Cryptocurrency deflation

One of the biggest problems with bitcoin, and with cryptocurrencies more generally, is deflation and instability. Because there’s no central authority to mediate supply according to demand, the value of bitcoin fluctuates wildly.

Are there any algorithmic, decentralized ways to correct for deflation – to basically create a trustworthy central bank in distributed, algorithmic form? You’d probably need (1) a well-defined, easily-measurable, non-gamable measure of deflation, and (2) an algorithm that mediated supply of currency accordingly.

(1) seems especially hard. In fact, there’s never been a really sturdy, objective measure of inflation. Basically we just look at how much a bunch of things cost over time and kind of make an educated guess. But (in theory), there are predictable ways rational actors should respond to inflation/deflation that might be easily measured.

When a currency is experiencing deflation, it will buy more apples tomorrow than it could today. So someone who wants apples has an incentive to wait. Under deflation, you expect money to move around more slowly as everyone waits for their money to become even more valuable tomorrow. You could measure that in a decentralized system where all transactions are public (like Bitcoin) – but it’s gamable. I can just create two accounts and have them trade the same penny back and forth a billion times a second, and suddenly the entire economy’s average speed is way up.

What if we could measure people’s tendency to hoard money rather than spend it, as a proxy for deflation? You would need some way to distinguish hyper-penny-trading cheats from actual savings, though.

Suppose we build a way to precommit to saving money – to “lock” money away and make it nontransferable for some period of time n, in exchange for some interest. Functionally like a CD, except that the money is really locked away and not being loaned out for productive projects in the meantime. Longer commitments earn a higher interest rate.

When deflation is high, people will be incentivized to lock more money in savings. If this is public information (and in cryptocurrencies, pretty much all information about the current state of money is public), you can have a well-defined, if approximate, measure of inflation. The mining algorithm can use this to tweak the speed at which coins can be mined.

When lots of people are saving, make the mining problems easier to increase supply. This makes all existing currency slightly less valuable, decreasing the incentive to save.

When lots of people are spending rapidly, make the problems harder. You can even tweak the interest rates on the pseudo-CDs to counter inflation when necessary – making saving more appealing when people are rapidly spending money.

Disclaimer: I am not an economist, and there are likely a lot of problems with this I’m not aware of. And I didn’t even touch on the nitty-gritty of what algorithms to actually use for tweaking mining difficulty and interest rates.

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