Expert Commentary

Bitcoin and Deflation

If Bitcoin's the future of money, get ready for deflation.

In 1820 a gloriously named Scotsman, Gregor MacGregor, invented a fictitious country. He then persuaded people to invest in said country and ran off with the loot. That country went by the name of Poyais. It's another story and, if you want to learn more click this, but we will use Poyais for our purposes here.

For what we are going to do is imagine a country that has a fixed amount of currency in circulation. Let's assume that there are 21 million Poyais dollars in the country and that amount cannot be increased by law. The only industry in the Poyais economy is farming. The population works to produce food which is then paid for and consumed. Let's suppose that each year, more land is developed for farming and, combined with more efficient processes, the economy's output of food grows. If the amount of food is growing but the amount of money available to buy the food is not, the value of a Poyais dollar per unit of food is going up. Put another way, the value (i.e., the price) of food per dollar is going down. This relative scarcity of money is deflation.

This is what will happen in the Bitcoin economy. Let's assume that the entire planet eventually moves to Bitcoin (completely unrealistic, yes, but bear with me). Once all Bitcoins have been "mined" (estimated by around 2040), the amount will be limited to 21 million coins. Products will then be priced in Bitcoins. As production increases, because there's only a finite amount of Bitcoin available to pay for it, the value of a Bitcoin goes up, meaning that the price of the product goes down. In Bitcoin world, prices will only increase if production, or economic growth, declines.

Let's be more realistic and assume that the Bitcoin economy becomes niche, with specific goods and services being paid for in the crypto currency. Assuming production growth, the price of those goods and services will exhibit steady declines due to the deflationary impact of the fixed amount of currency available.

Of course, this is what the founder of Bitcoin had in mind all along. Bitcoin was invented as a retaliation against the chronic inflation of sovereign fiat currency, meaning that more and more has been printed or created via the fractional reserve banking system. A Bitcoin economy would be akin to how economies operated under the Gold Standard when money supply was linked to the amount of gold a country had.

Many economic historians disparage the Gold Standard because it put limits on economic growth, but the flipside is that it produced long-term price stability. One criticism of the current monetary system is that since the Gold Standard has been abandoned, much of the economic growth, in the Western world at least, has been non-productive, fueled by increasing amounts of debt. Bitcoin may be the start of a monetary revolution that will take us back to a world of steady prices but slower economic growth. You pays your Bitcoin, you takes your choice.