Could deflation cause problems for bitcoin?

Although it has been overshadowed in recent months by mostly regulatory news, the issue of deflation and bitcoins is still a topic worthy of debate. It was one of the biggest criticisms that faced bitcoin earlier this year as the price rose to an all-time high. Most of the bearish views on bitcoin deflation came from economists, who may or may not have understood the true nature of bitcoin.

What is deflation?

The general idea is that deflation is a decrease in the price of goods and services. In this case, we are specifically talking about bitcoins. As bitcoin’s value goes up, the cost of paying for things in BTC goes down as a result of an item’s fiat monetary value staying the same. This might trigger deflation, and some economists believe that once it starts happening, deflation will spiral out of control.

Total bitcoins over time. Source: Wikimedia

Deflation’s overall drop in prices reduces economic activity. It can cause investors to hold onto a currency, which can make the problem even worse. This would be doubly bad for bitcoin considering the number of people who buy bitcoin simply to hold onto it with the idea that the value will go up.

Another problem for bitcoin is that there will eventually be a fixed supply. A confluence of events in bitcoin, namely it becoming a popular unit of exchange, will become very important for it to not become deflationary.

The babysitting co-op

As Forbes’ Pascal Emmanuel Gobry pointed out earlier this year, it might just be Paul Krugman’s 1998 article about a babysitting co-op that best explains how deflation might affect bitcoins. In short, the co-op, where people relied on each other to babysit their children, worked via a system of vouchers. It was as if the co-op had an alternative currency instead of using fiat money.

So what happened? The members of the co-op began to hoard their vouchers, which as a medium of exchange were each worth one hour of babysitting time. The number of vouchers that actually circulated became very low, which resulted in something akin to a babysitting recession.

Economist Paul Krugman has called the babysitting co-op “a story that changed my life” Source: Salon

How was this recession remedied? A mandate was put in place to inject more vouchers into circulation. This is a familiar method to stimulate any economy in today’s age. We’ve seen central banks simply increase the amount of fiat in circulation by purchasing government-backed securities.

Deflation: bitcoin versus fiat

Unfortunately, you theoretically cannot do this with the fixed monetary supply that exists in bitcoin. Economist Dr John Edmunds, author of Brave New Wealthy World, explains what happens with deflation, at least as it is concerned with fiat currencies:

“Central banks fight deflation by putting more fiat money into circulation. Consumers and business then spend it and raise the demand for goods and services. That creates inflation. That policy hasn’t worked very well since 2008 because the consumers and businesses have been so cautious. They have held onto money instead of spending it.”

Amount of USD in circulation. Source: Federal Reserve Bank of St. Louis

Jon Waller is a developer and bitcoin entrepreneur who started the incubator BitcoinEAST. He believes that the continuous creation of bitcoins staves off any sort of deflationary effect – at least for the time being.

“The coin generation rate right now is probably far above the loss rate, so the number of usable bitcoins are increasing; meaning we’re still experiencing inflation in the bitcoin world.”

When it stops growing, can it stop growing?

Bitcoins ultimately are limited by the number of them that can be created. The originators of bitcoin designed the system so that only 21 million can be made. This will eventually create a fixed money supply that can end up in serious liquidity problems if investors persistently hoard bicoins, hoping for an everlasting rise in price. Yet that’s not how a normal market works. Prices rise and they fall in an ebb and flow.

Divisable elements of bitcoin. Math-based currencies have an edge in this respect. Source: Bitcoin.it

There is one big difference, however, versus that of bitcoin and fiat money. Bitcoin is actually quite dividable. This could play a factor since a virtual currency is much easier to break down into smaller parts than that of today’s fiat system. Bitcoin is currently dividable down to .00000001 of one BTC. That seems like a small amount right now, but someday it could prove to be useful.

In the end

It’s more likely that price volatility is more of a threat than deflation to bitcoin right now. Plus it’s hard to tell what will happen to secondary decentralized virtual currencies like litecoin because of regulation. It’s possible that these other currencies might be able to act as a buffer.

As the price of bitcoin rises, that doesn’t necessarily mean people will hoard it. The most savvy and technology-inclined investors could easily trade in pricey bitcoins to buy another cheaper and possibly rising cryptocurrency. As we can see below, the activity of litecoins is similar to that of bitcoins over the past year, with the exception that litecoins are much cheaper to buy.

Look familiar? The LTC/USD chart appears similar to that of BTC/USD. Source: LTC-Charts

The volatility of bitcoin is a problem, as no one knows really where the price will be in six months, a year or even further out. It’s no wonder, then, that despite the controversial strategy of Ripple, being a payment network with less friction might be a better proposition than bitcoin itself. The fact that bitcoin offers less friction in payments is one of the factors that makes it valuable, despite the swings in its value.

What do you think about bitcoin and deflation? Will bitcoin be able to survive as a currency, or is it better fit to simply be a payment protocol?

Featured Image: Flickr