Halving Fallacy

Bitcoin consensus-rules produce a predictable rate of monetary inflation. This rate is reduced periodically at a point called the halving. There are several step functions in Bitcoin. The halving occurs every 210,000 strong blocks, the difficulty adjustment every 2,016 strong blocks and chain organization approximately every 10 minutes. The numeric values that control these intervals are arbitrary yet the discontinuity is necessary due to the discrete intervals required for proof of work.

There is a theory that the halving creates a financial cliff for miners that may lead to a perpetual stall. The theory is based on the confluence of two step functions (halving and difficulty), causing the period of another (organization) to expand dramatically. The theory assumes that the difficulty adjustment resets average miner economic profit to zero, allowing only the top 50% of miners to survive over time, eventually reducing mining to just a few miners. In other words the difficulty adjustment is considered a pooling pressure.

However there is no reason to believe that the adjustment reduces any miner's profit to zero. The consequence of the assumption is not that there will be few miners, but that there will be none, due to the difficulty adjustment alone. The adjustment actually does nothing to regulate miner profits, it controls only the organization period. Time preference, which dictates market return on capital, regulates miner profits just as it does in every market.

Consider the case of no price change. In this case there is no reason to expect a change in total hash rate. There are no adjustments to difficulty, and we can conclude that the average mine generates the market return on capital. Below market return on capital reduces hash rate and above market increases it, as capital chases returns. Increase of total hash power decreases profits, discouraging hash power, and reduction of total hash power increases profits, encouraging hash power.

In other words, in the absence of price changes, any number of independent miners can compete indefinitely (absent actual pooling pressures). However, the case where price is increasing or decreasing is no different than hash power increasing or decreasing, so this conclusion applies generally. Miner profits are expected to always average the market rate of return on capital, and therefore the theory builds on an invalid assumption.

The other holding of the theory is that reward may be insufficient to compensate miners for difficulty immediately following a halving. As such they may opt to reduce hash rate, extending confirmation times until fees rise, price rises and/or difficulty adjusts downward. Yet fees and price are determined in a market and can certainly rise to any level that people are willing to pay. There is no way to know what levels the market will support. Yet the two largest halvings have passed with no disruption, fees and price have both risen, encouraging significant increases in total hash rate.