins are always being saved by someone.

 
5. A reduction in the money supply leads to a further reduction in prices.

Savings doesn't reduce the supply. And reduced prices are good for everyone who uses things anyway.

 
6. Now we have a positive feedback. More deflation further encourages hoarding, which leads to more deflation, more hoarding and so on.

I don't know about you, but me and most people spend more when we get richer, not less. There is no spiral.

If you expect coins to go up in value faster than everything else it is true that you will store all excess value in them, but it is not true that you won't consume anything because you think they will go up in value.

[silversurfer]

http://en.wikipedia.org/wiki/Velocity_of_money

pertains to hording vs. spending... but whatever.  go bitcoin!

[FreeMoney]

http://en.wikipedia.org/wiki/Velocity_of_money

pertains to hording vs. spending... but whatever.  go bitcoin!

Hoarding: The evil your neighbor does.
Saving: The virtue that you preform.

[Tom]

Firstly yes, this has been discussed lots already. But I haven't seen the same logic that I've presented. In particular in relation to lending and positive feedback.

Personally I'd be really pleased if someone could humour me I'd love to improve my knowledge of economics, and you don't learn as much reading other people's arguments as you do defending your own.

People who make loans already ask themselves this question. Is the risk worth it is not a different type of question when you are looking at 100 units of value turning to 90 if you do nothing and getting 110 if you lend and 100 turning to 110 if you do nothing and getting 130 if you lend. You always have to balance risk and reward according to your preferences and knowledge.

Very true, but the difference is it never makes sense to lend out $100 and only be repaid $90. In a deflationary economy it could be that at the end of the term of the loan that $90 would actually buy a lot more than your $100 would have at the beginning of the term. However, even given that no-one would ever lend out $100 to be repaid $90 when they could just save the $100 and wait.

However in an inflationary economy the same $100 loan to the same person might be quite profitable, particularly given if you didn't lend the money out you'd lose the value to inflation.

I don't know the difference between hoarding and saving, but yes, every coin is always saved by someone. I kind of see what you mean by reducing the money supply, but that's not a helpful way to think about this. Is there a difference at a global level whether I am still saving a coin or if my hooker is saving it now? All coins are always being saved by someone.

Savings doesn't reduce the supply. And reduced prices are good for everyone who uses things anyway.

Ah so I think this is very interesting!

But I think the difference is whether the money is moving or not. I personally don't see any difference between saving and hoarding. But I do see a huge difference between saving/hoarding and lending/investing. If everyone sits on their money refusing to spend it or lend it then it is worthless.

Money is both a medium of exchange and a store of value. However, it cannot be a store of value for everyone at once. When someone decides to save their money (rather than spend it) they are temporarily taking the money out of circulation. This causes a very slight deflation, and this drop in prices encourages someone else to consume in their place. Later on when the saver decides to spend their money they are adding more money back into circulation. This causes a very slight inflation and this rise in prices encourages someone else to forgo their consumption in lieu of the saver.

If one person saves someone else will consume in their place. For someone to spend their savings someone else must forgo their consumption. However, this doesn't work if everyone tries to save (or spend) all at once.

I don't know about you, but me and most people spend more when we get richer, not less. There is no spiral.

If you expect coins to go up in value faster than everything else it is true that you will store all excess value in them, but it is not true that you won't consume anything because you think they will go up in value.

This essentially says that a deflationary spiral is impossible because people have to spend to live. I think this assumes a fair distribution of money, which doesn't have to be true at all.

In most economies a small percentage of the people own a large percentage of the money. They generally have so much that they cannot spend it all on themselves. So the only way those with no money can gain access to it is to borrow it from those who do have it. However, what happens if the rich decide not to lend it? The poor cannot spend money they don't have, no matter how hungry they might be. The rich can spend enough money to keep themselves well fed, but still not provide enough money into the system to keep it running.

Now of course eventually the balance would redress itself. Prices would drop so low that this small amount of money that is being spent would be enough for the whole economy to function on. However, this whole process would cause massive social chaos ... not to mention that a return to stable (low) prices would probably cause all that hoarded money to flood back into the economy into a massive inflationary boom.

 

[SgtSpike]

I think you have your lending logic backwards Tom.

Deflation encourages lending, but discourages borrowing.
Inflation encourages borrowing, but discourages lending.

This is why everyone always carries so much debt in inflation-based economies.  When I say that inflation discourages lending, I just mean that the interest rate has to raise to such a point as to make the risk/reward profitable to the lender.

Let's look at an example.  A lender gives a loan of $100 in an economy averaging 3% inflation/year.  Say the risk to the lender of default is 2%/year, and the lender wants a 1% above inflation ROI.  So 3% + 2% + 1% = 6% APR.

Now look at the same $100 loan in an economy averaging 3% deflation/year.  Say the risk to the lender of default is 2%/year, and the lender wants a 1% above inflation ROI.  So -3% + 2% + 1% = 0% APR.

It's a similar story on the borrower side.  They would require a lower interest rate on loans

Basically, no matter what the inflation/deflation rate is, APR rates on loans will auto-adjust to a supply/demand intersect.  You could potentially see negative APR rates in a deflationary economy.

[abyssobenthonic]

I think you have your lending logic backwards Tom.

Deflation encourages lending, but discourages borrowing.
Inflation encourages borrowing, but discourages lending.

This is why everyone always carries so much debt in inflation-based economies.  When I say that inflation discourages lending, I just mean that the interest rate has to raise to such a point as to make the risk/reward profitable to the lender.

Let's look at an example.  A lender gives a loan of $100 in an economy averaging 3% inflation/year.  Say the risk to the lender of default is 2%/year, and the lender wants a 1% above inflation ROI.  So 3% + 2% + 1% = 6% APR.

Now look at the same $100 loan in an economy averaging 3% deflation/year.  Say the risk to the lender of default is 2%/year, and the lender wants a 1% above inflation ROI.  So -3% + 2% + 1% = 0% APR.

It's a similar story on the borrower side.  They would require a lower interest rate on loans

Basically, no matter what the inflation/deflation rate is, APR rates on loans will auto-adjust to a supply/demand intersect.  You could potentially see negative APR rates in a deflationary economy.

What benefit is there to the lender in lending at zero though? [asks a hypothetical inflationist]

There's zero default risk in holding the money and you earn zero from holding it, so this holds:

lending at 0%: 0% interest - 2% default risk + 3% deflation = 1% net increase in purchasing power
holding at 0%: 0% interest - 0% default risk + 3% deflation = 3% net increase in purchasing power

(for comparison, with 3% inflation:
lending at 6%: 6% interest - 2% default risk - 3% inflation = 1% net increase in purchasing power
holding at 0%: 0% interest - 0% default risk - 3% inflation = 3% net decrease in purchasing power)

That said, there's a non-zero default risk in holding bitcoin: losing your private keys has a non-zero probability.  Measures to reduce that probability (e.g. backups) or for transferring that risk to someone else (i.e. insurance) have a non-zero cost: the equivalent of the default risk is then just the lower of the expected loss from a lost wallet, the cost of backing up to a desired standard of safety (plus the expected loss from backup failure), and the insurance premium (plus the expected loss from your insurer being unable to pay the claim).  It may well be better in such an environment to lend (especially at smaller amounts, given that the costs of backups and of insurance may tend to have large fixed components) than to hold.  OTOH, given that someone that you're lending bitcoin to is effectively shorting bitcoin, the nominal default rate is likely to be somewhat inversely correlated to the inflation rate.

[Tom]

Basically, no matter what the inflation/deflation rate is, APR rates on loans will auto-adjust to a supply/demand intersect.  

Agreed. Lenders want to lend for as a high an APR as possible, but they have to find borrowers willing to borrow at that rate. Borrowers want to borrow at as low an APR as possible, but they have to find someone to lend it to them at that rate.

Deflation makes it harder for borrowers, meaning that they will be less willing to take high APR loans. As a result lenders will have to offer low APRs to attract borrowers in order to remain competitive. However ...

You could potentially see negative APR rates in a deflationary economy.

... No matter how high the deflation a lender will never lend with a negative APR. This is because when the only rate borrowers will accept is a negative APR the lenders will choose a different strategy that is more profitable than lending: they will save their money.

Why would a lender lend out $100 and get $90 back 1 year later, when instead they could just save the money and still have $100 at the end of the year?

It doesn't matter how high the rate of deflation goes saving is more profitable than lending at a negative APR. And yet in a deflationary scenario a negative rate of interest might be the only rate many borrowers could afford to pay. As you've noted deflation makes it harder for borrowers to repay.

So my argument would be that deflation can reduce the amount of lending and increase the amount of saving/hoarding.

[da2ce7]

The deflationary spiral is a real problem for fiat, debt based money.  Becasue of the fixed future cost (repayment of the capital of the loan) v.s. the contracting monetary supply.

Bitcoin (and Gold, Silver, etc) are not effected by the deflationary spiral, as they are not debt.

See: https://en.bitcoin.it/wiki/Deflationary_spiral

 

[Tom]

The deflationary spiral is a real problem for fiat, debt based money.  Becasue of the fixed future cost (repayment of the capital of the loan) v.s. the contracting monetary supply.

I definitely agree that fiat fractional reserve currencies are also susceptible to deflationary spirals, but I don't think that a "gold standard" (fixed quantity of money) currency is immune either.

Bitcoin (and Gold, Silver, etc) are not effected by the deflationary spiral, as they are not debt.

See: https://en.bitcoin.it/wiki/Deflationary_spiral

 

Personally I don't find the wiki page to be a very compelling argument In my initial post I suggested a positive feedback that could lead to a deflationary spiral: deflation causes currency hoarding, which causes more deflation. To my mind the wiki page doesn't answer this scenario.

The top section of the wiki talks about hoarding commodities. However, I don't see hoarding individual commodities as the problem, I think the problem is hoarding currency.

The next section talks about fiat currencies. I agree that fiat fractional reserve currencies can suffer from deflationary spirals.

The last section of the wiki doesn't account for what would happen if BitCoins started being loaned. If BitCoins are never loaned then I agree there is no problem, but if they are loaned then I think deflationary spirals are a real possibility.

The argument I make only holds under certain circumstances, i.e.
- BitCoins have become really big (like a national currency) to the point where major economies require BitCoins to function.
- There is an uneven distribution of wealth with a small number of people owning the majority of the BitCoins.
- Most people get access to BitCoins through borrowing them, either directly or indirectly.

However, if the first condition is true then I think the other two are pretty likely to be true also. And in these circumstances I could see BitCoins suffering from deflationary spirals.

[da2ce7]

Personally I don't find the wiki page to be a very compelling argument The positive feedback that I suggest is as stated in my first post: deflation causes currency hoarding, which causes more deflation. To my mind the wiki page doesn't answer this scenario.

People hoard when they have a foreseen cost (or an unforeseen fixed cost) in the future.  This is the same as an economy, the economy hoards when there is a cost in the future that needs to be paid for.

If you had a loan, and had to make $10 repayments every day, and the value of the dollar was going up... you would hoard dollars for your repayments.  (your repayments don't change if $10 can buy a hat or a car)

If people traded Bitcoin or Gold, they are NOT in debt, so they have no 'fixed repayments' to make in the future.  When they hold large am mounts of Gold or Bitcoin we call that saving or investment.

When the value of Bitcoin or Gold go up, people are FREE TO SPEND IT because they do not need to REPAY IT.  This gives 'negative feedback' so the deflationary spiral doesn't accelerate, but it slows down.

Then the ENTIRE SOCIETY needs to repay MORE than the FLOATING MONETARY SUPPLY is when you see the Deflationary Spiral accelerate.  There isn't enough money to go around (as most of the money is locked up in investments), to repay the outstanding debt.

Those who have savings are holding those who are in DEBT to ransom for the repayments of their loans.  Becasue fiat money is debt.  Every bit needs to be repaid!  The only way to repay debt is to take out new debt.  Not until new debt has been taken on, or every person has sold all their holdings of money can the debt be repaid....

Fiat Debt based money are Oranges, and Gold and Silver are Apples.

[hazek]

FFS please read this: http://mises.org/money/2s9.asp

What Has Government Done to Our Money?
Murray N. Rothbard
II.
Money in a Free Society


9. The Problem of "Hoarding"

The critic of monetary freedom is not so easily silenced, however. There is, in particular, the ancient bugbear of "hoarding." The image is conjured up of the selfish old miser who, perhaps irrationally, perhaps from evil motives, hoards up gold unused in his cellar or treasure trove--thereby stopping the flow of circulation and trade, causing depressions and other problems. Is hoarding really a menace?

In the first place, what has simply happened is an increased demand for money on the part of the miser. As a result, prices of goods fall, and the purchasing power of the gold-ounce rises. There has been no loss to society, which simply carries on with a lower active supply of more "powerful" gold ounces.

Even in the worst possible view of the matter, then, nothing has gone wrong, and monetary freedom creates no difficulties. But there is more to the problem than that. For it is by no means irrational for people to desire more or less money in their cash balances.

Let us, at this point, study cash balances further... (continue at http://mises.org/money/2s9.asp)

[Tom]

When they hold large am mounts of Gold or Bitcoin we call that saving or investment.

Personally I see 'savings' and 'investments' as too very different things. Although this could simply be an issue of terminology.

Imagine someone comes to me with a good business idea, but they say they need money to get it going. I think that the idea is very lucrative and so I lend them the money they need to start the business, at interest. This is what I would call investment, I am giving up my money in the hope that they will be able to repay me more at a later date. Such investment does not remove the money from circulation and so does not cause deflation.

Saving (or hoarding) on the other hand is quite different. In this case I am deciding to simply sit on my money with the expectation that it would be more valuable later than it is today. This is temporarily removing the money from circulation and thus will cause deflation.

Modern banking uses 'saving' and 'investment' interchangeably because when you put your money in a savings account they use that as the basis to lend money to someone else, whether you ask them to or not. However in reality hoarding and investment are two different activities with very different economic consequences.

When the value of Bitcoin or Gold go up, people are FREE TO SPEND IT because they do not need to REPAY IT.  This gives 'negative feedback' so the deflationary spiral doesn't accelerate, but it slows down.

If I understand the thrust of your argument you are saying that people would never borrow BitCoins or Gold. Personally I think this highly unlikely. Money lending has gone on throughout history, based on all sorts of different currency systems. All that has to happen for money to be lent is someone who has money wanting to lend it, and someone who doesn't have it wanting to borrow it.

Now Fiat Fractional Reserve currencies are definitely worse in the sense that for money to come into existence it has to be lent to someone. This is not true of BitCoins or Gold. None the less I think in practice there would be a lot of lending of BitCoins and a large proportion of the BitCoins moving through the economy would in fact be owed as debt to someone.

[Tom]

FFS please read this: http://mises.org/money/2s9.asp

...

In the first place, what has simply happened is an increased demand for money on the part of the miser. As a result, prices of goods fall, and the purchasing power of the gold-ounce rises. There has been no loss to society, which simply carries on with a lower active supply of more "powerful" gold ounces.

I agree with this article from the perspective of an individual. Whether a single individual chooses to hoard or not is not important. The money is removed from circulation, prices drop slightly, someone else consumes in their place. Not an issue.

As I said earlier, I completely agree with this principle. When someone uses money as a store of value (hoards it) they are deferring their consumption to later. The hoarded money is temporarily removed from circulation. This causes a reduction in money supply, causing a drop in prices. This drop in prices encourages someone else to consume in the hoarders place.

However, this doesn't work if too many people all hoard all at once. If lots and lots of people all decide to hoard all at once then this causes a massive drop in prices. But people cannot necessarily be encouraged to consume more without limit. An economy that has built up to service 1000 people may suddenly find it only has 500 clients. The economy is now massively overproducing for the needs of the people. It doesn't matter how cheap bread might be, I'm not going to buy another loaf if my family and I are all stuffed full! If I use my car to drive to work, then I'm not going to drive to work and back again extra times just because petrol is really cheap now. So what happens is that the economy contracts to service the needs of the 500 people who are spending money. This means businesses closing, layoffs and all the traditional trappings of a recession.

So what could cause lots and lots of people to all hoard at once? The answer is a deflationary spiral ...
- Previously I was lending my money out at interest.
- Now there is deflation no one can afford to repay money at interest, to find borrowers I'd have to offer a negative rate of interest.
- But why lend money at a negative rate of interest when I can just hold onto it (hoard it) instead?
- This means previously I was investing (lending) and now I'm hoarding.
- This reduces the money supply, causing further deflation. This now encourages other lenders to hoard instead of lend, and so the cycle repeats.

As I said it would only happen when a large enough proportion of the money was being lent into circulation rather than being spent into circulation.

[hazek]

I think a deflationary spiral is a good thing if caused by the general public being afraid of something and wants to save their money to spend it in the future in case of an emergency. Sure businesses would fail, but not all. Essential goods would still get bought since we can't live on air and without heat or a roof over our heads but the resources for the rest of things would get saved and used to produce later when people decide to spend more.

If money available dictates goods and services available then don't you think it's a good way to know how we as a society should figure out when to to save vital resources and when to overproduce?

[Tom]

I think a deflationary spiral is a good thing if caused by the general public being afraid of something and wants to save their money to spend it in the future in case of an emergency. Sure businesses would fail, but not all. Essential goods would still get bought since we can't live on air and without heat or a roof over our heads but the resources for the rest of things would get saved and used to produce later when people decide to spend more.

Well the Great Depression was a well known deflationary spiral and most people thought it was a pretty big problem at the time Lots of people were unemployed and many starved during the Great Depression (about 7 million in the US I believe).

During a deflationary spiral some people are sacrificing their consumption, the question is who? One one possibility is the lenders, they are the ones hoarding so one possibility is that they are the ones sacrificing? I don't believe this is the case. Those with enough money to lend already had all the money they needed to meet their spending requirements, in fact they had so much money that they started lending some of it out. They will still be able to meet their needs and buy the things they want.

So what about the borrowers? And those employed by businesses that borrowed? These people become unemployed whilst often being heavily indebted. They have plenty of desire for material things, but no currency to pay for them. They "sacrifice" their consumption because they have no choice. So the economy contracts so as to fulfil the needs of those that do have money, and no longer meet the needs of those that do not have money.

If money available dictates goods and services available then don't you think it's a good way to know how we as a society should figure out when to to save vital resources and when to overproduce?

It would be fine for a society as a whole to decide that they wanted to save some resources and deliberately produce less. However, when a quirk of the money system forces it upon people, to the degree that many of them starve ... well then that's a problem.

[kiba]

Well the Great Depression was a well known deflationary spiral and most people thought it was a pretty big problem at the time Lots of people were unemployed and many starved during the Great Depression (about 7 million in the US I believe).

They also killed ton of cows during the Great Depression for the sake of economic intervention or at least what I remember.

Don't forget that history have more than one sides to the story. Two different people can look at the same data and come away with different conclusion.

[Tom]

They also killed ton of cows during the Great Depression for the sake of economic intervention or at least what I remember.

Ah now I never knew that Just read up on it. Farmers couldn't sell their half starved cows even though the prices were rock bottom, and even though people were starving. Definitely sounds like a scenario of overproduction, relative to a populace that didn't have the capital to pay. It looks like the government used their currency reserves to buy the cows and then gave the meat to the hungry. This raised meat prices, injected more currency into the economy and fed some hungry people. It's actually quite logical.

The case of Wörgl is also very interesting. During the Great Depression the town of Wörgl introduced their own local currency. Before the introduction of this currency they had massive unemployment, soon after the introduction of the currency the town was thriving. This strongly suggests that the thing that was lacking during the great depression was simply currency to trade with. Interestingly the Austrian central bank had it stamped out before it undermined the (failing) Austrian central currency. At which point Wörgl returned to mass unemployment.

Don't forget that history have more than one sides to the story. Two different people can look at the same data and come away with different conclusion.

Agreed entirely. However, I still think the Great Depression wasn't a good thing. Especially if it happened for no reason other than due to positive cycles in the money system.

[kiba]

Ah now I never knew that Just read up on it. Farmers couldn't sell their half starved cows even though the prices were rock bottom, and even though people were starving. Definitely sounds like a scenario of overproduction, relative to a populace that didn't have the capital to pay. It looks like the government used their currency reserves to buy the cows and then gave the meat to the hungry. This raised meat prices, injected more currency into the economy and fed some hungry people. It's actually quite logical.

Rock-bottom price is not rock-bottom if people aren't still buying.

Agreed entirely. However, I still think the Great Depression wasn't a good thing. Especially if it happened for no reason other than due to positive cycles in the money system.

The Great Depression is a bad thing is different from what actually cause The Great Depression. Here in the bitcoin economy, it is a good thing. People are buying, people are producing, etc.

My revenues actually grew 5 times in spite of the recent Great Price Deflation.