A few days ago, ex-Bloomberg columnist and rabbit-lover Noah Smith published an article titled “Economic misconceptions of the crypto world”.
I hold Noah Smith in high regard and encourage you to read his piece here.
Here’s the top-voted comment in Noah’s article:
You’re wasting your time arguing with these dudes on twitter though. They think they’re making economic arguments but in fact they’re making religious ones. And you cannot hope to disabuse them, for you cometh not into the House of Coin a true believer.
Actually, I agree with Richard a fair bit. I’m a believer in Bitcoin and am fascinated by the broader crypto space. Though there are excellent folks in crypto—as with most spaces, except MMT—it is true that religious and moral arguments are prevalent in the mainstream debate. That’s not a bad thing per se, but such arguments must be distinguished from economic ones.
Hence, in the spirit of nuance and productive discussion, I’d like to bring up some economic arguments for the anti-crypto world to read. The scope of this piece will be limited to Noah’s propositions on Bitcoiners’ misconceptions. It’s a good place to start before getting into the broader crypto space.
Noah, Point 1: Bitcoiners believe that Bitcoin should replace the dollar since the dollar is inflationary. But Bitcoiners forget that cash isn’t savings.
If Bitcoin actually did become the currency of the land, and its value rose year after year, that rising value would represent a transfer of real resources to people who sit on cash and do nothing at all with it. And where do those real resources come from? Well, they must come from productive workers and companies. So the world Bitcoiners imagine is a world where productive workers and companies are subsidizing the lifestyles of cash hoarders.
That doesn’t sound fair. And it’s not economically efficient either. Economists argue back and forth over whether the optimal rate of inflation is 0 or some small positive number, but you will find very few who argue that the optimal rate of inflation is negative.
As Noah pointed out, the argument that “Bitcoin should replace the dollar because the dollar is inflationary” has moral dimensions to it. I don’t want to get into that. Rather, my proposition is this: it doesn’t make sense to dismiss Bitcoin as a currency purely because it is deflationary.
In the future, should Bitcoin become one of the world’s reserve currencies, it could very much still be good currency, provided that it yields low and moderate deflation.
Stanford Economist John Cochrane’s 2014 classic shed light on deflationary concerns being overblown. Disclaimer: Cochrane does not believe that Bitcoin is good money, but I highly respect his analysis. Relevant points from his article are below:
Should deflation be moderate,
The sticky wage concern, where increasing real wages can cause unemployment and market inefficiencies, won’t realistically be a problem.
Debt payments aren’t an issue provided that the government runs moderate surpluses (as it should but never does). So, in a future where Bitcoin the currency is deflationary at 2% per annum, the government can owe Bitcoin and pay back its debtors.
The evidence suggesting that deflationary concerns are overblown does not end there. A 2005 working paper from Rutgers Economist Michael Bordo and Stanford Economist Andrew Filardo made the following very clear:
Deflation was historically viewed in a much more positive light. Conventional wisdom today about deflation being bad is drawn from “a more limited focus on deflation in Japan in the 1990s and deflation episodes in the Great Depression”.
Deflation can be good if it’s supply-driven (technology, productivity, etc.), and if people consistently see moderate deflation accompany real growth, all can be well. On this note, as Investment Manager Lawrence Lepard points out, inflation targeting in the current age is like fighting against the tide. We are trying to run a monetary system which must inflate in a world where technology is inherently deflationary.
The debate surrounding inflation targeting should be opened up to moderate deflation.
All this points to a simple narrative: if Bitcoin the deflationary currency becomes a reality, people will not necessarily stop considering riskier assets. Or stop spending. When you go to a McDonald’s to buy a burger, is inflation/deflation the thing at the forefront of your mind?
Noah also repeatedly brings up the idea of “freebies”.
If money earns a positive real return over time, that return doesn’t represent a reward for hard work done; it represents a freebie. A handout. In economic terms, this is called “rent”.
Firstly, however, if the freebies are small, it isn’t really a problem. We have just cited economists who said that moderate deflation isn’t exactly earth’s reckoning.
Secondly, Noah’s missing the other side of the coin. Freebies don’t exist in only deflationary systems. They exist in inflationary ones, too. For example, like Noah says, inflationary environments encourage putting your money in assets like stocks. A rule of thumb for the “regular shlubb” is to invest in the S&P500. So, many of these companies aren’t getting the majority of their capital thanks to their value propositions. Rather, they’re raising capital thanks to inflation. This causes inefficiencies, too. Incentives to innovate, compete, and be productive are stifled. Massive bubbles form.
In that vein, why is there no mention of the Fed funds rate? The biggest inefficiency of the inflationary system is the form of bubbles. But economists’ warnings have been ignored in that regard. As per Stanford’s John Taylor, the Fed funds rate should be above 6% today. Right now, that number is just upwards of 2%.
I appreciate Noah citing the potential inefficiencies raised by deflationary currencies. But not even touching on the inefficiencies from an inflationary system? Odd.
Ultimately, what would make for a more interesting debate is whether Bitcoin the currency would actually end up yielding moderate deflation. Dismissing Bitcoin purely because it’s deflationary, though, doesn’t make any economic sense.
Noah, Point 2: Scarcity, by itself, doesn’t create value.
Much of the crypto world is based on the idea that the way to make something valuable is to make it scarce. This is one of the basic theses of Bitcoin — the idea that because the total number of Bitcoins will ultimately be algorithmically limited, Bitcoin will rise in value over time.
I agree with Noah that scarcity alone does not necessarily create value. Indeed, Bitcoin’s cap being at 21,000,000 does not inherently mean that its price will go up.
But “the idea that because the total number of Bitcoins will ultimately be algorithmically limited, Bitcoin will rise in value over time” was never a basic Bitcoin thesis. Bitcoiners who propagate this are plain wrong. The basic Bitcoin thesis can be found here.
There are informed Bitcoiners who make references to capped supply, though. But they’re making a different argument. This argument has to do with adoption. At the time of writing, the vast majority of Bitcoins that will ever exist—about 90%—already exist. However, only ~1% of the world presently owns any Bitcoin. The argument goes something like this:
More people will begin seeing the use-cases for Bitcoin eventually, because there are just too many people (~99%) left out there.
Once that happens, they’ll start purchasing Bitcoin, too.
This trend should be bolstered by the user interface on crypto applications improving (the ease of purchasing and keeping Bitcoin will increase).
Essentially, when demand goes up and supply remains near-constant, mathematically, price must increase.
It is pointless to talk about the inefficiencies of deflation, without acknowledging the inefficiencies of inflation. Or the arguments of the misinformed, without addressing the arguments of the informed.
As writers, we have a duty to inform our readers. To propagate nuance, balance, and most importantly, ask the right questions.
I pose this article to Noah Smith hoping that he’ll continue to roll the ball.
P.S. I’m just a twenty-year-old who’s having fun reading, writing, and learning. If you felt like I got something wrong here, do let me know in the comments. You can find me on Twitter @ramwithouthorns.
P.P.S. Speaking of productive discussion in the crypto space, here’s a note from my friend, Sam, whose substack you can find below.
Inflation is happening worldwide, especially harming developing nations. You might be worried about your investments, the economy, or even how people cope with inflation. Inflated World is a simple way to stay up-to-date on what is happening worldwide - they send you personal anecdotes of people experiencing inflation from over 10 countries and weekly macroeconomic analyses. It's free to sign up - so why not give it a go?
Till next time,
Thanks Ram. I wouldn't even say Bitcoin is deflationary - it's actually inflationary until the year 2140, when inflation becomes 0. In practice, if you assume some coins get lost over time beyond 2140, then it will be deflationary.
Even though Bitcoin itself is inflationary until 2140, and then neutral, inflation or deflation (i.e. change in the aggregate price level) can still happen depending on whether the economy is growing or shrinking.
A good read, and I think that you raised some valid points.
I would argue however, that Bitcoin's attribute of being scare (that only 21 million BTC can ever exist) IS a basic Bitcoin thesis although not explicitly mentioned in the Bitcoin white paper. Bitcoin have the same properties that makes gold valuable, 1) scarcity, 2) takes time and large amounts of ressources to mine. If there were no limited cap supply on BTC, they would not be valuable, since they would not be scare. I have to admit that I am not super strong in economic theory, but as far as I understand, the the higher demand, and the lower the supply = more valuable.