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Inflation, Deflation and Bitcoin

While the Pandemic seems to slow down across Europe, it is still accelerating in other parts of the world such as in the Americas or in Africa. Nevertheless, some countries are giving into economic pressure and start opening up again. Will demand really come back? To support local economies and increase demand central banks worldwide have supported their governments in bringing rescue packages worth trillions of $ on the way.

This bears the question, what will happen to our money when so much more of it is created? While some argue that inflation will be the next logical consequence, others point out that deflation is more likely.

But what do both actually mean?

Inflation

In most developed nations inflation is relatively stable and low, hovering around 2–3% per year. Inflation means nothing but that one unit of currency will buy you less in the future than it does now — that the purchasing power of that currency is declining over time. This usually has an impact on the general costs of living as prices rise. Despite the obvious increase in money supply by central banks as a cause for inflation, there are other effects that are at play:

  • Demand-Pull: when demand for a product or service increases faster than production capacity increases, it creates a gap between demand and supply, ultimately leading to an increase in price. The higher the price, the fewer people can afford it until the price is high enough to reach supply-demand equilibrium.
  • Cost-Push: when the price of raw materials to produce a product or the production process itself is increasing, it’ll ultimately lead to an increase in prices as business want to ensure their margins. This rise contributes to inflation.
  • Built-in: when prices rise the rational thing for employees to do is to ask for higher salaries to maintain their living standard. This in return leads to higher costs for producers, who end up rising prices further and they end up in a wage-price spiral where one factor induces the other and vice versa.

Measuring inflation

The most common way to measure inflation is the CPI (Consumer Price Index) which compares the weighted average of prices of a basket of goods and services (including foods, real estate, medical care etc.) over time. The CPI is meant to reflect living costs in a nation and is frequently used to indicate inflation.

Inflation with CPI is calculated in the following way:

So if a basket of goods and services costs you now $1030 when last year it was still priced at $1000, you’d simply divide $1030 by $1000 and get 3, which is the percentage of inflation you had.

Is inflation good or bad?

The simple answer is it depends. Inflation itself is not necessarily a bad thing except when it gets out of control. But let’s take a step back and look at the benefits of inflation at controlled levels first:

  • promotes investment by businesses and individuals as they expect better returns than inflation which promotes economic growth
  • it encourages spending, if you know your money will be less valuable in the future, you’re more likely to spend now.
  • makes it easier for debtors to repay their debt, as the money they will have to pay back will be less valuable than the money they borrowed

The downsides of inflation become clear once inflation is very high.

  • cash holdings decrease quickly in value -> investors need to find other assets to store value
  • lack of investment as companies are unsure about the outlook
  • hoarding of goods is promoted
  • negative impact on the foreign exchange rate and on trade balances

And when inflation is at hyperinflation levels (50% per month or more) people will want to spend their money as fast as possible and at some point simply can't afford the most basic things anymore.

Controlled inflation benefits the economy and is, therefore, one of the goals of monetary policies driven by central banks. While many feared with the amount of money injected by the FED, inflation would follow, this has not been the case (yet). Some economists have instead pointed to deflationary trends.

Deflation

Deflation is pretty much the opposite of Inflation. It sounds good at first, but can be nasty for central banks to handle.

Deflation is a general decrease in prices and an increase in the value of money over time. Deflation often appears together with negative or stagnant economic growth. One famous example for a country in deflation is Japan, which has spent more than 10 years in deflation since 1991 (the time of the deflation and low economic growth is referred to as “lost decade”).

Deflation benefits consumers as the value of their money increases over time. Nevertheless, it can also result in companies cutting down salaries leaving consumers with a similar purchasing power as pre-deflation.

Reasons why deflation happens include:

  • fall in circulating money and credit supply
  • decrease in production costs leading to price decrease
  • decline of aggregate demand in combination with an increase in productivity
  • deflation as a natural consequence when economic output outperforms supply of money, this is fuelled by technological advances

Views on Deflation

Historically Deflation was associated with high rates of unemployment and rising debt defaults that contributed to an ongoing downward trend and led to depression.

However, recently these views have been challenged mainly by Atkeson and Kahoe, who observed 17 countries over 180 years time-period and found that 21 out of 29 experienced no deflation.

Nevertheless, Deflation changes debt and equity financing and makes companies with huge cash reserves much more attractive to investors than companies trying to raise via debt.

Deflation also contributes to lower economic growth, partly as it discourages spending and one of the main problems for modern economies is, that deflation is difficult to end as can be seen with Japan which struggled for 20 years with low economic growth and had already in 2013 reached a debt level of 230% of GDP.

What is next and how does Bitcoin fit in?

Currently, amid the Covid-19 pandemic inflation across OECD countries has been dropping to low levels indicating a period of deflation ahead. With lockdowns and social distancing implemented, many losing their jobs logically the economic growth of nations is haltered and productions are slowing or even coming to halt, which could fuel increases in price. Concerns have been voiced, that the effects of the pandemic could lead to a deflationary spiral, that would be hard to escape.

Even when lockdowns are lifted, demand is not expected to pick up to pre-lockdown levels? Will you really buy as many clothes as you would have before or spend that many nights out with friends bar-hopping?

However, with central banks offering unprecedented support to businesses and individuals, inflation could follow after a phase of deflation.

Whichever it is, it makes sense to put your eggs in different baskets. Traditionally, investors were advised to hedge against inflation with commodities, etfs or gold. With Bitcoin they have an alternative to all those. Let’s see how Bitcoin could be valuable during inflation and deflation.

Bitcoin during Inflation

The narrative of Bitcoin as a hedge against inflation has been pushed by Bitcoin maximalists since its inception in 2008. What speaks for Bitcoin as a value maintaining asset is that its supply is fixed with a total of 21 million maximum. Therefore, if demand increases the price should follow.

“Bitcoin can be best understood as distributed software that allows for transfer of value using a currency protected from unexpected inflation without relying on trusted third parties” — Saiffedean Ammous

Currently, new Bitcoin are still created every day. However, even the issuance of BTC issued per Block is declining pushing its inflation to lower levels with each halving. Additionally, more than 20% of the Bitcoin supply is assumed to be lost due to traders losing private keys or accidentally throwing away the wrong hard drive.

From the BTC inflation chart from charts.bitcoin.com

Another benefit of Bitcoin is that it’s a trustless system held up by a decentralized network of nodes that cannot be controlled by one single party. What we see in many countries with very high inflation is that the public loses trust in their government and their banks. Therefore, it doesn’t come as a surprise, that Bitcoin and other cryptocurrencies have increasingly been used across Latinamerica where many countries struggle with inflation and corrupt governments.

Despite major price swings in the history of Bitcoin, 75% of current bitcoin addresses are making money. Interesting is also that 65% of the addresses have held their Bitcoin for more than 1 year, which could indicate that it’s already seen as a store of value.

Source

Bitcoin during deflation

It’s pretty obvious how Bitcoin makes sense in an inflationary environment in particular as a store of value. Yet, could it also be a good investment during deflation?

During deflation, cash is king as it appreciates in value. This means people will be more comfortable keeping their savings in cash and could lead to traders liquidating their positions to keep it in cash instead.

Nevertheless, that doesn’t necessarily have to apply to Bitcoin. Even if Bitcoin trades in a tight range, it’s purchasing power would increase together with the purchasing power of the dollar, making it more valuable for real-world use. And with all of us realizing the importance of digital to us, this could push acceptance of Bitcoin as a Medium of Exchange.

One danger of deflation is that it leads to negative interest rates. If banks start charging their customers for keeping their savings, investors could start looking for other assets with zero-yield where Bitcoin would be a viable alternative.

All in all, Inflation and Deflation are both scenarios that could be triggered by the ongoing health crisis. Whichever it will be, Bitcoin is a viable alternative to hedge against inflation, but also doesn’t lose its value proposition in a deflationary time — in particular when negative interest rates become reality.

This is not to say, that you should keep all your savings in BTC if you’re not comfortable with it. You could start with just a small amount and see how it goes. Why don’t you turn 5% of your monthly salary into Bitcoin for a few months and see how it goes?

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