Bitcoin’s Deflationary Model and its Impact on the Price

Introduction

Last week the Fed lowered interest rates and Jerome Powell, the Federal Reserve’s Chairman shortly stated that “World Central Banks play an important role in combating the economic impact of the virus”. The statement may be simply interpreted as, “We will print money collectively and in a coordinated manner into oblivion in the event of a crisis”, which means that more currency will be created, and more currency in circulation causes higher inflation.

“Everyone knows that moderate inflation is good for the economy while deflation leads to stagnation” — this statement is so widespread that most people (including economists) do not even bother to evaluate its fairness.

Total number of minted bitcoins and projected bitcoin inflation rate. https://bashco.github.io/Bitcoin_Monetary_Inflation/

But Bitcoin’s supply is limited, therefore, its economy is deflationary.

This article will work through the differences between deflation and inflation as well as if Bitcoin’s deflation will lead to it’s a long-term price increase.

Traditional View of the Economy

Inflation is basically represented by the price increase for goods and services, while deflation has the opposite effect.

In a nutshell, in most cases, inflation and deflation are directly related to the Central Banks’ monetary policy. Using even simpler words, both inflation and deflation depend on how actively central banks print new currency.

It is interesting to know: previously inflation and deflation were directly defined as increasing/decreasing the total amount of money in circulation. The banking system is so complex nowadays that it is almost impossible to estimate exactly how much money is being injected into the economy.

The traditional Keynesian School of Economics is built on a thought that moderate inflation is necessary for the economy.

Rising prices prevent people and corporations from saving and incentivize them to spend and reinvest their earnings, thus stimulating the demand for goods and services and, therefore, the economy itself. Demand stimulates supply, production increases, and the economic machine goes on working.

If deflation suddenly occurs, the economy collapses. Prices fall, people spend less money, production falls, unemployment rises, prices fall even further, and so on. (This process is called a deflationary spiral).

Some of the deflation negative effects examples are the Great Depression in the United States in the 1930s and the deflationary spiral, which occurred in Japan in the 1990s.

It is interesting to know: The most conservative estimations show that due to inflation the U.S. dollar has lost more than 85% of its value over the past 50 years.

An Alternative View of the Economy

There are other schools of economics, Austrian School being one of them. These schools support different views which, when closely examined, prove to be quite reasonable.

In particular, they argue that falling prices do not necessarily lead to a dramatic reduction in demand. People will definitely continue buying food and other essential goods. Moreover, they won’t give up on luxury goods either.

The tech sector, for example, is now experiencing local deflation: a new phone, which costs $1000 today, will cost $800 in two years. At the same time, people are still actively buying new phones.

Though it looks like a joke, not science, doesn’t it? So what will happen if you dive deeper into the data? It turns out that in this case, the “typical” example of Japan looks very atypical.

Economists Andrew Atkeson and Timothy Kehoe have studied periods of deflation and economic depression in various countries over the period of past 180 years and found that out of 73 periods of deflation 63 did not lead to a decline in economic activity, and out of 29 periods of depression 21 happened during the period of inflation, rather than deflation.

Healthy Deflation

No one is arguing that increased deflation will actually lead to an economic collapse. The consequences would be no better than in the case of hyperinflation (which, by the way, we witness more often than the deflationary spiral).

But moderate deflation or zero inflation would ideally lead to sane consequences, which the market economy could cope with on its own.

- The value of money will not be diluted by inflation, so people and companies will be able to save their earnings.

- It will be harder to pay off the debts (and therefore borrow); those who have collected a lot of debts will be forced to declare themselves bankrupts and leave the business; many debts will be refinanced on more favorable terms.

- States will have to operate using tax money rather than printed money; fewer debts will lead to smoother economic development (fewer opportunities for bubbles).

It is interesting to know: In the late 1970s, the USA was on the edge of hyperinflation: the state printed money to stimulate the economy, yet production kept slowing down instead of rising. At that time, the US Federal Reserve took a number of measures to achieve deflation. It was not easy: unemployment rose briefly, many businesses went bankrupt, a number of protests took place, but within a couple of years the economy fully recovered.

So why do all Central Banks try to avoid deflation in such a diligent way?

- First of all, because all the governments are stuck in debt.

- Secondly, because printing money is better absorbed by the people than raising taxes.

- Finally, because monetary policies are to some extent effective in stimulating (and regulating) the economy (at least, in the short term).

US public debt vs GDP

Everything is much more complicated, but simply put, with each new dollar (euro/ruble/franc) printed, governments are increasingly pushing themselves towards an inflationary dead end, which is impossible to escape without external assistance.

Bitcoin’s Scarcity

What does that have to do with bitcoin? Neither governments nor Central Banks have any control over Bitcoin, it can’t be printed, it doesn’t care about one’s debt. Bitcoin offers an alternative to the current system.

On top of that, if you carefully calculate the number of existing Bitcoins at the moment, you will be able to state that its scarcity will only rise in the future. Nick Carter, one of the partners at Castle Island Ventures and a co-founder of Coinmetrics is convinced that market capitalization is an irrational and inaccurate tool for measuring the amount of capital contained in Bitcoin.

According to a number of studies, several million coins have not moved since 2009–2010, including Satoshi Nakamoto’s alleged addresses. They could probably be in a cold storage facility, yet could also be lost forever as well.

Realized capitalization of the bitcoins. Data by Coremetrics

So how do you calculate the number of bitcoins in the correct way?

In order to make the capitalization estimation more accurate, taking into account both lost coins and the ones not found by their owners, capitalization metrics are introduced. This metrics take into account only circulating bitcoins. For this purpose, the total value of all bitcoins at the time of their latest movement is calculated and does not consider coins that are lost or are not currently in circulation. Therefore, the value of realized capitalization is lower than the market value.

Conclusion

Bitcoin has a number of properties that fundamentally distinguish it from traditional money used in modern economy, e.g. monetary systems based on the dollar or gold standard. Traditional money, including the U.S. dollar, is based on debt, which is an integral property of fiat currencies. Bitcoin has properties that make it resistant to credit expansion as it is not directly related to debt. Therefore, in the event of an economic crisis and deflation in a Bitcoin-based economy, an increase in the real value of debt can lead to far more moderate consequences than one might imagine. Thus, the arguments for the deflationary debt spiral lose relevance when it comes to the Bitcoin economy. In our view, it is likely that many Bitcoin critics have not taken into account this point when evaluating the disadvantages of the Bitcoin’s deflationary model.

To sum up, Bitcoin’s deflationary nature, combined with the fact that it is not tied up in debt, makes it a truly interesting asset not only for long-term investment but potentially for the transformation of the current economic system as well.

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