Bitcoin and the Deflationary Spiral

Among the mainstream financial media and economic pundits there is a great deal of skepticism about Bitcoin. Critics have come up with all kinds of reasons why they believe Bitcoin fail. A particular argument you hear repeated ad nauseum is that Bitcoin’s limited supply will produce a deflationary spiral. Now there are two forms of the deflationary spiral argument: A more intellectually serious form involving a hypothetical sudden collapse of aggregate demand coupled with sticky wages and an ill informed caricature of the nature of deflation. Here’s an example of the later from alleged economic expert Matt Yglesias:

If over time more and more people want to use Bitcoins to conduct transactions of various kinds, then the price of bitcoins is going to have to rise and rise. The problem is that if the price of a bitcoin is on a steady upward trajectory, then nobody’s actually going to want to spend a Bitcoin on anything. And if everyone’s hoarding their Bitcoins, then the network is actually useless. Then, since it turns out to be useless, you get a crash.

The critics of Bitcoin almost always regurgitate this caricature. Before blowing up the fallacy, let’s take a moment to recap why Bitcoin (or any other currency with a fixed supply) would produce deflation. In a world where Bitcoin is the generally accepted medium of exchange (i.e. money) we would expect its demand to be relatively stable (in contrast to today). Demand might increase in times of growing economic uncertainty or decrease as the uncertainty wanes, but by and large it would be fairly stable. Presumably by this time the rate of Bitcoin creation will have slowed to the point where the supply is nearly fixed. Now we frequently hear price inflation referred to as situation where there is “more money chasing the same number of goods”, which bids up prices. What we would experience with Bitcoin, however, is the opposite. A growing economy implies a growing supply goods. We would have “more goods chasing the same amount of money”, bidding up the price of money, or to put it another way, pushing down the price of goods and services. In such a situation we would expect prices to fall on net by approximately the economic growth rate.

Let’s note also that falling prices do not imply that businesses would be suffering. The whole reason why prices would be falling is that capital investments have reduced the cost of production making it possible to expand supply. If costs fall more than prices, businesses will be more profitable, not less. The rest of the public would also see rising real incomes as prices fall while their wages either stay roughly the same or increase as they advance in their careers.

So in this situation the critics would have you believe that the mild deflation would create an expectation of falling prices and cause people to hoard their Bitcoin so they can pay lower prices in the future. The act of hoarding would only serve to increase the price of Bitcoin which would leading to more hoarding. Round and round we would go until nobody would spend Bitcoin at all.

Now here’s the problem, you could apply this same idiotic reasoning to any commodity or stock under the sun. For example, you could say that since Google’s stock price has been going up people would expect it to keep going up. (By the way, that is a fallacy in and of itself. We all know past performance doesn’t guarantee future return.) But since people expect it to keep going up everyone will hoard Google stock driving up it’s price and causing even more hoarding. Eventually so many people will hoard Google stock that it will stop trading and the price will crash to zero.

Obviously, outside the fantasy world of Krugman fanboys this doesn’t happen. The reason it doesn’t happen is that if people expect Google stock to increase in the future they will bid today’s price up to the present value of the expected future price. In other words, prices adjust to match this expectation. Prices don’t spiral upwards only to crash down to zero as these critics absurdly suggest. Neither does this happen if you invest in the monetary unit instead of stock.

Another fallacy is the notion that people will cut their spending down to zero in attempt to hoard bitcoin. This overlooks the universal phenomenon of time preference. That is, people prefer satisfaction of their wants now to satisfaction in the future. Sure, faced with the opportunity to earn a return on investment people are willing to cut back on consumption spending, but only up to a point. We still have to eat after all. Still have to pay rent, put gas in the car, pay our bills. All of these weigh more heavily on us than investing for the future. At best we will only cut back on discretionary spending and even then we will have to decide if we prefer present consumption (on entertainment as an example) more or less than the (potentially) greater level of future consumption.

I would cite myself as an example. I first started investing in Bitcoin when it was $12. As the price rose I was desperately looking for room in my budget to increase my investment. The problem was there wasn’t much I could cut out of my budget! I still had to make my car payment. Still payed my cell phone bill and gym membership.The best I was able to do was scrounge up a few thousand dollars (which is worth a pretty penny today). My personal consumption didn’t drop anywhere close to zero as Bitcoin climbed from $12 to a height of $266.

Now again we could take this idiotic reasoning out to its logical conclusion. Going back to Google stock, this theory would imply that as the stock price rose, people would continually cut their levels of consumption down to zero in a feverish attempt to buy more Google stock. When this happens nobody will spend any money on goods and services and the economy will grind to a halt all thanks to Google.

You have to be either logically impaired or blinded by ideology to believe such a thing.

Now I mentioned in the beginning that there is a more serious argument involving a random demand shock. I think there’s good reason to believe this argument is way oversold, but rather than critique it here I’ll just point you to a previous post where I offered my opinion.

Nonetheless, its the caricature of the deflationary spiral that gets bandied about in the media and blogosphere and unfortunately carries much more weight than it should. Still, Bitcoiners shouldn’t let the sloppy thinking their critics deter them from their quest to build a censorship-resistant global monetary system for the 21st century.

8 thoughts on “Bitcoin and the Deflationary Spiral

  1. Nice post. The thing about deflation that concerns me is this: if Bitcoin becomes a dominant word currency, then holding bitcoin will be similar to investing your money into an index fund tracking world GDP growth. You won’t have to actually invest your bitcoins for their value to grow at the rate of world GDP growth though. This means that to the extent that people simply hold their bitcoins instead of investing, they can benefit from growth caused by the investment of others, but no companies are able to make use of their bitcoins. If everyone does this, there will be less investment and less growth. I haven’t totally worked this out yet, but that’s my intuition. What do you think?

    • I think you’re partially right although I don’t think it would result in no investment. Interest rates will be a major determining factor in how much bitcoin people save vs invest. To the extend that people do save bitcoin instead of investing … prices would adjust downwards (assuming the market clears). It’s not clear that the resulting equilibrium would result in a higher consumption/investment ratio. Again interest rates will be a determining factor.

  2. I also don’t think there would be no investment, but it seems like we should expect significantly less the more deflation there is. Interest rates have to be tied to productivity at some level. If you’re asking me for 100 bitcoins for you business venture and you tell me you’ll give me 102 bitcoins at the end of the year, but bitcoins are expected to increase in value by 2% every year, then you business has to make at least a 4% ROI on my money for the loan to be worth it to you. If your could generate only 2% profit by buying a buch of stuff for your business and providing value to people then converting back to bitcoin at the end of the year, I’d never lend you the money because I can get a 2% profit by holding onto my bitcoins. So the value you would have provided people is never realized and the world is worse off.

    Just FYI in case you didn’t see it, there are a couple reddit threads about this:

    (one refers to the other)

  3. Pingback: Imagenes para el pin las mejores imagenes |

  4. Pingback: Bitcoin and Gresham’s Law | Escape Velocity

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s