If bitcoin becomes widely popular, it will be a subject to deflation because the currency cannot exceed 21 million bitcoins.
Reasons and effects of deflation
When deflation occurs, the purchasing power of the currency goes up, which means that costs of labor, goods, and services go down.
One of the biggest issues with deflation is that it makes it hard for players in the market to use debt financing. However, deflation increases the power of savings-based financing.
Economists that belong to the Keynesian school argue that deflation is bad for the economy because it provides the incentive for the participants of the marketplace to save money and not use it instead of putting it to work to grow the economy. The Austrian school does not agree with this argument and states that deflation may happen at any stage of production and parties who choose to invest during the periods of deflation do benefit from the issue. As a result, profit ratios stay the same and only their scale changes. In other words, the currency becomes more valuable and goods and services decrease in price but the resources necessary to produce them also decrease in price proportionately, effectively not hurting the economy. At the same time, price deflation does provide an incentive for hoarding, which is when individuals and businesses save money instead of spending it.
Here is an example how it could work in real life. Let’s say there is an economy that consists entirely of broccoli and spinach and the currency of exchange is silver. Because both broccoli and spinach are not consistent and can decay, they can’t become currencies instead of silver. In order to trade, participants in the marketplace use silver to get either spinach or broccoli. People start seeing silver as a store of value because they can’t store value long-term in spinach or broccoli, yet at the same time, they can exchange silver for spinach or broccoli any time they want. If the economy starts growing and produces more spinach and broccoli, their prices will start to go down. If the ratio of growth stays the same between the two, the exchange value between them will not change but those who chose to hold to silver will be able to purchase more product of their choice with the same amount of silver. That’s how deflation works.
A deflation spiral occurs when people start hoarding the currency in hopes of being able to purchase more goods and services in the future. As the value of currency increases, the incentive not to spend it also increases because by not investing the funds and merely keeping them people are hoping to get more for less in the future. In a complex economic system, a trend like this may lead to participants in the marketplace not willing to spend the funds and economy slowing down simply because there are not enough funds available in the marketplace.
Loss and willful destruction of bitcoins
There are several scenarios in which it is possible to lose or destroy bitcoins. For example, if you send funds to a bitcoin wallet but the owner of the wallet loses the private key from the wallet, the owner will not be able to access funds and bitcoins will become inaccessible and unusable.
The fact that the bitcoin network is a free decentralized network has its pros and cons. The pros of not having a central authority mean that a network is very secure because there is no central place for hackers to attack. It also means that every user on the network knows how bitcoins come into circulation and everyone plays by the same rules. There is no central bank that can suddenly decide to print more money because it needs more. This simply can’t happen on the bitcoin network.
The disadvantage of this structure is that if something goes wrong, for example, you send money to scammers or you lose the private key from a wallet, there’s nothing you can do about it. There is no phone number to call or support to contact. Once a transaction happens on the bitcoin network and gets confirmed, it becomes irreversible even if the user who initiated the transaction changes his or her mind about it.
While this may seem strange for a digital currency, it is true that it is possible to destroy bitcoins just like it is possible to destroy paper money. Destruction of bitcoins can occur by attaching conditions that make it impossible to spend the coins.
A common way of bitcoin destruction is to send them to an address that will pass validity checks but that has no known private key. An example of such address is 1BitcoinEaterAddressDontSendf59kuE.
Another way to destroy bitcoins is to send them in a transaction with conditions that are almost impossible or completely impossible to meet. An example of such a condition would be to use a script that requires the recipient to prove that in the decimal system 2 plus 2 equals five.
Yet another way is to send funds to an address that has a private key in the range outside of the valid private keys. An example of such address is 16QaFeudRUt8NYy2yzjm3BMvG4xBbAsBFM .
Finally, there are some technical issues that prevent some coins from being spent. For example, the first fifty mined bitcoins included in the Genesis Block can’t be spent. Also, a miner could create a transaction with an identification number that exactly matches a transaction in the previous block of the bitcoin blockchain. If this happens, the reward from the previous block will become unspendable. As of the writing of this article, there have been two such cases that are known.