Deflationary spiral is an economic argument that proposes that runaway deflation can eventually lead to the collapse of the currency given certain conditions and constraints. It is a common criticism made against the viability of Bitcoin. The ‘deflationary spiral’ is a real condition that affects the fiat fractional reserve backing system. Bitcoin is not affected by this because it is fundamentally different from fiat currency. (See below for a dissenting argument on this topic.)
Deflation is a decline in the general price level. Deflation occurs when the price of goods and services, relative to a specific measure, decline. It is not necessarily that the value of the goods and services themselves declined, but can be because the value of the currency itself increased.
For example, let us consider an economy comprised entirely of beef and oranges where the medium of exchange is gold. Both beef and oranges can decay and are not consistent, and therefore cannot be used as a currency. In order to trade, people exchange gold for either beef or oranges. They see gold as a store of value that they can use to purchase beef or oranges in the future. What happens when the economy grows and we can produce more beef and more oranges? The price of both beef and oranges will decline. To the extent our productive capacity for both beef and oranges increased at the same pace, the exchange value between the two (the amount of beef for a given number of oranges) will likely stay the same; however, those who held gold as a store of value would now be able to purchase more beef and more oranges for a given amount of gold.
A deflationary spiral occurs when the value of a currency, relative to the goods in an economy, increases continually as a result of hoarding. As the value of the currency relative to the goods in the economy increase, people have the incentive to hoard the currency, because by merely holding it, they hope to be able to purchase more goods for less money in the future. A lack of currency available in the market causes the price of goods to further decrease, resulting in more hoarding.
In our economy of beef and oranges it is easy to see how this could occur. First, people see a significant gain in productivity on the horizon; we will be able to produce more beef and oranges for the same effort in the future. The supply of gold, however, is fixed. As a result, people desire to hold gold, because they will be able to purchase more beef and oranges with their gold in the future than they can now. This will lead to a decline in the price of beef and oranges as measured by gold (an increase in the value of gold). Limiting the amount of currency in the market available for exchange can also make transactions more difficult. In a complex system where we do not only have beef, oranges and gold, this can result in a deflationary spiral where no one wishes to spend their currency and the economy itself slows as a result of the limited number of transactions. Limited demand with fixed output results in a decline in prices, which further exacerbates the problem.
A deflationary spiral occurs when the price of a traded article increases at some given rate, which causes people to hoard it. As people hoard the commodity, less and less of it is available thus causing the price to go up even more. In turn, even more people hoard the commodity. Thus a feedback loop or spiral of deflation occurs.
In practice, there is only a limited amount of 'value' that can be placed upon a good before it becomes too attractive to trade for other goods (thus ending the spiral). The only time that the 'Deflationary Spiral' can happen (to it's conclusion) is when people can foresee a time where they are forced to use that particular traded article. See below for a dissenting argument on this topic.
In The Fiat Fractional Reserve Banking System
The fiat money that we trade consists of the principal of the loans of other people. All this money must be someday 'repaid.' When people save (pay back their loans), the total monetary supply contracts. When people spend (take out loans), the total monetary supply is increasing.
If you have people who are hoarding money, the principal still needs to be repaid. Hoarding will make it harder for other people in the economy to pay back their loans.
Because people foresee a time where they need to pay back their loans (a future fixed expense), when the value of the money starts to increase (deflation), those with loans will endeavour to pay back the loans quicker. This causes the monetary supply to reduce, reducing the total amount of money available for repayment of loans, again making it harder for people to pay back what they owe.
This Deflationary spiral diverts funds away from the legitimate economy, to the repayment of debt. Causing the economy to stagnates and stop.
The key difference is that people don't foresee a fixed cost (unit amount) that they must pay with Bitcoin. If the value of the Bitcoins that they own increases, then any future cost will take a proportionally smaller amount of Bitcoins. There isn't any fixed incentive to holding Bitcoin other than speculation.
If the economy that uses Bitcoin grows, the per-unit value of Bitcoin proportionally increases also.
Everything is the opposite to the fiat fractional reserve banking system (because Bitcoin isn't a debt but an asset). Bitcoins only deflate in value when the Bitcoin Economy is growing.
Because the Deflationary spiral is a real problem in the traditional monetary system, doesn't necessarily mean that it will also be a problem in the Bitcoin economy.
"Elaborate controls to make sure that currency is not produced in greater numbers is not something any other currency, like the dollar or the euro, has," says Russ Roberts, professor of economics at George Mason University. The consequence will likely be slow and steady deflation, as the growth in circulating bitcoins declines and their value rises.
"That is considered very destructive in today's economies, mostly because when it occurs, it is unexpected," says Roberts. But he thinks that won't apply in an economy where deflation is expected. "In a Bitcoin world, everyone would anticipate that, and they know what they got paid would buy more then than it would now."
--MIT Technology Review: What Bitcoin Is, and Why It Matters, May 25, 2011
A deflationary spiral occurs when there is an incentive to hoard because of declining prices, which results in even less available currency on the market, further perpetuating declining prices.
How could this occur in the Bitcoin market? First, we see massive deflation occurring in the market right now, as the value of a Bitcoin relative to other currencies, and as a result goods and services as well, increases. To the extent there is value in a Bitcoin because there will be a limited number of them in the future and they are one of the few untraceable mediums of exchange that cannot be subjected to expropriation (at the moment), it is easy to see why their value is currently increasing. Already, however, this is creating the incentive for hoarding. Given there is a known limit on the future amount of Bitcoins in existence, the market expects that the "price" of Bitcoins as measured in other currencies will increase.
While this will not necessarily lead to a deflationary spiral, it will likely cause serious problems for Bitcoin which could ultimately trigger Bitcoin's demise, as outlined below.
1. Currently, with knowledge that there will be a limited number of Bitcoins in the future, the price of Bitcoins is increasingly rapidly. The result is limited price stability. Limited price stability has a negative impact on the acceptance of a currency. Vendors do not wish to speculate on the price of currency when selling goods or services.
2. Once prices do stabilize in the future, there will always be the knowledge that the number of Bitcoins in the market is limited. As a result, to the extent the GDP of the Bitcoin economy increases (the total value of all Bitcoin transactions completed increases in "real" terms), there will continue to be price deflation. Price deflation rewards the holders of the existing currency and provides an incentive to hoard the currency. The value held by the existing holders of the currency, and the resulting reward that they receive for future deflation, can be eliminated by a competing system. As a result, to the extent there is an expectation for inflation because demand for the currency itself is greater than the supply of Bitcoins, a competing system will emerge.
Fundamentally, the growth of Bitcoin will be limited because of the knowledge that there is a limited supply of coins. The fact that there is a limited supply of coins means that there is an expectation of deflation if the economy grows. The "cost" of that deflation, borne by new users, can be avoided if an alternative system is used.
While this is not a traditional deflationary spiral, the constraint on the actual money supply can produce the same result, which is a limit on the value of goods and services transacted using Bitcoins.
What can be done to deal with this issue?
There is a simple solution to this problem. For Bitcoins to avoid being supplanted by an alternative electronic currency in the future, the supply of Bitcoins must grow in proportion to the total value of transactions undertaken using the system. This will lead to price stability and will eliminate the benefit that accrues to existing holders of the currency. This is fundamentally necessary to protect the existing value of Bitcoins. If this does not occur then an alternative system that does recognize the risk of deflation and price instability will present itself which will achieve a greater level of acceptance, destroying Bitcoin in the process.