Late on Friday night, FT Alphaville (i.e. this reporter) attended an overly long clubhouse session with bitcoin blogger and math enthusiast Allen Farrington that touched on many different aspects of the world’s most famous orange novel financial system.
While many aspects of the conversation will be old territory for the readers of this blog, there was one discussion point that broke new ground. It was about whether or not Bitcoin is really a deflationary currency. Our opinion was that Bitcoin may not be as immune to inflation as many believe. (But also that that’s not necessarily a bad thing.)
You can catch up on the broad discussion on this incredibly detailed description by Farrington, which has the added bonus of having a lot of math applied to the ideas.
But for those who don’t feel like digesting an 11-minute read with equations, the crux of the matter is the point: In the Bitcoin world, it is often forgotten that it is not only the amount of money that affects inflation, but also its speed. And there’s a lot of pent-up speed to deal with in the Bitcoin economy, not least because of all of these wallets carrying huge sums of value that never transacts (like Satoshi’s own stash).
In the conventional fiat world of “fractional reserves”, speed is a function of monetary multiples that essentially depend on how quickly the commercial banking sector can reuse or lend the underlying reserves in the system. This in turn affects the money pyramid and the total amount of money. As the great experiment with QE has shown, the broader supply of money depends not only on central bank debt, but on the ability of the broader system to reuse these reserves and convert them into private debt.
In a fiat-based partial reserve system, you cannot escape the money multiplier effect. If you keep your wealth in the banking system, it will be used by someone by lending it on.
However, this does not apply to Bitcoin. In a hyper-bitcoinized world, you have the option to log out of the perpetual redistribution loop. While you can, if you wish, loan your savings back for an additional return (e.g. the underlying system is, at least in theory, completely reserved.
Those who believe that a full reserve system is a better and more stable system will argue that it is a good thing. And maybe it is or not. That would go beyond the scope of this article.
Our point is simply this: just because a system is fully reserved and all lending is done with the explicit and conscious consent of the asset owner does not mean that it is inflation resistant.
Bitcoin looks disinflationary right now. However, this is because those who choose not to use their money on work are effectively reducing the velocity of their money to zero. The nice thing about Bitcoin is that, thanks to the openness of the Bitcoin ledger, we can see very clearly how much cash is never handled this way. For example, according to a report by Crystal Blockchain, in July 2020 over 10 million bitcoins (then worth 85 billion 17.8 million bitcoins of around 18.75 million outstanding bitcoins are currently classified as resident in dormant addresses.
What does this mean for inflation?
We postulated that a structure in which lending is not possible without express consent transfers the risk of “fractional reserves” from the banks to the managers of the real economy.
This is because it is both impractical and overly wasteful to ensure that there is always enough goods and services in the economy to meet Bitcoin’s potential redeeming capacity should all of the coins suddenly be mobilized. The point of just-in-time inventory management is that no remaining or excess inventory should be kept on hand. Store owners determine how much inventory to hold based on historical demand trends, not how much money is in circulation or could potentially be.
Obviously, in a macro-level Bitcoin economy, inventory managers would underreserve physical goods relative to the potential monetary capacity to redeem those goods. Given how much bitcoin sits immovable in wallets that almost never conduct transactions, it wouldn’t be competitively inefficient and commercial madness.
However, this would undoubtedly also increase the system’s vulnerability to external supply shocks, shortages or other crises that could motivate Bitcoin savers to suddenly deplete previously immovable Bitcoin reserves and cause an effective run on inventories. Previously, out of circulation money could very suddenly come into circulation quickly.
The only corrective mechanism in such a scenario would be for the prices of goods and services, expressed in Bitcoin, to rise sharply to counter unexpected demand, which manifests itself in sudden and destabilizing inflation.
Farrington sensibly replies that in a Bitcoin world there would at least be an upper limit to the inflationary surge. The effects would be temporary until new inventory came online or until new excess wealth was created and thus immobilized. In theory, the price signals would be super strong and stimulate supply. Inflation could also increase social mobility as old wealth would be withdrawn and transferred to those who are able to create the new wealth the system needs.
The question is, is it really that different from the current system? And how limited is this type of inflation really?
In theory, if Bitcoin transactions were to reach maximum speed across all wallets, only supply shocks could trigger broad-based inflation. Additional demand, for example due to population growth, could never be met by money creation, which means that the consequences would always be deflationary. That is, any emerging imbalance could only be removed by making one part of the economy poorer and the other part richer by stimulating other parts of the economy to save more.
In such a world, it would be very unlikely that the Bitcoin economy could prevent other parallel monetary systems or credit creation from saving this money shortage. (Especially if the system were to remain a voluntary system without coercion and without fiat.) And then the monetarily induced inflation risks would come back on the table.
Chances are, whether it’s a Bitcoin or a Fiat world, money will remain endogenous, expand or contract, coupled with the ability of the underlying economy to provide its citizens with the things they need . That’s not to say that Bitcoin doesn’t have any uniquely useful properties. This reporter definitely comes to the idea that censorship resistance is an important property of a monetary system. Likewise, as we mean, the freedom to opt for alternative, tougher, stateless currency systems when your own hits the inflationary fan.
But whether Bitcoin’s best attribute is its inflation resistance in a broader hyper-bitcoinized context, we’re not so sure. Inflation is not necessarily removed from such a world, it is merely reshaped.
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