NOTE: This is the third in a series of articles on Bitcoin and inflation. Part 2 can be found here.
Throughout history, inflation in government money has caused hardship in families and communities, and even led to the overthrow of governments and entire societal orders.
Bitcoin was intentionally designed to reject inflationary pressures. A programmed distribution schedule and maximum supply cap ensure that one Bitcoin never feels like it’s shrinking as it sits in your wallet. That no single entity can change these rules without community support ensures that the system is resilient to bad ideas and reactionary politics.
But Bitcoin doesn’t merely resist inflation. It experiences deflation.
“Deflation,” in economics, describes a general decline in the price of goods. If a dollar can buy you more next year than last, that’s deflation. Another way to look at deflation is that, due to macroeconomic conditions, the value of a single dollar went up.
Nobody uses Bitcoin to buy things like gas and milk, but its value does rise and fall due to certain economic conditions. Unlike with dollars, though, the forces which act upon Bitcoin (and independent of other market forces, like speculation and general sentiment) tend to cause its value to rise. Some of these deflationary forces are design features in the network, and others are unexpected consequences of human nature.
Here are a few of the reasons why Bitcoin’s value might rise, simply due to how the system works in the first place:
- Maximum Supply Shrinkage
In 2013, James Howells–a programmer from the small city of Newport, Wales–found a lonely hard drive in a drawer at home.
He hadn’t even realized it was still around, until just now. It was the drive for his old computer. He’d spilled liquid on that computer way back, and then dismantled, threw out, and replaced it. For whatever reason, evidently, he’d decided to keep the drive.
At this point, he couldn’t think of a reason to keep it around. Heck, he hadn’t used it in years. So, like many of us would in his position, he tossed the thing in a bin.
“As soon as I put it in the bin at home,” he told the BBC, “I had a second thought, in the back of my mind: ‘You’ve never thrown a hard drive out before, why start now?” It was a nagging thought, a “demon in the back of my head sort of thing.” Still, he couldn’t think of a logical reason to keep it. So he didn’t.
Just a few weeks later, Howells read about a man from Norway who’d made a small fortune selling old Bitcoin he’d purchased years earlier. Howells remembered that he used to mine Bitcoin, so he went and checked how the price changed in the years since he’d left. The price, he discovered, had gone up exponentially.
James, who’d owned 7,500 Bitcoin, was now a millionaire.
But, of course, the account key that would allow him to redeem those Bitcoin was located on the hard drive he’d thrown out. Now, that drive was buried three to five feet deep, possibly destroyed, in a landfill about the size of two football pitches.
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Howells is hardly the only person with such a story. Stefan Thomas, a German programmer, owned 7,002 Bitcoin, stored on a hard drive called an Iron Key. The problem? He’d long since misplaced the sheet of paper where he’d written his password. Earlier this year, the New York Times interviewed Stephen. At that point, he had just two more chances to guess his password before the drive wiped itself.
(image by The New York Times)
You don’t see this kind of thing with government money, because most people store their cash with institutions that keep careful track of it. Your bank will almost certainly not lose count of how much money you own, and, even if you forget your bank account login credentials, you can use other forms of identification to retrieve access.
Bitcoin can be stored with middlemen, like banks and exchanges, but cryptocurrency middlemen have a history of cybersecurity failures and outright fraud. Plus, really, Bitcoin was created with the express purpose of eliminating such entities. That’s why sophisticated cryptocurrency users usually opt for “cold” storage: hardware devices that store private keys (access credentials), allowing them complete control over their funds.
Having full, unilateral control of your Bitcoin is useful, unless you’re prone to losing or throwing things out. Then, there’s no one to bail you out. The record of all that Bitcoin still exists on the public ledger, but nobody will ever be able to actually access it.
According to Chainalysis, a blockchain research group, around 20% of all Bitcoin ever minted is sitting on irreversibly lost or otherwise abandoned digital wallets. As of this writing, 20% of Bitcoin would equate to around 155 million dollars in value.
In a practical sense, then, Bitcoin experiences constant deflationary pressure. Every time somebody loses their password, or seed words, they permanently decrease the effective circulating supply of Bitcoin. People will never stop losing things, and so we can expect supply to slowly decrease over time.
As supply decreases, of course, Bitcoin becomes more scarce. All other things aside, this should increase the value of any given Bitcoin remaining in circulation. It’s as with any other good or service or currency: when there’s less BTC to bid on, buyers must compete more fiercely for what is available, which tends to drive up prices.
This price behavior should not be overstated, though. Expect deflation to slow significantly over time, in reverse proportion to how valuable, decentralized and mature the network becomes.
Think of James Howells. He might’ve only needed a few hundred dollars to accumulate 7,500. Nowadays, he’d need hundreds of millions. So we’re long past the point where ordinary people can accrue –and then lose–such a significant total on their own. Furthermore, it’s unlikely that Howells would’ve tossed his hard drive in a drawer and forgotten all about it had it been worth lots of money at the time. Anyone who owns any amount of Bitcoin today will likely be much more careful about where and how they store their private key data, because Bitcoin has become so valuable.
There are actually a whole host of technical, theoretical, and mostly unlikely ways in which Bitcoin can be lost to the market. But there’s one particular behavior most Bitcoin users take part in every day which, though not literally, has the effect of taking Bitcoin off the market:
To “hodl,” in crypto parlay, is to hold onto your investment assets for the long-term – no matter how everybody else reacts to market volatility, breaking news or market sentiment. Throughout history, almost without fail, it has been more profitable to buy and hold – hodl – Bitcoin than to sell it. For all but the most sophisticated, active traders, this strategy has paid dividends. Those who haven’t held their BTC have paid the price.
(image via u/arijitdas)
As BTC’s price has continued to rise over time, rewarding hodlers, more and more people have bought into BTC, and into hodling. As evidence, check out the following chart:
(image via Glassnode)
According to this data…
- The number of traders and short-term investors has stayed surprisingly consistent in the past decade, despite BTC’s immense growth
- The number of long-term hodlers has increased at a steady clip
- Following from a) and b), it appears BTC’s rate of growth has been driven, almost exclusively, by the hodlers
Hodlers have been the driving force behind Bitcoin’s rise in price over time, not simply because they represent the majority of new buyers in the market. It’s because they interact with Bitcoin in a characteristically different way than short-term holders do.
Traders and intermittent buyers go with the winds–they buy and sell and take profits and cut losses on weekly, daily, hourly bases. Their BTC is liquid.
Long-term investors buy Bitcoin, then hold it indefinitely. The term for this, in crypto parlay, is “strong hands.” Even if BTC is up or down–or way up or way down–hodlers hodl.
In effect, hodlers remove supply from the market. Almost like James Howells and Stefan Thomas. And because hodlers are the part of the Bitcoin community that’s been growing this whole time, more people are removing more supply from the market every year.
This is the exact opposite of how money usually works. Governments only ever multiply the supply of cash, causing the value of a single unit to erode over time. Bitcoin’s supply shrinks de jure–through lost wallets–and de facto–through increased hodling activity–over time, causing scarcity and, in turn, demand for any one unit to increase over time.
(image via u/CryptoBull80)
- Market Psychology
Have you ever lied in bed, trying to fall asleep, and the anxiety of not falling asleep kept you up? Or have you ever been so worried about a presentation at work that you end up causing yourself to mess up?
Often in life the mere expectation, the anticipation of an event actually makes that outcome more likely to occur. This is especially true in markets.
Consider, for example, one of the worst economic crises in U.S. history.
It was the 1970s. Watergate, the Vietnam War, Jimmy Carter. Americans were rollerblading at discos and lining up to see “Star Wars,” and, all the while, watching their money vanish in their hands.
(image by Federal Reserve History)
The dollar had always experienced inflation, but not quite like this. 6% one year, 11% the next. From 1979 to 1981: 11.25%, 13.55%, 10.33%. If that doesn’t sound so terrible, consider this:
- A car which cost $10,000 in early 1979 might have cost $14,000 just three years later.
- A $10,000 car in 1972, rising with inflation, would have cost $23,000 by 1982.
There were all kinds of macroeconomic factors that fed the problem. Monetary policy also played a role in inflation, as a succession of Federal Reserve Chairs – all too willing to kick the can down the road – kept borrowing costs down and money supply multiplying. More than anything else, however, what drove the worst period of inflation in U.S. history was expectation. How people reacted to what they saw, heard and experienced. Why?
Just imagine living at that time. The cost of everything in your life is going to be higher next year – next month, even – than it is today. What do you do?
You might assume that inflation causes people to buy less, because with the same amount of money they can’t get as much. In fact, the opposite is true. If you know something you need is going to be more expensive later, you’ll be motivated to buy it now. If you know something you might need is going to be more expensive later, you might buy it now, just in case.
Thus, in the ‘70s, as prices went up, more people bought more things, in anticipation of prices going up even more, thereby exacerbating the very thing they were concerned about.
The chain reaction extends even further than that, though. In an interview for NPR’s Planet Money, Paul Volcker – the Fed Chairman who, ultimately, solved the crisis – described a conversation he had with a business owner at the height of the crisis.
“He said: I just had a wage negotiation with my workers, and I agreed to give them a 13% increase for the next three years. Each year for the next three years ’cause that’s what I think inflation’s going to be. That was one reflection of the mood at the time.”
Now, how does this all relate to Bitcoin?
Bitcoin, as with any financial market, is subject to the guesses, emotions and impulses of human beings. People are more likely to buy more Bitcoin if they think it’ll be more expensive in the future, and less likely if they think it’ll be cheaper, whether what they think accords with reality or not. Remarkably, what people believe is going to happen often does happen, simply because of how they act on those beliefs, like Americans did in the ‘70s.
Let’s consider two examples where people’s expectations about Bitcoin’s rising price end up causing Bitcoin’s price to rise.
Consider the reason you’re reading this article now – why you became interested in Bitcoin in the first place. Was it out of a deep interest in byzantine fault tolerance, merkle trees, and cryptographic proofs? Or did you see how Bitcoin has made people rich – how it’s surpassed every other investment asset of the past decade?
When you see Bitcoin become more valuable, you become interested. You want to buy some before it becomes even more expensive, so you end up contributing to it becoming more expensive. The cycle compounds itself as more and more people have the same train of thought.
Of course, this pattern goes both ways. When some people start to become bearish about Bitcoin, it can cause an avalanche. But because, historically, Bitcoin has only risen in value in the long term, this self-fulfilling price action tends to apply more often in the upward rather than the downward direction.
This line of thinking applies to nations as well as individuals – countries around the world have historically stored their wealth in US treasury bonds. Knowing what you know about dollar inflation versus bitcoin deflation, now, would you want to be the first country to start converting some of those treasury bonds to bitcoin or the last? Where will the price of Bitcoin go if and when a dozen countries are hodling Bitcoin?
Because Bitcoin isn’t run by any government or company, its users have to process the transactions, provide security, and so on. Those users are rewarded for their work – “mining,” as we call it – with newly minted Bitcoin. New Bitcoin is generated for this purpose every ten minutes.
With every 210,000 blocks in the blockchain – a number reached every four years or so – those mining rewards halve. We refer to this semi-annual event as a “halving.”
When the mining reward halves, it means there’s going to be fewer Bitcoin to go around. People will have to barter over less. When equal demand chases less supply, the value of the coin in question rises. And, indeed, Bitcoin has always made tremendous gains in and around the point of halvings.
(image via Cointelegraph)
The value of Bitcoin tends to rise not just at the time of a halving, or after it, but even before it occurs. The reason is that, because everybody knows it’s coming, anyone can prepare by scooping up their own piece of a soon-to-be slowing supply. (Really, in theory, the value of Bitcoin at any point in time reflects expectations for every halving that will ever occur, because we can predict the time and effect of each one.)
In this way, again, people’s expectations create the very conditions under which those expectations come to be. People think Bitcoin will be rarer, and therefore more valuable, so they buy more of it for themselves, thereby making it rarer, and therefore more valuable.
The Bottom Line
So, now, we have two broad, opposite forces at play:
- Steady but declining inflation
- Declining yet surprisingly significant deflation
Now that we understand how Bitcoin experiences inflation, we must ask why. The system was built intentionally–designed with certain ideas and goals and philosophies in mind. Did the creator, Satoshi Nakamoto, intend for Bitcoin to be so complex? Why did he design it this way? Is it optimal? And can we change it?