Bitcoin and the Dangers of Deflation

Another common criticism that is leveled against Bitcoin is that, since the total number of bitcoins is capped at 21 million, their value will continually increase and nobody will actually want to spend them, making the currency useless (or worse, leading to dangerous deflation).

This argument relates to the economic concept of Keynesian economics,[1] which maintains, among other ideas, that frequent injection of new currency into the economy helps promote its growth. Regarding Bitcoin, Keynesians will argue that the inability of governments to print more currency units would seriously damage economic growth.[2] They contend that the scarcity enforced by Bitcoin's cap would drive nominal deflation, which is when the price of everyday goods denominated in bitcoins would drop over time, causing the circulation of the currency to freeze up and forcing the economy into a depression. The rationale is that individuals would postpone their purchases in anticipation of lower prices for goods in the future.

Bitcoin supporters counter the Keynesian arguments with ideas based in the philosophy of Austrian economics. This economic philosophy argues, among other ideas, that the price of a unit of currency has the ability to adjust appropriately on its own, guaranteeing that purchases and savings in an economy will remain at desirable levels, no matter how many units of currency exist at any point in time in the economy.

Bitcoin and Government Stability

Some contend that a successful Bitcoin system would be harmful because it could destabilize governments. It has been debated that Bitcoin is part of a larger movement, recently termed radical decentralization, which maintains that all decentralization (including the functions of the government) is desirable and possible. This idea is a direct extension of the philosophies of Friedrich Hayek, who reasoned that local control is usually preferable to central control, because local people have more knowledge about local conditions and can therefore behave more efficiently in most situations. However, it is true that governments benefit from having control over their currency supply. Governments encounter challenges when they attempt to raise funds via direct taxation, and printing money to fund government projects is known as "taxing by inflation," which is both easier for governments to do and harder for citizens to stop. The loss of this means of raising money for government projects (including military defense) could reduce the financial viability of some governments.

However, Bitcoin is not the only recent technology that is decentralized by design: BitTorrent, Gnutella, Tor, and Freenet are similarly immune to central control. Clearly, computers allow us to explore the idea of decentralization, and its merits and potential faults, in ways that were not possible before the Internet revolution. Many of these decentralized systems were thought to pose risks to government stability (especially the Internet in countries with oppressive laws against free speech), but we accepted them anyway due to the enormous benefits they brought to society. The loss of control by governments, in the case of the Internet, was compensated (and then some) by increased economic productivity. Computer engineers are continually pushing the boundaries of what's possible with decentralized networks, trying to drive financial contracts (such as software projects like Ethereum[3]) or communication systems (such as Bitmessage[4]) toward decentralized systems as well. Only time will tell what kind of impact these systems will have on governments, good or ill.

In the next chapter, we'll explore some of the underlying technology in Bitcoin in more detail, starting with Bitcoin cryptography.

  • [1] Named after John Maynard Keynes, the economist who is most strongly identified with this particular approach to monetary policy
  • [2] One well-articulated version of this argument is given by Paul Krugman in the article "Bitcoin Is Evil," New York Times, December 28, 2013, 12/28/bitcoin-is-evil/.
  • [3]
  • [4]
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