Original source: Anony, BTCStudy

Among the arguments that have been made to criticize Bitcoin, there is one that goes something like this: “Bitcoin’s supply will never increase after it reaches its upper limit, and something with an inelastic supply is not suitable to serve as a currency.” This view is special because it targets Bitcoin’s value position - Bitcoin is a currency with a capped supply, which is exactly why many people love it and think it has value.

Furthermore, this view would put forward two arguments: (1) in certain circumstances (especially when economic activity enters a downward cycle), increasing the money supply can stimulate economic activity and restore vitality to the economy; similarly, in certain circumstances, reducing the money supply can be beneficial; (2) people will inevitably forget or lose money in their daily lives, and this effect will accumulate over a long period of time, resulting in a continuous decrease in the amount of money in circulation and a shortage of money, which is not conducive to market trade [1].

I think these arguments are weak, but in order to analyze them, we must first understand money itself - at its core, money is also a commodity with its own market and price.

Currency markets and prices

In summary, money has two prices: purchasing power and interest rate.

Purchasing power refers to the ratio of currency to other goods. Some people refer to it as "price level". How much can a certain amount of currency units (such as 100 US dollars/Japanese yen/gram of gold) buy? This is the purchasing power of currency.

The interest rate refers to the exchange ratio of cash of the same currency in different time periods. How much is 100 yuan today equivalent to today next year? When you want to lend 100 yuan to someone, how much interest do you ask for? In such a lending phenomenon, what is involved is the exchange of cash (or something similar to cash) in different time periods (now, one year later), and this exchange will definitely involve interest. The reason for this is simple: cash itself is useful, "a bird in the hand is worth two in the bush." ​​In order to exchange the currency in people's hands, a certain price must be paid.

There is also a view that there are four types of currency prices, the other two being “parity” and “exchange rate” [2]. The former refers to the exchange ratio between currencies of the same but different types, such as the exchange ratio between cash and bank deposits. Generally speaking, such an exchange ratio needs to be 1:1. The latter refers to the exchange ratio between different currencies. These concepts are useful in some scenarios, but we will not discuss them here for the time being.

Purchasing power and interest rates, like the prices of other commodities: (1) arise in market transactions; (2) are regional; and (3) change constantly.

The purchasing power of money emerges in the process of price comparison, negotiation and transaction of consumers; similarly, the interest rate of money is also generated by the continuous matching between the supply and demand sides of money savings. The purchasing power of money is also regional, and the same number of currency units may buy different things in different places, and the quality is also different. In real life, we do not observe the real-time and continuous changes of these two prices, because price adjustments also require resources and time, which does not mean that they will never change.

Like the prices of other commodities, the price of money is also to coordinate the distribution of money among different groups of people and at different time periods, so as to meet people's various needs: using cash to buy goods and services, obtaining necessities of life, saving money to support long-term plans, saving money to hedge risks, and meeting turnover needs. In the past, in the era of metal currency, the price of money could also guide the production of new money.

So, what effect does a change in the quantity of money have on the price of money? Let’s start with purchasing power.

Fisher equation

Let's take a mathematical formula that is often cited in numismatics as our starting point:

Here, M represents the amount of money; V represents the velocity of money; P represents the price level (or purchasing power level); and T represents the number of goods traded. This equation must be true because it expresses a kind of "tautology" (also known as "tautology") - it describes two aspects of the same process (market transactions).

The right side of the equation expresses the transaction volume in the market. There is no such thing as "price level". It is a concept abstracted by people, and the process of abstracting it is just to divide the market transaction volume by the number of goods; so multiplying it by the number of goods is exactly equal to the market transaction volume. The left side of the equation is just the other side of the transaction process - no matter how large the transaction volume is, it means that people exchanged the same number of currency units, but the currency will not disappear after the transaction, and people must continue to let it participate in circulation, so we need to multiply it by a flow rate.

Economists often use this formula to illustrate the consequences of an increase in the "quantity of money" - let's not worry about the strict meaning of this concept, what counts as money and what doesn't: assuming that V and T remain unchanged, the result is an increase in P, or a decrease in the purchasing power of money.

This argument is useful - it shows us that an increase in the quantity of money will cause a decrease in its purchasing power, assuming that the things that cause the change in the quantity of money do not cause an opposite change in the velocity of money and the quantity of goods exchanged. However, it is not perfect - there is no guarantee that these two factors will not move in opposite directions.

Next we will look at another theory that is older, but actually more profound.

Cantillon effect

Cantillon [3] was a businessman who lived in the early 18th century. He keenly observed a phenomenon: when the amount of money increases, not everyone gets the newly issued money at the same time, which also means that not everyone knows at the same time that the value of the money is falling; the newly generated money will spread gradually outward with the economic activities of the first people to obtain the money, just like ripples caused by a stone thrown into the water, until it spreads to everyone; in this process, the first people to obtain the money will benefit more from the new money - because they can spend the money according to the relatively undepreciated purchasing power, while the later people to obtain the new money will suffer more. This situation is called the "Cantillon effect".

Cantillon's observation is more profound than Fisher's equation because it realizes that the economy is structured, and people carry out their activities over a period of time. The issuance of new money will not allow everyone to obtain new money equally according to the existing amount of money, nor will it instantly devalue the money in everyone's hands. Instead, it will spread outward along the structure of the economy and become clearer and clearer as it spreads. (Remember what we said above? The purchasing power of money also varies by region.)

This is the truth about the increase in money supply and the depreciation of purchasing power. No matter who claims that this process has any benefits, this benefit will not be equally available to everyone. Some people may get a lot, while others may get nothing. It will obviously become a source of polarization between the rich and the poor.

In the era of metal currency, mining metals is costly, and the scale and profits of currency production enterprises will be subject to the market itself. If the profit rate of currency manufacturing is higher than that of other industries, then people and capital in other industries will be attracted to the currency manufacturing industry, accelerating the production of currency (depreciation) while reducing the profit rate of the industry. This process controls the amount of additional currency. But in the era of paper currency, such a mechanism has disappeared. The lack of market constraints makes the amount of paper currency depend entirely on the mood of the currency issuing authorities, and they can have as much as they want. This is why the situation of excessive issuance of currency to the point of purchasing power collapse ("hyperinflation") observed in paper currency (China in the Yuan Dynasty, China in the Kuomintang era, Zimbabwe today, Venezuela) far exceeds that of metal currency.

The term “hyperinflation” is a clever one, suggesting that some inflation [4] is a good thing. However, this statement is actually akin to saying that poison quenches thirst.

Next, we need to consider the impact of changes in the money supply on another price of money—the interest rate—and its market.

Interest Rates, Savings, and Production

Interest rates are used to communicate between suppliers (people who have excess cash and are willing to lend cash) and consumers in the lending market. It should be pointed out that for suppliers and demanders, they may have different evaluations of the different utilities of money, but the nature of these utilities is the same for both parties: money can be exchanged for other goods in the market. For suppliers, lending cash means losing the benefits that cash can bring to them - the ability to hedge against risks; while for consumers, it means gaining the benefits of cash - immediate access to the goods and services they need, such as medical care, production equipment, and debt repayment ability.

Here, we are concerned with two phenomena: one is the separation of "nominal interest rate" and "real interest rate", and the other is the relationship between interest rate and production.

In the contract between the lender and the borrower, they only stipulate an interest rate, which translates to: I lend you 100 now, and after one year, you should return me 100 * (1 + i) units. This interest rate i is called the "nominal interest rate". However, the "real interest rate" obtained by the supplier/borne by the lender should be (1 + i) * (1 + d) - 1, where d refers to the change in the purchasing power of money. This is because the difficulty of repayment for the lender is determined not only by the nominal interest rate they agreed upon, but also by the change in the purchasing power of money itself - if money is becoming more difficult to obtain (purchasing power of money is rising, d > 0), the burden on the lender is greater than nominal; if money is becoming more accessible, the burden on the lender will be smaller.

There is no doubt that when negotiating the contract, the lender and the borrower will have their own estimates of d (which can only be estimates because it has not yet become a reality). This estimate will also be reflected in i. If the lender expects that the purchasing power of money will decrease, it will naturally increase the nominal interest rate accordingly to compensate itself. But estimates are just estimates - if the actual performance of d deviates from the expectations of both parties during the loan period, the benefits obtained from this contract will also deviate from their expectations.

As we have said before, in summary, there are two forces that affect d: (1) changes in the amount of money; and (2) changes in supply conditions. Technological progress, improvements in infrastructure, accumulation of knowledge, and improvements in international trade relations will increase production capacity and make goods cheaper, which means that the purchasing power of money will increase. Conversely, the deterioration of these conditions will also lead to a decrease in the purchasing power of money.

The increase in the amount of money will reduce the purchasing power of money, which will reduce the returns of creditors. This is why we often say that the increase in money supply is not good for creditors, and why kings in history like to dilute the purity of metal currency - the increase in money supply will also dilute their debt burden. In turn, it will increase the returns of creditors, but it will be disadvantageous to debtors.

But in any case, the greater the uncertainty caused by d, the greater the resistance in the lending market. This is why Milton Friedman advocated a fixed-rate monetary policy. Regularly increasing the issuance of money can minimize the impact of monetary factors on the purchasing power of money, thereby reducing the resistance in the lending market. Money with an inelastic supply also has this benefit.

On the other hand, interest rates also affect the expansion of production activities. Let us use an example to illustrate.

A is an entrepreneur who finds that he can currently borrow X units at a nominal interest rate of i for a loan period of Y. During the Y period of time, he can use X amount of money to increase production equipment and obtain monetary income Z when it matures, so that X * (1 - c) ^ Y + Z > X * (1 + i) ^ Y (here c is the depreciation rate of the production equipment). That is, if his income during the loan period is sufficient to cover the depreciation of the new equipment and the interest on the loan, he will borrow this money and convert it into production equipment to increase production.

This example can be used as a general case of the generation process of capital goods (a combination of all resources dedicated to the production of certain products). When A uses his own savings, he can be considered his own lender - the benefits of increasing production must also be greater than the benefits of saving money to attract him to implement the plan to increase production.

The amount of currency

We have left an unresolved question: What is the quantity of money? Assuming that we are using a paper currency, is the number of paper currency units that have been issued the quantity of this currency?

In other words, our question is: What form of change in the quantity of money will produce the effect mentioned above (decline in the purchasing power of money)?

This is not a question we have just raised today, nor is it a question that was just raised after the emergence of the Fisher equation - after all, people have known for a long time that an increase in the amount of money will lead to its depreciation.

In 19th century Britain, people lived in an era of using gold as currency, but at the same time, major banks also issued their own banknotes (paper money) that could be used to redeem gold deposited in the bank. Like us, people were arguing: What is currency? Is only gold considered currency? Is this paper money that is easier to circulate and can be used to redeem gold not considered currency?

On the one hand, discussing this issue is driven by policy interests: if these banknotes are considered currency, should the law also regulate the issuance of these banknotes [5]? On the other hand, it is also a requirement for academic progress.

Today we know that, theoretically, the importance of the currency identification standard lies not in itself, but in other things related to it: what we really want to know is, in addition to the cash entity of currency that we know - metal coins, banknotes with central bank stamps - whether changes in the quantity of their derivative forms will produce the same or similar effects as changes in the amount of cash?

The answer is, of course. Today, no one will deny that deposits in banks that can be circulated immediately are also money; time deposits and money funds that cannot be circulated immediately are also considered money, although their levels (or monetary nature) are different. Deposits in banks are not necessarily backed by 100% physical currency; under a non-100% reserve system, banks only need to provide cash in a certain proportion to the amount of deposits as a guarantee; when banks (within the scope permitted by law) decide to reduce the amount of margin, it will cause an increase in deposits, which will also have the effect of increasing the amount of money, but the strength is different.

We can now return to the arguments against inelastic money.

Stimulate production or stimulate mistakes

Those who support the use of money to "regulate" the economy do not deny that changes in the amount of money will affect the purchasing power of money and interest rates. On the contrary, they believe that this influence can be used to their advantage. For example, when the economy enters a downturn, the issuance of more money can cause the prices of goods to rise (because the purchasing power of money has decreased, the nominal price of goods has increased), and this price increase will make people think it is profitable, so people will resume production or increase production; at the same time, when the expansion of money reduces the nominal interest rate, people will also find that the cost of their risk-taking activities has become lower, which will naturally attract them to increase production.

Both of these claims sound appealing, and some observable phenomena are even consistent with them—but neither holds water.

Take the former as an example. This actually means that for these producers, profitability in the accounting sense actually depends entirely on the depreciating currency. That is, if the currency does not depreciate, they will not be able to observe that the monetary benefits of engaging in production activities are greater than the monetary value of their resource inputs. When they calculate their income at the end of the period, if they take into account the depreciation of the purchasing power of the currency itself, they may find that they not only have no income, but actually lose money, or in other words, it is better not to do it. Here, the depreciating currency actually creates an illusion, that is, it adds information noise to market activities and hinders people from forming a new production-consumption structure under new conditions. And the so-called economic downturn is actually people spontaneously moving towards this new structure.

The same is true for lowering the nominal interest rate in the market through the operation of increasing the money supply. In a fiat paper currency system, it is easy to increase the amount of money, and thus it is easy to lower the nominal interest rate for borrowing. But people forget that it is the savings of real resources, not the amount of money, that can support the expansion of production. During the formation of capital goods, these semi-finished products actually cannot bring any benefits to people, and it also requires people to continue to add resources to turn them into something that is truly productive. The artificially low nominal interest rate is exactly the opposite of this: when the nominal interest rate becomes low, people will think that the benefits of monetary savings have decreased, so they will increase consumption-consume the current finished products. Therefore, on the one hand, people increase consumption and require producers to produce what people need immediately; on the other hand, increasing capital goods requires producers to produce things that are useful in the future, that is, things that can be used to combine capital goods, rather than consumer goods that people need. The role of the interest rate market itself is to coordinate the production of the two, but now, the deliberately low nominal interest rate sends the wrong signal. The simultaneous expansion of demand for consumer goods and demand for capital goods is contradictory. One day, those who set up investment plans will find that the price of the required resources has soared too fast - or that there is not enough real savings available - making it impossible to complete the investment. However, investment that cannot be completed is meaningless. It means the complete bankruptcy of the investment plan.

The only support for this stimulus theory is that it seems difficult to find errors in statistics - monetary expansion may indeed lead to an increase in the statistical gross output (such as GDP). This can be seen from the Fisher equation - the right side of the equation is similar to the statistical concept of "gross output": the transaction volume of market exchanges that occur within a certain period of time and a certain region (or group). However, GDP is just a number, not a measure of the benefits people get from the market, and this benefit cannot be measured - when people have 10 yuan to trade a bunch of grapes, no one knows how much happiness TA gets from this bunch of grapes, and how much other happiness they can get beyond 10 yuan. The stabilization of the GDP figure does not mean that people have benefited, nor does it mean that a reasonable production-consumption structure has been formed. Perhaps this only postponed the outbreak of the crisis, rather than eliminating it.

Theories that call for monetary contraction would have the same problem.

All the ideas that call for changing the amount of money "on demand" are calls for an arbitrary power that overrides all market participants, which can dilute the wealth of others and create obstacles for people's spontaneous transactions at will without having to bear any responsibility.

Leakage of currency

This is actually self-explanatory. The reason why metal currencies are superior to previous currencies is that they are easier to divide, so it is easier to get smaller units of currency. Bitcoin has the same characteristics. In addition, it can also meet people's cash needs by speeding up the circulation of currency, which is something that technological progress can do.

Summarize

We analyze the effects of changes in the quantity of money to see if a "flexible" money supply actually provides any benefit to people. It turns out that, at least for now, the arguments for a flexible supply - especially the "stimulus theory" - are untenable. Not only that, they raise many more problems. These problems are more real and more destructive than the benefits that proponents of flexible money cite.

The "shortage" caused by currency leakage can be alleviated even if there is a problem. You can think that the various "scalability" solutions that have emerged in the current Bitcoin world are solving this problem.

To some, Bitcoin’s monetary policy is bold, but to others, it reflects centuries of human thinking about money.

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