Deflation and Cryptocurrencies: The Long Term Ramifications of Fixed Supply Currencies

Buckkets
Buckkets
Nov 30, 2018 · 9 min read
Traders outside the New York Stock Exchange on Oct. 24, 1929 [AP File]

Following World War I, Americans entered the “Roaring Twenties”. During the war, factory production had increased massively to produce equipment for the military. Following the war, these factories turned from the production of military to consumer goods, leading to an abundance. US President Calvin Coolidge encouraged growth by reducing taxes and regulation leading to further prosperity and production. With a booming economy, individuals felt safe making purchases, having confidence that the growth would continue.

On October 24th, 1929, the DOW dropped eleven percent and this day would be known as “Black Friday”. For the next decade, the entire US economy stood at a standstill. “Black Friday” signaled a pivot from the growth that had started nearly twenty years previous. The Federal Reserve increased the monetary supply by 240% since 1913, with a 60% increase from 1920–1929 alone (Daughty, 2011). From 1928 to 1931, however, 30% of the money supply was removed by the Federal Reserve creating a deflationary effect. The addition or subtraction of the money supply was not determined by market participants, but rather the Federal Reserve’s interpretation of the current and future needs. Economic growth disappeared due to rampant deflation. The factories which had been healthily producing suddenly disappeared along with nearly half of the country’s banks, leaving one in ten citizens unemployed and without savings (Great Depression History). A simple way to think about an economy is with a nod to Newton; an economy in motion tends to stay in motion. Once the economy slows, stops, or reverses, changing this becomes an impossible task. With large supply, the economy continued to crash as deflation took a permanent hold.

Soup kitchen lines during the Great Depression

Deflation occurs when the price of goods or services decreases over time, or when a currency has an increase in purchasing power or valuation (Deflation). The word “deflation” itself suggests there is a something being removed from a body or supply. Think of a fully inflated balloon; as air escapes, the balloon will lose pressure and “deflate” back to nothingness. During inflation, spending is incentivized as holding the currency will eventually lead to a decrease in purchasing power as prices rise. During deflation, saving will be incentivized as prices continue to fall in the face of increasing purchasing power. Without a constant flow of money or buying pressure, an economy will begin to deflate over time.

Gordon Gekko in “Wall Street”

Natural deflations to supply are absorbed and provide benefit to participants when done at a market-determined rate. For example, the cell phone used by Gordon Gekko in Wall Street (1987) was both large and bulky, costing $3,995 in 1983 (Breselor, 2010). In 2018, when adjusted for inflation, the Motorola DynaTac 8000X would be $10,090.81 (Inflation Calculator). Since then, decreased cost and increased production put cellphones in the hands of citizens around the world. This change in the price of cellphones was deflationary since the price decreased negatively over time. As long as this change is based on market participation, beneficial deflation will be absorbed and provide benefits such as cheaper phones. During the Great Depression, however, prices for products dropped so rapidly that there was a non-existent demand, diminishing profits, hindering production, creating a crushing wave of deflation. Factories and farms were devastated as no profit could be gained from a population with no ability to buy. A wave of bank closings eradicated the savings of citizens across the nation leaving hundreds of thousands of citizens bankrupt. With no savings and no work, any hope of growth rapidly disappeared. The US dollar was no longer a medium of exchange, but only a store of value as scarcity increased and prices decreased.

Deflation can be beneficial in short-run situations, but extended over a long period of time become devastating. Lending is one of the most effective vehicles of growth in an economy and is generally tied to the inflation rate. During periods of inflation, lending increases to outpace rising prices. However, during deflation, lending is rare or non-existent as outpacing deflation is difficult and many lenders become risk averse as purchasing power increases. In the case of 1929, price decreases leading up to the crash due to increases in the efficiency of production and a decrease in manufacturing costs meant a larger supply unmet by demand stalling growth. No buying demand existed as the US dollar deflated.

Today, the Federal Reserve attempts to maintain the value store of the dollar over time with a rate of inflation that matches theoretical optimal economic growth models. However, over the years, inflation has led to a decrease in store of value and purchasing power which has damaged holders of the US dollar. In response, Bitcoin was created with a fixed supply with no central authority (“Controlled supply”). New Bitcoins are created each time a block is mined or discovered, this being the primary source of supply inflation. As it stands, over 75% of the total supply has been realized, as the inflation rate makes its way towards zero. Roughly every four years, the rewards gathered from mined blocks are reduced, slowing the increase in supply overtime, creating a deflationary effect. It is projected that with the current hash rate, the final bitcoin block reward will be mined in 2140, although an increase in technology could theoretically reduce this time (CryptoCoinMastery, 2017). Currently, Bitcoin inflates at a rate of about 3–4% yearly which is called Golden Inflation. The deflationary nature of Bitcoin makes its long term use as a currency a questionable reality, as a store of value seems more probable while scarcity and purchasing power increase over time. Once Bitcoin’s value deflates enough, mining fees may need to be increased in order to incentive miners who protect the security of the chain. Not only does the store of value determine use, but also drives pure proof-of-work security. Contributing to this as the countless number of Bitcoins which have been lost, such as the individual who threw away a hard drive with 7,500 BTC, and does not account for intentional destruction of supply as well, an example being addresses without private keys for the sole purpose of removing Bitcoins from circulation (Carter, S. M., 2017). One such address is 1BitcoinEaterAddressDontSendf59kuE. The probability of generating a private key matching this address is almost nonexistent.

As the value of Bitcoin increases, individuals will be incentivized to save, not spend their Bitcoin, behavior which was observed during the Great Depression. Bitcoin’s nature as a medium of exchange will not be possible as was laid out in the whitepaper. For Bitcoin to function as a medium of exchange, it must have a level of inflation or else stagnation will take hold of any invested economy. Employers who wish to pay employees in Bitcoin will be hesitant to do so as the value grows over time. As a medium of exchange, Bitcoin users must be incentivized and comfortable enough to buy and sell other goods without worrying about an increase in purchasing power. What is needed is a currency that acts as both a store of value and a medium of exchange and is guided by participant determined rates of inflation and deflation.

Bitcoin Inflation chart (Bitcoin.com)

Peercoin solves the store of value and medium of exchange issue that Bitcoin is unable to solve due to its hard limit. With no hard limit on total coin supply, Peercoin allows for an inflation rate determined by participants, while remaining limited enough to maintain its store of value. New Peercoins must come from mining or minting, with mining being the primary determinant of the inflation rate. Bitcoin’s rudimentary deflationary mechanism of block reward halving is improved upon by Peercoin’s dynamic hash-rate/block-reward protocol for mining. This means that, as hash rate increases in the Peercoin network, the block reward will drop proportionally, determined solely by active participants. Simply put, growth is kept in balance by a level of deflationary reduction to output. This disincentivizes miners as profitability disappears, forcing a reduction in output, returning the hash rate and coin production to an equilibrium point. An increase in hash rate is observed by the change in block difficulty and the protocol adjusts accordingly. Pinning the inflation rate to the hash rate of available hardware was forward-thinking, as it is correctly assumed that hash rate would increase over time. This has been observed to be true as miners have gone from CPU, to GPUs, to ASICS miners. This dynamic change contributes in part to the energy efficiency of Peercoin which will be touched upon in a later article.

Hash Rate vs. Block Reward Inverse Chart

Peercoin has maintained an inflation rate of 2.47% YTD (Peercoin Inflation), nearly a percent and a half under Bitcoin which is at 3.85% YTD (Bitcoin.com). Simply put, if you held 1 BTC, you would need 3.85% more or, 1.0385 BTC to maintain relative purchasing power for the year. For Peercoin, you would only need around 1.47% more, since 1% would be created through annual minting.

Since supply is be determined by interest–while still allowing for long term supply growth and balanced inflation–Peercoin promotes a long term use case as a medium of exchange as well. With Bitcoin, mining interest can increase without repercussions, leading to higher inflation rate and energy consumption. The Peercoin inflation rate can be determined by participants rather than an arbitrary ruling such as the halvening of the block reward. Peercoin also burns the transaction fee included in each block, creating a small deflationary impulse that scales with chain activity. These factors allow Peercoin to maintain its status as a predictable store of value.

Peercoin Inflation chart (Peercoin Inflation)

Bitcoin as a global currency will be impossible once its full deflationary effects are felt. Being termed as digital gold is accurate as its store of value will increase as deflation drives an increase in valuation and scarcity; a deflationary currency cannot be used as a medium of exchange in the long term. Without a level of inflation, participants will never be incentivized to spend or invest, permanently stalling growth like witnessed in the Great Depression. With participant determined inflation and deflation, Peercoin serves both as a store of value and a medium of exchange in a way that Bitcoin cannot.


Resources:

Bitcoin.com. (n.d.). Retrieved from https://charts.bitcoin.com/btc/chart/inflation

Bitcoin Block Reward Halving Countdown. (n.d.). Retrieved from https://www.bitcoinblockhalf.com/

Breselor, S. (2010, September 23). Gordon Gekko’s Cell Phone. Retrieved from https://slate.com/culture/2010/09/gordon-gekkos-cell-phone.html

Carter, S. M. (2017, December 20). Man accidentally threw away $127 million in bitcoin and officials won’t allow a search. Retrieved from https://www.cnbc.com/2017/12/20/man-lost-127-million-worth-of-bitcoins-and-city-wont-let-him-look.html

Controlled supply. (n.d.). Retrieved from https://en.bitcoin.it/wiki/Controlled_supply

CryptoCoinMastery. (2018, February 06). What Happens When All 21,000,000 Bitcoins Have Been Mined? Retrieved from https://cryptocoinmastery.com/what-happens-when-all-bitcoins-have-been-mined/

Daughty, R. (2011, April 05). The US Federal Reserve: A Rich History of Financial Folly. Retrieved from https://dailyreckoning.com/the-us-federal-reserve-a-rich-history-of-financial-folly/

Deflation. (2018, October 21). Retrieved from https://www.investopedia.com/terms/d/deflation.asp

Great Depression History. (n.d.). Retrieved from https://www.history.com/topics/great-depression/great-depression-history

Inflation Calculator. (n.d.). Retrieved from https://www.dollartimes.com/inflation/inflation.php

Peercoin inflation. (n.d.). Retrieved from https://www.peercoinexplorer.net/inflation/

Timberlake, R. H. (1999, April 01). Money in the 1920s and 1930s | Richard H. Timberlake. Retrieved from https://fee.org/articles/money-in-the-1920s-and-1930s/

Why does the Federal Reserve aim for 2 percent inflation over time? (n.d.). Retrieved from https://www.federalreserve.gov/faqs/economy_14400.htm

Author’s Note:

Thanks to all of those individuals who offered feedback during the writing of this article.

Peercoin

Buckkets

Written by

Buckkets

Jack — Peercoin Community Manager

Peercoin

Peercoin

The Pioneer of Proof of Stake

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