March 29, 2018 Skalex

The Deflationary Economics of the Bitcoin Money Supply

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March 29, 2018

There’s a limit to the number of Bitcoin that will exist: 21 million. Once Bitcoin hits that amount, miners will no longer receive block rewards, and no new Bitcoins will enter the market. That might not seem like big news to you, but economists are up in arms over what will happen in a currency system that has a fixed supply.

In fact, the amount of available Bitcoin will decrease over the years. When someone forgets their private key, for instance, all the BTC that person owned are now lost and the system will never recover them. Over time, Bitcoins will continue to disappear from the system, meaning that the remaining BTC will rise in value as they become increasingly rare. However, this is not just true for Bitcoin. Most cryptocurrencies enforce an upper limit on their coin supply, after which no new coins will be mined.

Proponents of Bitcoin and other cryptocurrencies aren’t concerned about a dwindling money supply. They point to Bitcoin’s infinite divisibility as one solution. As BTC gets more valuable, we’ll just use smaller units, like Satoshis, to transact. Some economists agree with that logic, saying a deflationary currency system could fundamentally change all our assumptions about money. On the other hand, some economists feel that a deflationary currency would be a disaster, leading to a spiral of hoarding and not spending BTC.

The reality is that we don’t really have any history of deflationary currency systems to base our theories on. What will happen when Bitcoin reaches 21 million and no further coins are mined is anyone’s guess. In this article, we’ll take a look at the economics behind Bitcoin’s money supply (and the model most cryptocurrencies use, as well) to review the arguments on all sides and hopefully gain a better understanding of Bitcoin’s value long term.


What is money supply?

What is money supply?


If you’ve never studied economics, “money supply” might be a new term, so let’s take a minute to define it. If you have studied economics, it’s still worth reading this section because we’ll define money supply in the context of Bitcoin.

For Bitcoin, money supply is straightforward. It’s the total amount of a currency that exists at a given time. As of writing, 16.9 million BTC have already been mined, and more BTC will continue to be produced at a predictable rate until we reach 21 million. This is called a fixed money supply because there are predictable rules and a hard cap on production of new currency.

For a fiat currency, like euros or dollars, money supply is more difficult to understand. It refers to a set of policies set by a central bank that determines how much new money to print. Central banks also take currency out of circulation (when it gets old or defaced), so they can increase or even decrease the total supply of currency as needed. This gives the central bank power to issue currency in the face of a financial crisis, meaning currency is more easily available and allowing the central bank to control lending interest rates. Issuing more currency lowers interest rates and encourages businesses and individuals to take out low-interest loans. The result is more spending and economic stimulation. However, it also means that central banks are incredibly powerful and often serve corporate interests ahead of the common man.

Deflation vs. Inflation

Deflation vs. Inflation


Since a central bank can issue new money at any time and there’s no limit on how much money they can create, the value of a dollar or euro decreases over time. For example, in the United States, a loaf of bread cost $0.09 in 1930, $0.36 in 1970, and $1.98 in 2013. It hasn’t gotten more expensive to bake bread. It’s just that the dollar is less valuable now than it was decades ago.

The value of a fiat currency decreases because it becomes less rare over time, as central banks print more money. This growth of the money supply (and decrease in the buying power of the currency) is called inflation. All major fiat currencies today are inflationary, and all the assumptions we make in economics are based on an inflationary model.

In the case of Bitcoin, there’s no central bank constantly issuing money and controlling monetary policy. Instead, there’s an algorithm that runs out once it hits 21 million coins. After that, any BTC that get lost are permanently removed from the money supply, meaning the total supply will decrease, or deflate over time. As a result, BTC will become increasingly rare and increasingly valuable.

Saving vs. Spending

Saving versus spending currencies


Fiat currencies are typically inflationary, meaning their buying power decreases over time. If you put €100 under your mattress for 20 years, it will not buy you as much then as it will today. As a result, your incentive is to spend or invest the €100 today, since it will only decrease in value.

On the other hand, Bitcoin is deflationary, meaning buying power increases over time. If you put your private key under your mattress for 20 years (assuming Bitcoin is still around in 20 years), it will buy you more then than it will today. Your incentive is to save the Bitcoin and not spend it, since it will likely be worth more in the future.

You may think, “Wow, that’s awesome! If I save my Bitcoin, I can buy more with it in the future.” But Keynesian economists will argue that people hoarding their currency is bad for the overall economy. Without an incentive to spend, the economy will support fewer businesses, creating fewer jobs. This leads to a deflationary cycle where prices for things get lower while consumers continue to save in anticipation of even lower prices. This is the worst case scenario for a deflationary currency.

One extreme example of this deflationary spiral is Japan’s deflation monster that the country has been battling since the 1990s. Without getting into the complex economics of the situation, Japan’s deflation monster comes from an oversupply of goods and services that exceeds the demand. The Bank of Japan responded by lowering interest rates, eventually adopting negative interest rates (paying people to take out loans) to address the issue.

On the other hand the Austrian school of economics argues that people would still need to spend money to meet their daily needs and a deflationary currency would likely find a settling point of steady deflation over time.

Debt/Credit vs. Commodity

Debt/Credit versus Commodity


Another distinction to make between Bitcoin and fiat currencies is debt versus commodity basis. Bitcoin is more like gold than it is like dollars or euros. Its code makes it a rare commodity and store of value that can be traded and divided. However, it can’t be two places at once.

Fiat currencies have no fundamental rarity to them and they are not commodities but essentially signs of debt. When someone pays you in fiat, they’re not transferring something of inherent value. Instead, they’re saying “I owe you.” On a larger scale, banks accept deposits and then lend against those deposits with the total money supply growing because the bank has the currency listed in two places, once as a depository account and again as a line of credit to someone else. This type of lending isn’t possible with Bitcoin because BTC can only be in one place at any given time.

While you could, in theory, create a depository banking and lending system for Bitcoin, there are a few problems. First, it clashes with Bitcoin’s philosophy of decentralization to recreate the banking system. Second, a Bitcoin bank would be hard pressed to offer interest rates on a deflationary currency. The best option for lending is accepting Bitcoin deposits and then lending out fiat (inflationary) currencies.

This fundamentally changes how our economy functions, since so much of the global economy relies on debt and credit to facilitate investments and growth in new areas.


Conclusion about Bitcoin


The most likely scenario is that Bitcoin won’t be the sole global currency in the new world order. Instead, other currencies will continue to exist, including inflationary fiat currencies that encourage consumers to spend and lenders to lend. Bitcoin has proven itself as an effective store of value and could operate alongside markets like gold or as a go-between for global transactions or currency exchanges.

The future of the Bitcoin economy is unclear at the moment, and everything is theoretical. However, it’s probably best policy not to believe the extremists on either end of the spectrum. Bitcoin likely won’t end in a deflationary death spiral of its own creation. It also isn’t a perfect replacement for fiat currencies in a utopian future.