One of the main features of Bitcoin is that only a previously fixed number of coins will come into existence. There will not and can’t ever be more than 21 million Bitcoins. This makes Bitcoin a deflationary currency by definition. Deflation is a state where the price levels decline over a period of time, and a Bitcoin would then become more valuable.
As Bitcoins will be worth more in a definite amount of time, it will also cause a negative pressure on the velocity of money. Why? Because if Bitcoins become worth more, there are more reasons to delay spending it. Prices must then fall more rapidly and thus increase the deflationary effect.
Deflation means a decline in the general price level, the opposite of inflation. Or we could also think of it as an inflation below 0%. While inflation decreases the value of currency, deflation increases it. Because of deflation, people can afford to buy more with the same amount of money.
One of the main drivers for the negative view on deflation is from the time of the great depression and the idea of a deflationary debt spiral. The theory is – in short – that during a period of economic recession and deflation, the real value of debt increases. An increase like that exaggerates the misfortunes of an already weak economy.
The current economic narrative states that deflation is an undesirable economic phenomenon, while moderate inflation of around 2% per year is desired. This measuring can’t really distinguish quality (for example, for a smartphone this year and last year for the same price, although this year is much better), so it is considered that this 2% can also cover technological progress. Simply put – if, on average, everything is 2% better today but also 2% more expensive than last year, then the growth in prices per unit of quality is actually 0%.
The answer is actually quite simple – because some Bitcoins are lost whenever someone loses the password to their wallet or when they send Bitcoins to a non-Bitcoin address, or when they stay at an address in such a small amount that the fee cannot be paid to move them, even when someone voluntarily burns them. All the aforementioned will cause Bitcoin’s money supply to fall a little bit every year.
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Yes and no. Living in a world where new money comes from new loans, falling prices make debt relatively more expensive. For example, you owe a million and that million now has higher purchasing power, you owe relatively more. Plus, you cannot expect an increase in your salary, rather than the opposite. If debt is more expensive, fewer loans will be provided and as a result less new money will be created. This will lower the prices, which in turn puts even more pressure on monetary deflation and sends us spinning down the spiral.
Predictable deflation would easily be passed on to interest rates, and even if it was surprisingly higher and people took out less credit, it would not cause currency deflation. Because the money doesn’t come from thin-air loans with Bitcoin. The spiral would stop naturally as the interest rates in the market for loanable funds would adjust.
That in turn would make loans cheaper before a new equilibrium was found. It wouldn’t destroy the whole fragile system, like it would with fiat money. Ultimately, this is not some hypothetical theory, the exact same thing happened with the gold standard, although it was very imperfect. Prices would go up and down as supply and demand dictate but would do so without the artificial increases or decreases from interfering with the stock of money. With Bitcoin, we can afford to let everything happen naturally.
However, Bitcoin is in fact a new and unique system, which is still likely to cause more economic problems, probably the unexpected or new ones. After all, there isn’t a perfect money. Although it may be more difficult, identifying Bitcoin’s potential economic problems may need more analysis and a deeper understanding of the underlying technology.
Somewhat ironically, if you think these economic problems associated with deflation have a remote chance of being relevant, like many of the critics imply, it would mean that Bitcoin has a serious chance of becoming widely adopted and hugely successful.