On Bitcoin´s Inelastic Supply and it´s Use as Money

Introduction

Bitcoin was conceived as a decentralized monetary alternative to the current fiat system. Satoshi was aware of the challenges (perhaps insurmountable) of creating a currency that is both elastic and decentralized, hence, he conceived Bitcoin with an inelastic money supply. (1)

Although Nakamoto clearly envisioned Bitcoin bitcoin becoming money and not merely a sort of speculative asset, economists often argue that an asset with an inelastic supply can never become money. In the present article we will look at one such claim made by Nieto, who makes the case that due to its inelastic supply, Bitcoin will always be too volatile to ever be used as money. I contend that the argument is invalid both from a rational and an empirical perspective.

The Argument

The apodictic argument is based on the idea that, in a context of productivity growth, the purchasing power (in terms of goods and services) of an asset with 100% inelastic supply such as BTC would increase proportionally to economic output. In other words, we would see deflation due to economic growth.

If the supply of money is inelastic (as is the case in Bitcoin) and the velocity of money remains stable, any increase in output must necessarily lead to a proportional decrease in the general price level. We can show this phenomenon more clearly using the quantity equation of money:

Where M represents money supply, V represents the velocity of circulation of money, P is the price level and y is real economic output.

It is argued that this increase in the purchasing power of an inelastic asset necessarily leads to levels of volatility that are too high to allow its use as a medium of exchange and a unit of account. The following image shows the blue line representing the reduction in the general price level and the red line representing volatility.

In short, it is argued that the market has a preference for monetary assets with a more elastic supply and which therefore maintain a more stable purchasing power or even lose purchasing power over time, such as fiat money.

Why is the argument invalid?

In my opinion the argument is invalid because the empirical evidence suggests that a monetary asset can gain purchasing power alongside productivity increases without entailing levels of volatility that preclude its use as money. Moreover, historical evidence suggests that the market has a preference for more inelastic monetary assets:

• The 19th century contains empirical evidence of how a monetary asset can gain purchasing power over time without exhibiting levels of volatility that preclude its use as a unit of account and medium of exchange. In the United States, between 1880–1896 the purchasing power of gold increased by more than 30% (2) and the following graph shows the same phenomenon even more pronounced in the United Kingdom in the first half of the 19th century: (3)

• Gold is one of the most supply inelastic assets in existence, if the market had a preference for assets with a more elastic supply function silver and copper would have prevailed over gold and not the other way around. (4) India and China had to abandon the silver standard and switch to gold because the more inelastic alternative was gaining purchasing power at a faster rate. Bitcoin has the most inelastic supply of any asset ergo it is likely to eventually win out over other monetary alternatives even if it is slightly more volatile.
• We should expect Bitcoin will reach a point where it begins to devalue against productive economic assets (although it will continue to appreciate in terms of goods and services). At this point BTC will be less volatile than stock indexes since they will offer a higher return. The following graph illustrates the phenomenon in question:

• It is important to avoid falling into the Nirvana Fallacy and comparing Bitcoin to existing monetary alternatives such as fiat money and gold. It is not fair to compare BTC to ideal alternatives such as a supposedly decentralized money with an elastic supply that would supposedly be less volatile. Right now there is only one decentralized and inelastic money (Bitcoin) and a centralized and elastic money (fiat).
• In the absence of an elastic, decentralized monetary alternative, the market will prefer a decentralized money that appreciates with productivity with some volatility over a money that relies on trusted third parties with the promise of a more stable purchasing power of goods and services.
• Although Bitcoin could be more volatile relative to the price of goods and services, it could be less volatile against the price of productive assets such as stocks or productive factors than fiat is today.

Conclusions

Under a monetary system with an inelastic supply, changes in production levels necessarily result in price level fluctuations. When economic output increases, sellers are forced to seek marginal buyers at lower prices and when output decreases, buyers seek marginal sellers at higher prices. This “inherent volatility” is nothing more than the market adjusting to changes in demand through the price system and does not prevent an asset from being used as money.

Historical evidence shows how gold had long periods of appreciation without exhibiting levels of volatility that rendered it unusable as a medium of exchange and unit of account. Furthermore, we have empirical evidence that the market has a preference for monetary assets with an inelastic supply function over assets with a more elastic supply.

Given the above, it is not correct to infer that Bitcoin will have levels of volatility that preclude its use as money. On the contrary, it seems likely that the market will have a preference for a decentralized money that appreciates with productivity, even if it has higher levels of volatility than centralized alternatives.

As a final thought, I would add that any attempt to create a monetary asset without volatility in a world in a state of perpetual change is a futile enterprise. In Mises’ words:

“How many plans to structure a neutral and stable money turn out to be intimately contradictory. Money is an element of action and, therefore, a generator of change. The variations experienced by the monetary relation, that is, by the relation between the demand for and supply of money, influence the prevailing exchange ratio between money, on the one hand, and all salable goods, on the other. “ (5)

References

1 “Because I don’t know a way for software to know the real world value of things. If there was some clever way, or if we wanted to trust someone to actively manage the money supply to peg it to something, the rules could have been programmed for that.” Satoshi Nakamoto expresa (en mi opinión con un toque de sarcasmo) la imposibilidad de hacer un dinero descentralizado e inelástico. (Satoshi, Bitcointalk, 2009)

2 Bagus, Philipp- Indefense of Deflation.

3 Bank of England.

4 The Bitcoin Standard, Saifedean Ammous.

5 Mises, Human Action

Addendum

In this post I have sought to provide a rebuttal to the idea that deflation due to economic growth implies levels of volatility that preclude the use of Bitcoin as money. We should not confuse this position with the argument of monetary equilibrium theorists such as Selgin, Cachanosky or Luther. The latter also argue that Bitcoin will always be too much to be money, but for them volatility would be given by changes in the velocity of money circulation or hoarding.

We can use the quantitative equation of money again to see the differences between the two lines of argument: