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Bitcoin and deflation

written by jacob, on Aug 21, 2011 11:21:14 PM.

Rick Falkvinge writes about bitcoin again. This time he claims that the deflationary character of bitcoin is not a problem. This shows that Rick understands even less of national economics and global economics than I do, and I don’t feel all that educated in the field.

We have already had a deflationary currency standard in the form of gold. It was abandoned because it failed to serve the wishes of national governments. In particular, it limited the money supply in a way that made national control over economic policy limited. It is debatable whether this was good or bad, but it was disliked by people on power all over the world and got abolished. One might argue that the great recession in the United States would never have happened if the government had been free to put in a huge stimulation package to boost the economy.

At any rate, Rick fails to see the downsides of deflation. If you have a loan denominated in bitcoin it will forever become more and more expensive. If the government takes out loans in bitcoin, it will grow by much more than the interest rate. If you house mortgage is in bitcoin, you may end up with the mortgage being worth more than your house, at which point it will be reclaimed by the lender.

The natural answer to these problems is of course “don’t do that”, but the matter is not quite that simple. As someone with a surplus of money, I would prefer to have it denominated in bitcoin, under the assumption that it is a stable and trustworthy currency. If everyone reasons like I do (the basis for all market theory), this means that there will be a shortage of money available in inflationary currencies and a surplus in bitcoin. Indeed, I would rather have my money in my mattress in bitcoin, than to be lending it to anyone. If I were to lend it, it would still be at a substantial risk premium.

One of the foundations of the capitalist world is that enterprises and private individuals can borrow capital at reasonable interest rates. If they can’t, then entrepreneurs can’t get their business ideas off the ground and young couples can’t invest in housing for their families. Humanity has so far not found a better system than the capitalist one, and it is not for want of looking. Therefore, a successful bitcoin currency is a threat to the (already tenuous) stability of the affluent economies of the world.

It is quite widely accepted by national economists that a currency should have a small amount of inflation to be most beneficial to the people who use it. The SEK has been a model for this view in the last 15 years. Before that it was mismanaged in various different ways by governments from both ends of the political spectrum, with nasty results following suit.

The reason I am discussing this subject at all is that bitcoin has many compelling traits and that I can imagine global mainsteam uptake. However, the deflationary aspects are reason enough for governments to ban the use of bitcoin as an alternative currency. The only way I see this not happening is that bitcoin catches on so quickly that the governments fail to react before popular demand makes a ban impossible.

Comments

  • You miss an important point in that Bitcoin was meant to be used as a supplemental transaction currency as opposed to something to regulate the economy. This voids many, if not all of the benefits of an inflationary currency as economic stimulus or government revenue simply because Bitcoin does not replace, but rather coexists with national currencies. And though controlled inflation is generally healthy for a country, it does requires faith in government. Depending on where one lives, that faith may or may not be well placed (see Zimbabwe hyperinflation).

    In terms of interest rates, real interest rates are adjusted for inflation (as opposed to their nominal counterparts), and in any event can be adjusted for deflation as well. This applies to any currency, Bitcoin not excluded.

    “As someone with a surplus of money, I would prefer to have it denominated in bitcoin, under the assumption that it is a stable and trustworthy currency. If everyone reasons like I do (the basis for all market theory), this means that there will be a shortage of money available in inflationary currencies and a surplus in bitcoin.”

    You seem to imply that if people suddenly wanted to convert their savings into Bitcoins, the supply of currencies would suddenly shift. Let me remind you that the supply of national currencies and Bitcoins are predefined, by the government in the former, and by the protocol in the latter, and do not change when people will it. What you meant to say is that there is a rise in demand for Bitcoins and a decrease in demand for money, all of which are balanced under the exchange rate.

    I find many people too attached to the negative stigma of deflationary currency to fully consider it’s effects without bias. Especially in the light something as novel as Bitcoin, it may be constructive to look from a perspective which deviates from the status quo.

    Comment by Moomin — Aug 22, 2011 11:37:40 PM | # - re

    • I’m afraid your arguments don’t support your position. With a deflationary currency, you may be better off not lending your money. Especially if interest rates would be adjusted. Right now we have interest rates close to zero in many inflationary currencies. Some bonds actually yield negative net interest after inflation.

      In a deflationary currency your money increases in value if you do nothing. This means that you will demand a higher risk premium than with inflationary lending. For a capitalist, this a wonderful wet dream. I can sit on my money and it will yield returns without any risk at all.

      In your penultimate paragraph you talk about the balanced exchange between national currencies and bitcoin. But the balance comes from the price of bitcoin increasing as demand rises. This is why bitcoin is deflationary from the start. Demand will increase more rapidly than supply. A buy&hold strategy will decrease supply, which will drive up the exchange rate even further. The (natural) laws of markets require that supply increases as prices go up, but with bitcoin the supply is limited in the short term and capped in the longer term. This creates a hyperbolic system, not an asymptotic one.

      Comment by jacob — Aug 23, 2011 1:22:28 AM | # - re

  • “the supply of national currencies and Bitcoins are predefined, by the government in the former, and by the protocol in the latter, and do not change when people will it.”

    • actually (and people argue about this) the supply of national currency is not defined by a government, but by the actions of governments, central banks, and private high-street banks, and mostly by the latter, by private high-street banks (in conjunction with the public as borrowers). This is why BitCoin is naturally attractive.

    Comment by Stephen Lawrence, Cambridge, UK — Aug 23, 2011 6:45:32 PM | # - re

  • <i>It was abandoned because it failed to serve the wishes of national governments</i>

    When you say this, you do not seem to understand that ‘wishes of national governments’ means; waging war and stealing the money to pay for it.

    Your article is full of the fallacies that are taught under the guise of ‘Economics’; I strongly suggest you read these two books, which will greatly help you dispel these fallacies:

    mises.org/money.asp

    www.scribd.com/doc/8009736/Irwin-Schiff-How-an-Economy-Grows-and-Why-It-Doesnt

    The first book, by Murray Rothbard, gives you a completely factual and accurate description of what money is, and why Nixon took the USA off of the gold standard.

    The second book is a detailed illustrated book describing exactly what an economy is, where capital comes from and why paper money issued by governments cannot and has never lasted.

    I post these here not only for you, but for anyone who might come across your blog post, and who needs to be pointed in the right direction.

    Comment by William Andressen — Aug 26, 2011 4:23:08 PM | # - re

  • supplemental transaction currency . . . coexists with national currencies . . . requires no faith in government . . . mises.org/money.asp √

    Comment by x — Aug 26, 2011 4:54:52 PM | # - re

  • the OP misses the point that Bitcoin won’t be deflationary forever. in fact its inflationary now during its issuance. when the full 21M are completely distributed it becomes NEUTRAL, neither inflationary or deflationary. yes, its price will rise to its natural equilibrium but from there it should fluctuate very little in price. this would be the ideal situation for a national currency: a stable store of value. THEN business can concentrate on building its core functions instead of acting as currency speculators as well.

    Comment by cypherdoc — Aug 26, 2011 5:35:05 PM | # - re

  • The difference with other deflationary systems such as gold - is that bitcoin is not just highly divisible - but it’s easily divided. It’s like having change of any possible denomination. Also due to the global nature of bitcoin - the rate of deflation is not determined by the sharp ups and downs of a particular nations - but is likely to follow a smoother curve of the global economy. This suggests to me that the ultimate rate of deflation may be quite manageable and even allow for practical lending with small interest rates on top. As a supplementary currency - it may well have a strong niche. It’s an experiment that has never been run before - and it’s different enough that comparison to things like gold are as speculative as investing in bitcoin itself.

    Comment by Julz — Aug 30, 2011 5:58:00 AM | # - re

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