Deflation Isn't the Savior
Inflation is the boogeyman of economics but deflationary currencies might just be trading one set of problems for another
Pretty much anyone who pays attention to economics (and most people who don't) have heard of the dangers of inflation. It's the boogeyman of economics, responsible for destroying savings, transferring wealth from the poor to the rich, and even destroying entire economies. For advocates of deflationary cryptocurrencies— like Bitcoin— inflation serves as an easy attack vector to compare the benefits of their coin to fiat. The argument follows the idea that deflationary currency works for the common man because it avoids the situation where a central authority can print new money out of thin air, inflating asset values and increasing the net worth of rich capital holders while eating away at the savings of the lower and middle classes. At first this argument makes a lot of sense and I have to admit it was one of the biggest selling points to me when I first learned about Bitcoin but as time goes on I began to question the validity of such claims. Are deflationary currencies really better or are they just historically more rare and thus we have less examples about their downsides to learn from?
Perils of Inflation
Let's first take a look at some of the well-known dangers of inflation. As inflation begins to rise the amount of goods you can buy with a given denomination of currency goes down which means if you have cash savings then you are technically losing money. Even if your savings earns interest, at say 2% per year (no savings account in the US is paying anything close to 2% interest), if the inflation rate rises above 2% you will still be losing money. Everyday items like food and clothing goes up in price but so do things like housing which means if you own real estate the paper value of your net worth actually goes up which is why many consider inflation a wealth transfer from the poor to the rich. Most land and stocks are owned by the richest individuals and these assets increase in paper value during inflation while the bottom and middle classes that do not own such assets and rely more on cash savings watch their life's work slowly disintegrate.
This dynamic works for the rich at lower levels of inflation but once inflation spirals out of control even the upper class isn't spared from its effects. Businesses close, black markets spring up using foreign currencies for transactions, creditors lose their investments, and social unrest rises as the entire economy crumbles under the chaos. You don't need to look very hard to find historical examples of inflation destroying economies and upending nations such as Germany's Weimar republic in 1923, Hungary in 1946, Yugoslavia in 1994, Zimbabwe in 2008, and Venezuela in 2016. In all these instances of hyperinflation the respective nation experienced massive turmoil, the effects of which can still be seen today. With stories of individuals needing to bring wheelbarrows of cash to buy a loaf of bread or a cup of coffee doubling in price by the time you started drinking it and the time you finished it's no surprise that people are concerned when inflation in the US hits highs not seen in 4 decades.
Even without hyperinflation detractors of central banking will point to the fact that since 1913, when Federal Reserve was created, the US Dollar has lost 96% of its value and 93% since 1946! Unless you've been buying stocks, real estate, or other inflation-resistant assets you have been losing an incredible amount of wealth over the course of your lifetime.
Crypto to the Rescue, Maybe
So Bitcoin and other deflationary cryptocurrencies offer a way out from this threat, so they claim. The advocates of Bitcoin extoll the benefits of owning a deflationary asset and the rhetoric often portrays it as a cure for the ineptitude of central banks and inflationary fiat.
At first it makes sense: with Bitcoin there is no central authority that can print new Bitcoin at a whim so a corrupt or inept government body can't print new money out of thin air at the expense of a nation's citizens. On top of that you don't even need to worry about having deep knowledge of finance to get investment returns higher than the rate of inflation. Instead, you can just take your Bitcoin and save it and not worry that it will lose 90% of its value by the time you are ready to retire! But if you trade a currency that inflates over time with one that deflates over time are you just trading one set of problems for another?
It's hard to find historical examples of hyperdeflation that rival that of hyperinflation but that doesn't mean deflation doesn't exist. Japan experienced deflation in the '90s and US history is littered with periods of deflation including big moments such as the Great Depression and more recently the Great Recession. In times of deflation consumption declines as people are less likely to buy something today when it will be cheaper to buy tomorrow or the day after and investments decline for the same reason which leads to a decline in production. If this feedback loop spirals out of control an economy can experience stagnation, destabilization, and turmoil just as it would with hyperinflation. So is a deflationary currency really safer? Let's think about this from first principles.
First Principles
Money has no intrinsic value. This is obvious because if you're stranded on a desert island with someone and you have a million dollars in cash but they have a one seated boat off the island they won't take your money. Instead money acts as a store of value for a specific group of people to transfer work over time. If all you can do is barter with others then any good or service that is bartered needs to be provided at the time of the transaction. You could say "I'll give you this now if you give me something later" but then you'd want to write down that they owe you something of specific value and now you've invented money. Money just a mechanism for letting people exchange their work done at one time for someone else's work done at a later time.
So if we understand the purpose of money as a mechanism for storing the value created for society at a specific point in time then how does that help us think about deflationary currencies? Well let's substitute money for work. If you build a house and sell it for $100,000 then you could say society has valued your work at $100,000. If within a year the currency deflates and that $100,000 has the same purchasing power as $200,000 used to then essentially that's society currently valuing your work done a year ago twice as much as it did back then. Is this actually a good thing? Housing might not be a great example because it's not a proper market, not in the US at least. If you plant 100 bushels of corn and then harvest them and sell your yield for a total of $10,000 but in 5 years that work has the purchasing power that $15,000 used to have does that make sense? Why should society value the work done to plant the corn 5 years ago more than it did back then? Surely planting corn today is more important than planting it 5 years ago!
If money just stores the value of work done at a given point in time then inflation actually makes sense as a logical mechanism because it encourages new work. A society where all the most valuable work was done in the past is a society in decay. Of course, inflation does not always mean there's progress and in fact the opposite could be true: a society that progresses fast should experience deflationary pressure as technology makes products and services cheaper. But if we control for technological innovation then doesn't it make sense for wealth to erode over time? Even if it doesn't erode significantly over the course of a single lifetime it should be largely gone by the time it reaches someone's great-grandchildren unless further work is done. I have trouble seeing how it's beneficial for someone's great-grandchild to coast on a pile of cash created from the work done generations before they were even born. With inflation, descendants have the option of accepting the deterioration of their inheritance over time or choose to invest that money and try to make returns that outpace inflation but in that case they are doing work by deploying the capital in ways they think will create the most value. With this framework of money as stored work inflation actually makes sense as a general long term trend for a money supply. Emphasis on long term because acute moments of hyperinflation definitely create more harm than good but it's not so clear when looking at gradual inflation over long time spans.
Perils of Deflation
So inflation is dangerous and while maybe deflation doesn't really make sense from a conceptual lens is it actually dangerous? History has many examples of rapid inflation destroying economies but can the same thing happen with deflation? Well, maybe. It is theoretically possible for deflation to enter into a feedback loop that spirals out of control when people stop purchasing goods, production slows to prevent oversupply, investments dry up because you can earn a better return by just storing the money, production then slows further, consumption drops further and the spiral continues. The difference, it appears, is that deflation has natural pressures working against it because once the value of a currency reaches a certain threshold consumption naturally would rise. After all, if suddenly you can buy a new car, a new house, the finest clothes, etc. then why wouldn't you? So deflation is unlikely to spiral out of control to the same degree as inflation but during periods of deflation in the US we have seen consumption drop which depresses the economy, lowers GDP, and overall reduces quality of life. With deflation people also become more speculative with their currency instead of using it. Inflation encourages people to use their money— to exchange their work for the work of others— sooner rather than later but deflation has the opposite effect: do some work now then wait as long as possible before cashing in for the work of someone else because the value of your work will be higher the longer you wait. So people become speculative with your nation's currency instead of just using it and investments likely decrease and the money that does flow into investments focuses on less risky assets because there's no inflation to outpace. So a deflationary currency may not blow up an economy in a wild spectacle (it still might) but it could be a long slow death as progress and innovation slows gradually.
Deflation also hurts poor people because as the currency deflates any debts you owe become more pronounced, the opposite of inflation. This also has the added effect of making government services financed by debt more expensive as time goes on which means it would be even harder to run government programs to help those who need them. Inflation is often touted as uniquely bad for the poor, and that may be true, but deflation isn't perfect either. The truth is that being poor is rough regardless of the monetary policies of a government and deflation presents its own challenges.
The Takeaway
It's not clear to me that purely deflationary currencies like Bitcoin or other cryptocurrencies present such a clear advantage over inflationary ones. It seems that regardless of whether the currency inflates or deflates over time it's better for everyone to keep the rate of change low. A currency should not deflate or inflate much over the course of a lifetime regardless of which direction it moves in. With that in mind it's probably easier to enforce a low inflation rate than it is to enforce a low deflation rate because even if the natural tendency of a currency is to inflate it still needs to overcome deflationary pressures of advances in technology, an increasing population, and the loss or damage of existing money supply. So which is better? Well, I don't know but I don't think it's as clear-cut as many people would have you believe. Perhaps the risks of hyperinflation outweigh the risks of deflation but if you want to build an economy on top of a deflationary currency it's important to recognize the potential downsides and take steps to protect against those effects.
Of course, this could just all be wrong. Economies are some of the most complex systems created by mankind and it's very possible that all this reasoning, whether from first principles or extrapolation from historical events, just doesn't hold up when applied to a large economy over a long time frame. It's also worth noting that the measures for inflation and deflation are all just approximations and the formulas used to track these metrics have changed over time and do not necessarily reflect all the prices that are necessary to survive in the modern economy. Cryptocurrencies prevent an opportunity to experiment with different monetary policies at large scales which will hopefully shed some light on the long term characteristics of different currency regimes so that one day we can arrive at a better understanding of what system works best for everyone.
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This essay was written with Praxis in mind and is the second in a series of essays where I explore foundational concepts related to building great societies. Praxis is a movement to found a new type of city that aims to fix many of the broken or stuck institutions we are currently experiencing in the West. If that sounds interesting you can read the founding philosophy and get involved. You can read the previous essay in this series here and follow this newsletter or my Twitter for any future essays.