Thursday, March 6, 2014

Bitcoin is Very Vulnerable to Inflation

I am not an expert in Bitcoin, but I studied economics enough to know that its promise of inflation-proof store of value is obviously false. 

The claim is well known: no more than 21 million Bitcoins can exist. Unlike regular currency, more of which can be printed at any time, Bitcoin must become inflation-proof once no units can be added.

The problem is, inflation doesn't just occur when "more dollars are printed." Inflation happens when "too many units of any currency chase too few assets." These are the same in a single-currency world: if we can only use dollars, only printing more dollars can dilute their value. Add another currency and this changes: if shops in America accept Euros, the dollar price of everything rises though no new dollars are printed.

Bitcoin is inflation-proof if its the only game in town. Ironically, its existence proves that anyone can start a currency. We already see alternatives like Litecoin with non-trivial market capitalization. These and new currencies are accepted, and compete with Bitcoin for purchasing assets. This competition erodes the value of Bitcoins even if no more are mined.

Consider cryptos as a single currency. End of Bitcoin mining doesn't halt addition of other currency units. Inflation occurs anyway. Litecoin alone has a market capitalization of over 5% that of Bitcoin, today. Created out of thin air, these coins mean Bitcoin's purchasing power is theoretically 5% less than it would be otherwise.

Bitcoin is interesting and vulnerability to inflation doesn't necessarily invalidate its entire premise. I love hearing  Andre De Castro speak passionately about the blockchain changing the world. It may be an interesting mechanism of exchange. I just would not rely on it as an inflation-proof store of value. Continuing growth of competing currencies seem at least as likely as the government printing more dollars.

4 comments:

  1. Interesting thoughts. I've actually thought myself lately about "what if Bitcoin doesn't become the world's currency, because there are other ones that could become just as popular or more popular?"

    Have you heard Ethereum? It's meant to become a platform for thousands or perhaps millions of such currencies. Think of it as many companies launching their own coins to gather funding, and then being able to exchange those coins for whichever other coin you want. There are also other type of financial services that can be built on top of it based on "smart contracts".

    Personally, I'm a lot more interested in it becoming a platform for all sorts of P2P distributed applications and services, not just financial ones. I think with something like Ethereum we'll finally have a way to make almost anything P2P, instead of relying on centralized choke points.

    Take a look, if you haven't heard of it.

    https://www.ethereum.org/

    http://bitcoinmagazine.com/9671/ethereum-next-generation-cryptocurrency-decentralized-application-platform/

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  2. I don't believe it's true that competition with other currencies is inflationary. If every shop in America also accepted Euros, then there would be no increase in price.

    There are a couple of other things to note: 1) Bitcoin is inflating at about 11% per year at the moment. It will be decades before the addition of new coins stops; 2) The definition of inflation that you're using is different than the definition that is used by Bitcoin proponents. Bitcoin proponents specifically refer to inflation as inflation of the money supply. They are not referring to the effect of inflation, which is the increase in prices.

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  3. Snowdog is correct about the definition of inflation. "Too much currency chasing too few goods" is a function of supply and demand and prices, it's not a monetary definition. Inflation is the increase in the money supply.
    Bitcoin could be considered inflationary right now, since they are mining new coins, however the total supply is known, constant, and traceable, which makes it strictly not inflationary because the total cannot be increased.
    No one knows the future. Perhaps the current amount of Bitcoin in circulation will not change over the years. The additional mined coins will be added to the investment side of the economy, and each btc will increase in value.

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