Image: Markus Spiske

Crypto economics: debunking misconceptions about deflation

There is a mainstream narrative that cryptocurrencies cannot succeed, because deflation leads to lower spending, higher unemployment and recession, but is that true?

How to onboard your folks to crypto:

1. Modern financial system from gold to petroyuan & de-dollarization
2. Debunking misconceptions about crypto deflation (current)
3. How not to lose your money when entering a crypto market
4. How to choose the core holdings of a crypto portfolio
5. Structuring satellite holdings and rebalancing a crypto portfolio

Disclosure: I own BTC, ETH, BCH, and other coins, but my portfolio is heavily diversified, so I don’t have financial incentives to shill for any particular coin. This article is brought to you by a privacy-oriented peer-to-peer marketplace LocalCryptos.

Intro

In the previous article we’ve discussed how the modern financial system evolved from commodity money to absolutely unbacked fiat money, how the US dollar became the world’s dominant currency due to petrodollar warfare, how aggressive US foreign policy accelerates the de-dollarization process, and how many countries (China, Russia, Iran, Venezuela, etc.) lean towards cryptocurrencies in order to bypass US economic sanctions.

How to onboard your folks to crypto #1: from gold to petroyuan & de-dollarization

Once you can explain to your folks and friends how the modern financial system is a huge experiment which can lead to economic turmoil at any time, then you can begin explaining how cryptocurrencies are different and why crypto can help us make the world a better place.

Deflation

Side note: there are two common definitions of inflation. Some people see inflation as an increase in money supply (monetary inflation), and deflation as a decrease in money supply. So I should clarify that in this article by inflation we will mean price inflation, which is a constant increase in the general price level of goods and services regardless of money supply, and by deflation a decrease in price levels, which is aligned with wikipedia’s definitions. Anyway, the concepts behind definitions are more important, so if you disagree with definitions in this article, then just read inflation as “growing prices” and deflation as “decreasing prices”.

Before starting, let’s keep in mind the following things:

• Central banks are incentivized to push narrative that inflation is necessary in order to justify printing money out of thin air.
• People that print money have lots of power and can influence politicians, media, and the whole education system.
• Most economists are being taught that deflation should be avoided (conventional wisdom).

Infinite vs. fixed money supply

There is a mainstream narrative that deflation is bad, because consumers spend less, which leads to less production and higher unemployment. To challenge this misconception, we have to explain that modern economies experienced deflation in the face of the government’s ability to print money out of thin air, meaning that deflation was not caused by a restriction in money supply, but instead by a collapse in demand. Deflation in Bitcoin, on the other hand, is caused by a reduction in the money supply, not by a collapse in demand.

We should also emphasize that the perception of deflation has been significantly affected by correlated extremely adverse events such as the Great Depression, and that Austrian economists don’t consider deflation as inherently bad, because both inflation and deflation are zero-sum games.

Anticipation of deflation

We should understand that the main reason for the deflationary spiral (low demand, high unemployment and recession) is the lack of anticipation of deflation due to current inflationary monetary policy imposed by central banks. If the society began gradually shifting towards a crypto-based deflationary monetary system, then entrepreneurs would expect lower prices of their products in the future, and thus race to cut production costs. The price of labor, however, will decrease slower than the prices of raw materials, goods, and services, so there will be constant increase in real wages and aggregate demand that will fuel an economic growth.

However, it’s important to mention that any rapid change in the economy can lead to a recession. For example, after the collapse of the USSR, many former Soviet republics faced huge crises while transitioning from centrally-planned economies to more liberal market economies in the 1990s. It doesn’t mean though that a market economy is an ineffective model. In other words, deflation per se is not economically more harmful than any other major change occurring in the economy, so there is no reason to anticipate any problems for a growing economy within a deflationary context.

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Hoarding is a type of investing

We should also understand that hoarding non-commodity money is not inherently bad for a society. Many economists assume that hoarding is bad, because it decreases lending and spending, leading to businesses being unable to expand, however that’s just one side of a coin. We can treat hoarding or ‘non-spending’ as a way to lend to society as a whole. In case of hoarding, a producer exchanges goods and services for money, but doesn’t take back anything from society for a long time.

To better understand the concept above, let’s look at a simple example. Imagine a farmer, living in a small wooden hut, producing food and exchanging it for fiat money without spending anything. After 10 years he decided to exchange all his money for bricks to build a house. However, since he was saving money for a decade instead of buying bricks every month, the purchasing power of his money has changed. In an inflationary economy he could only afford to build a small house, because his money has lost its purchasing power. Whereas in a deflationary economy, saving money over a decade would allow him to afford more bricks and build a larger house. Now, tell me, which variant seems more fair? Probably, the deflationary variant, right? Because a farmer has been contributing to the community for 10 years straight without taking anything in return, so people were consuming his food, while distributing bricks to others in need. As a result, after 10 years a farmer deserves to receive an additional reward (i.e. more bricks) to build a larger house.

Another way to understand this concept is to imagine that Frank ‘burned’ 1,000 BTC by transferring it to an unspendable address, which is nearly the same as redistributing the coins to all other BTC holders, as burning BTC increases the purchasing power of the remaining coins by reducing BTC’s circulating supply. Was it good for society? Sure, Frank shared his wealth with everybody else. Now imagine that instead of burning 1,000 BTC, Frank transferred coins to time-locked address, which will release all the coins back to Frank in 10 years (similar to ‘hoarding’). Basically, Frank has redistributed the purchasing power of 1,000 BTC among all other BTC holders, and after 10 years he will get this purchasing power back with some interest. Is it still good for society? Sure, he basically lent 1,000 BTC to society for 10 years, instead of spending it himself.

Side note: this makes sense only with non-commodity money which are relatively easy to produce like fiat or cryptocurrencies. One can argue that it takes lots of electricity to produce each crypto coin, but that’s a misconception. Electricity is used to secure the network by providing a high degree of censorship-resistance via decentralization in a very adversary environment, but that’s a whole another topic. Additionally, there are many coins that don’t need much electricity, because they use non-proof-of-work consensus algorithms.

Banks accelerate demand-pull inflation

Of course, hoarding money in a deflationary system will make the rich even richer without any work, but deflation is not the root cause of that, because the same thing happens even with the current inflationary monetary system. One of the reasons of such phenomenon is that modern financial system issues too many loans to the consumer sector, increasing the inflationary gap, which leads to demand-pull inflation and creation of bubbles (e.g., the subprime mortgage crisis or skyrocketed tuition fees in the US). In other words, banks take money from the rich and lend it to the poor on an unprecedented scale, so consumers bid up all the prices, which makes them even poorer, because they have to lend more money to afford the same goods and services.

For example, Frank wanted to sell a house, but only Alice could pay $100k in that region. Thus, Frank decided to offer Bob a mortgage for 30 years, so he could compete with Alice for this house. As a result, demand rose higher than supply, so Alice and Bob started bidding up the price. In order to stay competitive, Alice also decided to borrow money from Frank, so the house was eventually sold for $200k to Alice, who not only paid twice as much, but now needs to pay interest every month for the additional money she borrowed. Rich became richer.

OK, but we still need banks to provide liquidity to businesses, right? Well, that’s a topic for a separate article, but keep in mind that the following:

• Firstly, many countries have overly-leveraged debt-based economies and a big portion of the money supply is created through fractional reserve banking, which is a very dangerous approach as the economy is vulnerable to a liquidity crisis.
• Secondly, many peer-to-peer lending platforms are being developed with a more decentralized approach. As for startups, the crypto community has successfully bootstrapped various projects from whitepapers to industry leaders (e.g., Ethereum, Binance) through different kinds of crowdfunding such as ICOs, IEOs, etc.

Spending within a deflationary context

According to the mainstream narrative, in a deflationary economy people spend less, but is that true? There are no solid examples in modern history because previously people faced deflation during or after a crisis, often caused by the collapse in demand.

Let’s look at a healthy economy in a deflationary context, when both consumers and producers are anticipating deflation. Will spending decrease? That’s more psychology than economics, but let me ask you this:

Did you spend money yesterday because money is constantly losing its value? Or did you spend because you wanted to get certain goods and services on that day, rather than the next year?

Most people still don’t have much savings and often live from paycheck to paycheck, so the vast majority of their spending cover only basic necessities such as food, healthcare, security, and commuting. It’s safe to suggest that deflation won’t affect this kind of spending.

OK, how about non-basic needs? Well, it’s hard to imagine that people will wait until the next year in order to watch a newly released movie for 95% of the initial price. It’s also very unlikely that anybody will cancel any of their subscriptions because of 5–10% deflation. Actually, the high-tech industry (e.g., smartphones, computers) has been developing in a deflationary context for decades, but the industry is still booming, which is the best example showing that deflation will not decrease spending in a healthy economy, where people have anticipation of inflation.

Many economists suggest that people will spend less on long-term purchases such as housing and cars, but most developed countries are an example of the opposite. Most consumers prefer to borrow huge money in order to buy a house and car as soon as possible, even though they will pay more over time due to interests, which are higher than inflation.

So can deflation at least slightly reduce aggregate demand? Well, we don’t know that for sure, but it might happen. For example, a shift from an inflationary monetary system to a deflationary monetary system can motivate people to learn more about economics and finance, so average consumers will have greater financial literacy, which might change their spending habits. However, if that ever happens, it will most likely reduce the inequality gap, because people will focus more on long-term goals, instead of pursuing short-term satisfactions.

Side note: it’s fair to mention that while small deflation doesn’t posses risks for a healthy economy, hyper-deflation is still very dangerous, but so is hyper-inflation.

Inflation with a fixed money supply

Interestingly, a limited coin supply doesn’t necessary mean that the prices of goods and services will constantly rise in crypto-based economy, because, firstly, some cryptocurrencies have no limited supply, and, secondly, new cryptocurrencies appear all the time.

We should also keep in mind that prices can rise even if everybody agrees to only use one cryptocurrency with fixed supply (e.g., 21 million BTC), because the supply of goods and services can shrink, production costs can increase, or inflation can be triggered purely by expectations of inflation.

Here are some examples:

1. Due to rapid deforestation, the supply of wooden furniture might decrease in the future, leading to higher prices.
2. Society slowly shifts to eco-friendly and ethical technologies, which often increase production costs, leading to higher prices.
3. A panic caused by rumors that supply will shrink can lead to higher prices.

Slow economic growth

An the end of the day, even if deflation will slightly slow economic growth, this will decrease environmental pollution, which has skyrocketed in the last few decades mostly due to exponential growth of fossil fuels consumption.

One can argue that even a slight slow down of economic growth can lead to a deflationary spiral (low demand, high unemployment and recession), but that’s very unlikely in a healthy crypto-based economy, because:

1. People will have an anticipation of inflation (as discussed above).
2. Demand will not fall below basic necessities.
3. When society shifts to a crypto-based economy, there should already be some form of basic universal income due to rapid automation, which will assure that aggregate demand will stay relatively stable even in the case of high unemployment.

CONCLUSION

Now you’ll be able to explain to your folks and friends that there is no reason to be afraid of a crypto-based economy, because deflation is not inherently bad, not all cryptos have a fixed supply, and inflation can occur even with a fixed supply.

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TL;DR

• Central banks are incentivized to push a narrative that inflation is necessary.
• Deflation periods in modern history were not caused by a restriction in the money supply, but a collapse in demand.
• In a deflationary monetary system people will anticipate deflation and thus adjust to expectations of future lower prices.
• Any rapid change in the economy is dangerous, so the shift to a deflationary economy should be gradual.
• Hoarding is not inherently bad because it’s a form of lending to the society.
• Banks accelerate demand-pull inflation by over-lending to consumers.
• A deflationary monetary system per se will not lead to a significant decrease in aggregate demand.
• Inflation can occur even with a fixed money supply.
• Decrease in economic growth might reduce environmental pollution.
• Deflationary spiral is very unlikely because of UBI, demand for basic needs and anticipation of deflation.
• Inflation and deflation are zero-sum games.
• Deflation is not inherently bad in a healthy economy.

Disclaimer: I am not a licensed financial advisor, and this article is not a financial advice. The information presented here is for educational purpose only, it represents my personal opinion, and is not purported to be fact. Cryptocurrencies are very volatile and can move quickly in any direction. I’m not responsible, directly or indirectly, for any damage or loss caused or alleged to be caused by or in connection with the use of or reliance on any content, goods, services or companies mentioned in this article. Seek a duly licensed professional for an investment advice.

If you still think that a small Tether market cap can’t significantly influence the whole crypto market, just read this article:

Biggest misconception about Tether market cap and why it’s totally different from all other coins

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