Inflation Fallacy

Bitcoin consensus rules create a perfectly predictable rate of monetary inflation. There is a theory that this causes loss of purchasing power. However it is essential to consider the effect of predictability on loss.

Consider the following scenario:

Alice sells Bob an acre of land for 1 bitcoin, confirmed at height 100. At the time of confirmation the supply of spendable bitcoin is (no more than) 5,000. Less than a week later, at height 1,000, Bob sells the same acre to Charlie for 10 bitcoin. Over this period the 1 bitcoin fraction of supply has been predictably reduced by monetary inflation from 0.02% to 0.002%. Let us assume that Charlie held his 10 bitcoin for the week prior to his purchase.

Charlie could have purchased the acre for 1 bitcoin but a week later it cost him 10. It would appear that over the span of one week Charlie has lost 90% of the purchasing power of his 10 bitcoin. In this example, a 10x increase in monetary supply correlates to a 10x increase in price over the same period. So has Charlie actually lost purchasing power?

Charlie had to first obtain the 10 bitcoin. He knew before obtaining his 10 bitcoin that this fraction of all bitcoin would be reduced from 0.2% to 0.02%, or that in a week his 10 bitcoin would be worth the current market price of one acre of land. Both Charlie and the seller of his 10 bitcoin discounted the trade for the net present value of the coin.

Charlie suffered no loss of purchasing power in his trade of 10 bitcoin for the acre, because he obtained the 10 bitcoin with full knowledge of its depreciation schedule. It is not possible to misjudge dilution caused by predictable increase in supply. Predictable dilution is always used in computing the net present value of stock holdings. For example, a shareholder must assume that option holders will exercise at a net positive value upon liquidation. Failing to reach this conclusion is simply a computational error, not a loss caused by the exercise.

When price inflation becomes fairly predictable, "indexing" can largely nullify its loss effect. This phenomenon was observed in the hyperinflation of the first Israeli Shekel.

The linkage system was very successful. In major economies around the world, consumers often feel the pinch of just 2-7% annual inflation. But Israelis, who had to deal with a much higher inflation rate, went about their business practically unaffected. For three and a half decades, their real income was protected by this index-linked mechanism.

However monetary inflation can be perfectly predictable. When it is so, and the schedule is public, the effect is entirely offset. Each exchange includes a discount for net present value. With positive monetary inflation the net present value of 1 unit is a fraction of 1 unit. As monetary inflation decreases, the net present value of 1 unit increases. Without monetary inflation the net present value of 1 unit is 1 unit. Note that this effect is orthogonal to demand. Variation in demand in a predictable money affects price inflation.

Commodity currencies such as gold exhibit monetary inflation in relation to exchange price. As price increases there is eventually an offsetting increase in supply, keeping return on mining capital generally consistent with broader investment returns. Bitcoin does not exhibit this characteristic; supply is independent of price. Bitcoin exhibits an increase in difficulty in relation to exchange price. Bitcoin price has no effect on supply whatsoever.