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Bitcoin vs. Inflation

As inflationary monetary economics and liquidity traps come into focus with zero percent interest rates or even negative interest rates, many are looking to Bitcoin as an inflationary hedge or a protection against inflation. Billionaire investors are lining up to compare Bitcoin to gold. That particular comparison has some nuances but the broad macro-theme of Bitcoin being a protection against an inflationary environment has broken through, especially after the recent halving.

Why is that, and what are the historical and economic reasons we might see Bitcoin act as counter-force to inflation and what does it mean to say that it has a deflationary philosophy?

It’s helpful here to define inflation and look at a few historical examples. In general, inflation is a general increase of services and goods in a country over a sustained period of time. That’s the Wikipedia definition, but it’s helpful here to understand why this might be the cause: inflation generally comes about because of a general decrease in the purchasing power of a fiat currency. It is termed hyperinflation if the decrease in purchasing power reaches a critical inflection point where the decrease in fiat currency value and increase in prices for goods and services happens in a very rapid period of time.

What might cause that decrease in fiat value? An increase in money supply, foreign investors pouring out of a particular currency, or even investors attacking a currency (what George Soros did to the Bank of England, for example). Some of these are under the direct discretion of monetary authorities, while others reflect an international flow of capital that can seldom be constrained.

As a consequence, goods like food and other essentials become more unaffordable for people, as wages tend to be more fixed or static than rapidly increasing factor prices. It also becomes much more expensive to operate any business that requires raw inputs.

Deflation is the opposite force. Here, prices decrease as fiat currency increases in value relative to different goods and services. There might be different causes for this, ranging from a controlled money supply in the form of central bank restrictions or an increase in innovation.

A stark example of this is technology-driven deflation, where for example, the consumer prices for compute power has exponentially decreased as technological innovation has fit more processing power into smaller chips — you can see this in how your cellphone contains more computing power than the rocket that sent astronauts to the moon or in how sequencing a human genome used to cost a million dollars in USD, and now costs sometimes less than a few thousand.

Inflation is usually correlated with unemployment in what’s called a Phillips Curve. Usually, increases in inflation are correlated with decreases in unemployment, since money supply is more evenly distributed and spent among the employed, who tend to have high money multipliers. It’s also true that as the number of employed people increase, they have more bargaining power versus employers, and wages should rise.

However, this is not true all the time. The 1970s, for example, saw a period where there was increased inflation and unemployment.

Inflation that comes with unemployment is part of the misery index which measures the combined sum of unemployment rate and inflation rate. When inflation increases, typically the average citizen feels the pinch, especially with their savings. They are incentivized to spend more in the current moment, but they get less with each passing moment for the nominal value of the money they have. Instead of spending $1 on a loaf of bread, they have to spend $1.10 and so on.

This is what happened in the 1970s in the United States, a period when gold boomed as a hedge for sliding currency value in an economy with mass unemployment. The COVID-19 world looks something like that: there’s massive inflationary monetary policy, with aggressive expansion of the monetary supply due to monetary policy, and prices keep on increasing due to supply shocks caused by lockdowns. The lockdowns have also shut down businesses that operate largely in physical spaces, leading to a mass increase in unemployment.

Bitcoin is theoretically positioned as a hedge against this scenario, deriving its value from both speculative interest as a hedge, as well as its deflationary and controlled money supply and its use as a potential primary means of exchange in a more digitally-oriented world economy. Cryptocurrencies like Bitcoin are built around those same principles as well. The 21 million Bitcoin limit means that at a certain point, there should be less Bitcoins versus the demand for them, meaning that in terms of value, the price per unit should increase as the supply decreases.

It’s instructional to look at a few well-known examples here for how inflation has shaken out, and how Bitcoin might serve as a countering force.

One of the most famous examples is the Weimar Republic, Nazi Germany’s democratic antecedent. Hyperinflation reigned after foreign reparation debts and economic irresponsibility pushed the value of the German mark so high that people piled paper notes into wheelbarrows to make payments.

Hyperinflation has happened throughout history in places like Venezuela, Hungary and Zimbabwe, examples and places with higher inflation rates in a relatively small window of time — but the hyperinflation of the Weimar Republic is often cited as the most historical and darkest of instances, because much of the economic malaise generated eventually led to the election victory that helped secure Adolf Hitler’s ascession as the head of the German state.

Another example here is the previously-cited period of the 1970s of stagflation in the United States. This was a period of relative economic stagnation and oil price shocks that brought prices up across the board. Full-employment policies as part of the Federal Reserve’s mandate came due with high inflation and high unemployment rates throughout the 1970s. The Federal Reserve had to raise interest rates to above 20%, strictly controlling money supply in order to control the inflation — though the drastic rate increases led to a recession, with people being priced out of car loans and mortgages.

Finally, the classic example of the consequences of deflation that is often cited in economics is the deflation in Japan of the 1990s with the deflationary mindset persisting to this day.

Throughout these examples, however, the unifying theme beyond them is the inflationary-Keynesian based economics that has become the norm in mainstream economics, and the deflationary, Austrian based economics popularized by Hayek, contrasted in a world where consumption is shut down by government mandate, and it has never been cheaper to start a business in certain sectors of the economy.

Bitcoin is structured technologically to encourage a deflationary attitude and a relatively stable store of value that partially harkens back to the “gold standard”. In this way, the community acts as a place where investors and community participants can raise their hand against the inflationary consensus. It is in this way that we can see Bitcoin and cryptocurrencies like it acting as a true and meaningful hedge against inflation — and the economics and policy thought that drive it.

Now, more than ever, inflationary hedges are important. Bitcoin might play part of this role for the 21st century, as gold did for the 20th century.

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