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, and consequently whether the loss is actual.

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.

Commodity currencies such as gold exhibit monetary inflation in relation to exchange price. As price increases competition creates an offsetting increase in supply, keeping return on capital generally consistent with broader investment returns. Bitcoin however exhibits an increase in difficulty in relation to exchange price. Bitcoin price has no effect on supply whatsoever.

Fiat currencies exhibit unpredictable and often secret monetary inflation. The purpose of such moneys is seigniorage, which is a tax on its holders. Unpredictability is important in maximizing the tax as otherwise the new money is immediately discounted to its net present value. Eventually price inflation discounts the money anyway, but not until the sovereign has reaped the benefit. When price inflation becomes fairly predictable, indexation 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. This computation is orthogonal to demand, which has an independent effect on price. Each exchange includes a discount for net present value (NPV). With positive monetary inflation the NPV of 1 unit is a fraction of 1 future unit. As monetary inflation decreases, the NPV of 1 unit increases relative to 1 future unit. With 0% monetary inflation the NPV of 1 unit is the same as 1 future unit.

So unlike victims of seigniorage, Charlie did not suffer an actual loss of purchasing power even if over time it took more units to purchase the same acre of land. The increase in units is a predictable function of the positive (despite decreasing) discount rate. It is neither a tax nor an outsized return on mining, it is simply a mathematical conversion.