Why is bitcoin deflationary?

Wim Maas

I often hear both proponents and opponents of bitcoin calling it deflationary. They either argue it makes bitcoin great to HODL or it makes bitcoin not viable as a currency. Both might be right, but how do we know? Let’s talk about the monetary economics of bitcoin. What makes a bitcoin so expensive and why does it keep appreciating compared to regular currencies? Should we compare it’s economics to gold or tulips?

Deflation 101

Let’s start with what deflation means and take you back to your high school economics class. Deflation is when the price of a basket of goods denominated in a currency decreases. It is the opposite of inflation and encourages holders of a currency NOT to spend their money. The reason is simple, if you think your money will be worth more goods next year than it is worth today, you will be less likely to spend it. This is the common argument against bitcoin being a viable currency.[1] Traditional currencies often lose their value over time (are inflationary) to encourage spending.

Next, let’s look at why bitcoin is deflationary. To explain it we have to look at two things: Money supply and economic activity. The first is easy. Since bitcoin’s money supply algorithm is determined in its code, it is known to all and not subject to change (learn more here). This is one of the core principles of the bitcoin network:

Bitcoin deflation is not in it's code
The bitcoin supply algorithm. Yep, that’s all.

The supply increases every 10 minutes and the miner of every block currently gets 12.5 bitcoin as a reward for keeping up the network. Initially this was 50 bitcoin but every 4 years the block reward halves. The last block reward will be in 2140 after which the maximum supply is reached. You will often read this maximum supply to be 21 million BTC while, fun fact, due to some rounded rewards it will actually be 20999999.9769 BTC.

Since we know that the supply of bitcoin increases slightly up until 2140 this cannot possibly explain deflation. An increasing supply would actually result in inflation (!) , presuming all else equal. For example, the yearly printed USD “lost” 86% of its purchasing power in the last 50 years – a cumulative inflation of 624.1%. Similarly, it is not the supply that makes bitcoin deflationary.

So what DOES make bitcoin deflationary?

A classical economic theory that tries to explain inflation is the quantitative theory of money. It states that the supply (M) * velocity (V) of money should equal the price (P) * economic activity(Q). The economic activity here being ‘real’ GPD or the amount of goods and services bought using this currency. Although it is an old (read: centuries-old) economic model that doesn’t hold in the short term it can still help us understand why bitcoin is deflationary.

Quantity theory of money applied to bitcoin
Quantity Theory of Money by Milton Friedman (1956)

Assuming the M increases slightly and the V stays the same in the long run then, as a consequence the product of P x Q should increase as well. However, we know that bitcoin is deflationary, i.e. product prices denominated in bitcoin went down by a lot in the past nine and a half years. Knowing this we can say P went down (decreased), the only explanation of which is the Y went up significantly enough to offset the increase in money supply.

Another explanation is the V going down significantly (offsetting the change in M) and thus pressuring P downwards. This can happen if bitcoins do not exchange hands as fast as they used to do. A reason for this could be people hoarding their bitcoin and using it as a store of value instead of spending it. There is a downward spiral here in that the price will go up if V declines, which makes hoarding more profitable, which pressures V downward again. See December 2017 as a meteoric example.

Conclusion

To conclude, its supply mechanism and scarcity alone cannot explain the fact that bitcoin is deflationary. The doodles I make in my coffee breaks are scarce, yet no-one seems to be interested in buying them. Two possible explanations for bitcoin’s value are explained above. (1) It’s increasing use in economic activity, and (2) a decrease in circulation because of hoarding users. Note that both can be at play at the same time and the second is self-reinforcing.

So, gold or tulips? That is for you to decide, both were used to settle economic activity or hoard value at some point in history. But only one of them was efficient at it in the long run. Let’s wait and see…

Wil bitcoin always have deflation?
Bitcoin in the long run. Does it float?

[1] Economists do not agree on whether inflation (or deflation) is a good thing or not and what level of it is desirable for a currency.

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