Bitcoin inflation, myth and reality

Monday 01 August 2016

Bitcoin’s inflation is algorithmically controlled - but its real level is unclear thanks to the number of lost coins.

With the Halving of bitcoin rewards - bitcoiners mention the term in hushed tones, like The Gathering in the Highlander franchise - the number of bitcoins issued with each new block will decrease from 25 BTC to 12.5 BTC.

Bitcoin is an inflationary currency, at least at present. Its supply is increasing and will continue to do so until some time in several decades’ time, after a few more Halving events and when the number of new coins issued is trivially small. At present, around 15,750,000 BTC have been mined - 75% of all bitcoins that will ever exist. Yet this does not mean the money supply is 15,750,000 BTC.


Inflation is changing more than we think

Locked, burned, lost

Almost 16m BTC may have been mined, but that doesn’t mean they’re all in play. Many bitcoins are out of the picture, probably for good. These include:

  • Burned coins. BTC are intentionally sent to unspendable addresses for various reasons, such as proof-of-burn. It’s hard to say how many have been burned over the course of bitcoin’s life, but it’s probably in the region of several thousand
  • Lost coins. That poor guy who threw out an old hard drive, only to realise shortly afterwards it contained 7,500 BTC mined back in 2009? That’s not uncommon. Many thousands of bitcoins are gone forever because people have lost their private keys, thrown out old hardware, or ended up with corrupted wallet files. Many more were probably ditched because they were CPU-mined by curious techies and then discarded, back when they were worthless and people were just playing with the protocol.
  • Satoshi’s coins. In the early years of bitcoin, Satoshi mined somewhere in the region of 1 million BTC. They’ve never moved from their original addresses. If you believe Craig Wright, they’re in the Tulip Trust and can’t be spent until 2020. If you don’t, they there’s a good chance they’re gone forever. (My view: something is wrong with the Trust story. You have a protocol that enables the peer-to-peer transfer of value, putting coins categorically beyond spending by the original owner. Instead of using that functionality, at minimal cost and inconvenience, you choose to accept private keys that could have been copied. ‘Trust’ here takes on a different meaning.)
  • Cold storage. Really cold storage, like three or more years. The owners have held through the bubble to $1,000, and maybe a couple of others. Chances are they’re not going to move them any time soon.

Back in 2014, John Ratcliff argued - pretty convincingly - that around 30% of coins were ‘Zombie’ bitcoins. At the time the supply was around 13 million, so we’re talking maybe 4 million BTC. Probably people are more careful with their private keys now, so that figure won’t have increased much. But bottom line: there are still millions of coins that aren’t going anywhere

Rate of change of inflation

This is important for a couple of reasons. Firstly, it means bitcoin’s supply and market cap effectively aren’t the figures regularly quoted. Supply is probably closer to 12 million than 16 million. Effective market cap is 25% lower than we typically assume. Real inflation is different to nominal inflation.

This has greater significance when it comes to the Halving of rewards. Why? Because it has implications for the rate of change of inflation. Vinny Lingham summarises the implications thus

  • In 2014, Bitcoin nominal inflation was 10.3% & real inflation was 15.1%
  • In 2015, Bitcoin nominal inflation was 9.3% & real inflation was 10.1%
  • In 2016, Bitcoin nominal inflation will be 6.4% & real inflation will be 8.7%
  • In 2017, Bitcoin nominal inflation will be 4% & real inflation will be 5.3%

Inflation in Bitcoin has an interestingly different application than inflation in the real world, in that prices aren’t going up because governments are printing money. Prices are going up because of scarcity (supply/demand). If you note that real “inflation” is dropping nearly 2/3 in around just 3 years, it means that for the current volume of Bitcoin buying to be satisfied, Bitcoin will need to find a new, and higher equilibrium point/clearing price. I don’t think these calculations have been adequately factored into the market price…

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