Problems with Deflation

Whether a hard cap, like Bitcoin, or soft cap, like Ethereum, these caped inflation rates turn coins into extremely deflationary asset where eventually more coin will be lost per year than are created thus shrinking the total supply and exacerbate all the intrinsic problems with deflation exponentially, this will eventually leave such coins essentially illiquid, or perpetually unable to meet market demands for liquidity. In addition to the basic liquidity issues caused, deflation leads to a host of other problems including; making the first-in the best-off , as well as the rich richer, and disincetivizing use, while some of these issues have not been massively detrimental thus far and may have even helped increase early adoption, they are not necessary to the protocols and will disincetivizes further adoption compared to identical inflationary coins.

First off, the supply caps on crypto assets, whether soft or hard, coupled with the nature of crypto assets (the fact that wallets will be lost and/or coins burnt) mean that eventually these coins will have negative inflation rates. So what does this mean for the value of these coins? Well, while many people like to compare Bitcoin to gold, gold actually has a very consistent positive inflation rate on a percentage bases, averaging 1.55% over the last 12 years and gold production has grown relatively consistently over the last century. So if Bitcoin’s inflation rate isn’t comparable to gold, then what is a good comparison? Well there aren’t many deflationary assets for good reason, they become illiquid over time and thus can’t be used practically or transacted in freely. The closest (though problematic) comparison I can come up with would be a particular vintage of wine, which do tend to increase in price over time, as the total supply decreases, never the less the market for any particular vintage also shrinks until it eventually becomes completely illiquid in the hands of a small number of collectors. While many Bitcoin enthusiasts argue that this will not happen to Bitcoin since they can be broken down into infinitely small fractions, allowing the market to sustain liquidity, the problem with this argument is that it’s only true if we measure that liquidity using an inflationary asset such as dollars, the liquidity measured in Bitcoin will obviously be decreasing. So inevitable you are left with an ever greater number of people competing for an ever shrinking quantity of Bitcoin until it becomes unsustainable and something has to give, since the quantity of Bitcoin can’t increase the number of people interested in competing for it will have to give.

One thing that deflation does that has, thus far, been helpful to crypt is that it makes the first-in best-off, which has incentivized lots of people to buy in, with the hopes that they will be bought out at a later date, and has increased early adoption. However long term this is not sustainable as it would require that every new wave of adoption buy in at a higher price, and rely on the wave of adoption that comes after them for the value of their coins. Effectively this making the coin very similar to a pyramid scheme where finding the new actors to buy-in and bringing in the new stakeholders needed to increase the overall level of adoption becomes exponentially harder, since new stakeholders benefit exponentially less, thus making scaling the coin increasingly difficult.

This leads me to the first important benefit of inflation, which is to prevent the rich-get-richer effect where, without inflation, people who have money will automatically gain wealth by not investing it, while people who spend money will loose wealth even when they use their money to buy useful products. So whoever can go the longest spending the smallest percent of their wealth ends up the richest, and since the wealthiest by definition have the most wealth and thus need to spend the smallest percent of that wealth to sustain themselves the rich-get-richer. This obviously encourages people to stop; spending, making risky investments, or using their coins at all.

Thus lack of inflation disincentivizes adoption of the coin for its intended use, as the longer you can go without spending the coin the more it will be worth and the less you will have to spend giving rise to the HODL state we see in many coins. To illustrate this, let’s say someone has half their money in dollars and half in a coin and they have to pay for something, since there is a cost to acquiring the coin (conversion fees, time and effort, etc) they are better off saving the coin they have, since it will likely be worth more tomorrow, and using their dollars, which will likely be worth less tomorrow, to make payments. This means that the expected appreciation of the value of the coin, relative to dollars, is actually an additional cost that the user must pay to realize the benefits of the coin (such as privacy). However, were the coin to be inflationary at the same rate as the dollar then the user would have an incentive to always opt to use the coin, since they would achieve the benefits that the coin offered for free, and these benefits could even offset the costs of exchange encouraging the user to exchanging dollars into coins and then use the coin, when possible, instead of dollars. What this means is that while deflation may make the coin appreciate in value, relative to the dollar, this appreciation becomes a cost to transacting in the coin and is detrimental to the overall value of the system as well as adoption and use of the coin as anything other than a store of value.