[dllthomas]

Here is how inflation encourages investment. Imagine a simplified world, wherein you are choosing whether or not to invest in a company. The company is able to produce 5000 utils of value later, with your investment, and is willing to give you 10% of the proceeds in exchange for your investment of $300 now.

If the going rate for utils is $1/util now, consider the following situations and strategies.

    Situation 1) Later, the market is clearing $0.50/util:
        Strategy a) Stick money under a mattress:
            You keep your $300 now.
            It becomes $300 later, and can buy you 600 utils.

        Strategy b) Invest in the company:
            You give your $300 now to the company.
            The company produces 5000 utils later.
            The company sells the 5000 utils for $2500.
            You get 10%, or $250, which can buy you 500 utils.

    2) Later, the market is clearing $1/util:
        a) Mattress:
            $300 now -> $300 later -> 600 utils.

        b) Invest:
            $300 now to company
            5000 utils later (for company) -> $5000 later (for company)
            10% is $500, which can buy you 500 utils.

    3) Later, $2/util:
        a) Mattress:
            $300 now -> $300 later -> 150 utils.

        b) Invest:
            $300 now to company
            5000 utils later (for company) -> $10000 later (for company)
            10% is $1000, which can buy you 500 utils.

As you can see, in the setup given - which is clearly a crude abstraction but shares some dynamics with reality - when there is sufficient deflation you would do better not to invest in the company, whereas with no inflation you do a little better to invest, and with inflation you do a lot better to invest. That's how inflation motivates investment. The key point is that investing now translates into some amount of value created that doesn't (in most cases) change with prices, so when you turn it back into money at the later rate (by selling what was produced) its relative value compared to not investing is lessened.

[grinnbearit]

You're not taking risk into account, the company is not guaranteed to produce 5000 utils of labour, it could produce less or worse go bankrupt and produce nothing.

With no inflation, my risk free investment of money under a mattress produces no return. My risky investment with the company has the probability of a positive or a negative return.

With inflation, I'm forced to make a risky investments to break even. True, I can no longer keep my money under a mattress but I'm still an unsophisticated investor and choose to park my labour in houses for example which inevitably leads to a housing bubble.

With deflation, I agree, people would rather not invest in a business producing a lower return than the rate of deflation but why would that deflation occur? One reason could be more goods chasing the same amount of money implying real economic growth.

The problem I have with the current inflationary system is the distribution of new money, if all currency held and prices denominated in that currency increased by the same factor. It would result in a nominal increase in prices. No one would be richer or poorer after the increase. The current system distributes new money to people who directly interact with the central bank, rewarding them at the expense of everyone else.

[dllthomas]

I didn't take risk into account because it simplified things. Run the numbers with risk and you'll see it doesn't change things substantially - it effectively just changes what percentage I expect to get from the company.

Your point about unsophisticated investors bearing more of that risk is a good one, but doesn't change the fact that inflation motivates investment and deflation motivates hoarding - it points out one negative consequence of motivating investment.

Regarding your last point, we're discussing potential problems with bitcoin. A criticism of the current system - well founded or not - doesn't amount to an endorsement of a particular policy in an alternative system. Do you object to bitcoin mining distributing new money to miners? If not, would you object to it continuing to do so through expansion of the bitcoin supply rather than switching over to paying miners more entirely through transaction fees? My broader point is simply and entirely that the cap on the number of bitcoins presents some long term risk to an economy using bitcoin as currency.

[grinnbearit]

A venture with a 75% chance of providing 5000 utils of value is not the same as a 100% chance of producing 3750 utils.

Put another way, inflation motivates gambling and deflation motivates saving - it points out a serious consequence of forced spending, namely a flight to other, less abstract stores of value.

I would like your views on what deflation represents in an economy, I understand people are saving/hoarding money but by never spending it don't they remove themselves from the system? On the other hand, wouldn't an increase in productivity lead to the same amount of money buying better/more goods?

Using a stupidly simple model, if the total productivity of a society using Bitcoin remained constant would there be any deflation? What if the total productivity fell?

We should discuss the implications of mining in another post :)