“The biggest problem with bitcoins, however, is conceptual: if they succeed, they fail.” –Felix Salmon, gearing up for a deflationary argument in The Bitcoin Bubble and the Future of Currency
Despite the polarizing question of Bitcoin's future, we can say with certainty
that particular arguments on the subject are good or bad ones. One bad
argument that has been making the rounds lately says that the protocol's fixed,
finite supply of coins makes the cryptocurrency useless as a medium of
exchange, because it would induce a deflationary spiral.
The argument goes: suppose, for the sake of contradiction, that Bitcoin has become used as a medium of exchange. This usage would presumably be increasing over time, similar to how the world economy grows overall. Perpetually increasing usage, when the supply of Bitcoins is fixed, means the value of each Bitcoin must also be perpetually increasing. But if their value is perpetually increasing, no one will want to spend their Bitcoins, because they'd rather hold on to them and capture that appreciation. Therefore, they won't be spent after all, so Bitcoin cannot work as a medium of exchange.
First of all, the present value of a perpetually appreciating asset is not infinity. Consider real estate. Like Bitcoins, they aren't making any more of it. It has major instrinsic value, which is growing, since they are indeed making more people. Yet the present value of a piece of real estate is clearly finite. That's because money in the future is worth less than money now, and people intuitively (and economists, mathematically) model this when valuing something.
Second, there is a liquid market for Bitcoins. The existence of this market distinguishes Bitcoin from any of the supposedly relevant historical examples of deflationary spirals. And the existence of a market price shows that people value Bitcoins differently: for every buyer, there is a seller. And someone who sells a Bitcoin for X would have been equally happy to spend it on something they value at X.
Third, the marginal utility of money is diminishing. Put simply, as a person's wealth increases, they want to spend more. As someone's Bitcoin wealth becomes worth more, each part of it becomes worth less to them. This is especially true because Bitcoin is one asset among several that someone is likely to hold, with its own risk profile.
Those are the fundamental flaws in the deflationary argument. In practice, people make several more, such as ignoring the time-value of purchases, conflating volatility and market corrections with deflation, making claims from society's perspective instead of the individual's (e.g., saying inflation is a good kind of taxation), and of course, ignoring the empirical fact that people are spending their Bitcoins.
There are real flaws with the Bitcoin protocol that detractors could focus on. Deflation isn't one of them.