16 min read

Is Deflation a Problem for Bitcoin?

Is Deflation a Problem for Bitcoin?


Note: This article is for our more advanced readers! Be sure to start with the basics of Bitcoin first so you can follow along:

- What is Bitcoin?
- Why Should You Care About Bitcoin? (Pt. 1)
- Why Should You Care About Bitcoin? (Pt. 2)

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Economists teach us that without inflation devaluing our currencies, we will stop consuming goods because we will start "hoarding" our money. This, they say, will lead to economic ruin.

But is this true? And if bitcoin is deflationary, does this mean it will ultimately fail?

Let's think about it from first principles.

The Argument

The most common deflation related anti-Bitcoin argument goes like this:

  1. Economies grow because of increasing consumption
  2. Inflationary currencies incentivize consumption instead of "hoarding"
  3. Therefore, economies require (mild) inflation to sustain growth
  4. Bitcoin's fixed supply makes it deflationary over the long term
  5. Deflationary currencies lead to "hoarding" instead of consumption
  6. Therefore, an economy running on Bitcoin cannot sustain growth

This is a compelling argument! However, there are some fundamental misconceptions inherent in this view, which we will explore below.

Bitcoin's Hitler Fallacy

You may be familiar with the classic Hitler Fallacy in common language, whereby any innocuous belief, if also previously shared by Hitler, is therefore argued to be bad. For example, Hitler ate sugar, therefore sugar is bad. Or Hitler was against smoking, therefore if you are against smoking, you are bad.

Bitcoin's Hitler Fallacy is a little different. It goes like this:

  1. Hitler came to power during a period of low level deflation
  2. Hitler's rise to power was to some extent caused by low level deflation
  3. This deflation was caused by inherently deflationary money (gold)
  4. Therefore, gold led to Hitler's rise to power
  5. Bitcoin is digital gold compatible with 21st century technology
  6. Therefore, Bitcoin will lead to the next Hitler

Let's think about this a different way:

Imagine a small country of 1 million people. In this country, if everyone believes in behaving justly toward one another, everyone benefits. If, instead, just one individual, Bob, decides to steal from the others, Bob benefits tremendously as long as he doesn't get caught. Moreover, if Bob uses his stolen wealth to subsequently gain economic control and power, then he can create long-lasting asymmetric advantages over the rest of society who are still behaving in a just manner.

Question: Would it therefore be correct to say the cause of Bob's rise to power is the fact that others are behaving in a just manner? Can we blame the fact that Bob came to power on the fact that everyone else behaved in a morally acceptable way?

Now let's switch to global currencies:

Imagine a world where sound money standards are preferred and used by all countries. What happens if just one country decides to instead switch to a paper currency, debase it through money printing to pay for large spending programs, and then issue tons of debt it can't afford in order to create artificial demand to prop the currency back up? When needed, it simply buys its own debt to manipulate the market. By doing these things, this country can now "afford" all sorts of things it couldn't afford previously, because it's essentially using lots of leverage. It uses this new "wealth" to buy weapons and quickly overpowers neighboring nations that were using sound money.

Question: Would it therefore be correct to say the cause of that country's rise to power is the fact that others are behaving in a just manner? Can we blame the country's rise to power on the fact that other countries didn't print money?

In both scenarios, it seems silly to say the just behavior of others is to blame. Rather, we can infer that there are insufficient incentives for all participants to avoid cheating, and therefore cheating is inevitable as it leads to more power.

What is Economic Growth?

Imagine a small economy comprised of a few people. This economy is based on fishing and 3 fish per person are needed per day on average to meet basic needs. If one person works extra hard and catches 6 fish, they can take a day off because they'll have 1 extra day of fish to live on. By saving their excess labor, they are able to do other things. For example, they could start building a house. This house would not be built if not for the savings in fish the prior day. Therefore, the house represents increased production, enabled by savings (fish).

Now imagine the small economy develops a currency: pebbles. It just so happens that 1 fish is worth 5 pebbles. One day, a fisherman catches 50 fish. This is more than he can store for himself without them going bad, so to store the value of that excess labor, he sells 40 fish (savings) for 200 pebbles (currency). Importantly: now he has 200 pebbles instead of fish, but the pebbles are NOT truly "savings". They are, instead, the conversion of real savings (fish), which can be consumed to meet primary needs, to an abstract representation of savings (pebbles), which are more durable and can be converted back into real savings (fish) later.

These 200 pebbles store lots of value for the fisherman. Now he can build three houses without worrying about food, as he can always buy more food if needed. His base level needs are met for now (10 fish) and his excess labor is stored for later (200 pebbles). This results in more projects being completed (3 houses).

Despite all this, the fisherman cannot eat, drink, or live inside the pebbles. So what happens if he runs out of savings (fish) to eat and goes out to use the pebbles he stored to purchase more, but nobody has any fish to give him? At this point, the pebbles (currency) have failed to adequately prepare the fisherman for his future needs because they are no longer convertible to fish for some reason or another.

Therefore, economic growth in this economy is a function of real savings from excess production, NOT currency nor consumption. Since it can be said that currency (pebbles) is not the same as real savings (fish), then as soon as the former fails to convert to the latter, no further growth can occur. In the above example, the extra projects (houses) must be halted.

What is Natural Deflation?

If the currency (pebbles) becomes highly sought after and "hoarded" by people in society, its conversion value to other goods will go up. In other words, fewer pebbles will function to purchase more goods than before. This is because with a lower available liquid supply of pebbles in the market but a static or increasing level of goods in the market, the proportion of pebbles to goods goes down.

But why would this happen? Is it bad? If people are hoarding pebbles, what does that imply? The answer is: it probably implies that everyone has tons of fish. Because, again, economic growth is a function of savings (fish) NOT currency (pebbles). If everyone has enough fish, there will be more demand for a conversion of those excess fish to pebbles such that long term value can be stored.

Therefore, in this example, the price of pebbles goes up, yet it can be said that the economy is stronger than ever and is likely growing. Pebbles are an abstract attempt to store the value of the excess real savings (fish) to meet future needs, and if everyone wants pebbles it signals everyone already has lots of fish.

This is natural deflation.

What is Debt?

In the above examples, debt can be thought of as a further abstraction of value through the form of a promise. While pebbles are a commodity that nobody creates artificially, debt can be created just by two people signing a contract and agreeing to the terms. This makes debt a less reliable, more risky form of value abstraction.

For example, let's imagine the fisherman above uses the 200 pebbles he obtained to issue debt. He finds another fisherman who has been struggling to catch just 3 fish per day to meet his own basic needs, and he offers this poor fisherman an opportunity: "I'll give you 150 pebbles now if you pay me back the 150 pebbles in a month, plus 2 pebbles per week in interest." Notice that this initial 150 pebble loan upfront must be done with REAL pebbles, right now. Otherwise, what's the point? The poor fisherman needs REAL pebbles now in order to generate any value for himself, or he wouldn't benefit from the loan. So the commodity money in this society (pebbles) constrains this type of lending such that the rich fisherman must have at least 150 pebbles stored to fund the loan.

Now imagine that instead of pebbles, the economy uses fiat money (dollars), which are created out of thin air by the government/central bank. If the rich fisherman runs a government certified institution, he can just type some numbers into a spreadsheet on his screen and say to the poor fisherman, "you are now granted a loan of $150 with $2 per week in interest". This is just created out of thin air; no need to actually have any real value stored ahead of time by the rich fisherman.

The poor fisherman can use this loan of $150 printed out of thin air to go start a business, and before you know it he may start issuing his own loans to other people, and those people will issue more loans to others, etc. This string of loans has the appearance of creating lots of economic growth! To an outsider, it seems like tons of people are starting businesses and projects in this economy, so it looks like Gross Domestic Product (GDP) is going up. Things are great.

This is the debt we are used to in fiat economies.

What is Credit Deflation?

Imagine next that the central bank decides to change the rules: it hikes interest rates. This makes its fake dollar money more expensive, which means $2 per week in interest is no longer enough to cover the real value of the original $150 loan.

To compensate, the rich fisherman increases the interest rate on his loan to the poor fisherman. Unfortunately for everyone, it turns out the poor fisherman already used up all his capital starting his business and lending to others, so now he can't meet the new, more expensive interest payment. Because he can no longer service his debt, he defaults on his loan and goes bankrupt.

As a result, ALL the people behind him in the long line of lending also default on their loans in one big house of cards collapse. Each one was dependent on the one in front of them in the lending line. Thankfully, halfway down the line, one prudent individual kept enough money saved in excess of her debt obligation, so instead of defaulting, she is able to service her debt. This has the effect of stopping the chain reaction, because from that point on in the remaining line of lenders, everyone else is saved from default.

Credit deflation happens fast, like a collapsing house of cards.

However, the damage is done. That long cascade of defaults did something important to the value of the currency: it created MASSIVE upward pressure on the currency's price relative to other goods. This is because when debt gets erased through defaults, this is essentially the same thing as destroying the currency itself. It's all just fiat money anyway, or promises upon promises upon promises all the way down, so if a huge chunk of those promises gets broken all at once, this is the same as a huge chunk of money being destroyed. When all that money vanishes from the system overnight, the available supply of money goes down, which means the relative amount of that currency compared to the amount of goods in the economy goes down. As a result, any given unit of that currency is worth more goods than before.

Therefore, debt creates a new form of deflation more insidious than the type discussed previously. Unlike natural deflation, this credit deflation is cascading in nature and has the effect of destroying large sums of money in very short periods of time. And if, as is usually the case, all those projects that were started by using debt were also being counted toward GDP, then similarly when all those projects have to be stopped short due to defaulting loans, the resulting sharp cutback in economic activity is likewise counted as negative GDP. Thus, to an outsider, it appears as though deflation causes economic contraction.

Misconceptions About Growth

So, do we even need debt? Surely we do, but if constrained by commodity money, then as we discussed above, debt can't be as easily funded via fake fiat promise money created out of thin air. Therefore, a system backed by commodity money has the appearance of decreasing the potential for economic growth, since fewer people can afford to issue or take on new debt, which results in fewer projects. However, this can be chalked up to a misconception; namely, that tons of projects being started based on a house of cards of debt is really the same thing as economic growth.

In reality, as we said, economic growth is a function of savings. Savings is NOT the same thing as currency nor debt, because currency and debt alike are just sets of promises for future conversion of stored value to real goods. If commodity money is the currency used, it at least has the feature that it cannot be printed arbitrarily, thus placing a constraint on the extent to which people can over-promise. However, even commodity money is just a value abstraction not equivalent to true economic growth, since at the end of the day if people can't afford to eat then nothing else matters.

Instead, if fiat money is the currency used, it doesn't even have this protective feature of unforgeability inherent in sound commodity money; instead, it can be printed arbitrarily, thus removing all constraints on over-promising. This creates a highly volatile house of cards wherein one default can spark a chain reaction of subsequent defaults, and any manipulation by the central bank with respect to interest rates or overall money supply will have an outsized impact on the viability of loans within that house of cards system.

The Game Theory of Bad Money

This brings us back to the original questions posed at the start of this article. If everyone uses sound money, all it takes is one country switching to a fake fiat currency and printing its own wealth through fake promises to ruin that system. So is sound money to blame?

This is game theory: each country has the incentive to debase its currency first in order to acquire more short term power, knowing full well that long term its currency is unstable. However, the long term doesn't matter if we never get there! If a country can stock up enough power in the short term by debasing its currency, it has now eliminated the need to worry about the long term because it can simply use its short term power to take over other countries and expand. If your country is the virtuous one still using a gold standard while everyone else is switched to fiat, then sure, your country might be trustworthy and remain able to meet its loan obligations in full, but if everyone else is printing money and getting "fake rich" temporarily in order to gain power and influence, then you will quickly lose out.

Now that we're several decades into this fiat experiment, most people alive today have grown up learning about economics through this fiat money lens. The people who built the schools and created the curricula that taught us what we know about economics did so under this fiat money paradigm. The way we think about value and money itself is therefore shaped by this very fiat system. As a result, we often lack the vocabulary necessary to discuss these concepts meaningfully.

Is it any surprise, then, that we commonly say "deflation is bad because it lowers GDP, just look at XYZ example from history!" and show each other charts as evidence, apparently illustrating declining GDP during deflationary periods? Never do we consider that there are different types of deflation caused by different things, or that GDP itself is a function of real savings in real resources rather than currency or debt, which are just value abstractions not tethered to any real resource savings.

By the end of these discussions, we are often left scratching our heads, puzzled by the apparent fact that honest financial accounting somehow leads to economic ruin, while making up fake money and printing trillions of dollars out of thin air regularly seems to lead to global prosperity.

It seems nutty because it is nutty, because the vocabulary is wrong.

Is Bad Money Inevitable?

This raises some important questions:

  • Does this mean we're stuck with bad fiat money because game theory encourages its use over sound money due to short term gains?
  • What exactly, if anything, could disincentivize bad money such that sound money provides asymmetric advantages even in the short term?

The answers to these questions begin with the shortcomings of gold: specifically portability and divisibility. Almost any size unit of gold, even the very small, tends to represent large amounts of economic value. This is through no fault of gold; it's just a coincidence of the amount of available gold in existence vs. the amount of available goods in existence. Given this ratio, it just so happens that gold isn't very easy to divide into sufficiently small units for daily transactions. This makes gold less than ideal as money. Moreover, large amounts of gold are difficult to store and transport, which eventually leads to centralization of gold storage. Its difficulty to hide also makes it vulnerable to government capture.

Looking back at history, fast advancements of other technologies in the 1900s led to a quick march toward globalized trade, which increasingly made the above shortcomings even more problematic. Global trade means trading over long distances, which requires fast communication of value. This is not something gold is good at. Hence, paper money backed by gold was formally established and normalized under the Bretton Woods agreement.

However, this led to the Triffin Dilemma: if you are the United States and the world has agreed to use dollars backed by promises of gold, then you have the responsibility to manage the global supply of dollars to maintain and grow foreign economies rather than just your own. The world therefore demands more dollars to facilitate growth, so you (the U.S.) have to provide that liquidity. You do this by buying more than you sell (importing more than exporting). This is called a trade deficit and it's unsustainable. A large trade deficit forced the U.S. to issue more and more debt, and eventually nobody trusted the ability of the U.S. to redeem dollars for gold anymore. This is why Nixon "temporarily" (in reality permanently) removed the dollar's peg to gold. France literally showed up with warships demanding its gold because it didn't trust the U.S. to keep the gold peg anymore!

In this way, gold backed paper money that could still just be printed to facilitate global trade led to a paradox where either the U.S. could act responsibly by not printing money and issuing lots of debt and the world would be unhappy (not enough dollars available to grow their economies), or the U.S. could act irresponsibly by printing lots of money and issuing lots of debt, but that would mean it eventually can't service that debt or back up the promise of the gold peg.


Moreover, once the gold peg was removed, the game theory of bad money came into play on a global scale: everyone is incentivized to debase currencies as much as possible without going into hyperinflation, because that lets you spend things you don't actually have and gain more power in the short term. The fuel added to this fire was that the U.S. still managed the global reserve currency, which meant it had more available space to fill with its dollar printing.

Think of it this way: if you're a small country and there's no global trade, then printing money directly affects your economy by however much printing you did. It's a closed system. This can be from issuing debt out of thin air, or literally sending citizens stimulus checks in the mail, etc. Either way, you're debasing your currency directly. Whatever borrowing you do is coming directly from your own economy.

However, if instead you live in a world of global trade where other countries are all using YOUR currency that you get to print whenever you want, then you can strategically export the inflation you cause to those other countries instead of your own. This is the United States' exorbitant privilege. If it runs into problems servicing its own debt, the U.S. can just print more currency, manipulate interest rates, and restructure things to help it get back on track. However, other countries can't do that, as they depend on the U.S. currency as the global reserve. If they try to print more of their own currency to service their debt, it's a failing strategy because their debt is denominated in dollars, so they need to print more and more currency to service the inflating dollar demands. Within their small country (relatively closed system), that currency hyperinflates. Eventually, other countries' currencies hyperinflate while the dollar remains relatively okay.

In this way, globalization temporarily subsidized money printing by opening the doors to more economies to flood with dollars. Imagine water filling up a bottle but before it overfills you cut a hole in the bottle that empties into an aquarium so the water just flows there. Eventually the aquarium is going to fill up too, and we'll be back to the original problem. But the bottle will be the last to fill up as it's closest to the source. The bottle is the United States and the water is inflation from money printing. The closest to the source will be the last to drown in hyperinflation.

Would Bitcoin Fix This?

What if bitcoin had existed back when technological advancements and commerce expansion first led to globalization? The shortcomings of sound money wouldn't have been portability and divisibility anymore. Instead, you would have been able to accurately store the value of excess production in a vehicle that doesn't tend toward centralization, can be easily secured, can be easily transported at the speed of light and in any quantity, and retains all the important characteristics of sound money that enable it to reliably convert value to real goods over long periods of time. Perhaps economies would have had a disincentive to turn toward fake fiat money. The emergence of paper money would have thus been less likely because paper money would have had significant shortcomings compared to the light speed final settlement capability of bitcoin.

As a counterargument, perhaps this would have stymied much of the "growth" we saw in the past several decades. Perhaps all that money printing led to a sugar rush renaissance of production fueled by fake money, which, because of its ability to be propped up for so long, could be argued to have contributed positively to human flourishing. More than likely though, this sugar rush would not end well on its own. The emergence of bitcoin as a new sound money could help the world safely detox from the fiat sugar rush of the past several decades without crashing.

What's Next?

As explained in our article Why Should You Care About Bitcoin? (Pt. 2), we should expect bitcoin to continue its meteoric rise in value due to its fundamental utility, scarcity, and network effects. Will its increasing adoption change our economies?

In all likelihood, in the medium term there will continue to be some combination of fiat and bitcoin use in the world, where bitcoin as sound money is more versatile and decentralized than its predecessors (gold, silver, etc.) and is therefore able to be more of a check on government power and abuse of money. This will lead to a gradual rather than sudden reversal of fiat trends of the past few decades, and an eventual symbiosis between multiple types of currency standards.

Over the long term, concerns about deflation in bitcoin will be proven misguided and based on misconceptions about what economic growth really means. As more of the global population discovers bitcoin, the incentives for countries to print money and debase currency will gradually dissipate as individuals who escaped the shackles of fiat and harnessed their savings independently become elected officials themselves. From the inside out, governments will realize the geopolitical advantages of adopting bitcoin reserves early. Rather than placing immediate constraints on debt creation, these reserves will serve as an insurance policy against the inevitable collapse of fiat currencies and lead to economic growth accompanied by natural currency deflation.

In the future, you will choose your currency rather than being born into it. Bitcoin will be chosen because of its deflationary nature, rather than in spite of it. The propensity of nations to debase their currencies will decrease as unstoppable individual sovereignty powered by bitcoin shifts governments' incentives toward financially appeasing rather than trapping their citizens.

For bitcoin, deflation is a feature; not a bug.

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πŸ‡©πŸ‡ͺ German Translation by Simon Satoshi

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