In this post, we explain what is a deflationary spiral, its causes, and its relation to Bitcoin. In the crypto world, especially in everything related to Bitcoin, you often hear the word deflation.
The reason is that Bitcoin is a deflationary currency. Along with each halving cycle, Bitcoin issuance halves until it reaches its maximum of 21 million coins. The maximum amount of issued Bitcoin would occur in the year 2144.
The other concept related to Bitcoin deflation and not so much talked about is the “deflationary spiral.” It is a much-misunderstood concept, and many people use it to attack Bitcoin, indicating that its model is unviable over time.
Contents
What is a Deflationary Spiral?
The concept “deflationary spiral” refers to an economic situation with persistent price declines, which can lead to a production reduction and employment and a contraction in demand and investment.
This phenomenon may relate to different conditions:
Decline in demand: Initial deflation can be caused by, among other things, declines in aggregate demand (e.g., a fall in consumption or investment).
Falling prices: With less demand, firms lower their prices to sell their products.
Reduction in production: Falling prices reduce companies’ profits, leading them to reduce production and lay off workers.
Lower wages: With less employment, workers have less bargaining power, and their wages fall.
Reduced consumption: Falling wages reduce people’s purchasing power, further reducing demand.
As we have seen, this phenomenon has economic and financial consequences. For this reason, most Keynesian economists, the leading proponents of the deflationary spiral, see this event as an “economic apocalypse.”
Why is a Deflationary Spiral Dangerous?
At present, most economies apply to a greater or lesser extent the “Keynesian Theory” with a capitalist line highly intervened by the State through Central Banks. Precisely, the intervention of the State or other factors of power changes everything since its intervention is not a natural element of the market.
With this in mind, imagine that a Central Bank announces that the prices of products would fall under its intervention. This situation would lead the country’s economic agents to postpone their purchases until the price drop becomes real. This situation can generate a vicious circle of falling prices and cause the economy to stagnate. All this is because economic agents reduce production, waiting for prices to fall. The situation will result in a drop in consumption, as consumers also expect a price drop. This fall in consumption means that manufactured stocks pile up, and excess supply becomes apparent. At the same time, lower prices cause companies to reduce their profits (they produce and sell less), impacting the labor market and leading to a recession.
Without profits and reduced production, companies cannot pay salaries and would reduce the number of employees. This situation, if maintained over time, generates the well-known deflationary spiral.
States and Economic Manipulation
As we have explained in the previous example, for the deflationary spiral to occur, the intervention of a power factor is necessary. In this case, the State through the Central Bank. Although it is difficult to think that the State could act this way, Central Banks have been driving this phenomenon with fiat money for years. By lowering or raising interest rates, issuing money arbitrarily, or manipulating the velocity of money, Central Banks move the hands of a “deflationary spiral” at will.
So, it is clear that a deflationary spiral is not a natural market event. In a free market, such actions are naturally self-regulating, making Bitcoin the best example.
Relationship with Bitcoin
Recall that Bitcoin is a cryptocurrency that has a fixed maximum supply of 21 million units, which means that there can be no more bitcoins in circulation once we all reach that number. This supply limitation is one of the reasons why Bitcoin is considered a deflationary asset.
Bitcoin’s limitation lies not only in the amount of bitcoins. With each halving, there is a decrease in the production of new bitcoins. Despite this, the issuance decrease does not mean the new Bitcoins are less valuable. On the contrary, their value increases, as you can see in the price history of this cryptocurrency.
The reason is simple: the Bitcoin market, being free as it is, regulates the supply (the amount of Bitcoin in circulation) and demand for the cryptocurrency. That self-regulation transfers directly to the price or value of bitcoin. With each halving and the expansion of interest in the cryptocurrency, the price of BTC grows. Even when some manipulate Bitcoin price, it quickly reacts and returns to its natural course.
Bitcoin, an asset to protect against Deflationary Spirals
This nature of Bitcoin serves to safeguard against deflationary spirals. As we said above, Bitcoin has a limited existence, and its use continues to expand, driving its appreciation. The opposite happens with fiat currencies. We see in some countries how inflation dilutes the purchasing power of citizens every year.
Faced with the manipulation of fiat money, Bitcoin presents itself as an opportunity to escape inflation and deflationary spirals or, even worse, stagflation (inflation in product prices, accompanied by deflation or general economic decline of a country). As the World Bank shows, Europe is currently undergoing such an event.