Bitcoin Deflation and Economic Activity

The Great Depression is the worst period of deflation the world has ever witnessed, but it’s not the last time deflation has struck the United States. In 2010, the Colorado minimum wage was lowered to account for a decrease in the cost of living. Colorado is one of the states whose minimum wage tracks inflation. That means that as the cost of living increases, so too does Colorado’s minimum wage. But when deflation occurs, the cost of living decreases, and by their laws they have to adjust their minimum wage accordingly. Which is to say, downward.

Wolman, L. Wages During the Depression. New York: National Bureau of Economic Research, 1933.

The downward adjustment was slight—$0.04 or one half of one percent—and it has since recovered. By comparison, average per-capita weekly earnings between 1931 and 1932 dropped by as much as 22.3%, depending on the industry. That doesn’t even compare to what would have happened to wages over the past several months if they were denominated in bitcoin. In that case between July 25 and November 25 of 2013, wages would have fallen by 88.4%, far exceeding the deflation experienced throughout the entirety of the Great Depression, nevermind a single year.

Making this comparison is a bit unfair, as it’s only a valid comparison if there is in fact a bitcoin economy. While there is undoubtedly a market for bitcoin transfers, as well as demand for bitcoins themselves, a bitcoin economy has yet to emerge that is capable of producing its own goods and services, and it very likely never will. The reason for this is of course deflation. The most succinct explanation of why that I know of comes from Greek economist Yanis Varoufakis. He writes:

… [D]eflation is unavoidable in the bitcoin community because the maximum supply of bitcoins is fixed to 21 million bitcoins and approximately half of them have already been ‘minted’ at a time when very, very few goods and services transactions are denominated in bitcoins. To put simply, if bitcoin succeeds in penetrating the marketplace, an increasing quantity of new goods and services will be traded in bitcoin. […] In short, a restricted supply of bitcoins will be chasing after an increasing number of goods and services. Thus, the available quantity of bitcoins per each unit of goods and services will be falling causing deflation. And why is this a problem? For two reasons: First, because an expected fall in bitcoin prices motivates people with bitcoins to delay, as much as they can, their bitcoin expenditure (why buy something today if it will be cheaper tomorrow?). Secondly, because to the extent that bitcoins are used to buy factors of production that are used to produce goods and services, and assuming that there is some time lag between the purchase of these factors and the delivery of the final product to the bitcoin market, a steady fall in average prices will translate into a constantly shrinking price-cost margin for firms dealing in bitcoins.

That second point warrants further explanation with an example. Suppose you find yourself with 100 BTC and a great idea for a new type of widget you want to sell. After some careful calculation, you determine that it will cost you 1 BTC to produce, market, and sell a single widget, and that it is only worth your effort if you can sell each widget for 2 BTC, a handsome 100% margin. Your 100 BTC investment will allow you to produce 100 widgets, leading to 200 BTC in revenue from their sale, which will leave you with a profit of 100 BTC.

100 widgets × 1 BTC / widget = 100 BTC total cost × 100% margin = 200 BTC total revenue 100 BTC total profit

You spend your bitcoins on the materials, goods, and services that you need to build your widget empire, and get to work building those widgets and preparing them for sale.

A deflation rate of 90% seems unrealistic and ridiculous, but as mentioned above that's very close to what happened to bitcoin between July and November of 2013.

A few months go by and your widgets are ready to be sold on the open market. But while you’ve been working, deflation has also been at work driving down prices across the bitcoin market. A few months ago, you could buy a pound of butter for 2 BTC and 10,000 op-amps for 1 BTC. But now, a pound of butter will set you back only 0.2 BTC, and 1 BTC will buy you 100,000 op-amps. In short the bitcoin economy experienced 90% deflation between the time you started working on your widgets and the time you were ready to sell them.

You now have virtually no chance of selling your widgets at 2 BTC. In order to actually move them on the market, you’ll have to deflation-adjust their price, which would put your asking price at 0.2 BTC per widget. Once all your 100 widgets are sold at that price point, that will leave you with 20 BTC in revenue, and a total profit of -80 BTC.

Note that deflation is not incorporated into the cost calculation. That's because you spent those bitcoins on materials and goods—such as butter and op-amps—before deflation struck. Since then you've used those materials and goods in the construction of your widgets.

100 widgets × 1 BTC / widget = 100 BTC total cost × 100% margin @ 90% deflation = 20 BTC total revenue -80 BTC total profit

You started your widget empire with 100 BTC, and now you’re left with 20 BTC. Deflation has turned your 100% profit into a 80% loss. You would have been better off never starting your bitcoin empire, and instead keeping your 100 BTC in your own personal bitcoin wallet empire, which would have grown in real value ten-fold without you doing anything.

In any deflationary economy there is no economic reason to invest in producing goods and services. You’re better off saving your bitcoins, which will rise in real value without you expending any effort. By the same token, consumers will put off their expenditures for as long as possible. Why buy a pound of butter today for 2 BTC if you could buy 10 pounds of butter for the same price in a couple weeks? Buy as little butter as you absolutely need today, and try to stretch it for as long as you can while deflation does it work. These two effects together in the end may lead to a deflationary spiral.

Why This Isn’t Happening

Note that this deflationary effect is only felt by those who are holding bitcoin. To everybody else, it's perceived and felt as appreciation relative to other currencies, a point which comes into play shortly.

Since the bitcoin economy is experiencing deflation, then according to this model you should see shrinking supply and demand for goods and services denominated in bitcoin. However, this is not happening. If anything, there are an increasing number of goods and services that are offering bitcoin as a payment option. And recently there’s been much ado about the size of bitcoin transactions, which would seem to indicate that consumers are taking advantage of these payment options.

In spite of deflation, the number of bitcoin-denominated goods and services is increasing because those good and services are being produced using dollars, not bitcoins. For example, when you order Chinese delivery on Foodler using bitcoin, you are not buying bitcoin-bought sesame chicken and crab rangoon. The Chinese restaurant is paid via Foodler in dollars, which it will use at a later date to buy chicken, sesame oil, and cream cheese to make their delicious dishes, as well as their profit. They never see a single bitcoin. Because of Foodler, the Chinese restaurant can operate being completely unaware of bitcoin’s existence, and yet you can still pay for their food using bitcoin.

It seems that the vast majority of companies accepting bitcoins follow this same pattern. The bitcoin-denominated goods and services that they sell are not produced using bitcoins. There is some other monetary and financial system at work outside of bitcoin that provides these companies the capital they need to produce goods and services. After they’re produced, the companies are free to accept bitcoin as payment, with prices determined by the exchange rate with USD or a similar currency. In this way they can still use the bitcoin currency while avoiding its deflationary downside.

Consider again your widgets from before. But rather than investing bitcoins to produce them, you invest US dollars instead. And once they’re produced, you’ll still accept bitcoin as payment. At the time of investment, the exchange rate is 1 BTC : $1 USD.

Before Deflation - 1 BTC : $1 USD

100 widgets × $1 / widget = — $100 USD total cost 100% margin = 200 BTC $200 USD total revenue 100 BTC $100 USD total profit

According to this table, you can hit your 100% margin target at a time when the exchange rate is 1 BTC : $1 USD by making 200 BTC in revenue, or $200 USD. But as before, deflation in the bitcoin economy strikes while you’re producing your widgets, and the bitcoin price you’re charging must fall. Assuming that the exchange market between BTC and USD is efficient, the deflationary effect should be accounted for in the exchange rate, which following the previous scenario would now be 1 BTC : $10 USD.

After Deflation – 1 BTC : $10 USD

100 widgets × $1 / widget = — $100 USD total cost 100% margin = 20 BTC $200 USD total revenue 10 BTC $100 USD total profit

Despite deflation in the bitcoin economy and the concordant fall in the bitcoin-denominated price of your widget, in this scenario you can still hit your 100% margin target by making 20 BTC, or $200 USD. Your USD revenue target remains unchanged even when there is deflation in the bitcoin economy, and because you’re measuring your costs, revenue, and therefore profit in USD, you can still make an economic profit by accepting bitcoins as payment.

With your newly-acquired bitcoins you can do with as you please. You can exchange them for USD and lock in your economic gain, or use them to speculate on the future value of bitcoin. As bitcoin is susceptible to deflation, the real value of those bitcoins is bound to go up, so you should probably hold on to them and join in on the speculation, as is likely the intention of most companies that are now offering a bitcoin payment option. However that means that you no longer have capital to build more widgets and the demand for widgets in the market will be starved of supply. Alternatively, you can acquire capital denominated in USD by other means, .e.g, other revenue streams you may have, debt or equity financing, etc. With that newly acquired capital denominated in USD, you can build more widgets, acquire bitcoin through their sale, and wait for deflation to run its course again.

It seems then that the increase in bitcoin-denominated goods and services is not due to the viability of the bitcoin economy. Rather, this increase is due to the fact that the bitcoin currency is operating along side an economy and financial system that’s capable of providing capital to fund the production of goods and services, as well as a stable currency in which economic profit is possible and can be preserved. Without that parallel system, the bitcoin economy would have to fund its own production of goods, which due to a deflationary spiral would eventually grind to a halt, causing the bitcoin economy to fail.

Final Notes on Transacting in Bitcoin

As bitcoin rises in value, there are two effects that should keep the bitcoins in your wallet when you’re shopping for goods and services. The first is the expectation that the value of bitcoin will continue to rise, and the second is the lag in prices to adjust to bitcoin’s new value. In times like this, it’s almost guaranteed that for any given good, its bitcoin price will be higher than its USD price, given the exchange rate.

Some people point out that deflation does not mean that you shouldn’t spend your bitcoins. Rather, it means that you should always maintain or increase the number of bitcoins you own. Thus, you’re free to use bitcoin in transactions as long as you immediately purchase new bitcoins using your dollars or your fiat currency of choice. This is true only in a model of the economy that is completely divorced from reality. For one thing, you pay a fee when you buy bitcoins with your dollars, so this currency dance will always leave you with less money than if had you just paid using dollars. Setting fees aside, this also assumes that there will always be somebody ready and willing to sell you as many bitcoins as you want to buy. In a deflationary environment where everybody is hoarding bitcoin, this is unlikely. The only reason to use bitcoin in this environment is for the anonymous transfer of value, where that is still possible.