Stellars inflation mechanism gives every holder 1% in new tokens a year. This means that someone holding 100 tokens now, will hold 101 tokens next year. Generally one of the reasons mentioned for such a mechanism to exist is to incentivize spending. This article assesses to what extent the current implementation does this and to what extent it would actually be needed to incentivize spending through (currency supply) inflation.
The difference with fiat inflation
It’s important to distinguish how this is different than regular inflation (in fiat money).In regular fiat, new money is created by people that take out loans.
This new money does not get into the hands of everyone. Only those that take out loans initially receive this new money. This means that a big portion of people will see the value of their money diluted. The idea is that these people will have a bigger incentive to spend their money now (since they can buy less next year).
Back to Stellar
As explained, in Stellar every holder receives 1% inflation every year. This example illustrates what happens:
The exchange rate might have decreased by 1%, but because someone also has 1% more coins, there is no decrease in total wealth. Everyone has the same share in freshly created money.
There is thus no incentive to spend.
As an analogy, imagine an island with 100 oranges, nothing else. The currency on the island is lumens, there are 100 in circulation. Everyone has 1 XLM and can thus pay for 1 orange. Now Stellar inflation kicks in. The total amount of lumens is 101, but there are still 100 oranges. The price of orange would likely change to 1.01 XLM. Which means, every person can still pay for exactly 1 orange.
Should we have an incentive to spend?
Another question is whether we want to build a mechanism that is aimed at depreciating the value of XLM at all? The reasoning behind this is that people should be incentivized to spend their money and not hoard it. Let’s take a look at where this reasoning comes from.
Deflation is scary
Some economists (mostly Keynesian) argue that a decrease in the general price level leads to a delay in spending (I can buy this cheaper next year). This effect is however not forever. As von Mises argues, buying that new iPhone today is more expensive, but “ the value of using an iPhone over the next six months is worth more than the savings in delaying its purchase”.
The 19th century shows us that long periods of decreasing price levels can go hand in hand with significant economic growth.
So then why are all economists fearing deflation? For one, it is because we have a system in which money is created through debt. This means that if the value of currency increases, it becomes harder to pay back a (government)debt.
Artificially lowering interest rates and thereby increasing the money supply, lead to malinvestments (it’s easy to run a business with free money). If at some point these businesses go broke, the money supply decreases (loans = money). Decreasing money supply can lead to an increase in the value of a currency (deflation). Deflation is thus often more a result of increases in the money supply instead of triggers for a recession.
Concluding, in the fiat world, deflation is mainly scary because of the enormous amounts of debt that were created by artificially lowering interest rates. Not because a small decrease in price levels by itself is so scary.
This short article, which I highly recommend to read, explains this in more detail.
But what if the economy grows, we need more money right?
As seen above, a gradual but slow decrease in price level is not bad perse. Keynesian economists argue that if the economy few 2% a year, we would need 2% in additional money supply to keep prices stable. However, the existing money supply can easily be used to pay for the increased demand. Yes, prices could decrease by 2%. But is that bad? Don’t we all want decreasing prices? It would mean that everyone would profit from the increase in productivity since everyone’s money would increase in value.
This article is an interesting read that goes into more detail.
But what if people start hoarding currency? Then economic activity will decrease, which will lower the demand for money and bring prices up again.
Deflation in fiat money, which is created through debt, should thus not be compared to an asset like lumens, which is not created by debt. Lumens can be a great medium-of-exchange without artificially increasing the money supply.
Wait, but what about the giveaways, don’t they inflate the money supply?
Yes, they do. For a medium-of-exchange to function, you need to distribute it to people. Bitcoin does this by mining. We can see that only a small group of people now holds 90% of the Bitcoin. This is not ideal. Stellar chooses to distribute the supply by giving them away for free. By not instantly giving away the total supply to a small group of enthusiasts, they are able to create a more even distribution of money. This is part of the reason for the gradual inflation of the circulating supply.
Another reason is that giving away lumens can create a lot of value. If for example, a grant of $1 million in lumens enables a company to create a product that is used by thousands of people, that $1 million will have created a lot more value for the total ecosystem. Those thousands of people will also eventually need or want to hold lumens. As long as giveaways create more value than the dilution costs, they benefit the ecosystem in the longterm.
A very good example of this mechanism is the PayPal giveaways in the ’00s. Read more about how they gave away millions of dollars, but got millions of customers in return.
Let’s hope Stellar Org can do the same.
TL;DR
1. The current inflation model in stellar does not incentivize spending.
2. Stellar lumens is not a debt bases asset like fiat money is. It, therefore, has different characteristics. Incentivizing spending is not really needed. Added to that, do we want to incentivize spending by depreciating the value of XLM?
P.S. There are more arguments for and against keeping the 1% inflation. This post focused solely on the “we should incentivize spending” argument.
