One of the core advantages over traditional paper money, so the story goes, is that bitcoins supply was fixed from day one, making it the perfect form of non-debaseable (sic) money. This chapter explores the problems of using an inelastic money supply to compete with elastic money supplies.
Teunis Brosens, an economist with ING, explained in a July 2014 video report that if they are accepted more widely, cryptocurrencies such as bitcoin could become a medium of exchange but that because the value of bitcoin was very volatile it would be problematic as a store of value or unit of account.471 Stating:
Bitcoin’s value increased tenfold in 2013 but it has also had several speculative crises in its short history. With real currencies, central banks dampen these fluctuations by regulating money supply and prices through interest rates. But it is an explicit goal of bitcoin and other cryptocurrencies to do away with central authorities. The supply of bitcoins increases at a predetermined rate by mining. But demand for bitcoin varies, so its price and the exchange rate with currencies, such as the dollar and the euro,
fluctuate. These fluctuations could be bitcoin’s undoing as they complicate its adoption as real money.
There is a way out: a bitcoin algorithm that smoothly matches money supply and demand. It is not impossible, but the inventors of that successful algorithm would make such a momentous step forward that they would surely qualify for the Nobel Prize in Economics.
To be fair, volatility is not the same as deflation. A currency can be volatile without being deflationary (notably such as the Korean Won, ₩, during 2008) and vice-versa. And a currency can be elastic without being volatile.
Yet what are the problems with deflation and inelasticity in Bitcoin?
Many Bitcoin adopters point to these two attributes as positive features. Yet as this chapter will show, they are bugs. For example, Dan Kervick explains why the latter is a drawback:472
Deflation might appear to be an attractive thing at first look. Wouldn’t it be nice for our money to appreciate in value as the prices for goods and services continually fall? But economists associate deflation with two negative phenomena: First, if prices are falling then the incentive to hoard the currency increases, since anybody who possesses that currency is seeing its value increase each day. Thus, the currency itself becomes an appreciating investment vehicle for its owner, so long as it isn’t spent. Hoarding by an individual agent is no big deal, but it is clearly bad news for the economy when hoarding is widespread, since if people stop buying things, then producers stop producing things
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and stop paying workers to produce things. That’s one reason why downturns are often associated with deflation, and growth is usually associated with modest inflation.
In its July 2014 report, Congressional Research Service came to similar conclusion:473
Because the supply is capped in the long run, widespread use of Bitcoin would mean that the demand for Bitcoin would likely outstrip supply, causing Bitcoin’s price to steadily increase. The corollary of that increase is that the Bitcoin price of goods and services would steadily fall causing deflation. Faced with deflation, there is a strong incentive to hoard Bitcoins and not spend them, causing the current level of
transactions to fall.
As has been established, Bitcoin (the network) is not a banking system because banking is a cornucopia of financial services including lending, payments processing, safe-keeping, notary, interest rate setting, underwriting debt and equity and an assortment of other services.474 Incidentally, one popular method for large holders of bitcoin to secure the bitcoins is to create a “paper wallet” and in turn store the piece of paper in a bank safe deposit box.
Customers depositing savings in a bank is semantically an investment, as those funds are then lent to others. In contrast, there is no mechanism within the Bitcoin network to provide such functionality, in essence these funds are inert.
What does this look like in practice?
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The chart (above) was created by Peter Coy.475 He created a Bitcoin Consumer Price Index which is modeled on the US Bureau of Labor Statistics CPI. During the time span, January 2013 through early December 2013, the market price in US dollars of a bitcoin increased 64x.
However prices measured in Bitcoin were down 98.5% during the same period. What does this mean? This is deflation, the mirror reflection illustrating the aforementioned volatility in purchasing power. As a consequence, when the price of Bitcoin goes up, why would Bob use his bitcoins to buy things when those bitcoins might double in value in a week, a day—or an hour?476
As Coy notes:
Two bad things happen in a deflation. First, people tend to postpone purchases as they wait for prices to get lower. That slows the economy to a crawl. Second, debts get more and more burdensome because they don’t shrink the way everything else does. If you owed 1,000 Bitcoins before the deflation, you still owe 1,000 Bitcoins after it, only now your paycheck has shrunk by 98.5 percent. The only solution is to default. That’s what happened on a massive scale in the Great Depression.
One frequently used argument against this line of reasoning regularly cited by some Bitcoin advocates is that technological improvements are deflationary. For instance, the nominal cost of an Apple II in 1977 was $1298 and adjusted for inflation it would be $5,095 today.477 And in the following 37 years not only has the nominal price dropped for contemporary systems but the technological performance as measured by hard drive, CPU, RAM and other attributes increased by many orders of magnitude. Yet people still buy them, why do they buy despite what seems to be “deflation” (e.g., a decline in prices)?
This misses two points. The first is, bitcoin (the token) is not a “technology,” the blockchain / protocol is. The second is that a product such as a laptop is not divisible into smaller units while simultaneously being able to still function as a laptop (e.g., Bob cannot cut up a laptop into 100 smaller units and expect it to work as a computational device). Or in short, laptops are not money. Bitcoins (the token), on the other hand, are divisible and consequently many of the adopters have attempted to shoe-horn it into a role of what effectively is (in the long-run) a deflationary currency.
Deflationary currencies historically absorb the purchasing power of the real economy and incentivize users not to actually spend them. They can – but not always do – make a potential store of value or unit of account but sometimes not an effective medium of exchange. Notable exceptions include the US dollar in the 1930’s, the yen and, at times the yuan.478
What about the investing example mentioned by Coy?
In practice, an investment is not worth doing unless it generates a higher return than the risk free rate (the theoretical rate of return of an investment with no risk of financial loss).479
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Every investment has a minimum acceptable rate of return (MARR) or “hurdle rate” which is the rate of return that it has to “jump over” to be alluring and viable to outside investors. For instance, if Bob can get 2% a year from a government bond then a minimum return on a
competing investment has to be at least over 2% (and much higher), because Bob also needs to factor in the chance, the risk that the investment could stall or fail. In a deflationary
environment such as Bitcoin, this is exacerbated by the fact that there is a disincentive to invest bitcoins in other asset classes.
Or more precisely, if a risk free interest rate did exist for Bitcoin, it would probably be either zero or negative. For instance, let us assume that Bitcoin appreciates at 20% a year. When Bitcoin is used to make an investment, this project would need to generate at least a 20% real return to merely break even with the alternative of just holding the currency. Nonetheless, we need to factor in the risk premium of this project so the MARR would be greater than 20%. This would mean that only the safest and most desirable projects would ever go forward, while the majority of projects would be discarded and consequently productive resources would lie idle.
In essence, deflation would lead to non-allocation of capital that could otherwise have been efficient.
What this illustrates then is that bitcoins are not currently fulfilling the role of both a store of value and a medium of exchange. Again, this is a lengthy topic that is probably best discussed by Robert Sams “growthcoin” and Ferdinando Ametrano’s “stablecoin” publications which also describe how volatility is a factor; yet implementing either solution would likely fork the
community, dividing them into one group who wants to spend coins and another who wants to hold.480
Does the deflation in bitcoin prices really delay purchases? Earlier this year Edward Hadas, the economic editor for Reuters Breakingviews made the comparison that it was noting that:481
Deflation is an obvious issue. Price declines are inevitable when a finite supply of Bitcoin money, a feature of the software, meets an expanding supply of purchased goods and services. That would uncomfortable. Consumers might delay purchases as they wait for prices to fall, workers might chafe at regular annual wage cuts, and creditors would be even worse off.
Hadas concluded that the situation Bitcoin as an economy faces is akin to the paradox of thrift, a downward spiral in economic activity (i.e., a depression).
Volatility
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In practice, volatility is a poor property for a medium of exchange to have – bitcoin values were eighteen times (18x) more volatile than the euro in the first quarter of 2014 (see Table 1 from David Evans above).482 Furthermore, it is the implication of wanting to hold cash for the
transaction motive. In practice, people are risk adverse, and the existence of transactions costs mean more costly rebalancing of the medium of exchange that balance the more volatile the medium of exchange. Perhaps as some have suggested, when BitLicenses are issued later in 2014, new institutional participants will provide larger amounts of volume and liquidity, subduing some of the volatility.483
Or maybe not.
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The chart above comes from a February 2014 report by John Normand at Global FX Strategy with JP Morgan.484 As visualized over a four year period, bitcoins are 20 times more volatile than the dollar/yen trading pair.
Normand also notes that:
A virtual currency’s transactional use will always be limited unless it performs the other two functions of money better than a fiat currency. As a unit of account and store of value, bitcoin also falls well short of fiat currencies given its extreme volatility. As highlighted earlier in chart 2, bitcoin's realised volatility has averaged 120% over the past three years, with a range of 50% to 400%. By comparison, typical G10 currency volatility is 8% with a range of 7% to 16% over the past three years. Typical emerging markets FX volatility is about 9% with a range of 7% to 20% over the past three years.
Even during periods of extreme financial market stress such as the Asian Crisis of 1997/98 and the Argentine Default of 2002, currency volatility reached levels closer to 50% (Asia) or 120% (Argentina), and then only persisted for a few weeks.
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True, these swings may represent simply normal volatility for a start-up currency just like the fluctuations of start-up companies’ share prices during the 1990s. Even by dot-com standards, however, these moves are brutal. The Nasdaq only quintoupled in value in three years (1997-2000), while bitcoin's price has risen 50-fold in the past year (charts 5 and 6). Such price fluctuations make it impossible to seriously consider bitcoin as a unit of account or store of value for an material amount of corporate or investor exposure.
Could this change with time and more liquidity? Perhaps, but maybe not.
There is also a chance that when BitLicenses are issued later this fall, it will likely bring new professional traders into this market, and traders are largely interested in volatility for arbitrage opportunities. Thus, the smoothing out volatility that some predict could happen might not;
the phrase “be careful what you wish for” might be apt here. The armchair day traders on reddit could very well get cleaned out if and when real professionals with actual HFT experience come online. In addition, there is a very real incentive to also create artificial arbitrage
opportunities such as a denial-of-service on exchanges or pools and impact the market just a little bit but this cannot be known a priori either.
Stalled and at a stand still
The discussion of inflation versus deflation with respect to Bitcoin has gone on since at least November 2008, with Ray Dillinger explaining to the same listserve Bitcoin was originally announced on that:485
I know the same (lack of intrinsic value) can be said of fiat currencies, but an artificial demand for fiat currencies is created by (among other things) taxation and legal-tender laws. Also, even a fiat currency can be an inflation hedge against another fiat currency's higher rate of inflation. But in the case of bitcoins the inflation rate of 35% is almost guaranteed by the technology, there are no supporting mechanisms for taxation, and no legal-tender laws. People will not hold assets in this highly-inflationary currency if they can help it.
One common refrain from some adopters is that even if the value fluctuates, bitcoin holders have to spend to buy food and satiate the lower tier of Maslow’s hierarchy. This could be the case in a few instances (those who converted all their savings into bitcoins), but in practice most holders of bitcoin (or rather, most individuals with the knowledge of the private key) typically are diversified and live in a developed country and consequently have other means to purchase such necessities. So while it may be difficult to delay purchases indefinitely (no one besides Kevin Kelly regularly uses a 1980s Panasonic dial-pad), the economy as a whole is depressed because no activity is taking place (e.g., few spend, few lend).486 Why, as a lender would you lend if the price measured in bitcoin could decrease?487488
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For instance, in the Coy example noted above, if Bob loaned a friend, Alice, 100 bitcoins on December 31, 2012, Alice might not have had the ability to pay it back a year later. She would, at the time, be taking out roughly $1,350 ($13.50 per bitcoin) but by the end of the year in December 2013 would owe 64 times that or roughly $86,400. Faced with such decisions, few borrowers would bother taking out loans and most would simply default. In general, with deflation, the lender gets paid back an amount that is worth more than what he originally lent.
However when deflation is as extreme as the example above, the default rate will be high.
Facing such a possibility as seen with bitcoin in 2013, few lenders might be interested in lending, but would rather just hold onto the asset and await for its appreciation; especially considering how the rest of the bitcoin ecosystem (e.g., credit ratings) is non-existent, which makes the risk of default higher than it otherwise would be.489 After all, what kind of business could Alice realistically create, get off the ground and produce a profitable return of 64x in one year?490
Or to use another example: Bob’s barbeque business. The revenue of the business would be the same in real terms but the nominal amount of currency units from sales would go down due to deflation. What happens in this case is that if Bob had a debt that is pre-set in terms of nominal currency units, he ends up having an increasingly harder time to pay because he would have to deliver more real value with each succeeding payment. This is why deflation is bad for businesses. It makes their debt burden in real value higher and higher every year. If the currency is deflationary, theoretically the interest rates would be much lower, offsetting this cost. However, that is only if deflation levels are predictable and built into the interest cost – which according to Brian Hanley’s analysis, is essentially impossible with Bitcoin since there's no central clearing house or method of coordination to provide Bob and market participant’s inflation targets while adjusting the money supply to hit those targets.491 In effect, Bob ends up with a much less predictable investment environment and the bane of business is lack of
stability and future predictability. Consequently, Bob’s decisions are no longer accounting-based but are simply gambles.
In an exchange with Massimo Morini, author of the earlier cited paper Inv and Sav Wallets, came to similar conclusions:492
This is essentially a syllogistic paradox: for Bitcoin to grow in economic relevance, people need to spend bitcoins for transactions. But if people anticipate that Bitcoin will grow in economic relevance, they know bitcoins will also grow in value so people will be motivated not to spend them but to hoard them. Thus bitcoins will not grow in
economic relevance, and in this case they will also stop growing in terms of value. We may not be so far away from seeing this happen.
Non-flexible supply or demand is one crucial curse of bitcoins. This is one of the things I try to address in this paper: dividing the players who have an incentive to hoard because they get the gains from growth of the currency, from the normal player that want stable 144
prices and wallets and like the currency for its transactional abilities. Unfortunately, even the idea proposed by Ferdinando, to transform the growth of bitcoin value into a proportional growth of wallet amount for everyone, there remains a distorted incentive to hoard.
In the real economy, saving money with financial institutions is beneficial because it does not
“sit on the sidelines.” Bob deposits it in a bank and they in turn lend it out for productive purposes (e.g., loaned out to Alice who then builds a factory). Hoarding a medium of exchange does not do anything or create value; it has no productive input on the economy because it simply sits and remains stagnant.
According to Brian Hanley, one of the core hurdles that Bitcoin as start-up economy faces:493 You can't expand a money supply by deflation, this is deadly to an economy. Reserve banking is impossible with bitcoin; it has unified the unit of account and the unit of exchange. Because you can't do banking, the only thing that can be done with bitcoin is hoarding, which is not saving. In a bank, money saved is kept in circulation, it is used.
When a medium of exchange is hoarded, it is useless to anyone. There is little meaningful difference between hoarded bitcoin and lost bitcoins.
Bitcoin creators misunderstand wealth creation. Wealth is created by loans. Loans are money in the present given with the promise to do useful work for society in the future.
Similarly, virtually all money in existence is debt money. It exists because it is owed to someone else. Society uses money as a circulatory system for distribution of goods and services to individuals. Any hard-currency monetary system that cannot create new money as needed (through loans or minting it to meet requirements) is a zero-sum game. Zero sum games have interesting characteristics. They force all loans to get
Similarly, virtually all money in existence is debt money. It exists because it is owed to someone else. Society uses money as a circulatory system for distribution of goods and services to individuals. Any hard-currency monetary system that cannot create new money as needed (through loans or minting it to meet requirements) is a zero-sum game. Zero sum games have interesting characteristics. They force all loans to get