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An argument concerning Bitcoin, Peercoin, inflation and transaction fees

Background

First some background. Bitcoin's appeal right now is that is has the potential to become a useful “medium of exchange”. That is I can trade it as a unit for to gain a product or service, with the expectation that everyone else will also accept it as a unit the products and services I produce. Bitcoin has the ability to give us this network effect value with far less friction and cost than current currencies and that ABILITY is hugely important and hugely valuable.

I'm oversimplifying slightly, but all in all this ABILITY is the core value of bitcoin. Here is an analyst note that dives more deeply into this topic http://www.scribd.com/doc/188644617/Bitcoin-Intrinsic-Value-Wedbush-Report-December-2013

One of the attributes about bitcoin and all of the other crypto currencies is their inherently deflationary structure because of their tie to people and computers. People's hard drives get through in the garbage. computers crash. Passwords get forgotten or lost. Etc etc. All of these things mean that the total total number of available bitcoins (and other cryptos) in the world will inexorably fall shrink over time. As the number of accessible coins shrinks, there will be fewer coins to pay for goods and services meaning each coin will need to buy more.

As an analogy - imagine an island with 100 people and 1000 dollars. each person has 10 dollars they can split into 100 pennies so there are really, at most 100,000 units that we can use as a medium to exchange our goods and services. How lets say our populations grows and we have 10,000 people all producing goods and services. the 100,000 pennies will have to account for all of that. Suddenly, that load of bread was charging 1 penny for when we have 100 people now needs to pay for 3 loaves of break. But what if I only want to buy 1 load? How do I split my penny up? The answer is that you can't! And this causes all sorts of trouble including reducing peoples encouragement to produce more loaves of bread. Even if others would eat the bread, since those people don't have the pennies to pay the bread doesn't get made. One way to think of this is that because money supply has to represents all of the goods and services in society, if the money supply is too small, then the number of goods and services shrinks to match the money so that everything is still represented. This is why central banks increase the supply of money over time (look at academic research on the relative shrinking of the money supply during the great depression to see how this plays out in real life). If central banks (or treasury or some other actor in society, I'm not here to argue about who the course of money supply should be ;-) ) creates an extra 100,000 pennies, now there are enough pennies to go around and represent the cost of goods and everyone can spend and eat and everyone is encouraged to produce all society needs.

However the cost, the deep burden, of issuing more pennies is inflation. Inflation means that the relative purchasing power of the original penny holders is cut in half. No one likes this experience, even if it frees up enough units of currency so that everyone can buy bread.

Bitcoin and peercoin

Turning back to cryptocoins and bitcoins in particular - in a world of deflationary bitcoins we could expect the same eventual shrinking money supply problem. As passwords get lost etc, eventually there wont be enough coins to go around to represent all the goods and services - BUT FOR ONE THING! Bitcoin has the ability to add decimals. Unlike pennies which we can't split into half pennies and the like, we can easy split BTC down to smaller and smaller unites. So as long as we remember the password to a wallet that has even only 1 BTC, we can always split it up enough to be a useful medium of exchange that others will trust throughout society. And the best part of splitting is that everyone's relative purchasing power will stay the same! There will be no inflation as more and more goods get produced. Instead everyone becomes relatively richer because there will always be enough fractions of a bitcoin to represent all of the new goods and services in the society and so society can price them using those fractions.

And again, the central value of bitcoin is the ability to represent all of the good and services in society, and to be transferred from person to person. That ABILITY is the value of bitcoin.

PPC's value question is the same as BTC. Can PPC be transferred from person to person and used to represent all of the goods in society? Yes. And like bitcoin, this value will only exist if enough people adopt it to create a network effect. To repeat, only if PPC is adopted by enough people will this value be realized and PPC last.

Now, PPC is different from bitcoin because the transaction fee exacerbates the deflationary aspects of bitcoin. Instead of lost hard drives and forgotten passwords reducing the number of available coin, coins are destroyed by the transactions themselves! Over time this reduces the number of PPC that can represent goods and services. If these lost coins can't be replaces, PPC is dead because the supply constantly shrinks.

Unlike bitcoin, PPC uses PoS interest to offset the shrinkage of the money supply. As long as interest is high enough to offset the lost coins and the coin transactions, then the relative supply will stay stable. However because the increase in the money supply isn't through subdivision like bitcoin, and instead is through minting additional coins, it is possible that the PoS rate could be set too high, and too much inflation occur, and the relative purchasing power of each holder will get destroyed. Just as happens with runaway inflation in normal currencies. Thus PPC's balancing act between the fee and the PoS interest rate is VERY important and delicate. If the fee is fixed, PPC is very vulnerable to the balance growing out of whack.

On the other hand, if the transaction fee can be moved out by a decimal over time, this allows PPC to respond to lost supply in the same way at BTC, and removes and the interest rate can be kept very small just as it is now.

All in all, the fee and interest rate have to be kept in careful balance. The higher the fee, or the higher the rate, the harder it will be to find that balance. Just as central banks today have a devil of a time figuring out what interest rate to set for society. It's not easy. During early days, the FEE is super useful to prevent block chain bloat and protect the coin as more people adopt it. However this benefit is only temporary. Over time, if the fee remains as it is, it is VERY uncertain whether the coin will be adopted by enough people to be a trusted medium of exchange, and if that doesn't become a true medium of exchange (which is the central value proposition for any cryptocoin) then the coin will eventually be abandoned.

We should do everything we can to reduce uncertainty around the coin by making it as flexible as possible so that it can respond to changing circumstances and truly be sustainable.

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