Chapter 3: Stable Bitcoin
Prices always change. So why should a money be stable?
“We must look at the price system as a mechanism for communicating information.”
– F.A. Hayek (1945)
“Who says a currency must have a stable value?” a bitcoiner once asked me after a discussion about Bitcredit Protocol. “What’s so bad about deflation as Bitcoin increases in value over time?”
It is striking how today’s bitcoiners and modern central bankers favour opposing kinds of monetary instability while both groups shrug off the neutral middle path.
Central bankers claim that an annual inflation rate of two percent is needed to prevent deflation. They argue that deflation discourages consumer spending and investment, they say it slows down the economy, creates unemployment, and traps debtors’ as their burden grows in real terms. They can point to many deflationary periods in history that brought economic depressions and misery, such as the Great Bullion Famine in the Middle Ages and the Great Depression of the 1930s.
Bitcoiners, conversely, recognise the problems caused by inflation but most seem oblivious to the downsides of deflation. “Inflation is bad because it erodes people’s purchasing power”, they reason, “therefore deflation must be good.” Not so. Overeating is bad for one’s health but starving to death is not good either. Their casual attitude toward deflation rationalises their self-interest: they hold Bitcoin and expect to benefit from its appreciating exchange value.
However, Bitcoin is not just any asset. As a money, its utility lies in facilitating exchange transactions. We cannot consider only one-sided interest when both parties must mutually agree on which money to use: buyers and sellers, tenants and landlords, debtors and creditors, payers and payees.
Therefore, I disagree with both camps. I maintain that a stable exchange value is a critically important property of money. It is also a natural, spontaneously emerging quality of a well-designed, neutral monetary system as I will explain in the next chapter.
Furthermore, currencies not only compete on long-term inflation or deflation but also on short-term volatility, the more stable, the better. The rise of stablecoins, pegged to inflationary fiat currencies, is testament to this preference of users.
Finally, falling prices can be the visible effect of a deeper issue: a shortage of media of exchange with specific actors at time of need. Then supply chains grind to a halt, not for lack of goods produced or labour available, but because transactions cannot be completed. In this case, it is the lack of liquidity that must be addressed not inflation or deflation which are but indicative symptoms of the real problem.
At this point, we must recognise two difficulties:
The concept of a stable money is somewhat elusive. What does ‘stable’ really mean and what not?
What are the rules of a well-designed monetary system that produces a stable money?
This chapter addresses the first question which requires nuance and precise definitions beyond that of everyday conversations.
Prices and Intuition
Our brains are wired to expect stable prices, people think in nominal terms. In 2014, I conducted a study with two colleagues to investigate how accurately shoppers in the UK could predict the current prices of a wide range of consumer products.1 Among other interesting insights we found that, on average, shoppers’ price estimates were approximately 9 percent lower than actual market prices. The differences varied by gender, shopping frequency, and product category, ranging from dishwasher tablets and chocolate bars to leather sofas and diamond rings.
Interestingly, this average gap corresponded roughly to four years worth of UK inflation at the time. We concluded that the underestimation was not a cognitive bias or a flaw in people’s abilities but a consequence of the unnatural debasement of the British Pound by the Bank of England.
Three Causes of Price Changes
Prices are condensed information. They aggregate dispersed, even private, information about markets and coordinate the economic decisions of free individuals spontaneously, without central command. Much of our planning and decision-making is intuitive. When our intuition about market prices is distorted, this leads to inefficiencies and misallocation of labour, capital, and resources – in severe cases to the collapse of entire economies.
Price changes stem from three main categories of causes: (1) fundamental, (2) political, and (3) technical. Depending on the cause, price changes can be beneficial or harmful, as follows:
Fundamental causes arise from two types of real-world events.
Variabilities, such as good or bad harvests, commodity discoveries or shortages, and weather events.
Progress, such as new technologies, scientific breakthroughs, product and business model innovations, and general productivity improvements.
From an economic perspective, price changes from fundamental causes are desirable, their signal helps producers and consumers to adapt and fine-tune to the changing reality in affected industries and regions. Progress, of course, is best as it increases the abundance or quality of goods, and makes them more affordable.
Political causes change prices directly or indirectly.
Direct interventions include price caps or floors, tariffs, and taxes.
Indirect influences include geopolitical tensions, wars, sanctions, regulations, as well as government interventionism and cronyism.
Price changes from political causes sometimes work as intended, most often they do not because – due to poorly predicted outcomes by regulators – they ultimately result in just the opposite of what the responsible politicians originally promised, like rent controls leading to a decline in construction and maintenance, thereby causing a scarcity of available rental properties.
Technical causes for price changes can stem from monetary policy or system design flaws.
Policy mistakes include an oversupply of money causing inflation or a scarcity of money causing deflation, or deliberate central bank manipulation of interest rates and government-driven credit expansion.
Design flaws or gaps in monetary systems cause the severest price distortions, especially in fiat systems but also in badly regulated commodity-based systems, like Bitcoin’s lack of an elastic layer. They often cause self-reinforcing vicious circles like financial bubbles, bank runs, and hyperinflation, or deflationary spirals and adoption blockages.
This last category always produces harmful price changes which will divert the economy from the productive path, followed by stagnating or declining standards of living, or in extreme cases, ending in catastrophic hardship for entire nations.
In this book, I use the terms ‘inflation’ and ‘deflation’ strictly for changes in the price of money with distortions from such technical causes. A mere increase or decrease in the total money supply is not the same as inflation or deflation; if fluctuations in money demand are well balanced by supply changes, then the monetary stance is neutral or ‘stable’. Therefore, a stable money neither means that prices of goods are stable, nor does it necessarily mean that a money’s purchasing power is stable. It just means that monetary matters do not distort prices in a way where they cannot perform their important systemic function correctly. No more, no less.
Therefore, the monetary policy of central banks aiming at a constant inflation target is not ‘stable’ in the true sense, as it eliminates the informative changes in the exchange value of money needed to guide economic adaptation. Conversely, Bitcoin’s lack of monetary elasticity creates a problem for the real economy as the fluctuating demand for Bitcoin holdings causes unnecessary erratical price changes of all other goods.
Some economists also speak of the ‘money illusion’. Psychologically and on average, people feel richer in times of inflation and poorer when there is deflation. While this concept contains some truth, it lacks nuance. The difficulty is that inflation and deflation move through the economy in a highly chaotic way. It is quite impossible to dissect the manifold real reasons for price changes of specific goods.
Accordingly, the populist commentary about inflation in the media and by the political class rarely talks about the faults in the monetary system or mistakes in monetary policy, but about superficial, visible observations. Usually, the reported ‘causes’ support self-interest and a political agenda: they either blame ‘greedy’ groups of people, such as profit-seeking corporations or wage-seeking workers, or they single out certain product groups or geopolitical events as the ‘cause’ for the broader, slow, and chaotic phenomenon.
The Ills of Deflation
This brings us back to the initial question about “deflation as the value of Bitcoin rises”. Most bitcoiners know about the Cantillon effect that follows an expanding money supply: when new money enters the economy, it benefits the few who receive and spend it earliest, before the prices subsequently rise for all others. In a fiat system this benefits the government, its bureaucracy, and cronies at the expense of trade and industry, the wealth of nations. As an unintended consequence, it also creates social strife, due to the different dynamics of company profits – which rise first – and workers’ wages, where annual wage increases involve a time lag of up to one year
For the economy, deflation is just as bad as inflation. In fact it is worse: the agreed prices of all kinds of long-term contracts lose their link to the economic reality. Businesses must continually reduce workers’ wages or fail, rents become unaffordable unless renegotiated down, pensions and insurance obligations must be adjusted or bankrupt their providers.
When money is too scarce, businesses reduce their investment activities and people reduce their consumption. The weakest economic actors suffer first, low margin businesses close down, indebted businesses go bankrupt. This further reduces incomes, thus savings and consumption. Soon a so-called deflationary spiral takes hold: falling prices force wage cuts, job insecurity and mass unemployment follow. Social unrest and political radicalisation grow faster than with inflation because deflation feels like a trap, a long-lasting depression with hardship and wide-spread hopelessness.
The Bitcoin system, as long as it consists only of a fixed base money layer, will remain deflationary as long as the demand for saving purposes increases. This already poses a significant barrier to business adoption in a modern, capital-intensive economy.
The Ills of Volatility
Unfortunately there is an even bigger hindrance to business and broader adoption which is Bitcoin’s volatility.
Volatility: Bitcoin vs. Fiat Currencies (2015-2025)
A chart of Bitcoin’s volatility over the past ten years shows that it (red line) is much higher than that of the major fiat currencies (blue line), i.e. the US dollar, the Euro, and the British Pound. Most bitcoiners believe that volatility will decline over time, with more adoption as a store of value, and an increasing market capitalisation. However, it is visible to the naked eye that this intuition is incorrect. While these factors may have contributed to a lesser volatility of volatility, the outright volatility of Bitcoin has not improved significantly, despite time passed, growing adoption as a store of value, and its much higher price.
It is logical that Bitcoin’s volatility cannot improve. Bitcoin has fixed supply which is the very property which makes it an ideal base money. However, market demand is highly variable, and the price of Bitcoin changes constantly for manifold reasons such as macroeconomic developments, political acceptance or rejection by governments and political parties, technological advances or failures, and last but not least, the hostility levels of central banks, the incumbent monopoly producers of inferior base money. Every progress or setback influences demand and when a fluctuating demand for a good meets a fixed supply the only possible adjustment is its market price which duly captures and communicates the swings.
The Roadblock Hypothesis
I think - and have been saying this since the Greek Crisis of 2015 - that volatility is an almost insurmountable roadblock for the adoption of Bitcoin by businesses in the supply chain, thus for the development of a circular Bitcoin economy, with the notable exception of very rudimentary, local experiments driven by motivated enthusiasts.
The narrative of an ‘ever increasing’ value of Bitcoin over the four-year halving cycle cannot tip the scales for businesses. They operate with a certain net margin and often with debt capital. If the volatility of Bitcoin runs against them, the effect is much the same as with deflation: marginal businesses realise losses and indebted businesses cannot meet their obligations or covenants. They cannot risk failure for an avoidable monetary deficiency, it would be tantamount to gambling their company.
For people, volatility is just as problematic. The average family just gets by on their monthly income. They risk hardship if they cannot make ends meet due to the large swings in Bitcoin’s exchange value. Neither do they have much leeway for saving nor can they wait out four year price cycles for their bigger purchases.
Events in Lebanon and other countries in a fiat currency crisis have consistently confirmed this problem. People switched to stablecoins pegged – mostly – to the U.S. dollar which they consider stable despite its inflationary nature. Even in El Salvador, where Bitcoin became legal tender besides the dollar in 2021, it could predictably not gain traction against the dollar. The dollar’s annual inflation rate of two percent is less Bitcoin’s daily volatility.
We are all caught in a web of contracts where obligations denominated in a volatile currency would introduce enormous unnecessary risk: supply agreements, employment contracts, lease agreements, pension contracts, insurance contracts, loan agreements, and many more. Currencies compete on stability because businesses and people alike prefer stable currencies over volatile ones.
Next
Having established what ‘stable money’ means and why an ideal money must be stable, we can now turn to a decentralised free market mechanism that produces this stability.
Hofkirchner, Puleston, Wheatley: ”Predicting the Future” (ESOMAR 2014)