Bitcoin: Is inflation of Digital currency systems possible?

In an earlier post
https://masculineffort.wordpress.com/2013/04/12/some-questions-about-bit-coins/
I had raised some concerns about Bit Coins. Those are broadly divided into two categories
1. Technical concerns
2. Barriers to entry from competitors

While I am not qualified to discuss technical concerns, my feeling is that all technical issues will eventually be resolved. My biggest concern is regarding inflation by means of other competitors jumping onto the Digital currency bandwagon and thus diluting the buying power of BitCoin. My assumption was that it is not all that technically difficult to form another digital currency network and therefore each additional digital currency will dilute the purchasing power of a unit of BitCoin. A comment by Peter Surda, on my last post on Bitcoin convinced me to do a rethink. Now I am not so sure that it is so easy for a competitor to muscle into a mature Digital Currency space and dilute the purchasing power of the existing players. Peter has an excellent blog on various aspects of BitCoin at
http://www.economicsofbitcoin.com/

He also has a master’s thesis on the topic that you can obtain by doing a simple google search. I’m reading it at the moment, and I expect the effort to last a few days. In the meantime, let’s do some analysis with some questions

What is the Primary reason that BitCoin use is expanding?
Bitcoin’s main competitors are various fiat currencies all of which are rotten with some being extremely rotten. It does not take much to displace them. I hear several businesses in Argentina are now accepting BitCoins. The Argentine Peso is a truly sick currency. It does not take much to displace the Peso. It is my view that if various central banks had not made such a mess of their national currencies, BitCoin would have no takers. The early adopters of BitCoins have been desperate people with few options (eg: Businesses in Argentina). If there were to be a hyper-inflationary environment in any country now, I bet that there would be a stampede to get into BitCoin among people in that country. The current spike in BitCoin would seem like a molehill in comparison to that mountain. Note that BitCoin is not displacing any national currency yet. It is merely muscling in on some of the transaction. This can be expected to continue as long as central banks continue their policy of competitive devaluation. Here BitCoin is providing users a significant advantage over their Fiat competitors.

If BitCoin becomes established, can copycat competitors muscle in?
When I say copycat competitor, I mean another network which is similar to BitCoin. Another network not providing any significant advantages over BitCoin. So let’s do this thought experiment.

Let’s assume that BitCoin is an established player as a medium of exchange or a store of value in the Digital Currency space. Now another currency, say Bytecoin comes up. Could ByteCoins displace BitCoins from some of the market share just by virtue of being available as an option to buyers and sellers.

Let’s analyse this from a point of view of a business that accepts BitCoins. Suppose I am the owner of a Business that accepts BitCoins. Would I now start accepting ByteCoins which is a brand new Digital currency network? Before I accept ByteCoins from my customers, I would ask myself the following questions
1. Does ByteCoin give me some significant advantage over BitCoin?
2. Will it be easy for me to redeem ByteCoins?
3. Would my suppliers accept ByteCoins?
4. Could I use ByteCoins for personal or business transactions?

The answer to all questions above is probably No. It is currently very hard to redeem ByteCoins in comparison to BitCoins. The reason is that the ByteCoin network is so much smaller than the BitCoin network. The reason I would be so reluctant to accept Bytecoins is that difficulty in redeeming them due to the small size of the ByteCoin network. And the reason that the ByteCoin network is so small is the reluctance of business owners to accept the new currency. This is a classic positive Feedback loop or the chicken and the egg problem. It is well known that it will be far harder for me to redeem a ByteCoin over a BitCoin. Also, only a minority of my customers want to pay in ByteCoins (Due to the small size of the ByteCoin network). Why then would I accept a ByteCoin? It sounds like too much effort for a small amount of revenue.

The only valid reason for me to accept a ByteCoin is if there is a fundamental Flaw with BitCoin. But since I have assumed above that ByteCoin is similar to BitCoin, there is no real reason for me to accept ByteCoin

 

 

Once BitCoin is established, what features are needed for a viable competitor
From the analysis so far, we get some indications as how to how some other digital currency could muscle in on Bitcoin and dilute it’s purchasing power
1. The new currency provides a significant competitive/technical/technological advantage over BitCoin
2. Some Big Flaw is exposed in the BitCoin network
3. The new digital currency has backing from a big corporate house (a competitive advantage again. Just a rewording of 1.)

This is a big relief for me. My earlier assumption was that the barriers to entry were very low. This assumption is wrong. The barriers to entry are not low. Once BitCoin is established, it will be very difficult for copycat competitors with no significant advantage to muscle in on the Digital currency space and dilute the purchasing power of the established players.

Conclusion
While inflation of Digital currency networks is possible, it is not easy. Nowhere as easy as the inflation of the fiat currency systems. New competitors can certainly enter the Digital currency space at any time, but it is nowhere as easy as I originally thought.

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About masculineffort

A Man should be able to change a diaper, plan an invasion, butcher a hog, conn a ship, design a building, write a sonnet, balance accounts, build a wall, set a bone, comfort the dying, take orders, give orders, cooperate, act alone, solve equations, seduce a woman, analyze a new problem, pitch manure, program a computer, cook a tasty meal, fight efficiently, die gallantly. Specialization is for insects.
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3 Responses to Bitcoin: Is inflation of Digital currency systems possible?

  1. Pingback: BitCoin: State interference | masculineffort

  2. Peter Šurda says:

    First I’d like to stress that it is not impossible for something else to displace Bitcoin. However, this would, to a certain degree, occur along predictable lines, es I elaborate in my thesis in Section 3.4. It is not an exhaustive listing of all possible new winners, rather an explanation of vectors along which the displacement could occur. The argument of, for example, Patrik Korda, that the low barriers to entry are all that matters, I do not view as convincing. There are plenty of areas, in particular with communication protocols (of which Bitcoin can be said is a subset), where the barrier to entry from technical point of view is also non-existent, yet we do not see protocols displacing each other randomly, rather we see cycles of innovation and maturation. Some protocols are generic and open enough to make a displacement very slow (e.g. IPv4 vs. IPv6). Bitcoin is similarly an open standard with multiple open source implementations and can adapt to a wide variety of changes in requirements, even if it cannot adapt to everything.

    Do not be misled by the evolution of prices, that is not the most reliable indicator of adoption, similarly as the price of the shares of Facebook is not the most reliable factor of Facebook’s market share among social network sites.

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