Bitcoin has a fixed supply. Ethereum has a variable supply whereby the supply decreases if the velocity of money increases, and vice versa.
That’s a new invention in crypto money. Until now, there was either a fixed total supply or a fixed new supply like for Dogecoin. Tying supply to demand however is only being tried now.
Since September 15th 2022, ethereum has been taking eth out of the total supply if the number of transactions, and thus network fees, arises above circa 2,000 eth a day, adding otherwise.
Through this process it contributes to a complex part of economics that we can simplify by asking: how do you design a moving measurer of value.
Moving because money does come from trees. We have one dollar in total circulation and we have one apple. The apple came from “nothing” in as far as it naturally grew from nature, but we still need to give it value, or measure it with fiat in this case rather than a ruler.
Unlike a table that is of fixed length and can’t itself grow, a new apple can come from nothing. We now have two apples, still one dollar, and each is worth 50 cent. That’s severe deflation and potentially depression.
So we print another dollar. Each apple is now still worth one dollar, we have price stability, we don’t have inflation, but that is presuming we do print one dollar and not a cent more which is not the practice in current fiat money where they print $1.02 to target 2% inflation.
That’s in theory, in practice just how many cents they print or destroy is open to significant errors due to the lack of complete information and due to what we’ll umbrella as political risks.
But even in theory, their aim is not to keep prices stable, but for prices to increase. In the simplified world of two apples we’ve given, that’s basically a 2% tax because the apple is not worth $1 but 98 cent as 2 cent of purchasing power has been taken from inflation.
If we try to justify this, one can say the dollar is not printed but loaned, and that loan has to come at a cost, if for nothing else than the loaner to cover the cost of business. The 2% therefore is not quite a tax, but a network fee.
In this way we can make fiat work a bit more objectively by central banks targeting an interest rate of 2% and no higher nor lower.
As it happens their target moves all the time and now they’re targeting less than 2%, but overall they’re trying to apply what economist Friedrich Hayek said, the Nobel prize winner who focused on money.
His view was that one dollar today should buy about the same as now in one hundred years. With a target of 2% inflation this is impossible, especially as inflation is year over year, so 4% two years from now.
Having neutral money however, neither inflation nor deflation so fixed in purchasing power, is difficult because you need to know what in the complex world is far more than just apple production, including the value of this very article for example.
We have all sorts of bureaus that try and crunch these numbers and get estimates, but they are estimates and they are limited.
Rather than measuring production, from a theoretical point of view – even if it may have not been intended – ethereum may be asking why not base it on the velocity of money.
MV (What is bought) = PQ (What is sold). (M= Money supply, V = Velocity of circulation, P = Average price level/inflation, Q = quantity of goods/services sold).
So says the Fisher equation in describing inflation. If the money supply or its velocity increases while the second part of the equation remains the same, then prices increase.
By decreasing the total money supply, an increase in the velocity of money might be cancelled out, and so we keep prices stable in eth.
In theory. In practice this is very new and what prices are there exactly in eth? Well there’s the Apes and other NFTs, and plenty of tokens priced in eth, with it acting as a unit of account though to a limited extent. And then obviously there’s its value against the dollar or bitcoin.
In ethereum and other public blockchains we can directly measure velocity through the number of transactions.
This used to be very simple because everything happened on the base blockchain, but now with second layers, there is plenty of activity happening elsewhere, although it does still settle on the base blockchain so we can still overall measure it.
With traditional money, measuring velocity directly can be impossible if cash is used. Crypto therefore has a new tool, velocity, and since we can directly use it, for the first time it has become part of tokenomics.
It’s all automatic and it is not clear whether it came by accident as what we’re calling this variable monetary policy based on the velocity of money is made of two parts.
There’s the burning or the destruction of a percentage of eth that is used in a network transaction fee, and this primarily came about because miners were gaming the system.
Rather than designing some velocity money, the aim was to add a cost for a transaction even for miners, but looking at it all now, the end result is a velocity design.
Then there’s the stakers reward, the actual cost for running the ethereum monetary system. That’s variable too depending on how many stake and therefore on how high is the security, but it generally amounts to about 2,000 eth a day.
Until 2,000 eth is burned in fees, the network is inflationary which according to orthodox economics incentives activity.
After that 2,000, we don’t want any inflation from the velocity of money, so we reduce supply. Something that when there is high demand translates to deflation, keeping inflation in check.
Where wider economics is concerned, this is obviously a sort of lab experiment because very few would be buying or pricing apples in eth, or indeed this article although subscribers can pay the dollar denominated amount in eth, which is kept in eth.
Nonetheless, very unnoticeably, this is the first time in the history of man as far as we are aware whereby a monetary system is automatically manipulating its supply based on the velocity of money.
That got to be quite an experiment that may well contribute to wider economics and potentially our collective knowledge on this moving measurer of value.