Deflation Part 2: Is Bitcoin Price Deflation Good or Bad?

Last updated on October 13th, 2017 at 12:15 am

In part one of this two part series, we discussed the hard-coded deflationary nature of Bitcoin and examined whether or not the Bitcoin price has been deflationary in real life. We concluded that, yes, Bitcoin has indeed been deflationary throughout its five-year lifespan.

Now we can raise the question: is the deflationary nature of Bitcoin value good or bad for the Bitcoin economy? This question returns to the debate of whether deflation is desirable over inflation or vice-versa. In order to answer this question, we must consider the economic soundness of both the pro-inflation and pro-deflation arguments.

The inflationists argue that the money supply must be in a constant state of slight inflation in order to offset the natural tendency of deflation (and now they even say that we must avoid too little inflation as well!). They stress the need to avoid inflation because of a fear of the “deflationary death spiral,” which has already been mentioned above. As stated earlier, this infinite downward spiral of deflation happens because, supposedly, individuals will stop consuming in favor of holding their money so that it can gain value. This saving sets off a chain reaction; the initial saving makes the value of the currency go up, which encourages even more saving, and so forth. If deflation were to happen, it could cause massive waves of unemployment due to all of the money being hoarded. Therefore, a solution to this problem is to maintain a “healthy” amount of inflation, which is generally believed to be at 2%, in order counteract deflationary tendencies and keep the purchasing power of money stable.

Those who argue that deflation can actually be healthy for the economy—these people generally come from the Austrian school of economics—argue that deflation and the subsequent decrease in prices merely signals a shift of the individual demands on the market. In periods of deflation, time preferences are decreased, which means they save more of their wealth rather than consume it. This act of increased savings lowers interest rates, which makes investment cheaper and thereby shifts the production structure so that it pursues projects that produce goods further into the future rather than producing more immediate, consumer’s goods. This method of saving is how an economy progresses; investment is the engine that drives the machinery of production, which increases the standard of living for the general population.

The “Deflationary Death Spiral”

But the inflationists warn that too much saving makes existing businesses unprofitable and causes mass unemployment. And this fear would be justifiable, if the amount of saving the inflationists are terrified of was actually possible in the real world. The notion of the “deflationary death spiral” makes three fallacious assumptions when judging human action.

First, and most fallacious, it assumes a static economy, or an evenly rotating economy (ERE). The ERE is a purely theoretical construct in which the economy is in perfect equilibrium, there is no competition and profits equal costs, and all factors remain equal and constant, which means there is no change in the economy. Everything is stable. In order for deflation to cause the damage worried about by the mainstream economists, this theoretical construct would have to exist in the real world; the deflationary trend could not be interrupted by any changes in the market, it would have to continue in perpetuity until the entire economy collapsed. In other words, there can be no uncertainty in the economy. And that is simply impossible. Furthermore, if the ERE were achieved, deflation would not even be possible at all! There is no change whatsoever in the ERE, so time preferences do not exist, therefore they cannot shift so that the demand for money is higher than its supply. Everything in the ERE is in perfect equilibrium with each other, including the money-relation. So even in the realm of staticity, where the positivist economist house all of their empirical models and equations, their own argument is untenable!

By Gage Skidmore [CC BY-SA 2.0], via Flickr

By Gage Skidmore [CC BY-SA 2.0], via Flickr

The second flaw in the inflationist argument against deflation is that it assumes, or at least implies, perfect knowledge on the part of the individuals who are faced with an appreciating currency. The individuals, in order to indefinitely hoard their cash, must know that the deflationary trend will continue in perpetuity. They must be aware that the value of their cash holdings will continue to increase as long as they hold them and refrain from consuming them. This situation could occur, individuals could and likely would become aware of their currency quickly gaining value. But this scenario assumes that the time preferences of the individuals cannot change, which again brings us back to the assumption of the ERE, something that can never be reached in the real world. It is highly unlikely—impossible, even—for time preferences to remain so low and stay there indefinitely so that no individual would ever spend their money. But, who’s to say that individuals would never value consumer’s goods over their money? Again, that can only happen ceteris paribus, all things being equal, which assumes the realization of an impossible achievement of a static economy, or an ERE.

The third problem with the “deflationary death spiral” argument is that humans are physiologically and biologically incapable of refraining form consumption to such an extent that deflation could become so severe. At the bare minimum, human beings must eat and drink, which requires a consumption of an at least minimal part of their wealth. So, at the very least, enough money would circulate to facilitate the continuance of human life. It is also safe to assume that humans in the modern era would prefer to have decent clothes to cover their bodies and sturdy housing in which they can dwell. These things also require an expenditure of money, labor, and resources, meaning that there will always be at least that much consumptive activity working against infinite deflation.

A Brief Examination of Inflation and Business Cycles

By reway2007 [CC BY-NC-SA 2.0], via Flickr

By reway2007 [CC BY-NC-SA 2.0], via Flickr

The impossibility of a “death spiral” of deflation is in stark contrast to the very real possibility of an inflationary death spiral. There have been several times throughout history where such an event has almost occurred. The hyperinflations of Germany, Zimbabwe, Argentina, Venezuela, and the Confederate States of America are just a few examples of massive bouts of inflation that essentially destroyed the economies of these states. While humans cannot save indefinitely due to the laws of biology, they can certainly spend indefinitely as long as money is being pumped into circulation. Inflation, even the “mild” inflation the mainstream economists praise, has always caused severely damaging business cycles that, although only occasionally resulting in a death spiral, have definitely exposed the face of the destructive nature of inflation.

As central banks lower interest rates and inject stimulating liquidity into the economy, the production structure is altered so that it aims at more remote modes of production. However, the enterprises that spring up from this credit expansion are not necessarily profitable. In fact, they are often entirely unprofitable and rely solely upon this credit to thrive. Therefore, as soon as the credit stops, a large portion of these new enterprises will come crashing down. But not before they have had time to grow to dangerously unsustainable levels and employ many people in the process. So, when these businesses fail, many people are forced out of work and are left without income. Consequently, people can no longer afford the high prices that resulted from the inflation, so their decreased demand forces prices down. The central banks see these falling prices as a negative rather than a simple reallocation of capital, and administer another dose of inflation to the economy, thus starting the cycle all over again.

The scenario above represents a very brief explanation of business cycles, an economic phenomenon that has repeated itself continuously since the Great Depression because of the inflationary policies of central banks.

Conclusion: Bitcoin Value Ultimately Benefits from Bitcoin Price Deflation

So, after examining both arguments in support of inflation and deflation and looking at their economic soundness, we can determine that deflation realistically poses none of the threats that the inflationists fear. Therefore, we can conclude that Bitcoin’s deflationary nature is ultimately good for the long term persistence of a high Bitcoin value. Why? Deflation, as we have seen above, encourages investment by stimulating saving—but not complete, indefinite saving, so the economy will not collapse from this deflation. Such investment only serves to strengthen the financial infrastructure being build around Bitcoin, thus reinforcing the Bitcoin value.

Granted, Bitcoin is still in its very early stages and no real Bitcoin oriented money market exists; however, deflation still increases the Bitcoin value so that the incentive to build the required financial infrastructure remains in tact. As the demand to acquire and use Bitcoin as a medium of exchange increases, the expansion of Bitcoin’s supply is simultaneously slowing. This necessarily means that the Bitcoin value will continue to increase as long as there is a substantial market demand for the digital currency. Even though there is not a solidified money market surrounding the Bitcoin system right now, people are still saving their coins and are benefiting from the Bitcoin value appreciation. So, as the economy grows, and that money market is eventually established, a very sturdy foundation for economic investment in Bitcoin will have been built by previous saving.

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thank you for clearing thing out for me :) nice article