THIS week's Free exchange column looks at some of the monetary economics of Bitcoin. One of the funny (and telling) things about Bitcoin is that its basic technical details are sufficiently complicated that every piece on the subject must begin with some sort of explainer. For that, let me direct you to a companion piece to the Free exchange, which looks at Bitcoin as a technological platform.

Bitcoin is really quite ingenious and elegant, but it has all sorts of basic flaws that make it an unlikely candidate for world domination. The Free exchange focuses on one in particular: limited supply.

The currency’s “money supply” will eventually be capped at 21m units. To Bitcoin’s libertarian disciples, that is a neat way to preclude the inflationary central-bank meddling to which most currencies are prone. Yet modern central banks favour low but positive inflation for good reason. In the real world wages are “sticky”: firms find it difficult to cut their employees’ pay. A modicum of inflation greases the system by, in effect, cutting the wages of workers whose pay cheques fail to keep pace with inflation. If the money supply grows too slowly, then prices fall and workers with sticky wages become more costly. Unemployment tends to rise as a result. If employed workers hoard cash in expectation of further price reductions, the downturn gathers momentum. Bitcoin’s money supply is still growing; its miners are just over halfway to producing the total possible number. New coins will be minted until around 2030. Miners may then introduce transaction fees as compensation for their critical verification work. More worryingly, deflation is already a reality. Soaring demand for the currency is partly responsible for boosting its price (therefore reducing the price of everything else in Bitcoin terms, generating deflation). But the knowledge that supply is ultimately finite is also a factor. That other currencies remain the medium of account has so far been the Bitcoin economy’s saving grace. If Bitcoin matured into a complete currency, with large numbers of workers using it as their medium of account, then its inflexibility could bring economic havoc. Money-supply “shocks”, like the disappearance of Mt Gox, could set off a systemic collapse. Given a loss of faith in exchanges, users might withdraw their coins in a panic, leading to a dangerous decline in transaction volume. Such hoarding could threaten Bitcoin’s status as a medium of exchange, leading to its complete demise as a currency. Reputable exchanges with large institutional holdings could help stem such panics by advertising a willingness to sell their Bitcoins to meet liquidity demand. Yet because Bitcoin reserves are finite, users may not find the promise credible. By contrast, central banks with the inexhaustible resources of the printing press face no such inconvenient constraints.

What is interesting to me is that the supply cap is by no means a critical part of the system's inner workings. In the original white paper on the currency, Satoshi Nakamoto muses that supply could be capped to prevent inflation, but he (she? they?) does not at all insist that it must be. Money supply implications aside, the cap will challenge Bitcoin's basic business model, since the "miners" that encode every transaction in the currency's permanent record are now compensated for their work with new coins—through seignorage, effectively. And since the cost of that seignorage is spread across every outstanding Bitcoin, transaction fees in the system remain very low. That will change once miners switch to transaction fees as the main mode of compensation.

The cap is even weirder since a fixed supply isn't remotely necessary to keep inflation in check. Bitcoin already has a built in mechanism to limit supply, which is the difficulty of the proof-of-work task miners are required to complete to get their new Bitcoin. At the moment, the difficulty is adjusted so that one new block (a unit of verified transactions added to the "blockchain", which is the system's permanent record) is created every ten minutes, but it could conceivably be adjusted to mimic any monetary policy rule you like. What's more, the idea that modern central banks with their loosey-goosey printing presses have generated an epidemic of inflation is a little nuts; if anything, rich-world central banks have become too effective at protecting the value of their respective currencies.

It is true that 1.5% inflation per year is not nothing. Bitcoin conceivably offers an entirely inflation-free place to park resources. But what should be clear now is that the inflation central bankers generate is buying the economy something. It's buying resilience in the face of economic shocks; if Bitcoin actually were the unit of account in a Bitcoin economy, the Mt Gox turmoil would have generated a deep depression. It's buying the promise that when your bank is robbed the government will make you whole.

That's an important point, because if Bitcoin is going to grow it is going to need to grow dependable banks and exchanges. The overwhelming majority of consumers in an economy will not be bothered to learn the details required to safely store their Bitcoin in a wallet on their personal hard drive. But if you're going to have central exchanges you're going to have liquidity risk, you're going to have guarantee schemes, and you're going to want the flexibility of supply needed to keep such systems afloat.

The cap can be adjusted or eliminated altogether, as it happens. All that's needed is a change in Bitcoin's software, which is then "ratified" by miners representing more than half of the system's computing power. One might say that whether or not the system takes that decision, or is capable of taking that decision, will determine Bitcoin's potential as something more than (as the Free exchange says) Mastercard for geeks.

In the meantime, existing central banks may ultimately explore the use of cryptographically protected digital money as a replacement for existing currency forms. As they should; Bitcoin transfers are cheap, relatively fast, and secure. While richer economies are considering such steps, which could prove to be Bitcoin killers, it will be interesting to see if Bitcoin takes off in markets that do not have credible central banks capable of keeping inflation in check (or credible banks capable of not losing and/or stealing depositor money). Infrastructure limitations will be a problem in many places, but Bitcoin is a much more obvious solution to monetary woes in the developing world than elsewhere.