‘Deflation’ is a dumb way to approach tokenomics… and other sacred cows – Cointelegraph Magazine

Having taught and studied token economics at the University of Nicosia, I’ve found that students often have some decidedly muddled beliefs about how what tokens are and how business and token economies work.

Unlike microeconomics and macroeconomics — which are based on decades of research, debate and inquiry that have produced some commonly accepted principles — tokenomics is a much newer field of study full of people without economics experience.

There are many self-professed “experts” who provide advice that sounds fine and is often even sensible in theory but that fails in practice.

When designing a token economy, what you really want to focus on is:

• Is the economic strategy repeatable?
• Is there some way of diagnosing when and how to deploy the strategy for your token and the estimated value of doing so?
• Is there research that validates the strategy so you can talk about it more credibly?

Deflationary tokens

Take, for instance, the idea held dear by many that deflationary tokens have an absolute advantage. “Deflationary” means an ever decreasing supply of tokens, which in theory increases the purchasing power and value of each remaining token. “Inflationary” means the opposite: an ever increasing supply which, in theory, reduces the value of each token.

You’ll hear commentary along the lines of “how deflationary tokens empower a crypto project’s value” from blockchain pundits such as Tanvir Zafar celebrating the limited supply of Bitcoin and the deflationary supply of Ether following the Merge.

It’s an idea even propagated by a widely recognized community for tokenomics best practices, the Tokenomics DAO, which has a “Tokenomics 101” page that states: 

“People who understand Bitcoin will see great value in the fact that it is so simple, elegant and has a limited total supply. Bitcoin’s tokenomics have created digital scarcity that is enforced (through token incentives) by the network.”

But while many token designs emphasize deflation, “they are not optimally designed,” according to Will Cong, the Rudd family professor of management and faculty director of the FinTech at Cornell initiative at Cornell University.

Taking their cues instead from tweets and community ideologies, “many platforms also can’t even write down a logical objective for their token supply and allocation policy,” Cong continues.

Focusing on whether a token is inflationary or deflationary shifts attention to second-order issues. The price of a token can always adjust to meet supply, and each token can be arbitrarily fractionalized, so a fixed supply is a moot point if the token does not provide value to end-users. 

“In fact, some inflationary coins with robust burn rates may regularly switch between being inflationary or deflationary, like Solana,” explains Eloisa Marchesoni, a tokenomics consultant. “The inflation rate started at 10% and will reach its final rate of 1.5% in about 10 years, but there are also deflationary features, like a percentage of each transaction fee getting burned.”

“With enough transactions per second, the transaction fees that are burned could be even higher than 1.5% per year if many transactions occur, which would bring Solana’s inflation rate to 0% and make it deflationary in the long run.”

Token price falls and deflation

Although cryptocurrencies behave very differently than traditional asset classes — according to research by professors Yukun Liu and Aleh Tsyvinski — they are heavily influenced by momentum and market size. In other words, investor sentiment and the number of users on a platform are significant predictors of cryptocurrency returns and volatility.

Fluctuations in the valuation of traditional asset classes may not have a direct effect on crypto, but they can indirectly affect it through spillover effects. For example, changes in interest rates will dampen the risk appetite of investors who are heavily exposed to sectors like real estate.

In this sense, even if a token has deflationary properties, a common macro shock that stifles aggregate demand renders these deflationary properties less useful since the decline in demand lowers the price of the tokens, and as a result, they cannot buy as much.

That said, in general, the cryptocurrencies with the highest market cap are also the most resilient to the current global recession, so we are mainly talking about Bitcoin and Ether.

Novelty tokenomics

Many tokens with novel tokenomics have risen with transient social media momentum but subsequently collapsed as the fads passed.

“SafeMoon relied on heavy selling fees and deflationary mechanics to convince holders that the price would go up endlessly even though the protocol never actually identified the problem it was actually solving,” says Eric Waisanen, chief financial officer of Phi Labs…