Why Bitcoin Will Never Have A Problem With Deflation

BitcoinREUTERS/Andy ClarkSigns on window advertise a bitcoin ATM machine that has been installed in a Waves Coffee House in Vancouver, British Columbia October 28, 2013.

There’s a lingering misconception out there that deflation will be a problem for Bitcoin, and that will prevent it from widespread use.

The argument (which, full disclosure I used to believe) basically goes like this: Because there’s a fixed amount of the coins, people will horde them on anticipation of rising prices, and this hording will prevent the actual spending of currency, and therefore Bitcoins can only be speculative tools.

This argument stems from the correct argument that economists make about national fiat currencies, which is that when you’re in a period of deflation (characterised by falling prices and a rising currency) economic activity slows down, because you’ll have more buying power tomorrow than you did today, and so what’s the rush to spend?

But the argument does not work for Bitcoin.

Bitcoin is fundamentally a way to make transactions in a fiat currency. If you want to sell me something for $US850, I could pay you in cash, credit card, via PayPal, bank wire, or possibly Bitcoin. How many Bitcoins this transaction requires (currently it would be right around one) is a function of fluctuating Bitcoin prices, but essentially we’re carrying out a dollar-priced transaction and using the Bitcoin as the payment system.

If the price of a Bitcoin were to surge 10-fold from here, it really wouldn’t matter for the purposes of our transaction, because then I’d just pay you 0.1 Bitcoins. It’s still just a $US850.

Now some are still concerned that there will be Bitcoin hoarding since the supply will be fixed, but this isn’t really an issue. Suppose I own a lot of Bitcoins because I believe the price will continue to rise, should I be reluctant to make a Bitcoin-based purchase and part with some of my coins? Nah. If there’s a purchase that makes sense for me to do in Bitcoin (such as buy chips in an online casino) I’ll do that, and then just replenish my pile with the amount that I spent. No big deal. Ultimately, the price will clear somewhere. It’s probably a safe bet that the majority of Bitcoin activity is currently speculative (people trying to make money) and yet there’s no shortage for people who want to make an actual transaction. The market makes that not an issue.

Ultimately it really doesn’t matter how many coins there are. The relevant issue is not the amount of coins, but rather the total outstanding value of all the coins when priced in another currency. With a current market cap of over $US10 billion, the Bitcoin ecosystem can absorb and pass through many more transactions than say Peercoin, which has a total outstanding value of coins of $US118 million. This is the relevant number, not the amount of coins. And this number will be determined by total interest, the demand for coins (as a payment system) and by the number of people who want to hold them for speculative purposes.

There’s an irony. Bitcoin doesn’t have a deflation problem, because it’s a conduit for making normal currency transactions. That being said, may Bitcoin diehards do dream about it supplanting fiat currencies, and leaving central banks in its wake. If that were to happen and it became the currency (it won’t) then it would have a deflation problem. But that doesn’t need to happen for Bitcoin to be a success.

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