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  • Why Bitcoin Is Technically an Inflationary Currency—Even Though Its Purchasing Power Is Increasing

    Inflation is commonly defined as “a general increase in prices and fall in the purchasing value of money.” For example, if a six-pack of beers cost $8 last year, but this year the same six-pack costs $16 then the annual inflation rate was 100 percent. This is because the price doubled for the same quality and quantity of beer.

    To put it in perspective, the most famous hyperinflations occurred in Zimbabwe and in Germany. In 2003, Zimbabwe’s monthly inflation rate hit 7.96 x 1010 percent, and in 1923 the German government’s hyperinflation caused the exchange rate to rocket to 4.2 trillion German Marks to one U.S. dollar.

    Using the common definition, Bitcoin is deflationary because Bitcoin’s purchasing power increases over time.

    However, the traditional definition of inflation, according to the British Currency School, was an increase in the supply of money that was unbacked by gold. According to Reinhart and Rogoff’s This Time is Different, governments have been inflating currency over the past 800 years.

    Originally, governments would inflate the currency by debasing gold coins. During the 20th century, government inflation technology advanced to printing presses, and currently, governments are able to inflate the monetary base by digitally creating money by updating internal databases that track fiat money, which is predominately digital.

    Using the traditional definition, Bitcoin is inflationary because the supply of Bitcoin increases over time.

    Gold is considered the ultimate store of value because of one specific characteristic: scarcity. No person or group can will gold into existence. Instead, the supply is controlled by nature. Figure 1 (above) shows the supply of gold has had a stable inflation rate. The creators of Bitcoin designed its inflation rate to mimic gold’s stable inflation rate.

    Figure 2 (below) shows the circulating Bitcoin since its creation in 2009. As the inflation rate decreases, the price for each Bitcoin should increase, ceteris paribus. Bitcoin’s inflation rate was hardcoded into the software that operates Bitcoin. Hardcoding Bitcoin’s inflation is similar to Milton Friedman’s K percent rule that called for an algorithmic and regulated inflation rate that would eliminate human-error and the temptation to manipulate the monetary base for political reasons. However, Bitcoin’s inflation algorithm was designed to make Bitcoin even scarcer than gold.

    There is a fixed amount of 21 million Bitcoin that can be minted, which means that no coins can be minted once this amount is reached. Approximately 80 percent of the total amount of Bitcoin has already been minted. Bitcoin’s algorithmic inflation rate since 2010 is displayed in Figure 3 (below) and is explained in the original white paper written by Satoshi Nakamoto.

    “To compensate for increasing hardware speed and varying interest in running nodes over time, the proof-of-work difficulty is determined by a moving average targeting an average number of blocks per hour,” Nakamoto explained. “If they are generated too fast, the difficulty increases”.

    As of July, the inflation rate of Bitcoin was 4.25 percent. The difficulty re-adjustment makes it impossible to simply mine more Bitcoin by allocating more computer resources to the network. As more people try to mine Bitcoin, the software automatically increases the difficulty of successfully mining a Bitcoin and vice-a-versa.

    Once the inflation rate reaches zero, miners will no longer be able to earn money from minting newly created bitcoins. Instead, transaction fees will have to increase or the number of transactions will have to increase. The last edition of the Crypto Research Report contains an in-depth explanation of how transactions are confirmed on the network and how miners earn income by confirming transactions and minting new coins.

    Although Bitcoin and gold are currently inflationary monies, according to the traditional definition of inflation, their inflation rates are predictable and constantly decreasing. Similar to gold, Bitcoin’s annual inflation rate will eventually reach zero percent.

    According to the mainstream economic definition of inflation, Bitcoin is deflationary because the purchasing power of Bitcoin increases over time. Currently, Bitcoin’s purchasing power is extremely volatile, although, this is expected to stabilize in the long-run. Since Bitcoin’s total supply is fixed, Bitcoin’s purchasing power will continue to grow slowly over time if demand continues to increase.

    Source: Why Bitcoin Is Technically an Inflationary Currency—Even Though Its Purchasing Power Is Increasing – Foundation for Economic Education



  • How a Bitcoin System is Like and Unlike a Gold Standard

    Many commentators have compared Bitcoin to gold as an investment asset. “Can Bitcoin Be Gold 2.0,” asks a portfolio analyst. “Bitcoin is increasingly set to replace gold as a hedge against uncertainty,” suggests a Cointelegraph reporter.

    Economists, by contrast, are more interested in considering how a monetary system based on Bitcoin compares to a gold-standard monetary system. In a noteworthy journal article published in 2015, George Selgin characterized Bitcoin as a “synthetic commodity money.” Monetary historian Warren Weber in 2016 released an interesting Bank of Canada working paper entitled “A Bitcoin Standard: Lessons from the Gold Standard,” which analyzes a hypothetical international Bitcoin-based monetary system on the supposition that “the Bitcoin standard would closely resemble the gold standard” of the pre-WWI era. More recently, University of Chicago economist John Cochrane in a blog post has characterized Bitcoin as “an electronic version of gold.”

    In what important respects are the Bitcoin system and a gold standard similar? In what other important respects are they different?

    Similarities and Differences

    Bitcoin is similar to a gold standard in at least two ways. (1) Both Bitcoin and gold are stateless, so either can provide an international base money that is not the creature of any national central bank or finance ministry. (2) Both provide a base money that is reliably limited in quantity (this is the grounding for Selgin’s characterization), unlike a fiat money that a central bank can create in any quantity it likes, “out of thin air.”

    Bitcoin and the gold standard are obviously different in other ways. Gold is a tangible physical commodity; bitcoin is a purely digital asset. This difference is not important for the customer’s experience in paying them out, as ownership of (or a claim to) either asset can be transferred online, or in person by phone app or card.

    The “front ends” of payments are basically the same nowadays. The “back ends” can be different. Gold payments can go peer-to-peer without third-party involvement only when a physical coin or bar is handed over. Electronic gold payments require a trusted vault-keeping intermediary. Bitcoin payments operate on a distributed ledger and can go peer-to-peer electronically without the help of a financial institution. In practice, however, many Bitcoin transactions use the services of commercial storage and exchange providers like Coinbase.

    The most important difference between Bitcoin and gold lies in their contrasting supply and demand mechanisms, which give them very different degrees of purchasing power stability. The stock of gold above ground is slowly augmented each year by gold mines around the world, at a rate that responds to, and stabilizes, the purchasing power of gold. Commodity (non-monetary) demands also respond to the price of gold and dampen movements in its value. The rate of Bitcoin creation, by contrast, is entirely programmed. It does not respond to its purchasing power, and there are no commodity demands.

    Difference in Supply Mechanisms

    Let’s consider supply in more detail. Secularly, annual production of gold has been a small percentage (typically 1% to 4%) of the existing stock, but not zero. Because the absorption of gold by non-monetary uses from which it is not recoverable (like tooth fillings that will go into graves and stay there, but unlike jewelry) is small, the total stock of gold grows over time. Historically this has produced a near-zero secular rate of inflation in gold standard countries.

    The number of BTC in circulation was programmed to expand at 4.0 percent in 2017, but the expansion rate is programmed to fall progressively in the future and to reach zero in 2140. At that point, assuming that real demand to hold BTC grows merely at the same rate as real GDP, Bitcoin would exhibit mild secular growth in its purchasing power, or equivalently we would see mild deflation in BTC-denominated prices of goods and services. (Warren Weber’s paper similarly derives this result.) This kind of growth-driven deflation is benign, but the difference is small in real economic welfare consequences between a money stock that steadily grows 3% per year and one that grows 0%.

    The key difference in the supply mechanisms is in the induced variation in the rate of production of monetary gold in response to its purchasing power, by contrast to the non-variation in BTC. A rise in the purchasing power of BTC does not provoke any change in the quantity of BTC in the short run or in the long run. In Econ 101 language, the supply curve for BTC is always vertical. (The supply curve is, however, programmed to shift to the right over time, ever more slowly, until it stops at 21 million units).

    By contrast, a non-transitory rise in the purchasing power of gold brings about some s