On Inflation And Bitcoin As A Currency
Should bitcoin replace national currencies?
Bitcoin is revolutionary and holds great promise. It is the first purely digital good that cannot be copied. It is an anonymous cooperative system that does not require trust. It is a form of money that is fully decentralized and a-political. It has absolute scarcity by design. Many have taken to calling it ‘digital gold’. And many are wondering about the ability of bitcoin to compete with, and perhaps replace national fiat currencies.
This last point is what I will be examining in this article, by focusing on the main monetary difference between bitcoin and fiat currencies: inflation. Conventional wisdom among modern economists holds that low and stable inflation of currencies is not just desirable, but the main goal of monetary policy. Proponents of bitcoin argue that inflation is theft, harmful, or even that it destroys families and corrupts and depresses people.
In order to understand what we are talking about, we should first define the terms. What exactly is inflation? That’s simple: inflation occurs when prices of goods and services rise. That leads us to a somewhat more complicated question: why do prices rise? There are three basic reasons why prices may rise: (1) market demand increases, (2) cost of production increases, and (3) the monetary supply increases.
What is important to note is that, while the first two reasons are the result of natural changes in supply and demand, the change in the money supply is artificially managed by a central bank. This third cause of inflation is generally referred to as monetary inflation, and it’s what we are interested in here.
While Inflation, In General, Is A Natural Phenomenon, Monetary Inflation Is A Policy Choice.
Why would you choose a policy of inflation for your currency? According to modern economic theory, there are a number of reasons for doing so:
· Since money loses value over time, it encourages spending and investing rather than saving. This boosts economic growth.
· It encourages lending by reducing the cost of debt over time. This encourages people to invest in higher education and buy houses. This also boosts economic growth.
· It improves the competitive position of the country, which boosts exports and thus economic growth.
· Central banks can influence the inflation rate to stabilize the economy. In a downturn, inflation is increased to induce growth via the above channels. Conversely, when the economy is running hot, inflation is decreased.
· Lastly, it allows for more labor market flexibility by alleviating the problem of nominal wage rigidity: firms may need to cut wages to stay competitive, but cutting wages is very difficult in practice due to being socially unacceptable. As a result, rather than cutting wages, firms resort to firing workers instead. This was demonstrated particularly painfully in Spain after the 2008 financial crisis. Inflation offers a way of lowering real wages without having to actually cut wages.
There is however a risk that inflation may turn into hyperinflation. Hyperinflation occurs when a currency loses credibility and generally occurs when a weak and unstable government starts printing money freely to finance itself, taking down the entire economy in its collapse. The tragic results hereof can currently be observed in Venezuela, where hyperinflation has completely derailed daily life and people are literally starving in the streets.
Many bitcoiners regard any monetary inflation as an evil of modern economics, whereby the wealth of hardworking citizens is stolen by central banks who keep devaluing the existing currency. A popular story is a dollar losing 96% of its value since 1913, which sounds bad until you compare it with the economic growth since 1913: roughly 50,000%. What matters is not the purchasing power of a single dollar, but the purchasing power of your total income and wealth. And while the purchasing power of a single dollar has indeed fallen, average income and asset valuation have risen far more, resulting in a massive net wealth increase.
If Economic Growth Exceeds Inflation, Total Purchasing Power Rises.
Bitcoin is often praised for its hard supply cap of 21 million, making it inflation resistant. Quite the contrary, the available supply of bitcoin actually shrinks over time as a certain percentage of bitcoin is lost forever, due to people losing their keys or their storage devices. Estimates are that as much as 20% of all bitcoin is now lost forever. Furthermore, as demand for bitcoin increases while the supply remains constant or dwindling, the value of bitcoin increases. Rather than being inflationary, these properties of limited available supply and a continued increase in value makes Bitcoin, in fact, deflationary in the long run.
With deflation, the purchasing power of a currency increases over time (or the price of goods and services expressed in this currency decreases over time). So, while a single bitcoin may buy a computer today, next year it might buy a car, and, who knows, in ten years it might buy a house. As a result, people tend to hodl instead of spending their bitcoin. This makes for a great property for a store of value but works poorly for actual currency. Let’s imagine a world where the dollar suddenly becomes deflationary:
1. As people expect the purchasing power of their dollars to go up over time, both individuals and companies start saving up as many dollars as possible, deferring on unnecessary or big expenses and investments.
2. As people stop spending their dollars, companies sell fewer products and services, slowing down the economy.
3. Because of the increasing price of the dollar, goods and services from other countries become cheaper compared to US goods and services, which slows down the sale of US goods and services even more.
4. As companies sell fewer products and services, they start decreasing prices on excess supply and laying off excess workers, thereby increasing unemployment.
5. As unemployment grows, people have less money to spend, slowing down the economy even more.
6. Moreover, the same deflationary property that makes dollar savings grow in value, also makes all dollar-denominated debt grow in value. Both private debt (mortgages, student debt, business loans) and public debt (government debt) become harder to repay, resulting in more debt defaults and an even greater drag on the economy.
7. As the economy slows down further, companies are once again forced to decrease prices on excess supply and to lay off even more workers, further increasing unemployment.
8. We are now trapped in the so-called ‘deflationary spiral’, which continues until a new lower equilibrium of supply and demand is found.
End result: The economy has shrunk considerably, unemployment is high, and defaults are causing people to lose their house, businesses to go bankrupt and states to be forced into Greece-like austerity. Debts will either have to be restructured or written off, resulting in losses for the debt-holders. Prices of goods and services are lower, which results in lower profit margins and lower wages. Economic growth is lower due to a decrease in investments. On the positive side, people who have significant cash reserves will benefit, since all their money is now worth even more. But that’s a pretty low upside to a pretty significant downside.
A Sudden Shift From An Inflation-Based Currency To A Deflation-Based Currency Triggers A Painful Recession.
Clearly, this is not a desirable result. In fact, the single biggest reason to maintain a policy of inflation is that compared to deflation, inflation is the lesser of two evils. But does that automatically lead us to the conclusion that inflation is thus desirable? Can’t we instead choose a neutral option: a currency that has an actual stable supply, and is somehow perfectly stable in purchasing power over time? You might imagine that people eventually learn how to manage their bitcoin and stop losing keys and storage devices so that the supply of bitcoin eventually becomes stable.
Unfortunately, in a dynamic economy, stable supply and stable purchasing power are mutually exclusive: you can’t have both at the same time. The reason for this is that a stable money supply only has a stable value if the economy itself is stable. If the economy grows while the supply of money remains constant, the purchasing power of the money will have to increase to serve the expanded economy (too few coins chasing too many goods and services).
Imagine an economy with a fixed money supply of 1000 bitcoin, a population of 1000 people, and a production of 1000 thingamabobs. Each year, each person produces and sells 1 thingamabob, earns 1 bitcoin, and buys 1 thingamabob (nevermind why someone would sell a thingamabob only to buy another one…). But what happens if we increase the population to 2000 people, and we produce 2000 thingamabobs instead? Since there are only 1000 bitcoin to go around, the price needs to fall to 0,5 bitcoin per thingamabob in order to sell 2000 thingamabobs. This also means that income will fall to 0,5 bitcoin per person per year since each person still produces just one thingamabob per year. The supply of bitcoin has remained stable, but the purchasing power has doubled.
A Stable Money Supply Does Not Lead To A Stable Purchasing Power Of Money.
In the absence of a monetary policy affecting the supply of money, all shocks to the economy are translated into changes in the purchasing power of money. And since economies on average tend to grow, the de facto monetary policy of a stable supply currency like bitcoin is one of deflation. The only way to obtain a currency that retains its purchasing power over time is by allowing the supply to grow at a level that mirrors the growth of the economy. So any society that adopts a fixed supply currency like bitcoin as its main currency becomes a deflation-based society.
Earlier, we saw the effects of the dollar suddenly becoming deflationary. While this did not paint a rosy picture, the recession that followed is the temporary result of transitioning from an inflation-based society to a deflation-based society. Eventually the economy will adjust and stabilize in a new equilibrium. What would happen once we survive the painful transition period? What does a deflation-based society look like?
Here we enter unexplored territory. While there have historically been some deflationary periods, no society in history has been deflation-based by default. But that does not mean we cannot make some statements about certain aspects of such a society:
· As cash continually increases in value, savings will increase. This will make saving for retirement or rainy days easier and more appealing.
· The increasing purchasing power will continually lower the price of goods and services. While this eventually affects all goods and services, the effect will be more immediate on foreign goods and services, since they are directly affected by changes in the exchange rate. The price of domestic goods and services take longer to adjust, as they are dependent on a decrease in domestic wages. This time lag creates a negative competitive advantage for domestic goods and services, which increases imports and decreases exports and is generally bad for economic growth.
· Rather than wages being adjusted upward for inflation each year, they will have to be adjusted downward for deflation. Aside from a major mentality shift, this shifts the balance of earned money vs inherited money in the favor of inheritance.
· Long-term domestic investments will decrease, as the chance that future revenues will cover your current investment cost (return on investment) will decrease.
· Foreign investments will increase. From a foreign perspective, investments in your country are extra attractive, as the returns of the investment itself are complemented by the increasing value of your currency. While this is good for economic growth, this will create revenue streams out of the country as more and more assets become foreign-owned.
· Loans will be more expensive: you will still have to pay interests, but on top of that the initial amount you loaned is increasing in value.
· The higher cost of loans coupled with falling wages will make higher education less appealing: the costs-to-payoff ratio will worsen significantly. This effect becomes more pronounced the longer the education takes.
· The higher cost of loans coupled with falling prices will make owning a house less appealing: the risk of having a mortgage that is higher than the price of your house increases significantly, as does the risk of your house declining in value over time.
· A decrease in loans and credit, in general, will make the economy more resistant to boom-and-bust cycles. For an excellent explanation of the machinery of boom-and-bust cycles, I would suggest watching Ray Dalio’s How The Economic Machine Works.
While this is a somewhat mixed bag of results, I would argue that overall the negatives easily outweigh the positives, and are certainly not worth the painful and risky transition. To be fair, part of the negative outcomes are related to negative effects on international trade and exchange rates. Should the entire world adopt bitcoin simultaneously, the overall effect becomes decidedly less negative, but arguably still be net negative. Additionally, if the entire world adopts a single currency we venture into optimal currency area theory, which predicts an entirely new set of problems already observed with the introduction of the Euro.
A Country That Adopts A Deflationary Currency Is Expected To Produce Worse Results Than With An Inflationary Currency.
Should we accept the notion that deflation in general is not a good monetary policy choice, what does that mean for bitcoin as a currency? In my opinion, the same monetary characteristics of bitcoin that make it an excellent investment and store of value, also make it unsuitable as a currency. A good currency should have a certain measure of inflation to help an economy flourish and grow. How high that inflation should be, and how it should be managed and attained is a different story. But the conventional wisdom of ‘low and stable inflation’ certainly seems like a good guideline to follow.
This does not mean that fiat currencies are the ideal solution. The current system of central banks suffers from being subject to extreme political pressures and contemporary economic doctrines. The bailout of banks in 2008 was questionable at best, Quantitative Easing is a risky experiment that may well backfire, and the potential for the financing of wars or corrupt regimes through money creation is still a real danger.
However, all else being equal, an inflationary currency is highly preferable over a deflationary currency. In fact, bitcoin with inflation would be a great currency, and may indeed be preferable over current fiat currencies. But bitcoin is not inflationary, and bitcoin with inflation would not be bitcoin. The hard supply cap is integral to the story of bitcoin, and a key element of its value proposition. The great paradox of cryptocurrency is that an essential currency feature like inflation is bad for the adoption of the currency.
The true value of bitcoin is not as a replacement of current fiat currencies, but as a hedge against hyperinflation, unfair capital controls, and general abuse of control over money, as well as a good alternative for safely storing and earning return on excess savings. And that is more than enough.