Why deflation threatens Bitcoin

It is a well-known fact that Bitcoin is a deflationary cryptocurrency. As Bitcoin only has a fixed supply of coins to come into existence, the value of a single coin will therefore keep on increasing. This can easily be verified through the quantity theory of money. It is recommended to read the article Bitcoin deflation explained for more details on this. With the help of this theory, it can also be shown that Bitcoin’s deflationary nature poses a serious threat to its future.

Deflation and its effects on Bitcoin

To quickly recap, the equation that has to be balanced is: (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in quantity of the output). The Bitcoin supply is fixed and the velocity is relatively constant in the long run as it concerns spending habits. Production must keep on growing for stable employment rates, so prices must continue to fall to balance the equation. This means one Bitcoin will be worth more in a certain amount of time than it is today. The latter also enforces the deflationary effect, because people will delay spending if they know they can buy more with the same Bitcoin at a later date.

As the value of Bitcoin must continue to increase, it prevents the digital currency from becoming a stable store of value. A store of value is “the function of an asset that can be saved, retrieved and exchanged at a later time, and be predictably useful when retrieved.” In the case of the dollar, this is ensured by existence of a monetary policy. The money supply can be influenced, so prices can remain stable or even increase to promote spending. With a fixed supply, there is no monetary policy to have a dampening effect on price levels. In other words, price volatility will remain relatively high, leaving one Bitcoin far from “predictably useful when retrieved.” On the other hand, it was also noted that Bitcoin’s deflationary nature discourages spending by design. This seems like a poor perspective for a network that is intended to be funded by transaction costs, once the release of new coins comes to a halt.

Alternatives are biggest threat

But for Bitcoin, the previous would not even matter if it was not for the availability of alternative coins. Bitcoin’s biggest weakness is that it is not backed by any real asset, which makes it easy to copy the digital currency. Currently there are well over one hundred altcoins, and some offer significant improvements over Bitcoin. Dogecoin, for example, does not have a fixed supply. It is set up to release five billion new coins annually, which means the left hand side of the equation (percent change in the money supply) + (percent change in velocity) is increasing instead of constant. Given perpetual production growth, this will produce relatively more stable prices than Bitcoin. It is still not perfect, as the growth rate is a dynamic value while the inflation in cryptocurrencies is always a predefined variable which makes it a difficult balancing act. But when Bitcoin reaches its limit in 2040, Dogecoin will still be adding over 2% of new coins to its supply per year securing its network, encouraging transactions and keeping prices relatively stable.