To understand deflation we must first define its opposite: monetary inflation. We hear a lot about inflation on the news, but what exactly does it mean?
As the term itself suggests, inflation is an increase in the supply of some value or product. In the case of currencies in general, we have monetary inflation, which is an increase in the money supply. For instance, in the present day banking system, monetary authorities, namely the central banks, are free to print more money or remove money from the markets whenever they think some aspect of the economy needs a correction.
Cryptocurrencies are the complete opposite of central banking as one of the cornerstones of Bitcoin is decentralization. As you may know, mining is the process by which more Bitcoins are injected into the markets. The rate of inflation is hardcoded into the Bitcoin system: one block every 10 minutes on average. Every block pays 12.5 BTC at today’s rate which means that approximately U$ 120,000 are injected into the Bitcoin economy with every mined block. Every 4 years, the Bitcoin mining reward is made half of the previous amount. Initially miners were paid 50 BTC per mined block, then it was halved to 25 and today we’re midway through the second halving when the block reward is 12.5 BTC. So, what happens after the year 2040 when the reward will tend to zero? At that point, no more BTC will be injected into the system and Bitcoin will become a deflationary currency. Coins will be naturally lost and there will be no replacement for them.
This is why Bitcoin is called a deflationary currency: the rate at which money is printed is slower than the rate at which currency is lost or hoarded by investors.
In the fractional reserve banking system (what fiat money uses today) there is, for all practical purposes, unlimited money supply. In fact, central banks have been indiscriminately printing money to artificially pump the stock markets for almost 10 years now, after the 2008 subprime crash. Our whole economy is based on the premise that currency can simply be printed by banks when needed. Fiat money is, therefore, an inflationary currency. People must work more and more for their money, because with every unit that is created, an inversely proportional amount of value is lost.
If the whole economy had one single dollar in circulation and apples cost 10 cents, if another 9 dollars were suddenly artificially injected into this economy, apples would have their price raised to a dollar in order to compensate, otherwise all the apples would be gone now that 10X more money is available on the market. In order to maintain the value of supplies, the prices go up when money is printed and they go down when money is drained from the markets.
What happens, then, in a deflationary system? In this case, money does not lose value, but instead gains value with time. Bitcoins will be lost at a certain average rate per year and after some time no more coins will ever be minted. This means that in 100 years Bitcoins tend to naturally be worth multiple times their current value.
So, is this good or bad? Well, it depends. If the system is fluid, there’s ample liquidity and the money is flowing freely, then a deflationary system can be very good for market participants. They will, after all, be able to buy more goods and services later on while spending the same amount of currency. But, as we know, there is a large amount of mining power held by small groups of professional Bitcoin miners.
As evidenced by the following Blockchain.info chart, there is immense amount of mining power concentrated in the hands of very few pools:
It is visually obvious, from the above chart, that the four pools, clockwise from BTC.com to BTC.TOP, control over 50% of all Bitcoin mining power. As we know, there’d be the possibility of a majority attack in case these 4 pools colluded to do so, but that’s not our focus on this article. What we’d like to note here is that concentration of mining power leads to the concentration of wealth as well. After all, the new Bitcoins being minted are being distributed proportionally to the mining power these pools are able to contribute to the total network hashrate.
Concentration of wealth in a deflationary system can lead to its collapse.
For example, one risk in a deflationary currency system is an effect called the deflationary spiral. This situation happens when there is more incentive to hold (HODL) currency as a store of value than there is incentive to spend it. When this happens, the value of currency rises with respect to the goods, which makes products and services become cheaper, but as this happens people have further incentive to hoard the coins, making them gain even more value. This process feeds itself until the currency is no longer viable for commerce, but only as a store of value.
This contrasts with the mainstream banking system, where central banks compete to print more money in order to devalue their currency. A weaker currency boosts exports, which is every country’s main goal in the globalized economy. China wants to sell more goods to the US. Americans can access Alibaba or similar Chinese sites and they find the prices are very attractive, why? Because the US Dollar is worth a lot more than the Chinese Yuan. This happens because China has been printing absurd amounts of money on purpose, to increase its exports to Europe and the USA. But Americans want to export too, and so do the Europeans. The result is a seemingly endless amount of money being printed by central banks in order to boost the stock markets and also to promote exports. This system has led to absurd wealth concentration in the hands of bankers and widespread wealth inequality becoming a global problem. While the average citizen will work 9 to 5 for a relatively fixed wage, central banks keep printing and pumping money into banks. While an individual investor only has limited amount of purchasing power to allocate for stocks or savings, banks have unlimited spending power and easily overwhelm the average citizen.
As we can see, there are problems both with inflationary and deflationary systems. The currency supply by itself does not determine the success or failure of an economy. How, exactly, the system is configured and how efficiently this system is able to distribute value is the main determining factor of the success of an economy. Bitcoin can be divided into 8 decimal places, into tiny bits called Satoshis. Even if a single Bitcoin were worth over a million dollars, as predicted by Hal Finney and others, a satoshi would be worth a few cents of a dollar. The only change we’d see is prices being listed in satoshis and no longer in Bitcoin.
In fact, there are more millionaires in the world than there will ever be Bitcoins. According to the pigeonhole principle, there will be millionaires who will not be able to own a full Bitcoin even if they wanted to. This is one of the consequences of a deflationary system: currency becomes more and more scarce. How this will play out in the long run is unknown, but one fact remains: unless a large technical problem is found in Bitcoin, which seems improbable after 9 years of bombardment by hackers, its value will continue to rise as more participants join the network.