Is Bitcoin in Inflation or Deflation? Setting the record straight, Krugman Debunked.

Over on Reddit.com i saw this post;
The 800 pound gorilla in the room: The price of bitcoin is going down because miners are printing 50 BTC per 10 minutes.
 
"50 BTC per 10 minutes, means 7200 new bitcoins are introduced each day. The total supply of bitcoins is at 7 millionish. These numbers yields a daily inflation rate of 0.1%, or about 37% on a yearly basis. That is hardly deflationary. The economy has to grow 37% on a yearly basis just to keep up with inflation. You would expect the value of bitcoins to go down about 3-5% per month due to inflation alone. I think that is the main cause for the continuous drop in value experienced since the bubble bursted. It should continue until the economy starts growing at a faster pace than the miners are spitting coins out."

Then over at the New York Times, I saw this post;
http://krugman.blogs.nytimes.com/2011/09/07/golden-cyberfetters/

"Over the past few months a number of people have asked what I think of Bitcoin, an attempt to create a sort of private cybercurrency. Now Alexander Kowalski at Bloomberg News directs me to this Jim Surowiecki article on Bitcoin, which is very interesting.

My first reaction to Bitcoin was to say, what’s new? We have lots of ways of making payments electronically; in fact, a lot of the conventional monetary system is already virtual, relying on digital accounting rather than green pieces of paper. But it turns out that there is a difference: Bitcoin, rather than fixing the value of the virtual currency in terms of those green pieces of paper, fixes the total quantity of cybercurrency instead, and lets its dollar value float. In effect, Bitcoin has created its own private gold standard world, in which the money supply is fixed rather than subject to increase via the printing press.
So how’s it going? The dollar value of that cybercurrency has fluctuated sharply, but overall it has soared. So buying into Bitcoin has, at least so far, been a good investment.
But does that make the experiment a success? Um, no. What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin.
Bear in mind that dollar prices have been relatively stable over the past few years – yes, some deflation in 2008-2009, then some inflation as commodity prices rebounded, but overall consumer prices are only slightly higher than they were three years ago. What that means is that if you measure prices in Bitcoins, they have plunged; the Bitcoin economy has in effect experienced massive deflation.
And because of that, there has been an incentive to hoard the virtual currency rather than spending it. The actual value of transactions in Bitcoins has fallen rather than rising. In effect, real gross Bitcoin product has fallen sharply.
So to the extent that the experiment tells us anything about monetary regimes, it reinforces the case against anything like a new gold standard – because it shows just how vulnerable such a standard would be to money-hoarding, deflation, and depression."

So who is right? some random guy on Reddit, or establishment economic/political columnist Paul Krugman?  TL;DR version? Neither, But I encourage you to read on.

First off, my thoughts on Krugman:

While at first glance Krugman may seem to have made reasonable deductions, deeper analysis reveal a few flaws. Primarily, I feel that its kind of a generic cop out to say that Bitcoin is a good investment so far but a failed experiment. One could apply this logic to nearly anything like, The United States is a good place for investment so far (worlds largest economy) but a failed experiment (super power on its last legs). Or cheeseburgers are a good investment so far (as in tasty), but a failed experiment (as eating too many may cause an overall decline in health). And finally Apple Inc. is a good investment so far (one of the biggest companies in the US with a frenzied consumer base) but a failed experiment ((vendor lock in/greedy policies never work long term) (analyze the decline of Microsoft and Sony for further inquiry)). I feel that he is taking a short term view and trying to stretch it to the long term which is a mistake. I leave my commentary on this paragraph with one of my sayings in life which is; "While its good to plan for the long haul, in the long run we are all dead, so plan accordingly."

The other glaring flaw in the Krugman piece is when he says "What we want from a monetary system isn't to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin." Again with the generic but good sounding line. You can say the same thing about the US Dollar or the Euro which is that the banks and the mega corporations holding money get rich while the economy as a whole suffers.

And finally the crux of the Krugman piece debunked:
"Bear in mind that dollar prices have been relatively stable over the past few years – yes, some deflation in 2008-2009, then some inflation as commodity prices rebounded, but overall consumer prices are only slightly higher than they were three years ago. What that means is that if you measure prices in Bitcoins, they have plunged; the Bitcoin economy has in effect experienced massive deflation.
And because of that, there has been an incentive to hoard the virtual currency rather than spending it. The actual value of transactions in Bitcoins has fallen rather than rising. In effect, real gross Bitcoin product has fallen sharply."

Yes Bitcoin price instability has been a problem, but since most people and businesses peg their exchange rates to the going rate on mtgox.com its an issue that's in triage for now. But massive deflation? that's a bit of a stretch. In 2009 Bitcoins were essentially worthless because it was just several people mucking around with it as a hobby. But people mucking around as a hobby can lead to huge things (think origins of the Linux kernel). During the beginning of 2010, the overall Bitcoin network hash rate was around 9 megahashes. Considering that most computers can output at least 1 megahash without too much trouble, that's like saying there were 9 miners in the Bitcoin community. By the end of 2010 that hashrate jumped to over 100 gigahashes, which if you do the math, is a huge increase in mining power. The value and hashrate made a meteoric jump for the first half of 2011 thanks to a huge media blitz. In addition, a US Senator commented on Bitcoin, and it was revealed to the masses that you can buy crystal meth with Bitcoin (implying buying drugs with money is news, yawn).

When I first learned about Bitcoin at the beginning of June 2011, the value was 13 USD per BTC. I was planning on buying some then but, literally within the next 48 hours the value soared to 30 USD per BTC. A few years ago my fathers friend told me how to spot bubbles and to be weary of them. So having remembered his advice, I refrained from making any purchases. A few days later prices were back down to 17 USD per BTC and have been falling ever since. So yes during this first half of 2011 value was soaring out of control but at the same time, transactions were growing day by day which is hardly money-hoarding, deflation, or a depression. Not deflation, just a typical bubble Mr. Krugman, nothing more. Keynesian economic theory suggests that some inflation is good, deflation is bad, and hyperinflation is bad. Bitcoin doesn't seem to fall in any of these categories so that may explain why Krugman went so wrong with his analysis.

I'm done with debunking Krugman, so lets move on to the random guy on Reddit. In case you forgot what the post stated:

"50 BTC per 10 minutes, means 7200 new bitcoins are introduced each day. The total supply of bitcoins is at 7 millionish. These numbers yields a daily inflation rate of 0.1%, or about 37% on a yearly basis. That is hardly deflationary. The economy has to grow 37% on a yearly basis just to keep up with inflation. You would expect the value of bitcoins to go down about 3-5% per month due to inflation alone. I think that is the main cause for the continuous drop in value experienced since the bubble bursted. It should continue until the economy starts growing at a faster pace than the miners are spitting coins out."

First off, 50 BTC per 10 minutes has always been true and will remain true until sometime late next year. When that happens Bitcoin will be mined at 25 BTC per 10 minutes. and there will be several more cuts to the mining reward rate until finally no more can be mined. This is hardly an inflationary trend from a money supply perspective but, looking at money supply alone is a mistake.

In a capitalistic system, it's a mistake to look at money supply alone when calling if a currency is in inflation or deflation. A good example of why that can fail can be found by looking at the economic policies of Japan and the USA. Both countries experienced a massive bubble and when they burst (1990 in Japan, 2008 in the USA) both governments have been scrambling to increase lending by printing an obscene amount of money and by maintaining very low interest rates. Yet despite their best efforts, Japan has been experiencing mostly deflationary forces and the USA is following the same overall path of zero growth. US banks are sitting on massive reserves with no credit worthy people to pass that along to because of structural problems like high unemployment and the hoarding of cash from the mega rich. Hardly inflationary.

Now if we are looking at a command economy, when governments print money, they can force lending which causes inflation rather quickly. The USSR was a good example of that and they ended up collapsing. Several years after Zimbabwe abandoned its market driven economy, we got the now infamous 100 trillion dollar bank note. China is currently experiencing the problem of expanded credit and inflation thanks to government mandated infrastructure growth which is leading to the creation of some of the most amazing ghost towns I have ever seen. I'm talking about massive cities with vacant highrises and 6 lane highways no one uses! (Though I concede that The PRC isn't really a command economy anymore either). If a non command economy like the US were to go on a path of hyperinflation today, it wouldn't be because of the Feds Monetary policy, but it would be because Congress has decided to act on something stupid.

That said, Bitcoin is slightly different because there is no central bank. When people mine for Bitcoin, most of it gets injected directly into the Bitcoin mining pools which is the closest thing thing the Bitcoin community has to a central banking system. Never mind the small pools or the solo miners since they make up less than 25% of all mining activity. I am talking about the big three which are Deepbit, BTCguild, and Slush. Since the Bitcoin community is a paranoid one thanks to the large number of knowledgeable network security types it attracts, and also combined with the fact that there have been a lot of scams and exploits in the Bitcoin world, many miners are quick to withdraw their BTC from the pools. From there the Bitcoin goes to their wallet.dat files. Its safe to say that most miners have bills to pay so they then sell their excess coins to pay for their hardware/electricity/datacenter costs and/or to make some money in the form of other currencies. With the collapse of popular e-wallet/payment processor site mybitcoin.com, its also safe to say that overall Bitcoin transactions for goods and services have declined since there has been no payment processor to take its place for the masses.

Currently, most of the Bitcoin economy is based on its own Forex market which add little value to Bitcoin itself. Bitcoin lotteries and gambling sites are also prevalent, which can be fun but, many are straight up scams. Bitcoins are being mined at a rate faster than the growth of the goods and services it could be attracting if payment processor/e-wallet sites like mybitcoin.com had not gone down. Finally, now that everyone knows that you can buy crystal meth with Bitcoin, the media hype surrounding Bitcoin has cooled off, which means many of the speculators are now back on the sidelines. If you combine everything I stated, then saying Bitcoin is in serious inflation is only half accurate. It is not experiencing serious inflation, but rather steady inflation in the form of serious stagflation. As the Wikipedia definition of stagflation states; "stagflation is a situation in which the inflation rate is high and the economic growth rate is low." I think this is the most accurate take on the current Bitcoin economy.

For as long as the structural problems of lack of payment processing, lack of goods and services, but most importantly a overall lack of user friendly infrastructure, Expect to see an exchange rate of no greater than 10 USD per Bitcoin for awhile longer (Probably for the rest of 2011). If these structural problems remain and the price does reach new highs above the 10 USD per 1 BTC rate, Then you will know its just another speculative bubble waiting to burst. Plan accordingly.