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May 052013

Much ado has been made about how deflationary Bitcoin is. This is mildly comical, as it conflates three independent processes, as anyone who comments on monetary matters should know. As I have pointed out before:

In general, and all other things held constant (or, as we say in the business, ceteris paribus), prices can rise for three reasons: demand increases (e.g., an auction or a popular restaurant), supply decreases (e.g., lower efficiency, war, or natural disaster), or the number of units of currency increases faster than the rate of increase of goods and services (inflation).”

In the case of Bitcoin, the number of units in circulation is always increasing, albeit at a decelerating rate, thus Bitcoin is inflationary. Granted, Bitcoin can be lost, never to be recovered, and when that rate eventually exceeds the rate of Bitcoin creation, sometime before the hard cap of 21 million is reached, only then can we talk of deflation.

For now, what we are seeing with the general run-up in value of Bitcoin relative to fiat national currencies is a combination of demand increases for Bitcoin and the debasement of fiat currencies by central bankers at a rate that is significantly higher than the rate of Bitcoin creation.

Seen from the perspective of Bitcoin-qua-money, the general fall in prices is a function of users’ preference to hold money and to put off consumption into the future. While it is tempting to call this ‘deflation’, an increase in the demand for money is categorically different from a decrease in the supply of money.

With Bitcoin, we are seeing a radical reduction in time preference—i.e., putting consumption off into the future—which is associated with low discount rates (‘interest’), low risk, and a move away from scarcity toward plenty.

The bigger story here is that if Bitcoin users can find ways to dampen the fiat-price volatility—itself, a form of risk, which reduces present value—then Bitcoin’s value could rise even more dramatically. Think of it this way: people will pay more for a safe bet, like an apartment in Luxembourg, than for a risky bet, like an otherwise identical apartment in Syria. Today, the Bitcoin market is more like Syria than many like, and so they stay away; if Bitcoin’s value were more predictable, demand could increase even more as risk-averse individuals began to see it as a viable asset.

Were this to happen, it would not lead to deflation. Instead, it would show that Bitcoin currently is undervalued.

Invest accordingly.

Prof. Evans

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