Let’s suppose, for a moment, that Bitcoins turn out to be everything it could be.
One of the problems with bitcoins, and any currency that has a real-world dependency, is that the currency cannot grow to match the growth of the economies that use it.
Imagine a dollar in your pocket. Now, imagine what would happen to the value of that dollar over time. For instance, if you decided to keep it in your pocket over the next ten years, would the dollar be more or less valuable?
If it becomes less valuable, then you would buy less with that same dollar. Maybe you can buy a nice candy bar today, but in the future, you would only be able to afford a few tiny pieces of candy. This is called inflation.
If it becomes more valuable, then you would buy more with that same dollar. Today’s candy bar would be tomorrow’s box of chocolates. This is called deflation.
Or maybe its value stays roughly the same, so that you can buy a candy bar of roughly the same value today or tomorrow.
Ideally, money should maintain the same value. That’s because people treat the money weirdly when it doesn’t.
Under inflation, people have an incentive to spend the money as quickly as possible. Unfortunately, this has a nasty side effect. People that would normally put off a purchase until later show up now looking to buy. Stores see this, and they increase prices so that supply meets demand. This only makes inflation worse, until people stop buying and decide to put off the purchase until later. This can only happen when they run out of money, or when they gain confidence that prices will no longer increase.
The great white hope of inflation is that it will equalize the classes by providing the poor with cash and the incentive to spend it. The problem is that people will not only burn through their cash, but then they will start borrowing on credit. This has a tendency to enslave the poor to the rich. Money, once borrowed, is not easily returned.
Under deflation, something more insidious happens. People have an incentive to hold off on purchases. A great example is the computer and electronics industry. If you wait a year or two, prices sometimes drop by as much or more than 50%. You can get video games at half off as long as you are willing to wait until they are no longer popular. You can also pick up last year’s HDTVs for a fraction of what those who bought them last year paid for them. The net effect is that people who sell these products have to lower their prices to get people to buy things. And this only contributes to the downward spiral.
A more insidious effect of deflation is that the cash flows into the hands of the wealthy, not unlike what we saw in 19th Century England. See, the rich, not the poor, can delay purchases. The rich already have the food and clothing they need, and they are in no hurry to rush out and buy things. The poor, however, do not have reserves and need to spend the money right away. However, their source of income, which ultimately depends on others making purchases, starts drying up.
How can you measure inflation and deflation? This is not an easy task, but a good rule of thumb is as follows. First, measure the increase in value of the economy. That would show up as net profit of everyone. Then, measure the increase of available cash. If the two are roughly the same, then you’re in balance. If there is more cash than profit, then you have a problem with inflation. If there is less cash than profit, then you have deflation. How would you measure profit, especially the profit of hundreds of millions of families? I don’t know.
Another way is to peg your money value monitors to key commodities. These are things that pretty much everyone buys all the time. You can do things like milk and eggs and flour, or tvs and cars. Measure what the actual sale prices of these goods are, and see how the prices change over time. Because electronics is such an important component of our economy, and every year offers different features than last year, this is not going to be particularly effective. It’s like if people bought VW bugs one year, and then everyone started buying Rolls Royces the next year for 10 times the price. Has the price of cars gone up, or have people just shifted their buying habits while the prices remained the same?
Ideally, you’d like to keep the supply of money in proportion to the economy. That is, as the economy grows at 2%, 5%, or 10%, you increase the number of dollars by 2%, 5%, or 10%. However, as I demonstrated above, actually measuring inflation and deflation is almost impossible.
Bitcoins, and metal or other commodity-based currencies, do not have, built into them, a way to increase or even decrease the supply of money over time. If bitcoins prove popular, then you’re going to see deflation as people shift to bitcoins. This means people who own bitcoins and can afford to hold them will do so, in the hopes of being able to buy more in the future. This will drive bitcoin prices down into the depths of deflation.
Or it may work the other way. After a strong showing, people begin slowly shifting away from bitcoins. Now there are more bitcoins chasing fewer goods, and so prices rise up. The inflationary spiral hits, and soon bitcoins are worthless.
We know from experience that our currency needs to be flexible. If not, then we get hit, and hit hard, when either inflation or deflation occurs. Simple controls, such as printing or taxing money, is effective enough to control inflation and deflation, provided the right actions occur at the right time.
The Founding Fathers, who experimented with their own currency, highly successfully during the Revolutionary War but ineffectively in subsequent times, knew that the only group of people who could decide, appropriately, whether to print or tax would be the people themselves, composed of regular laborers and business men and bankers. They, therefore, put the powers to tax and print in the hands of congress, particularly the House of Representatives.
In 1913, that power was delegated to the Fed, which has since proven itself to be wholly incompetent. If the Fed did what it was supposed to do, a dollar today would be worth as much as a dollar in 1913. Instead, we suffer from inflation cycle after inflation cycle, with occasional deflation cycles in between. This isn’t because the Fed is full of incompetent nincompoops, or because the Fed is controlled by an elite cabal of foreign bankers bent on subjugating the American people to an impossible debt. This is because even if the Fed were full of angels from heaven, they still would be incapable of determining whether to print money because they are not the people.
If I were to design a currency, I would either design it in one of two ways.
One, I would allow anyone and everyone to print their own currency, however they liked. They could trade their currency for other people’s currencies, and a system of buying and selling could adapt from that. That is what we do in our stock exchanges. Shares of a corporation are a currency of sorts. However, they are connected too much with the real world, and so I propose worthless bits of paper that people sell for other people’s worthless bits of paper. Those who manage their paper properly will find that people like to use their currency as a basis for all other currencies. Once they violate that trust, then the people shift to using some other currency as a basis. People can have, at their fingertips, the current exchange rates for all currencies, and so know how many Jonathan Gardners convert to one Barack Obamas. When someone prints any more currency, it would be known to everyone, as a matter of policy. In this scenario, which is the scenario of the real world, bitcoins are just another currency among millions.
Alternatively, I would go back to the way the Founding Fathers did it. The congress controls the press and taxation, and the people control who is in congress, and the question of whether to print or to tax is handled at that level. Of course, whether the people actually use that dollar is up to them.