Nihar Ajmera
Alternative currencies such as Bitcoin or the ones backed by Gold have one feature that is particularly charming in the post-QE world – the promise of finite supply and nil dependence on central planners. Such currencies are supposed to be a free-market counter to ‘deep state’ monetary interference.
But the concept of a finite monetary supply system deserves a deeper review. While the merits are relatively well-known, it is time we look closer at some demerits of such a fixed supply system. Many such demerits are well-documented but not widely-appreciated.
Let’s say the world starts transacting and storing value exclusively in Bitcoins (or some other fixed-supply currency such as Gold). In other words, there is no fiat currency and central bankers are jobless. No authority in the world can create currency out of thin air and indirectly devalue/deflate the hard-earned currency stashed in our wallet. We are in far more control of our economic lives than ever. So far, so good. Or so we think.
A few simple thought experiments will reveal that some very amusing and unintended consequences are possible. These consequences will most definitely manifest over the long-run, say over 50-100 years, which is the least planning horizon for any currency policy.
We will not need to bother with complicated economic theories; we can appreciate the issues using just first principles and common sense.
- Price deflation will be a norm and everyone will be less happy
Say most people in the world use one cell phone today. Tomorrow, many of us will probably need one smart connected trouser, an IoT control system, and a personal AR/VR device besides the cell phone. Our needs and wants will have increased. World’s output would also need to increase to keep up with this demand. But world money supply will be constant. Finite money has to get allocated towards the ever increasing quantity and type of products.
Therefore, the price of products such as a new cell phone will go down. A few years from then, the price of a new IoT system will also go down with our needs and market innovation increasing even further.
Psychologically, no seller likes to see prices of his wares drop. No buyer likes to buy now if he knows that prices will drop if he waits.
So what happens:
- Producers will counter deflation by restricting output growth and reducing innovations – so that the price of their existing inventory does not fall
- Consumers will post-pone consumption and will hoard money. Gratification of ‘wants’ will be postponed. Discretionary spends will come down in hope that they can buy an item tomorrow, at a lesser price. In practice, hoarding can last for extended periods (an equilibrium between demand and supply of goods may be ultimately found but the process may be chaotic)
- More hoarding implies less money in circulation and less number of economic transactions. Value movement across the economy will slow down. The transactional lifeline that keeps an economy racing ahead will get strangled
Human needs and wants have always increased. Thankfully, so have technological innovations. A monetary system, at the very least, has to catalyze the ascendance of needs, wants, and technology – and not do the opposite. Unless mankind reconsiders materialism and consumerism, a fixed money supply system is unlikely to work.
- Asymmetric deflation is possible which can lead to price volatility in everyday items
Say we overcome the specter of discouraging innovation and there is indeed technological progress. Say there is a seismic medical innovation that helps cure any disease instantly. With such a technology in huge demand and money in finite supply, it is but likely that the finite money will chase this ‘scarce’ technology, inflating its price. Obvious consequence is a drastic deflation in price of other items that have a share in our wallet (food, clothing, entertainment, etc.).
With life-threatening diseases conquered, alcohol and cigarette prices may increase suddenly. Netflix subscription that was costing say x bitcoins a month (or any other currency) will suddenly quote at a substantial discount (because fewer currency is chasing it). Given such changes, how will an alcohol producer know how much inventory to keep? How will Netflix then know the right price to produce House of Cards at?
If the pace of technological change accelerates (this has happened in the last century), the prices of everyday items can change like stock prices can change on a very frequent basis. The volatility and uncertainty will get amplified. This can dis-incentivize risk-taking behavior in genuine businesses. Besides, the common consumer is infatuated with stability and predictability (our neural wiring hates uncertainty and risk). How can one possibly expect the common man to deal with such heightened volatility on a periodic basis? Do we impede technological innovation to solve this problem?
To be sure, in case of a flexible money supply system as well, such price volatility does happen. Inventory uncertainty and pricing risk is common. But all this happens with relatively lesser intensity and relatively more predictability. Even today, the prices of everyday items change to reflect the new demand-supply dynamic but generally do so on a gradual basis. At a macro level, the volatility is controllable because the central banker is consciously playing with money supply and the government is playing with fiscal engineering.
- The rich may continue to be rich; the middle-class and poor may lose even hope
Economics 101 says that generally, capital is a huge barrier to entry in most businesses. In many others, it is technology, scale, knowledge, etc. – which may again require capital to protect/grow.
Let’s assume that a fixed supply system prohibits lending/loan-making – most likely it may; where will the borrower generate interest from?
If so, then a legitimate route of funding is closed for smaller but highly entrepreneurial businessmen who want to innovate and disrupt the status quo. Such innovators will be left to attract funding through equity, which could be difficult for first-timers. Or sell their ideas/prototypes to the existing big businessmen.
The latter alternative does not allow the innovator to capitalize on maximized value while it absolutely benefits the biggies. More so, the biggies will set the price – buyer’s market after all. Why, in such a case, should the innovator bother working hard in the first place?
This is unlike in the current system where the government can give grants/loans/incentives (some of which is money created out of thin air) to budding entrepreneurs. In the current system, private equity also chases innovators because even LPs/GPs know that there are many funding options available to the innovator. It is difficult to deny that, to some extent, the private funding craze observed globally has been a consequence of the monetary shindig. Rich get richer even today but the ones down the pyramid can still hope about getting there. In a fixed system, the hope may vanish over time.
In conclusion, fixed supply systems may lead to many unintended consequences, just like the fiat flexible supply system has. Even if one believes that only an iota of the several above-mentioned consequences is likely, it is good enough grounds to reconsider our collective position on fixed supply systems.
Let’s also not forget that Concentration of wealth in the hands of a few + Choking of trickle-down value transfer from rich to aspiring-rich + Murder of hope is a perfect recipe for social unrest.
Perhaps a flexible money supply system where supply is governed by economic value/output growth is far better than all other alternatives. What will really help is appropriate checks and balances so that central bankers don’t create money arbitrarily. Till we find that solution, the current monetary shindig is a price we may have to pay to prevent our return to the 17th century.
PS:
A note for capitalism enthusiasts who despise central bank meddling
A free-market system is one in which the demand, supply, and price of any commodity are all decided by market forces. Currency is also ultimately a commodity. Fixed supply systems violate free-market rules by fixing an upper-limit on money supply. This is no less than the violation done by central banks today when they fix the supply and price of currency. Bitcoin and gold-based currencies, after all, may not be as free-market as we think.
(The author is part of the Corporate Strategy team at Network 18)
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