The role of Bitcoin in the future - why inflation matters

While the crypto ecosystem is evolving, crypto is trying to find its place in our current economic system. Mirroring the legal dispute about how to classify different cryptocurrencies, it is also interesting to try to answer this question from an economic perspective. Here I want to mainly discuss the consequences that would come from establishing Bitcoin as a replacement for fiat currencies, like Euro, Dollar or Pounds.

Fiat currencies are mainly used to pay for goods and services in everyday life and they come mainly in the form of cash or bank deposits. We are paid mostly in fiat and we pay our rent in fiat. This has proved quite useful as fiat is unversially accepted and we do not have to go back to barter, that is trade goods for goods. The second role of fiat currency is as a unit of account. We see prices in Euro or Dollar, which mirrors the role of fiat currency as a means of payment. The third use is as a store of value. Although fiat is subject to inflation, the value of the currencies of developed countries is relatively stable in comparison to many other assets.

Cryptocurrencies like Bitcoin offer both of the first two functions, although acceptance is still in the very beginning, but is arguably a better store of value. This is because the total supply of bitcoin is capped at around 21 million units. Other issues aside, does this not mean that Bitcoin is potentially the better currency?

The consequences of adopting Bitcoin as a currency are far reaching. Since economic output is steadily growing but the money supply in form of Bitcoin would be ultimately capped, the price level will be steadily declining. What sounds good to each individual costumer, may quickly prove to be a big problem. Let's say you want to make a big purchase like a car, but you do not need it immediately. If the price level is steadily falling, waiting to make the purchase seems like a great idea. After all, what are a couple of months when you can save 20%? Adopting this behaviour on a broad basis will by itself cause prices to decline, because nobody will want to buy at the given price level. Vendors will then decrease prices to try to generate demand, but only confirm expectations about prices falling. Consumers will continue to wait and vendors will continue to cut prices. The lack of demand will lead to decreases in production - why produce if nobody wants to buy? - and this is when consumers are hit again, because they are losing their jobs. The alternative would be to decrease wages at which point deflation becomes a zero-sum game, but there are reasons why wages are typically not easy to adjust downwards. Consumers' money is appreciating in value, so they can buy more goods and services with it, but at the same time they are earning less/no money, eating up all of the effect.

This is why Bitcoin or any other deflationary currency is not desirable from an economic perspective. Mild inflation reverts said effect. The best time to do most purchases is today. On average, goods and services are not getting cheaper in the future. At the same time wages can easily adjust upwards, compensating workers for the loss in purchasing power. Assets with real value (stocks, real estate) are available to insure against inflation. Bitcoin could very well end up mainly as a store of value much like gold nowadays, with all its superior properties (easy and costless to store, cheap to split up, sell and send), while fiat currencies remain in place.

Of course there is a host of other issues which should be discussed, but I reserve those topics for future posts.

To illustrate the same argument, view the political infomercial below that was made during the Great Depression. The price level was falling between 1929 and 1933 in the US, but consumers did not get richer, quite the opposite. Only when inflation returned did the economy return to growth and unemployment started falling.