Bitcoin, A Worthy Hedge Against Inflation?

Sanchit Gupta
Jan 24 · 6 min read

Exploring the scope of bitcoin as a safe haven against apparent inflation

Photo by Bermix Studio on Unsplash

The overnight currency ban in India and the irresponsible money printing that lead to hyperinflation in Zimbabwe are just a few instances where careless government policies around money have uprooted the daily lives of its citizens.

One of the major responsibilities of a government is to generate and regulate currency. The currency, since its inception, has always been backed by precious metals like gold and silver. This was common because these metals hold intrinsic value, they are mined, refined, and minted which makes them precious and worthy of value. To have these metals back (fixed exchange rate) currency means that the currency also holds an intrinsic value. In 1914, the US dollar was chosen to be the world's reserve currency and was backed by gold at an exchange rate of 35 dollars for 1 ounce of gold. Other currencies were then backed by the US dollar and hence were indirectly backed by gold.

However, in 1971, the US made the dollar independent of gold thereby removing any backing from precious metals. This made the dollar and all the other currencies in the world, Fiat Currencies.

Fiat currency is a legal tender government issued currency that is not backed by a commodity

In simpler terms today, the government has the power to declare any piece of paper as money and it will circulate in the economy as money until people have confidence in the currency and the government. This is the power that was misused by the government of Zimbabwe when they printed loads of money without thinking of its ramifications. The increased supply decreased the confidence level in the currency and hence its value plummeted.

Since last year, Covid-19 has stirred up the economy in the US. Thousands of people have been laid off or are on temporary leave from their daily jobs. Even after 2 stimulus packages by congress in 2020, more than 1.15 million people filed for unemployment claims in the US. The Biden presidency has already planned a hefty 1.9 trillion dollar economic package, that includes more direct payments to Americans and funding to help in the distribution of vaccines. To further bring the economy back, the interest rates are almost touching zero and people have speculated them to go down in the negative as well. Democrats believe that the apparent inflation these quantitative easing actions can cause isn’t a pressing concern for now.

To pay for this hefty package, the US government plans to take more debt from the borrowers. The ratio of public debt to GDP touched almost 140% in 2020 and will likely go higher as more stimulus checks are issued. The only way to pay all this debt later is to either increase taxes, increase inflation (decrease in the value of money), or by an economic growth boom that helps people make more money and hence pay more tax.

Some people believe that the actions of the US government will drastically increase inflation and hence they are trying to find alternative investment sources to protect their assets from declining in value. This is where Bitcoin seems like a golden opportunity, but is it?

“Internet will be the major force to reduce the role of government in society” — Milton Friedman

Bitcoin is the same alternative to money that has been declared dead far too many times in mass media, yet it sustains today and has become of the major talking topics in the past few months. The recent rally which made bitcoin almost touch 40,000 dollars in value is driven not by retail investors (like you and me), but by institutional big players. This rally and the sudden interest in bitcoin can be credited to the future inflation that investors forecast.

Fig: price of bitcoin. Image taken from here

Why do people believe bitcoin is a safeguard against inflation?

The number of bitcoins that can ever exist in circulation is fixed to 21 million and the number of bitcoins generated(mined) is based on a geometrically decreasing function, which halves the number of bitcoins created every 4 years. This is done to maintain the value of bitcoin and make sure that there aren’t an unlimited number in circulation. Mining of bitcoin takes resources like very powerful ASIC (Application Specific Integrated Circuits) computers and a huge amount of electricity. Combining all these features, the bitcoin is a rare commodity that can only be mined using a large number of resources, doesn’t it sound like it is the internet’s gold. On top of this, bitcoin enjoys the freedom of being decentralized and outside the control of any government regulations, this means that any transaction in bitcoin is a peer to peer without the need for any bank or government. Bitcoin challenges a lot of government power and control. In economies with an unstable government and currency pressure, it has the potential to become commonplace and can indeed remove the need for a federal fiat currency.

However, to use bitcoin as a safe haven against apparent inflation is another thing.

Bitcoin a volatile hedge?

Another reason people feel bitcoin or in fact cryptocurrency can not be considered as a safe haven for anything because they are too volatile. The price fluctuations of bitcoin in a day alone can make someone's heart skip a beat.

The price of the bitcoin is only driven by demand and supply and can not be regulated by any central authority. This sounds good till the demand is high and people still want bitcoins. As and when people lose confidence in bitcoin due to any reason, the value of bitcoin can plummet almost immediately and there is no regulatory body to stop this fall. A hedge, which is meant to be a safe place should not be this uncertain. This concept is called confidence crisis and yes, other fiat currencies are also subjected to this crisis but due to the presence of a regulatory body the fall of these currencies can be limited.

The reason people want to build a hedge against inflation is because they expect hyperinflation due to large scale printing of dollars by the FED. Many economists on the other hand believe that very high inflation will not take place. They argue that because the velocity of money, which means the amount of money in circulation is low right now, the stimulus money will allow people to spend, aka circulate more money which will inturn help to build the economy. Yes, there will be inflation after things have gone back to normal, but it won’t be as bad as people suspect and will not happen immediately. To prepare for something which won’t happen in the near future with something like bitcoin, which is very volatile doesn’t seem like a good strategy. Read more about it here.

Final Thoughts

I am still learning about the world of finance and economics, if I missed something or might have gotten some facts wrong, please feel free to point out in the comments. Let’s learn and grow together, until then keep reading and supporting. Cheers!!

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