I apologize for the length of this post, but somebody is wrong on the internet. A while ago, I wrote a blog entry on Bitcoin and Deflation. I got several comments that disagreed with my conclusions including one from William Andressen who pointed me to a book by Murray Rothbard arguing that we should reintroduce the gold standard and a comic book by Irwin Schiff which tries to explain the economic system in simple terms.
They are both quite good reads, as far as they go. Indeed, I would recommend them as rather good starting points for anyone trying to understand where money comes from and how the fiscal system works. However, your model of money after reading these works will be extremely simplistic and totally inaccurate. You need to learn more before you actually have some working understanding.
A fixed size economy versus a growing one
The omission that both books make is that they assume that the economy is of a fixed size. Under those circumstances the model they are advocating actually works. You can have a gold standard, because the availability of gold is not going to change very much. Compared to the amount of gold in circulation, the amount that is lost in industrial products and dropped to the bottom of the sea is small, as is the amount of gold mined each year. If the amount of gold would increase a lot in this economy that has no increase in products or services (like it did when the conquistadors brought the gold of the Aztecs, Mayans and Incas to Europe), you get inflation. If, instead, the gold would be consumed in industrial processes and not be recoverable, you would get deflation. The gold would increase in value as it got more scarce.
In a growing economy, gold becomes more and more scarce because it has to represent the value of more and more goods and services.
There are two things that cause economies to grow - improved efficiency and population increase. The first one once consisted of finding more land to extract resources from and inventions to get more out of existing resources. Except for very brief periods the global population has been growing in historic times. The Black Death was a remarkable exception and it was followed by an economic depression that makes the Depression in the 1930ies look like a walk in the park.
So, when the economy grows, the money supply needs to grow. Otherwise you get deflation. We will soon return to why deflation is such a bad thing.
The character of a good currency
The reasons why gold was such a good currency standard were several. The first one is that gold is extremely stable and durable. It stays the same and does not tarnish. Second, it is rare enough that a reasonable amount of wealth can be carried around (though the limitations were a factor in replacing gold with paper money). Third, the available supply of gold is stable enough that people expect very few surprises. (If we found 100 000 tons of pure gold under the ice in Antarctica, it would have a dramatic effect on the gold price. It would also come as a total surprise.) Fourth, the supply of gold historically grew at about the same rate as the general economy. This was not true in the years from WW2 until the gold standard was abandoned. In the 1980ies and 1990ies, the growth of the gold reserves exceeded the population growth, but in the last 10 years or so, the amount of gold extracted every year has been almost constant.
There are few naturally occurring substances that could compete with gold, and they all have drawbacks. Platinum is probably the best, but it is too rare, it is mined in too few places and it has industrial applications which makes the supply unstable. Plutonium may be rare enough, but handling it is a bitch. Silver was a long time contender, but it tarnishes, it has industrial applications, it is in more abundant supply in the earth, and it requires more volume and weight to represent the same amount of value as gold.
Abandoning the gold standard
With a very slowly growing supply of gold it was extremely hard to manage the supply of paper money in the decades after WW2. The dollar was supposed to have a fixed exchange rate into ounces of gold. However, that would have lead to deflation in the climate of strong economic growth, so the governments and the central banks of the world cheated in various ways. The US printed more bills and the de-facto exchange rate from dollars to gold deteriorated. Richard Nixon put an end to the farce and abandoned the tie between the dollar and the gold. What Rothbard and others fail to understand is that increasing the money supply was necessary in order for there to be enough money to handle the economic growth.
Money as storage
There is another factor we need to take into account when we want to understand money, and that is how well things keep. Milk keeps for a few days, grain stores for a year if kept dry, wood keeps for several years, brick for a hundred years or more. At one end of this scale we find money/gold which keeps forever and at the other we find human labour which is wasted the moment it goes unused. If it is used, it can be converted into something more durable, like getting milk from a cow, sawing planks, or building a house. If we do this for others, we will want to exchange the work for something that is exchangeable with anyone. The best option is money, because it is infinitely durable and therefore infinitely exchangeable.
The evils of deflation
Some people have stores of money which they have acquired by their own labour or by doing trades in which they acquire the results of other people’s labour (this can be through fair trade or through unfair abuse). If the cost of everything halves, the stored money will have doubled in value, without the owner having done anything. In a deflationary economy, you are being paid to be rich. This is very unfair to the poor, because they are the ones who are paying the rich. The poor can’t raise the prices of their labour, because work is not storable. It has to get done/sold or be lost for ever.
This is the basis of why governments hate deflation so much. The rich no longer have to take any risks to generate more wealth, while the poorest people will have to leave their homes because they can’t make ends meet.
How this relates to Bitcoin
Bitcoins are mined, like gold. The algorithm ensures a dwindling supply and one day we will reach a point where the Bitcoin supply is capped. The currently available Bitcoin are distributed over a population which is in the tens of thousands. If the population of Bitcoin users grows 10 times while the supply grows by a factor of 2, you will have a huge deflationary factor. The people who already own Bitcoin will have a “risk free” increase in value of a couple of hundred percent. This will draw more capitalists who want the same return. As the supply of Bitcoin gets tied up, deflation will spiral until it reaches an equilibrium. This is when so large a part of the supply is tied up in people’s mattresses that it stops being usable for trade.
The value of Bitcoin comes from its superior trade-ability (and the fact that the supply is capped).
Bitcoin as a threat to the world’s currencies
The accessibilty of Bitcoin makes it easy for anyone to exchange part of his/her savings into Bitcoin and store them on a memory stick at home. It really makes sense for an individual to do so, because many currencies are in a bad shape. The purchasing power of a US Dollar abroad is about 40% of what it was 4 years ago. The money stored that way will not go into consumption and it will not go to investments. It is the power of everyone making a small change in the same direction that cause the cycles in the economy.
This is why the various governments of the world can’t accept competition from a successful Bitcoin. When they wake up, they will use all the legislative power to make Bitcoin unusable.