Envisioning a Bitcoin Standard (Part II)

In part one, we discussed the effects and practical implications of a worldwide Bitcoin Standard.

We saw how the cryptocurrency's fixed supply would render useless Central Banks' efforts to guide the economy through the expansion and contraction of the money supply.

Without the indiscriminate buying from state agents -such as the Bank of Japan, which controls 75% of the ETF market in the country - stock valuations would deflate by a factor of perhaps 50%, obliterating retail investors and pension funds.

In this article, I would like to go beyond the points we discussed in part one, and attempt to gain a better understanding of economic activity under a deflationary currency like Bitcoin.

Bitcoin is deflationary because it has a shrinking circulating supply. In the beginning, people would burn thousands of Bitcoin at a time in the pursuit of activities with no clear economic incentive, such as recording the original Bitcoin whitepaper, or the script for the original Star Wars movie onto the blockchain.

Some chose to deliberately part with their Bitcoin, while others lost access to private keys containing what would be considered massive fortunes at today's exchange rate.

To be sure, the rate at which Bitcoin private keys are lost through theft or hardware failure, is likely to continue going down, as the currency becomes more valuable and more widely transacted.

Still, the circulating supply is virtually guaranteed to shrink over time, causing deflationary pressure on prices.

This is the first of two types of deflationary forces operating under a Bitcoin Standard: a supply-side contraction in the form of lost coins.

However, given the slow nature of this phenomenon (much less than 1% per year), we can probably discount it as being mostly harmless.

All things being equal, wage rigidity dictates deflationary price action for goods and services would outpace salary cuts, allowing for the maintenance of a new regime of marginally falling prices and wages, compatible with low to moderate unemployment.

It is the second category of deflation that poses a larger threat to the ideal of a Bitcoin Utopia: a demand-side glut in economic activity.

The Great Depression in the US is often cited as an example of a deflationary spiral. Following the debt-fueled excesses of the Roaring Twenties, people came to the sullen realization most of the growth had been illusory. The collective immune system known as the free market went through a period of shock, during which it purged malinvestments by businesses in the form of economically unsustainable enterprises built upon a foundation of debt.

Still, and while this ruthlessness might have been necessary for the survival of the patient, it doesn't play very well with our modern day sensibilities.

To be fair, rampant deflation is almost as bad as hyperinflation, but in all honesty, I don't think we'd even have price deflation anywhere near the degree of severity seen in major recessionary episodes over the past 100 years.

Take the 18 month period from January 1920 to July 1921, which saw double digit deflation in the United States. This glut in economic activity is know as the 'Depression of 1920/1921,' and is thought to have been caused by a surge in the civilian labor force following the end of World War I, combined with falling agricultural commodity prices resulting from higher production output in Europe.

The first thing to note, though, is that while price levels fell as much as 18% during this period, production output suffered a much less pronounced decline of 'only' 7%. In fact, prices fell more rapidly than during the Great Depression, but as you can see, production output did not fall as much.

Moreover, the collective folly known as the First World War was only possible through a temporary departure from the Gold Standard, and the issuance of debt.

Under a Bitcoin Standard, the Great War would have been over in no time, as depleted reserves for all belligerents would have precluded the continuation of hostilities in Europe.

German and French cities and agricultural output would have been spared, and with smaller scale mobilization, the labor market in the US would have more easily absorbed the influx of returning troops.

The same reasoning applies to the housing crash of 2007, as well. Hadn't the Government encouraged the mantra of home ownership at any cost, and provided virtual assurance to banks they'd be bailed out when the whole thing collapsed, the fallout from the Sub-prime mortgage crisis could have been easily contained.

Now, obviously, not all debt is bad. Since not all transactions settle instantly, and there's a delay between the time goods are supplied and payment is received, businesses often need to resort to loans in order to guarantee a cash cushion plushy enough to keep operations afloat in the short term.

A good way to make sure debtors are not unfairly punished, is to index the amount owed to the price of a basket of goods.

The US government already does this in the form of Treasury Inflation Protected Securities, for which the principal is adjusted to the Consumer Price Index used to measure inflation.

This system makes it fair for borrowers and lenders alike, and would likely be widely used under a Bitcoin Standard. It looks to me like a very elegant and mature solution to a serious problem, and one that would bring stability and prosperity to the world economy.

So, in summation, in this article I attempted to refute the common argument by 'mainstream' economists like Paul Krugman, that deflation is bad for the economy.

We saw how things like botched thefts and hardware failure causing people to lose access to their private keys would have a deflationary impact on price.

However, as Bitcoin continues to appreciate in value, the number of keys lost due to user carelessness is likely to go down asymptotically over the next few years.

Another issued we explored in this piece, was the dangers of a deflationary spiral resulting from debt-fueled speculative bubbles.

Most forms of economic distortions are caused by Central Bank interventionism and Soviet style top-down economic planning, so it's highly unlikely monstrosities like the Housing Bubble of the late 2000s would have been able to gain traction under a Bitcoin Standard.

Finally, and in order to protect borrowers, personal and business loans could be indexed to a basket of goods closely tracking the real rate of inflation/deflation in the economy.

I know I'm probably preaching to the choir here, but do you think the adoption of a Bitcoin Standard would be beneficial for the world economy?

If not, I'd be interested in hearing your reasoning as to why.

As always, thank you for taking the time to read this article. Please upvote this post if you found its content informative, thought provoking, or in any way useful.

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