Sunday, December 1, 2013

Understanding bitcoin price behavior with the Quantity theory of money.

Several arguments against the success of Bitcoin are doing the round:
  1. Bitcoin is a bubble, the present $1000+ price level bears no relation to the small bitcoin economy.
  2. People are hoarding bitcoin and not using it. How can that possibly be a successful currency?
  3. Bitcoin has a deflation problem. The general price level has to keep falling to accommodate the growing bitcoin economy, because of the fixed supply of bitcoin.

These arguments are false, and below I will show why. I will do this in terms that many students of economics are familiar with; the Quantity theory of money:
· V = P · Q

or the Money supply times the Velocity of money equals the Price level times the Quantity of goods. This relationship holds by definition.

People could argue that when the money supply M is fixed and the economy Q grows, the price level P must drop to accommodate it, which would mean deflation.
But then you are falsely assuming V, the velocity of money, to be constant.
What happens when people expect a drop in price level P? They will postpone spending. You know your bitcoin will be worth more tomorrow, so there is a free profit to be had. This drop in spending now would mean there is less bitcoin chasing after goods today. People are hoarding bitcoin. Price levels in bitcoin will adjust, going down now. Saying that the price level in bitcoin goes down, is the same as saying the value of a bitcoin goes up.
This hoarding will continue until the price level expectation does not provide a free lunch anymore. In a bitcoin economy with its fixed money supply, it isn't the price level adjusting to the growing economy. Instead it is the amount of bitcoin used in spending, or the Velocity of money.

So we can expect bitcoin to be hoarded at first. The bitcoin value should be expected to climb rapidly and then stabilize. 

So what the Quantity theory of money shows us is;
  1. The price of a bitcoin wil move now, up to a level fitting the size of the expected future bitcoin economy. Assuming bitcoin adoption, the $1000+ price is no bubble. The total value of bitcoin of about $15 billion is still very low compared to any reasonably sized economy. (
  2. Bitcoin hoarding is normal. The velocity of bitcoin will speed up over time. Bitcoin hoarding is a logical consequence of the expected growth in the bitcoin economy, in combination with the limited supply of bitcoin.
  3. There will be no constant deflation with bitcoin. The value of a bitcoin will jump to a level that fits the future bitcoin economy size and then stabilize. It is the number of bitcoin used in spending that will adjust to the growing bitcoin economy over time, not the price level.