What is wrong with the Bitcoin supply mechanism?

When developing Bitcoin, Nakamoto severely limited its offer. The supply of Bitcoins is growing along a given path at a decreasing rate. There will never be more than 21 million PTS in circulation. As a result, there is no need to worry about unexpected changes in the BTC offer, since it is very predictable.

A new Bitcoin is created in the process of adding a transaction block to the block chain. Recall that it is computationally difficult to process a block of transactions. Transaction processing requires work on a computing device, which in turn consumes a large amount of electricity and leads to the depreciation of the machine.

To encourage people to bear these costs, the protocol rewards the first user who successfully hashes a block of transactions with a new Bitcoin. The block reward decreases over time and will eventually be completely replaced by the transaction fee. However, until then, the supply will grow at a predictable pace.

According to Coinmarketrate.com, the block reward schedule was defined from the very beginning and built into the core of the BTC. Initially, it was set at 50 WATTS per block. The reward was halved every 210,000 blocks. It fell to 25 BTC per block in 2012 and to 12.5 BTC per block in 2016. Currently, the reward is 6.25 Bitcoins per block. According to forecasts, in 2024 it will fall to 3,125.

To ensure that Bitcoin arrives on schedule, the network regularly adjusts the complexity of transaction processing. Recall that transactions are processed when the user successfully hashes a block. The successful hash must be less than or equal to the target hash set by the network. Reducing the target hash value makes it difficult to find an acceptable solution and thereby process a batch of transactions. Increasing the target hash value makes it easier to find an acceptable solution.

The Bitcoin protocol was designed to process a batch of transactions approximately every ten minutes. When working on a schedule, six blocks are processed every hour and one hundred and forty-four blocks are processed every day. The target hash value is adjusted every 2016 blocks, which is approximately two weeks. If the Bitcoin protocol is behind schedule, the target hash increases.

By simplifying transaction processing, increasing the target hash value allows the system to process transactions faster and thus return to the schedule. Similarly, if the bitcoin protocol is running ahead of schedule, the target hash code is lowered to make transaction processing more complex and therefore slower.

A predefined block reward schedule and the usual adjustment of the target hash value allows you to predict the supply of Bitcoins at any time in the future with a high degree of confidence. For example, we know that 6.25 BTC will be created approximately every ten minutes for the next two years. This means that in two years, about 65,700 BTC will be added to circulation (6,25 BTC / 10 minutes x 60 minutes / hour x 24 hours / day x 365 days / year x 2 years = 65,700 BTC).

The actual number may be slightly higher or lower, depending on whether the system is currently running too fast or too slow. But any discrepancy found will soon be eliminated. Thus, it is possible to assess the supply of Bitcoins in the future with sufficient confidence.

The offer mechanism is not perfect

By imposing strict restrictions on the supply of Bitcoins, Nakamoto effectively assured users that they now do not need to worry about abuses committed using the most poorly managed fiat money in history, since BTC appeared. But its supply mechanism is far from ideal. It provides predictability of the value of the coin, but does not make any effort to ensure monetary stability.

The ideal monetary base is stable in the long term, and demand is elastic in the short term. Long-term purchasing power stability supports expectations, facilitating the conclusion of long-term contracts, and thereby contributing to economic growth. An elastic supply that expands and narrows as needed to adapt to changes in the demand for money contributes to monetary stability and allows the price system to work more efficiently.

A well-functioning gold standard provides a reliable long-term binding, but its supply is slowly adapting to changes in demand. Fiat money has the potential to adjust more quickly in the short term, but it usually lacks a reliable long-term binding.

The supply of Bitcoin is effectively fixed on the path of its long-term growth. An increase in demand for it leads to an increase in its purchasing power. As long as the block reward is positive, the higher purchasing power will encourage those who use the protocol to allocate additional computing power to process transactions. The increased computing power will temporarily speed up the processing and, as a result, the creation of new coins.

But the effect is short. When the hashing target value is adjusted, as it happens every 2016 blocks, the offer will return to its long-term trajectory. Instead of increasing supply to meet demand and thereby stabilizing purchasing power, the Bitcoin protocol increases the cost of producing more coins to meet higher purchasing power.

In the future, when the block reward drops to zero and the system relies solely on the transaction fee, the offer will not change at all. Changes in the demand for a crypto asset then and now lead to changes in its purchasing power.

The unstable purchasing power of an asset makes it difficult to use it as money. Entering into a long-term contract expressed in Bitcoins is very risky, since you do not know how much it will cost when the contract expires. To reduce this risk, you can enter into contracts with the price of a product, a basket of goods or a stable base currency with calculations in Bitcoins.

However, at present, few long-term contracts are adjusted for inflation, which suggests that most parties prefer to conclude contracts in relatively stable money, rather than incur the costs of indexing.

Is volatility really a problem for Bitcoin?

Bitcoin proponents often say that purchasing power volatility is not a particular concern, since growing demand means that its purchasing power will grow over time. In fact, the growing purchasing power is of little comfort. Consider, first, the costs of monetary inflation, which are well known.

When the supply of money increases faster than demand, those who set prices for goods and services in monetary terms must bear the costs to raise their prices. The same can be said about monetary deflation. When the demand for money grows faster than the supply, those who set prices for goods and services in monetary terms must bear the costs of reducing their prices. In the case of monetary deflation, nominal prices fall, not rise. But the necessary price adjustments, nevertheless, are expensive.

Monetary inflation and deflation lead to unnecessary price adjustments and make the price system less efficient. As F. A. Hayek explained in the 1940s, the beauty of the price system in a market economy lies in its ability to inform participants about relative rarity at a low cost.

An increase in the demand for money requires an increase in all prices at non-trivial costs. However, the initial price vector conveys relative rarity just as well as the subsequent price vector. In other words, the price system has to do more work to achieve the same goal with higher costs when the money supply does not adapt to meet demand.

Faced with the previous argument, many bitcoin enthusiasts object that a drop in the price of money is desirable in a growing economy. In fact, this answer is not an objection at all. A drop in prices is desirable in a growing economy. Technological growth in a certain industry leads to a decrease in the prices of goods produced in this industry. There is no good reason to incur the cost of raising prices in all other industries just to prevent the general price level from falling.

But the fact that technology-driven price deflation is desirable does not mean that monetary policy deflation is desirable. Indeed, the latter is undesirable for the same reason as the former. The price system works best when it is not subjected to unnecessary expensive adjustments.

Over shorter periods of time, changes in the demand for money that is not used can lead to undesirable macroeconomic fluctuations. As noted earlier, an increase in the demand for money requires a decrease in the prices of goods and services. Changing or correcting some prices is especially expensive for the duration of the contract. These prices will be slowly adjusted. Until they do this, the price vector will not reflect the true relative shortage of goods and services in the economy. Those goods and services that are relatively expensive due to their low price will, as a rule, be insufficiently secured. And in general, the performance will be lower than we would like.

Summing up

The Bitcoin supply mechanism cannot provide a long-term nominal anchor or contribute to monetary stability. Long-term Bitcoin contracts are relatively expensive. In shorter periods of time, a Bitcoin-based economy is likely to be marked by a greater degree of undesirable macroeconomic fluctuations.

Both of these problems could be mitigated to some extent by setting prices for goods and services in terms of a more stable unit of account that would be floating relative to Bitcoin. But mitigation strategies are expensive. The best money will use the supply mechanism, which compensates for changes in demand, to keep them.