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I've recently read about the Great Depression period of the USA and made a striking relevance with Bitcoin.

In short, the Great Depression was caused by a drastic decrease in the circulating money (more than 1/3). This in turn lead to prices going down and therefore an increase in the purchasing power of money. Nothing new so far. However, we often tend to undervalue the importance of the financial institutions, which play a big role in increasing the standard of living of a society as a whole. Why?

Well, they gather little amount of money from a big part of the community and then finance big enterprises, which, could have not succeeded if they had not started with a great initial investment.

Think about it for a moment:

  • Almost every person in developed countries is able to afford a car because of the initial investment that the financial institutions were able to give various companies for scientific researches and building factories which facilitate the economic of scale.
  • We are now able to fly to the other part of Earth in less than a day, thanks to the initial researches and work, financed by various institutions.

Now, that everyone understands the significance of the financial institutions, let's imagine a world without them being able to operate. It's evident that there would be a drastic decrease in the standard of living.

What can cause the financial institutions to stop working?

  1. Put yourself in the situation of a person in debt
  2. Now add deflation into the situation (as it had been during the Great Depression)

This means that your debt will cost you more than you initially agreed upon (that is because of the increase of the purchasing power of money). A lot of people defaulted on their debts during the Great Depression. A lot more were unlikely to take any debts. Moreover, people saved their money in cash rather than investing them, because believed that the ROI (return on investment) would be much less compared to the situation if they just kept their money.

Now, please tell me, don't you think that bitcoin would face the exactly same problems, because of its deflationary nature?

And don't you think that in order for bitcoin to fulfill its dream of becoming a currency, it should make a fork which will let in a fixed amount of coins per year even after the initial supply plans have been met?

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3 Answers 3

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To answer your second question:

What purpose would extending the amount of Bitcoin by a fixed yearly supply serve? A Bitcoin consists of 100.000.000 Satoshis - even if large amounts of Bitcoin were lost (e.g., forgetting keys, burning, etc.) there should not be any payment problems for a long time to come. Extending the yearly supply would, as far as I see, merely add a slight inflationary drift to it (similar to gold which is being mined physically at a continuous rate). Question is, would that be desired? What economic purpose would it serve? Would it not undermine one of Bitcoin's core principles?

As to your first question:

Deflation occurs when the value of money increases in relation to goods present in an economy. In a world where the total supply of money is fixed (e.g., Bitcoin), the currency would be perceived as being deflationary if the amount of goods was increasing. Due to innovation and improvements in production, this would likely be the case in the future (e.g., technology is a leading deflationary pressure). In a way, you would be getting more for the same amount of money, effectively increasing your wealth. By itself, this would not be a bad thing.

The problem during the great depression was the debt burden. When debt is paid back, it effectively erases credit and thereby restricts the money supply - leading to deflationary effects because instead of the amount of goods increasing, it is the amount of money that is decreasing. Eventually, this lead to the US abandoning the gold standard and extending credit lines to the banking system, effectively pumping money into the system.

If the money being inserted into the system is used to pay back debts, the net effect on inflation/deflation tends to be negligible. The same is true if the supply of goods increases in rate with the supply of money. Problem is, as is nowadays the case, when the money created is being used to purchase assets (real estate, securities, etc.) and the supply of goods is constricted (problems with supply chains, etc.). Then inflation is felt on multiple frontiers (consumer prices, prices of securities, etc.). This decreases the wealth of the average person, and benefits those that owned securities before the money printing started.

To cut discussion short, I would recommend the following two books by Ray Dalio:

  1. Principles For Navigating Big Debt Crises (explains financial crises and also deals with the great depression) available for free at link
  2. Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail (deals with long term debt cycles and the implications of money printing in FIAT currencies, among other)

The book "The Price of Tomorrow: Why Deflation is the Key to an Abundant Future" link can be seen as a simplified summary of the above two, should you be pressed for time.

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Your question is probably better suited in an economic theory forum where this open ended question is discussed at length amongst scholars. You are making the Keynesian argument that the ability to adjust the money supply is inherently good for the economy. This is contradicted by other scholars, mainly from the Austrian School of Economics.

The very reason bitcoin was created was to have an immutable and predictable money supply in response to the dissatisfaction with an array of factors associated with traditional currencies with elastic, inflationary supply founded on Keynesian principles.

With any argument you give that inflation in such and such economic scenarios may be good, I am afraid you're preaching to the wrong choir, as it is implicit that bitcoin holders are adherents of the Austrian School that ultimately believe on the whole that fine tuning an elastic money supply is not a good thing and feel very strongly about not inflating the money supply. There is no indication that the bitcoin community would ever deviate from that consensus. Nevertheless, no one is stopping you or anyone from making a fork of bitcoin to test if there is a market interested in an inflationary bitcoin.

As I mentioned, whether adjusting the money supply is good or bad for the economy is an open ended academic question, with no consensus amongst scholars of economic theory. Bitcoin is the first real world experiment of a deflationary currency where this idea can be tested. Bitcoin does not stop other inflationary currencies from existing and time will tell which currency people choose in various hypothetical economic scenarios.

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I wish more people asked macro questions like this!

First of all, bitcoin can never be deflationary to the real economy, only inflationary. To see why, we need to think in fundamental terms. Let's imagine there is an isolated island. The island has some people and some resources (coconuts and fish). The people trade to increase their wealth. A tall man trades some of his coconuts for fish from a woman who is an excellent swimmer.

One day someone invents bitcoin on this island. They have no computers so the difficulty of this on-island chain stays very low - but it is possible to mint a block with a few hours of work using pencil and pad, so everyone spends several hours a day calculating rather than fishing or picking coconuts.

Now everyone on the island is flush in bitcoin. Bitcoin is the only kind of money on the island and all the people are now bitcoin millionaires.

So are the people better off or worse off? At first you might say everyone is of course better off since now they are all bitcoin millionaires and can now trade their coconuts and fish so much more efficiently using a distributed and non-modifiable ledger. If they have a very good day fishing, they can sell their fish for bitcoin and store the value of those fish on the blockchain until they need some coconuts (or have a bad day fishing). But in the context of this tiny island economy, this obvious how silly this is.

In fact they are all now much worse off thanks to the invention of bitcoin because every hour that people spent calculating hashes was an hour they did not spend picking coconuts or fishing. (OK, maybe not ALL, since there was a guy who happened to be wearing a CA53W when they were stranded. He secretly was able to mine a lot more blocks than anyone else, and he wisely converted all of his rewards into fish and coconuts the moment they were spendable. He got very good smoking fish and making coconut jerky.)

There are now much fewer fish and coconuts available, and so there is massive inflation if you use the metric [how many fish and coconuts you can have for each day of your labor]. The introduction of bitcoin was massively inflationary! You now have to work more hours per day to have the same number of fish and coconuts you had before bitcoin, even if you are not mining bitcoin yourself. See why?

Even if a storm hits the island and blows away every single notepad that has private keys written on it, you can never deflate even just back to where you were before bitcoin was invented. The invention of bitcoin will always be net inflationary.

Note that if you now view the island as the whole Earth and give everyone ASICs and add in lots of other currencies and goods and services... things get much more complex, but the fundamental outcome does not change. The introduction of bitcoin will always and everywhere be net inflationary.

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