Bitcoin is Deflationary, Inflationary, & Both/Neither
“Bitcoin is deflationary.” No, it isn’t. Stop saying that. The truth is complicated, and this article is going to break it down into three easy-to-understand chunks by exploring the way “time” affects the economic “view” of Bitcoin’s supply.
Let me just say: explaining Bitcoin is hard.
There’s a real temptation to try and compare Bitcoin to real-world analogues — to apply skeuomorphic and familiar thinking to something that is decidedly not rooted in the “real” at all.
For instance, because it involves “mining” or “minting”, one might think of it as digital gold just waiting to be discovered by a lucky few.
Or compare it to cash by focusing on its transactional utility: the ability to treat it as a currency and trade things for it.
Or even as a store of value due to the apparent preservation (and even increase) of any invested monies over time.
Maybe it’s closer to a speculative investment, or a glorified bet. Or maybe when you look deeper you might find rational counter-arguments for any of the assertions above.
But if you think there’s controversy just in explaining what Bitcoin is, wait until you try to understand its economic model.
Because inevitably, when someone is trying to explain Bitcoin, they try to tell you it’s special because it’s deflationary.
C’mon. Lots of stuff is deflationary. That’s not special. The gold standard is deflationary, after all.
And even saying Bitcoin is deflationary is a half-truth at best.
Bitcoin can do something — be something — that neither gold nor the U.S. dollar are: it can be deflationary, inflationary, & disinflationary all at once.
Talking with The Bitcoin Community
I dropped a question on the Bitcoin Talk forums: “Why is deflation considered to be an admirable feature of Bitcoin?”
Given that we’ve seen other cryptocurrencies & blockchains that have inflationary models still “succeed” in the sense of having transactional value, why is deflation considered an admirable feature of Bitcoin?
In virtual world economies we know that closed supplies inevitably lead to mudflation, unsustainable pricing, and rampant speculation (Koster, et al).
How much did the deflationary model contribute to Bitcoin’s shift to store-of-value?
Was the whole premise of starting Bitcoin under a deflationary model based on an economic fallacy in the hopes it would encourage valuation?
Several pages of responses later I had a big takeaway: my original question was rooted in a bit of a false premise that Bitcoin was even a deflationary cryptocurrency.
The community members had a vigorous debate demonstrating why (and why not), with evidence (and counter-evidence), that Bitcoin’s model was:
- (None of the Above)
And all of those are true — sort of.
It just depends on which point of time you’re looking at Bitcoin from.
Is Bitcoin Inflationary?
Bitcoin doesn’t seem inflationary on the surface because the purchasing power of each Bitcoin, over time, has measurably increased.
However, Demelza Hays, in her article “Why Bitcoin Is Technically an Inflationary Currency — Even Though Its Purchasing Power Is Increasing,” makes an excellent counterpoint.
While the common definition of inflation is that of “a general increase in prices and fall in the purchasing value of money,” the traditional economic definition of inflation is about an increase of a currency’s supply.⁴
And yes, today, right now, when this article is being written, Bitcoin is experiencing inflationary growth.
Every 10 minutes, on average, a Bitcoin “block” is mined, and this rewards the miner with 6.25₿.
Bitcoin ex nihilo — money from nothing
This block-by-block Bitcoin reward isn’t taken from other miners, and isn’t part of any other transfer of value within the system: it’s created from thin-air and assigned to the miner.
Just like how a U.S. bank “creates” money by recording loans on their balance sheets, Bitcoin is just adding numbers to a massively distributed accounting ledger.
Instead of the centralized Fed watching bank activity and setting rates, the Bitcoin community has adopted automated consensus protocols that verify a block’s validity and accept that a miner has gifted themselves a reward of completely new Bitcoin.
Thus, the Bitcoin supply is increasing. Every 10 minutes.
And because the supply is increasing Bitcoin is currently an inflationary currency.
Is Bitcoin Disinflationary?
“But hold on then, if Bitcoin is demonstrably inflationary, how can it be disinflationary too?”
Let’s look at the common definition of disinflation, at least, the one most used by the Fed in order to explain market conditions and try to calm the masses.
The key takeaway here is that disinflation is a temporary reduction in the rate of inflation.
If we accept that Bitcoin’s is inflationary because it has a “reward schedule” that increases its monetary supply, then we must also accept that it’s disinflationary because that “reward schedule” is programmed to decrease itself over time!
Look at this chart showing the historical rate of inflation of Bitcoin. Notice anything about the inflation rate? Do you see those sharp downward spikes in the blue line?
Each of those downward drops correlates strongly with the “halving event” of Bitcoin, where, every 210,000 blocks (~ every 4 years), the miner reward per block is cut in half going forward.
When Bitcoin began, it was 50₿. Around four years later: 25₿. Then 12.5₿. And currently 6.25₿.
Sometime around March 18th, 2024 the reward will halve again to 3.125₿.
(Coincidentally, extremely strong upwards price increases have also correlated with those halving events.)
Because the rate of supply inflation is decreasing over time, Bitcoin is also a disinflationary currency.
Is Bitcoin Deflationary?
Well, yes. And no. It is right now. Or at least, it will be.
This is the Schrödinger’s cat of Bitcoin economic analysis.
Deflation as an Increase in Purchasing Power
In common usage an increase in a currency’s purchasing power correlates with deflation. (Forbes)
Bitcoin’s purchasing power — or price in USD — has risen from $0.0009 in 2009 to around $21,115 in November, 2022. Wow! We’ve certainly come a long way from Martti Malmi’s sale of 5,050₿ for just $5.02 USD.
Just from a test of purchasing power over time Bitcoin meets the simplest criteria for being a deflationary currency, today! Right now!
But what if we look at it through the same lens of Demelza Hays’ work that we applied to inflation and disinflation, using the traditional definition about the supply of the currency?
It has increasing purchasing power (which could be explained purely by speculation), but Bitcoin isn’t deflationary in its supply.
From Disinflation to Deflation
One day the halving of Bitcoin’s reward schedule will end, because the fractional decimal point will get so small that it rounds to zero.
That’s the uncharted territory: the great unknown. What happens then? Will transaction fees be enough of an incentive for the miners to keep mining without direct rewards per block?
(Note: by this point miners will already be relying on transaction fees due to the extremely small block rewards, so there will be many years for the sentiment to shake out.)
It’s at this point though, that we transition from Bitcoin being disinflationary to something… else.
Deflationary by Design or None of the Above?
Satoshi Nakamoto, the creator of Bitcoin, proposed that Bitcoin would eventually have a fixed supply of coins, and thus transition to being completely disinflationary.⁵
Or did he?
“Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.” — Satoshi Nakamoto, on Bitcoin’s Deflationary Model
His words was quite distinct in the original white paper: “inflation free.”
Is that the same as deflation? If a supply isn’t changing one way or another, neither directly inflating or deflating, is it deflation? Or is it simply a fixed supply?
Will Bitcoin truly become deflationary if it’s supply of 21,000,000 coins is forever fixed in place?
Deflation as a Practical Consequence of Forgetfulness
There’s a simple argument that Bitcoin will become deflationary because the moment someone loses their private keys that means that a certain sum of Bitcoin has been forever “lost” from the system.
This illustrates the difference between the “circulating supply” and the actual supply, since it’s not like the coins themselves have actually been deleted.
For instance: Bitcoin can even be sent to addresses that no one actually has a private key for, a process known as “burning.” That means unless someone makes a near 2²⁵⁶ : 1 shot in the dark at guessing the right magic number then those Bitcoins are lost forever, too.
So, as a practical matter, yes. Bitcoin can deflate.
In fact, Bitcoin already has deflationary pressures on it being caused by the loss of “access” to Bitcoin. The overall supply of 21M coins won’t change, but Bitcoin would already “be deflationary” today due to the various losses of access to private keys and wallets — if not for the ongoing inflationary reward schedule that’s increasing the overall supply.
But belief in Bitcoin’s deflationary end game is strong. Perhaps it even explains the correlation of purchasing power to reduction in mining rewards we’ve seen over time. Maybe the community finds the eventual “deflationary” event credible.
In short: Bitcoin WILL be deflationary, it’s just not deflationary YET.
The way we think about Bitcoin’s economics — whether its inflationary/deflationary/disinflationary — really depends on the timeframe and economic definition we’re considering.
Sure, there are other dimensions, such as considering the circulating supply versus the total supply, and in the previous segment I readily accepted that Bitcoin can only be deflationary if we consider the “loss of access” as actually affecting the supply.
If we focus on Time & Supply as the primary dimensions to analyze, then Bitcoin is, right now:
- Inflationary (due to its reward schedule)
- Disinflationary (due to the halving of its rewards)
And in the year 2140 CE Bitcoin will transition to being:
- Deflationary (due to the end of its inflationary pressure and the continuing loss of access to coins through mistakes or intentional “burning”).
BUT! If you consider other dimensions, like Purchasing Power, well, now Bitcoin is suddenly deflationary!
Perhaps the best thing to call Bitcoin, since it seems to be so many things at once while being none of them at all, is: -flationary.
Bitcoin is just… -flationary!
- Dirk G. Baur, Lai Hoang, “The Bitcoin gold correlation puzzle,” Journal of Behavioral and Experimental Finance, Volume 32, 2021.
- Peetz, Dietmar and Mall, Gregory, “Why Bitcoin is Not a Currency But a Speculative Real Asset”. 2017.
- Baur, D.G., Dimpfl, T. “The volatility of Bitcoin and its role as a medium of exchange and a store of value.” Empir Econ 61, 2021.
- Hays, Demelza. “Why Bitcoin is Technically an Inflationary Currency — Even Though Its Purchasing Power is Increasing”.
- Nakamoto, Satoshi. “Bitcoin: A Peer-to-Peer Electronic Cash System”.