Tag Archives: bitcoin deflation

The Economic Functions of Bitcoin

The economic functions of the bitcoin network causes it to behave like a central bank. This has a few effects: bitcoins (the payment unit) behave like stock due to the fixed, known supply of units being subject to open market operations. What happens when the market price of bitcoin changes is the velocity of bitcoin falls into disequilibrium until a new equilibrium is found. This is why the transaction volume of bitcoin its extraordinarily high during the bubble cycle, both on the way up, and on the way down. From this observation we can see the velocity of bitcoin also serves as the price finding mechanism for the immediate price of bitcoin. Before we dive in deeper, lets first take a look at how bitcoin acts as a private bank in the digital world.

Bitcoin: The Private Bank for The Digital World

If bitcoin was a private bank it would have the following maxim as its monetary policy:      

  • Whomever secures the Network shall be reward 50 bitcoin with each new block. This amount shall decrease by 1/2 every 210,000 blocks until it cannot be halved any longer.

This is the issuance of bit-coins, the currency unit, is made from the electrical energy spent mining bitcoins. We can see the monetary inflation schedule for bitcoin below. The supply of bitcoins is 100% totally fixed–the only way that new coins can be created is through solving a specific block, and the reward for that is drops every 4 years.  

bitcoin supply growth over time

bitcoin supply growth over time

In order to have a money system that needs no central authority, Satoshi made bitcoin based upon rules that are fixed and secured by the mining process. This allows for a system where all bitcoin units are known at all times, thus making the double spend problem solved.

trinityIf bitcoin is a central bank, it would have to solve the impossible trinity problem that all central banks face (except the U.S. but that is a different story). Bitcoin accomplished this by creating a computer program with an independent monetary policy that humans cannot interfere with. The block reward, how the competition for the block reward is done, and the fixed supply of units are all parts of the bitcoin program that cannot be changed.

Anyone with a bitcoin address can use bitcoin, and it is impossible to know who is controlling each address, so bitcoin must be freely exchangeable. This means that the ‘sacrifice’ that bitcoin has made in terms of the impossible trinity is that it has no fixed exchange rate–the market must find an exchange rate based upon bitcoin’s perceived value, and the number of units available to the market. This free flow of capital from any sources is what allows for bitcoin to have been worthless just a few years ago, and why it could be worth $10,000s per coin one day. The free flow of capital is what creates the total elasticity that bitcoin experiences. 

Bitcoin and Deflation

When economist have called bitcoin deflationary they are referring to its economic property of rising in value over time. This is due to the restricted supply of bitcoins while there is increasing demand for them. This is similar to how if you had bought Apple stock in 1980 during its IPO you would have paid $22 per share. Due to the restricted supply of Apple stock and the increase in demand, today it is valued at $520 per share–and that is after 3 splits.

apple price

You could say that Apple stock “deflated” in value.

This occurred while the supply of the stock (# of shares) of Apple increased–it inflated. On three different occasions Apple had their stock split increasing the total number of Apple stocks there were. Again, this is due to the dramatic increase in demand for the stock. This is the kind of deflation that Bitcoin is experiencing overall, despite the volatile ride bitcoin has had over the last few year.

Why Deflation Supposedly Bad

Deflation is bad according to modern monetary theorist who charade as economist because contemporary economies are based upon debt. Fractional reserve banking and debt cannot exist without one another, so when deflation happens, it happens to debt as well. This means the real value of debt becomes harder to service, which means defaults, and bankruptcy will increase. In 1931, Irving Fisher  presented his theory on debt-deflation, which explains this process in greater detail.

This kind of deflation does not happen with bitcoin. There is no need to service ‘debt-bitcoin’ with bitcoin, so debt deflation does not happen. If this were true, we would see a similar collapse in the velocity of bitcoin during deflationary episodes, but in fact we see the opposite. The velocity of bitcoin increases correlatively to the price change of bitcoin in the short-term.

The Price of bitcoin

The price of bitcoin is derived from the total utility of the bitcoin network. In otherwords, bitcoin’s value is specifically tied to how many people are in the network, how useful the network is, and what the perceived value of bitcoin is. This is similar to how Twitter and Facebook have created social value that has translated into real economic value; which is reflected in the stock price of both of these companies. Without their userbases, each one of these networks would be worthless. All networks have a hidden utility that translates into direct economic value. 

The value of bitcoin is based in part off of this network abstraction. In order for price discovery to happen individuals need to use their subjective preference to decide how much each bitcoin is worth, and how much the network itself is worth. This is how the general, long-term price levels for bitcoin are discovered.

The short-term price is discovered according to network externality, such as exchange failures, or political issues. An example would be how bitcoin is ‘more expensive’ in Argentina because of the high rate of inflation that the peso is experiencing. Another would be the dramatic drop in price, and then recovery after the Silk Road was shut down. These network externalities, unlike fiat money, causes for great volititly in the price because there is no goverment to fix the price of bitcoin; only the market. The price of bitcoin reponds to these events through change, which causes for the velocity of bitcoin to increase until a new equilibrium is found.

The Velocity of Bitcoin

Due to the fixed supply of bitcoin, the only way that the price can be adjusted is in one way: through exchange and transaction. This is why during the most volatile times of bitcoin, we see a higher transaction volume. This applies to both increases as well as decreases in the price. Due to the fixed supply of bitcoin, the only way someone can acquire bitcoins is to mine them, or to buy them. Thus if the price of bitcoin is to increase or decrease in ANY WAY, an exchange or transaction must take place for that value to be accounted into the market.

Conclusion

Bitcoin’s deflation is similar to a technology stock where individuals are making real gains though holding a risky asset while it grows. Because bitcoin has a fixed monetary supply that cannot be manipulated, the price of each bitcoin is determined through supply and demand mechanisms. This is reflected in the increase of the velocity of bitcoin. If bitcoin were facing true currency deflation, we would not see the velocity of money decrease.

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Next: Gresham’s Law and Bitcoin

The Hope of Bitcoin

The world is a screwed up place and things for many do not seem to be getting better. The U.S. Federal government is dysfunctional beyond repair, with 85% of Americans disapprove of Congress, and the total integrity of the United States being called into questing from the President’s repeated lies and support for the NSA spying. Food Stamp usage is at an all-time high with nearly 48 million people on food stamps, which even that the federal government is slashing that program back, Mean while, it is becoming more and more clear that the Federal Reserve may not be able to service their $4 Trillion dollar deficit, and may also need a tax payer bail out. All in all, the United States is has monumental problems in front of it, and there is no one to lead us out of this mess. We are Screwed.

The Global Stage

The Global stage looks even more bleak. Europe is clearly entering into another major depression, with deflationary pressure forcing down the value of the Euro. Considering that some countries already have +20% unemployment, Europe is entering into a more major and sever economic crisis than the one it is in today. China is bloated with foreign currency loans, which could easily spin out of control and drag the west down with it. The Indian economy is the weakest it has been in 10 years, and does not look like it shall be recovering soon. Argentina is also looking at getting back on the currency crisis merry-go-round, with their foreign currency reserves dwindling and confidence plummeting. All in all, the global economy looks like it is heading for another Great Depression.

Thank God for Bitcoin

Despite all of these horrors going on in the world, I’ve seen my savings increase by more than 200% in the last year–and it looks poised to go up another 200% over the next year. Bitcoin as a storage of wealth I believe to be a relatively safe investment because of its liquidity–I can cash out all of my savings in less than an hour–though I never world. Bitcoin is just too good of a savings instrument in a world where governments can legally allow for banks to steal from you. It is clear that the majority of the governments in the world are nepotistic, corrupt, oligarchic alliances among corporations, bankers, and crooked politicians, who have no interest in you, your friends, family, community, or economic prosperity.

That is why bitcoin is so powerful–it takes back the power of having independent money that cannot be controlled or manipulated. This is money that has value because of its utility of being able to send money anywhere in the world in under one hour, but also from its built-in scarcity. You have the assurance of knowing that there will only ever be 21 million bitcoins created, and you can also know what the monetary supply will be at any point in time. This means that bitcoins are pretty much impossible to counterfeit.

All of the powerful features of bitcoin that got it to the success that we are seeing today is part of what makes it such a powerful savings vehicle. For the first time in one hundred years, people have a commodity money that is not controlled by the state, or their corrupt allies. There is a huge and powerful opportunity for those of us that are involved in the globalized society that is the internet, to create our own economic prosperity together. It is clear that we are doing that with the epic rise in the price of each bitcoin, along with the multitude of products, services, and number of business that are starting to accept bitcoins.

What indicates to me that this is not a bubble is that there is very, very real cost savings that bitcoin is offering. So much so that bitcoin has an almost-zero transaction cost, and when compared to fiat currencies, it has a negative transaction cost! It is obvious for anyone who looks at the macroeconomic statistics of what the cost of governance is compared to bitcoin, which has no cost of governance. Thus we find ourselves using a currency that is simply more efficient in all ways over fiat currency.

Final thoughts

Everyone, even those heavily involved in bitcoin generally say, “Only invest that which you can afford to lose.” I agree to an extent. Where I disagree is the idea that your 401K, savings account, or cash in hand is any safer. It’s not, and frankly over the next 10 years, I would call those investments dangerous. Simply look at what has happened over the last 5 years, and look at the direction we are heading for the next 5 years. Things are NOT looking up, and investing with the vast majority of the world means that you will stuck in their luxury liner as it is going down. The global economy is slowing down faster than it has any time in modern history. The days of 4% unemployment will never return–we have reached the end of growth, and when the house of cards falls, it will be spectacular. For your own safety, I advise everyone to invest just $100 and see what it does for you over the next 6 months. Just watch it and see what you think at the end of the 6 months, I guarantee you will be happy with yourself.