With the limited total quantity of bitcoins, and people losing their wallets constantly decreasing that number, won't rampant deflation destroy Bitcoin?
There are two potential ways in which monetary deflation can impact a currency:
Most modern currencies have a minimum unit, such as the penny in the United States, or the yen in Japan. If these currencies existed in only finite quantities, then as the economy grew and/or physical money was lost, there might eventually be too few of these units in circulation to allow normal commerce. Imagine if, for example, the U.S. dollar became so rare that you could buy a car with a single U.S. penny. How would you buy a loaf of bread?
Bitcoin, however, does not have this problem because unlike the physical currencies of most countries, bitcoins are infinitely divisible. Even if only one bitcoin remained, it would be sufficient to run a substantial economy on, based on the ability to use tiny fractions of it like the Satoshi. If even the Satoshi were to become too highly valued/unavailable for commerce, the Bitcoin protocol could be updated to allow even smaller denominations. So the usability of bitcoins is safe from the effects of deflation.
2. Broader economic consequences from deflation
Many economists believe that deflation is bad for an economy because people will be less likely to invest their money if they can "earn" increased value simply by holding on to it. Why buy something today, the argument goes, if you could buy it for half as much in a few months time? Also, taking out loans becomes very difficult, because to be practical they have to have negative interest rates and then why would anyone loan out money in the first place?
However, there is good reason to believe that deflation might not have such a negative effect on Bitcoin. For one, Bitcoin is unlikely to become the only currency in the world economy, so investments, loans, etc. can simply be denominated in another currency. But even more importantly there are several concrete examples from history of strictly deflationary currencies.
For example, the Iraqi "Swiss" dinar was a currency that ceased being printed after the first Gulf War, and was left in use only by the Kurdish regions of the country. With a finite number of "Swiss" dinars in existence, and some being lost or damaged over time, this left the currency in precisely the same state as Bitcoin. Since it was no longer backed by a government, many economists expected the currency and its economy to collapse. Instead, the Kurdish economy continued largely as normal for 13 years, and the "Swiss" dinar even appreciated against the "Saddam" dinar that was meant to replace it.
Rick Falkvinge also raises another excellent point regarding deflationary economies. If, as economists expect, people would decline to buy something today as opposed to next year for half price, then it should be the case that no one ever buys computers, right? But in fact, the computer industry thrives despite this continued trend of "whatever something costs today, it will cost a fraction of that within a few years".
Ultimately, this is a question for economists to duke out, and you can find more information about how different economic schools approach the problem here. Suffice it to say, this cannot be considered a crippling fault in Bitcoin as a technology.
No. There are many things that could destroy bitcoin, but deflation is not one of them. While deflation is problematic for a currency backed by debt (as most, if not all, national currencies are), it is not an issue for commodity currencies (and bitcoin is most similar to commodity currencies).
The deflation argument goes something like this: everyone, believing that the value of the currency is going to rise will simply hold the currency and never spend it. But this argument completely ignores the need for diversification (would you put all of your wealth into bitcoin?). It also ignores the fact that if people decided to put all their wealth into bitcoin and save everything, they would still need to eat and buy things at some point. They would have no choice but to spend it. And, if everyone actually did invest everything into bitcoin, it would create a bubble in the value that would eventually deflate and teach everyone why diversification is good. The argument also ignores the fact that hoarding itself is not bad...when people hoard bitcoin, they cause the value to rise and that creates wealth that others can use for their needs. In a way, hoarding is an investment in the broad bitcoin economy.
No, for two reasons:
First, Bitcoins are very divisible. So it wouldn't create the kinds of problems having a penny be enough to buy a car would create. (How would you buy a candy bar?)
Second, while deflation would provide an incentive for people to hoard a currency rather than spend it, it provides an equal incentive for people to try to pry that currency out of other people's hands by any means. If I'd rather hold my Bitcoins than spend them (so that you'd have to offer me more for them), you'd rather have my Bitcoins than something else (so you'd be willing to offer me more for them). It simply cancels out.
If we lived in a world with stable currencies rather than inflating currencies, you could make this very same argument to show that people would never agree to be paid in dollars, because that requires them to get constant wage hikes, something employers will not accept. But they do. So this is pure speculation that is against the evidence. Employees accept inflating currencies, there's no reason to think employers won't accept deflating ones.
Again, if we had a stable currency, this same argument would be used to show people will never accept the dollar. Why would anyone sell me anything today if they can sell it for more tomorrow? Don't rising prices cause people to delay sales?
This is essentially the very same argument recently put forth by paul krugman. And it is wrong. Deflation is only a problem with debt-based money. Therefore not a problem with bitcoin. For details see the following article:
I appreciate the enthusiasm of those who have answered this question. Everyone here clearly wants bitcoin to succeed, and so everyone is enthusiastic. I am enthusiastic, too.
I am afraid, however, that this enthusiasm is coloring respondents' logic. Literally every response on this page (especially the highest ranked one) is wrong.
In order for a currency to be used to pay wages, and therefore widely used in general, the prices for goods that people buy would be fairly stable. Otherwise, people will reject the currency. Perhaps more importantly, employers will not agree to pay workers in a currency that is appreciating in value, as this would require them to lower wages constantly, something workers will not accept.
The upshot is that inflation must ideally be between 0 and 4%.
In order for that to happen, the supply of money must grow at the same rate as the overall economy. If the supply of money is constant, then the prices of goods will fall in a growing economy. And the economy generally does grow.
Falling prices will cause people to delay purchases, and is symptomatic of lower demand in general. This causes a depression. The example of computers given by many respondents is wrong. This is a case where new, higher quality models are replacing older models at the same price-point. It would be correct if the overall amount of money spent on computers (new and old) declined, but this is not the case.
In the 1930s in Europe, abandonment of the gold standard was the key that allowed the European economies to grow again. Those who held onto the gold standard longest suffered the most greatly.
It is just a fact that a fixed money supply in a growing economy is deflationary. This will limit bitcoin to the same role that gold holds now. It is a useful hedge against inflation, but not capable of replacing the more flexible fiat currency, because it cannot maintain price stability.
One has to distinguish between three different sources of deflation. Based on the famous quantity equation there are three possible scenarios how a deflation can happen.
M * V = Y * P
M= Money Supply; V= Money Velocity; Y= Output/Production/Real GDP; P= Price Level
Deflation is commonly defined as a decrease in overall price level (e.g. P goes down). So there are 3 ways this can happen:
M decreases: So called Debt Deflation. This is a huge problem for banks and that is what most economists fear. Obviously this cannot happen to Bitcoin because M is fixed. (Except for lost wallets).
Y increases: This would be economiv growth due to an increase in productivity. Since that is a good thing there is no problem here.
V decreases: This means that people hoard their money and dont spend it. Usually this happens in times of high economic uncertainty. When you are unsure wether you will get income next month you will save a little bit more. This could become a problem in a bitcoin economy if that money is just asleep in peoples wallets.
The value of bitcoin is roughly proportional to the size of the bitcoin economy, since bitcoin has a fixed supply. This means that for the value of bitcoin to go up (deflation), the bitcoin economy must be experiencing growth. How can growth kill an economy?
The deflation spiral theory is self contradicting, at least in the case of bitcoin. In the case of the fractionally reserved fiat paper banking system that our governments impose on us, it's a little different.
Bitcoin was modeled after a non-renewable resource extraction curve similar to gold, silver, and oil. Gold and silver have be used throughout history as an effective currency. To say that it would fail due to deflation, would be to say that gold/silver would have met the same fate.
Until the modern era, gold and silver was the main form of money used throughout the world. People did carry it around with them and spend it freely to acquire goods and services.
If someone says to you that deflation will kill bitcoin, tell them to show how gold/silver didn't work for spans of time up to a millennia.
Understanding bitcoin price behavior with the Quantity theory of money
Money supply times the Velocity of money equals the Price level times the Quantity of goods.
Several arguments against the success of Bitcoin are doing the round:
People could use this theory to 'prove' that when the money supply M is fixed and the economy Q grows, the price level P must drop to accommodate it, which would mean deflation.
What happens when people expect a drop in price level P? They will postpone spending. You know your bitcoins will be worth more tomorrow, so there is a free profit to be had. This drop in spending now would mean there is less bitcoin chasing after goods today. People are hoarding bitcoin. Price levels in bitcoin will adjust, going down today. Saying that the price level in bitcoin goes down, is the same as saying the value of a bitcoin goes up. This hoarding will continue until the expected change in price level does not provide a free lunch anymore. In a bitcoin economy with a fixed money supply it can't be the Price level adjusting to the growing economy. It is the amount of bitcoin used in spending, or the Velocity of money.
People will hold on to their bitcoin at first. The bitcoin value should be expected to climb rapidly and stabilize.
Deflation: Because the monetary base of bitcoins cannot be expanded, the currency would be subject to severe deflation if it becomes widely used. Keynesian economists argue that deflation is bad for an economy because it incentivises individuals and businesses to save money rather than invest in businesses and create jobs. The Austrian school of thought counters this criticism, claiming that as deflation occurs in all stages of production, entrepreneurs who invest benefit from it. As a result, profit ratios tend to stay the same and only their magnitudes change. In other words, in a deflationary environment, goods and services decrease in price, but at the same time the cost for the production of these goods and services tend to decrease proportionally, effectively not affecting profits. Price deflation encourages an increase in hoarding — hence savings — which in turn tends to lower interest rates and increase the incentive for entrepreneurs to invest in projects of longer term.
It's been a long time since my Econ101 class but let's see if I can get this right...
Deflation of the currency is only an issue in two circumstances, neither of which currently apply to bitcoin.
To my knowledge, no one is making or taking out substantial loans denominated in BTC with fixed payment plans, though that may soon change. There are also many discussions on the forums and elsewhere regarding how loans denominated in BTC might be made more feasible in a deflationary system.
As for #2, there are few (if any) companies who hold stock purchased with BTC and sell at fixed BTC prices. Almost all companies have stock purchased with fiat currency and their pricing is automatically updated at the time of sale to reflect a fiat value, so they do not face the "selling at a 'loss'" scenario.
"Every man has his price."
Sooner or later, you're going to find something priced in BTC that you want or need. And you'll want or need it "now." Consider the situation when buying a computer: they are always going down in price. By the deflationista's argument, nobody would be buying electronics. Ever. If a faster computer is going to be cheaper next week, then I won't buy one this week. Same thing for next month. And next year. Forever...
Except it misses one important point: computers are useful, and sooner or later a buyer's price (the tradeoff between the computer's usefulness and future computer purchasing power of money) will be met.
The "deflation" argument falls down with this one simple example.
If people don't spend bitcoin, then miners will not collect fees. And without fees, there's no incentive to mine. So miners will drop off. As miners drop off, the network becomes vulnerable to a 51% attack. So, yes, severe deflation is a major problem, but not solely for the economic reasons people are concerned about. Far before deflation is a concern, lack of transaction volume and a decreasing money supply will kill bitcoin unless the monetary supply is loosened. I'm guessing miners will feel the pinch and many will start dropping off by year-end 2014.
Fortunately there are many solutions. The Bitcoin money supply can be easily changed by a majority of miners agreeing to a change.
Unsure, can't tell at this stage if deflation will be negative, positive, or neutral. Nothing quit like bitcoin has existed before to compare it against.
For traditional currencies, deflation is a bad thing as deflation was present during most economic depressions in US history. Historically, deflationary currency equates, more often than not, to massive poverty.
The argument against this is that bitcoin is a commodity currency: (such as gold)
Bitcoin sounds a lot more like fiat money than commodity currency though. Especially in light that bitcoins don't "exist" in the physical world in the same way commodity currency does. Bitcoins do exist in on-line spaces and exchanges in much the same was fiat money does.
But even if we say bitcoin is a commodity currency there is still the problem of it being unstable and, as a result, untrust-worthy. Developing countries whose economy is heavily dependance on commodity currency don't have the best track record of stability. A developed country example is the Iraqi "Swiss" dinar which went through deflationary trends - but didn't have long term use.
The counter argument seems pretty bad: diversify your investments. While being obviously good advice, it comes across as giving up on the system as a whole. "Who cares if Bitcoin fails, you should have other investments and will be fine."
Despite the uncertainty of long-term deflation, one of the best things about this currency is its reliance on mathematical models. If/when deflation is causing horrendous problems, I am confidant the mathematical model will be adjusted for the benefit of all.
Only time will tell, after all, Bitcoin is still experimental.