Last Friday, FT Alphaville (i.e. this reporter) participated in an excessively lengthy Clubhouse session with bitcoin blogger and math lover Allen Farrington, who touched on many aspects of the world’s most famous financial system.
While many aspects of the conversation will be old ground for readers of this blog, there was one talking point that touched new territory. It was a question of whether bitcoin is really a deflationary currency or not. Our take was that bitcoin may not be as immune to inflation as many believe. (But also that that’s not necessarily a bad thing.)
You can catch up with the broad brush of the discussion via this an incredibly detailed essay by Farrington, which comes with the added benefit of a lot of math applied to ideas.
But for those who don’t feel like digesting an 11-minute read with equations, the bottom line is this: We often forget in the bitcoin world that it’s not just the amount of money that influences the amount of money. inflation, but also speed. And in the bitcoin economy, there is a lot of pent-up speed to contend with, not least because of all these wallets carrying huge sums of value that never compromise (like Satoshi’s own hiding place).
In the conventional “fractional reserve” fiat world, velocity is a function of monetary multiples, which are primarily a function of how quickly the commercial banking industry can reuse or re-lend the underlying reserves in the system. This in turn influences the money pyramid and the overall money supply. As the great experience of quantitative easing has shown, the broad money supply is not only a function of the central bank‘s core liabilities, but of the capacity of the broad system to reuse those reserves and to save them. transform into private commitments.
In a fractional reserve system based on fiat, you cannot escape the money multiplier effect. If you keep your wealth in the banking system, someone somewhere is putting it to good use by lending it out again.
This, however, is not true for bitcoin. In a hyper-bitcoinized world, you have the option of opting out of the perpetual loan loop. While you can, if you wish, commit to having your savings re-loaned to earn a little extra return (say to those who wish to use loans as a short-selling mechanism), ultimately it does. is completely voluntary. The underlying system, at least in theory, is fully reserved.
Those who believe that a full reserve system is a better and more stable system will say that is a good thing. And it may or may not be. It is beyond the scope of this post.
Our argument is simply this: Just because a system is fully booked and all loans are made with the explicit conscious consent of the holder of the wealth does not mean that it is resistant to inflation.
Bitcoin appears to be disinflationary right now. But that’s because those who choose not to put their money to work effectively reduce the velocity of their money to zero. The nice thing about bitcoin is that thanks to the opening of the bitcoin ledger, we can see quite clearly how much money is never being treated this way. For example, according to to a report by Crystal Blockchain, as of July 2020, there were over 10 million bitcoins (worth $ 85 billion at the time) accumulated in dormant bitcoin addresses without any outgoing transactions in 2019. Most recent data from bitinfocharts suggests some 17.8 million bitcoins out of about 18.75 million in circulation are currently classified as residing in dormant addresses.
So what does this mean for inflation?
What we have postulated is that a structure in which loans cannot be made without explicit consent transfers “fractional reserve” risk from banks to stock managers in the real economy.
Indeed, ensuring that there are always enough goods and services in the economy to meet the potential buyback capacity of bitcoin, if all the coins were suddenly mobilized, is both impractical and excessively unnecessary. . The whole point of just-in-time inventory management is that residual or excess inventory should not be held on hold. Traders determine how much inventory they need to hold based on historical trends in demand, not how much money is or may be in circulation.
It stands to reason that in a bitcoin economy, inventory managers would end up, at the macro level, under-reserving physical goods relative to the potential monetary capacity to redeem those goods. Given the amount of bitcoin standing still in wallets that hardly ever trade, not doing so would be inefficient and commercial folly.
But it would also undoubtedly increase the fragility of the system to external supply shocks, bottlenecks or other crises that have the capacity to motivate bitcoin savers to suddenly dip into previously immobile bitcoin reserves and to cause an efficient run of stocks. Previously uncirculating money could very suddenly start to flow quickly.
The only corrective mechanism in such a scenario would be for the price of goods and services in terms of bitcoin to rise sharply to counter unexpected demand, manifesting itself in sudden and destabilizing inflation.
Farrington retorts reasonably reasonably that in a bitcoin world, there would at least be a cap on exploding inflation. The effects would be transitory until a new inventory is put online or until new excess wealth has been created, and therefore immobilized. In theory, the price signals would be super strong and stimulate the supply. Inflation could also improve social mobility, as old wealth would be withdrawn and transferred to those with the capacity to create the new wealth the system needs.
The question is: is it really that different from the current system? And just how capped is this kind of inflation?
If bitcoin transactions were, in theory, to reach maximum speed across all wallets, only supply shocks could induce general inflation. Additional demand, for example due to population growth, could never be met by money creation, which means that the consequences would always be deflationary. That is, any emerging imbalance could only be eliminated by impoverishing one part of the economy and the other richer part by inducing other parts of the economy to save more.
In such a world, it would be highly unlikely that the bitcoin economy could prevent other parallel monetary systems or the creation of credit from coming to the rescue of this money shortage. (Especially if the system were to remain a voluntary, non-coercive, non-fiduciary system.) And then the threats of currency-induced inflation would come back to the table.
Whether it is a bitcoin world or a fiat world, there is a good chance that money will remain endogenous, expanding or contracting in conjunction with the underlying economy’s ability to deliver. to its citizens what they need. That’s not to say that bitcoin doesn’t have unique useful properties. This journalist definitely comes to the idea that resistance to censorship is an important quality to be offered by a monetary system. This, in our view, is the freedom to opt for harsher, stateless alternative monetary systems if yours hits the inflationary fan.
But if bitcoin’s best attribute is its resistance to inflation in a larger hyper-bitcoinized context, we’re not so sure. Inflation is not necessarily taken out of such a world, just cropped.