Bitcoin Again: Inflation

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In an online discussion on Bitcoin, kidmercury pointed out an error of mine, related to Bitcoin (BTC) and inflation.

In the earlier post, I mentioned that all fiat currencies, controlled by central bankers, are subject to inflation for technical reasons (bankers misjudge the amount of currency necessary), and political reasons (bankers know they need fewer dollars or euros, but by printing too much, they inflate the currency, reducing the cost of already outstanding debt to the government).

It is worth pointing out that the inflation trick only works for a short period of time. If you are a lender/investor who buys the bonds of country X, and inflation is running around 3% a year, you demand, say 5%, because you need to earn a real 2% on your loans (5% nominal interest - 3% inflation = 2% real interest). If this government's debt starts getting a little out of control, the bankers are sorely tempted to print money. When they do, let's say way too much, inflation surges to 10%. The nominal amount of the old debt (e.g. the $1000 they borrowed from you) is the same, but because of inflation, the value of that $1000 has gone down. In other terms, it takes less labour and services to pay it off. Seems like a good deal for the government. It is not a good deal for the citizens, since the value of heir hard earned savings just went down as well. Further, prices for most things will rise, but the average worker (which most citizens are) will have a tough negotiation for a higher wage, and the raise will lag. This is why Milton Friedman called inflation a "hidden tax."

But it turns out it isn't such a good deal for the government either. As soon as you figure out what the government has done, and they want to borrow more, you are still going to want your real 2% return. Add that to inflation, now 10% instead of 3%, and you will demand 12%! To boot, because they are behaving in such a risky fashion, you will want to get compensated for your risk, and your old 5% interest requirement just became 13%! This is a pretty bad deal for the government, too, but politicians need to think beyond today's problems, something at which they are particularly poor.

How does that relate to BTC? As kidmercury pointed out, the number of BTC is mathematically limited. As such, eventually the number of BTC will be less than the demand, even if entire economies moved to BTC. Deflation is inevitable. Similarly, as the number of BTC grows at a predefined mathematical rate, the demand for BTC may not keep up, until it hits its ceiling, and inflation may ensure. Most likely, BTC will suffer periods of inflation and deflation, until the cap is reached and ongoing deflation occurs.

At the very least, corruptible as central banks are (because a central bank is nothing more or less than the sum of the people working there), they are likely to keep money supply within some growth range of economic activity. To be fair, that isn't necessarily true; they didn't do so in the late 1970s (inflation), early 2000s (inflation), 1930s (deflation), etc.

In order for BTC to be truly inflation and deflation free, it would require a different algorithm, one that adjusted mathematically to keep itself stable, sort of an algorithmic Taylor rule. I do not even know if that is possible without making it subject to manipulation.

In the end, we choose between a currency that responds to actual economic behaviour, however imperfectly, but is subject to potential and actual political manipulation, and one that is not subject at all, and thus will experience inflation and deflation, but at least predictably. This is a values question; one the market will answer.