How Do Inflation and Deflation Relate to Crypto?
Inflation, inflationary, deflation, and deflationary are terms that get discussed quite a bit in the crypto community. They are not always used in the same way or to refer to the same concept. I thought it would be helpful to my own understanding to sift through the various ways these terms are used. Hopefully, this survey will be of use to others, as well.
Let’s start with what “inflation” is generally. A rise in the prices of goods and services and a corresponding decline in the purchasing power of a currency used to buy those goods and services, such as the U.S. dollar, is called inflation. Put another way, inflation causes a decline in the value of the dollar. Inflation is officially measured in the U.S. by reference to consumer price indices. Increases in these indices indicate inflation. Whether these indices are accurate measures of inflation is a separate discussion which I will not cover here.
In any event, inflation enters crypto discussions in several ways. One of the most common is when Bitcoin is described as an “inflation hedge.” Meaning Bitcoin holders will see their purchasing power (the value of their Bitcoins) increase, or at least decline more slowly, compared to the purchasing power (the value) of a particular fiat currency. It is usually the U.S. dollar that is compared to Bitcoin when inflation is discussed.
If the theory that Bitcoin is a hedge against inflation was accurate, one would expect to see the value of Bitcoin increase as inflation increases. That has happened at some times, but not others. The recent buzz from some Bitcoin critics is that inflation has been increasing in the U.S. while Bitcoin’s price has crashed. Thus, according to these critics, Bitcoin is a poor inflation hedge. This argument assumes a perfect correlation between Bitcoin and inflation. The correlation is certainly not perfect but it does not have to be for Bitcoin to serve as a hedge, even if an imperfect one.
Consider also that Bitcoin’s value has increased many thousands of times since 2008, even if the increases don’t perfectly track increases in the consumer price indices over this period. These returns have certainly protected Bitcoin holders against inflation. Critics of the Bitcoin-as-inflation-hedge argument also often fail to point out that gold, which has widely been regarded as one of the best hedges against inflation, also has a relatively weak correlation to consumer price indices. In other words, gold is also, at best, an imperfect hedge against inflation.
What does gold have to do with Bitcoin and inflation? The origin of the Bitcoin-as-inflation-hedge argument is grounded partly in the assertion by Bitcoin supporters that Bitcoin is akin to “digital gold” and, like gold, can also serve as an inflation hedge. Why is Bitcoin compared to gold? Because both assets are mined and both are arguably scarce. Gold is scarce because only so much of it can be mined at one time and it is ultimately finite. Bitcoin is scarce because only 21 million Bitcoins will ever be mined (per Bitcoin’s algorithm) and it appears that several million may have already been lost by: (1) being locked behind irretrievable passwords; or (2) burned by having been sent to incorrect addresses. Thus, some say Bitcoin is a provably scarce asset akin to gold. In any event, whether scarce or not, neither Bitcoin nor gold correlate as perfect hedges against inflation and scarcity should be viewed as a concept separate from inflation.
And why are Bitcoin supporters so focused on the benefit of hedging against inflation anyway? Because, as they often put it, the U.S. Federal Reserve has been “printing” money at historically unprecedented rates since 2008. Now, the Fed doesn’t actually print money, it creates it digitally on its balance sheet and those of its member banks. But it is fair to say that the Fed has greatly increased the supply of dollars in the world since 2008 and it appears to be far from done. According to Bitcoin supporters, it is a simple matter of understanding supply and demand to conclude that the dollar’s value will decrease and inflation will result due to Fed policy: the greater the supply of dollars, the lower the demand for dollars; the lower the demand, the lower the value of the dollar; the lower the value of the dollar, the more dollars that will be needed to purchase goods and services; thus, inflation will occur as a result of the increased supply of dollars.
Until recently, there has been little evidence in the consumer price indices that inflation has increased significantly (more than 2% annually) as a result of all the new dollars injected into the money supply by the Fed. Personally, I don’t think the indices measure inflation sufficiently but that is a subject for another day. However, a key point here is that the type of inflation that Bitcoin supporters are actually describing is “monetary inflation,” not price inflation. In other words, inflation caused by an increase in the supply of money. The actual relationship between monetary inflation and price inflation is not entirely clear. But one way of describing sovereign currencies like the dollar is that they are generally “inflationary” because their supply tends to increase over time and they can be “printed” essentially at will by the sovereign governments which control them. Presumably, the greater the supply of a currency, the greater the chance that demand will decline and the currency’s value will go down — emphasis on “presumably.”
This is actually the crux of Bitcoin supporters’ inflation hedge argument, putting the gold comparison aside: holding Bitcoin protects you from monetary inflation because code enforces Bitcoin’s supply and maintains its rate of inflation in a knowable manner. As we have already seen, however, this is really an argument about scarcity, not inflation.
Some go so far as to argue that Bitcoin is actually deflationary. I will get to deflation in a moment but want to point out that this argument is likely wrong. Bitcoin is currently inflationary because new Bitcoins are constantly created to reward miners. Thus, the Bitcoin supply is inflating. Over time, mining rewards will decline to nothing (per Bitcoin’s code), at which point Bitcoin will be stable — neither inflationary nor deflationary. The current rate of Bitcoin inflation is around 2%. The only way Bitcoin could be net deflationary is if more Bitcoins were being permanently lost than are being mined. There is no evidence this is the case but it is possible.
So, that covers inflation. What is deflation? Not surprisingly, it is the opposite of inflation: the value of money increases and the prices of goods and services decrease. This sounds great in theory but there are some arguments as to why it isn’t so wonderful in reality. I won’t cover that debate here. But, like monetary inflation, there is also monetary deflation, which means a decrease in the supply of money, i.e. the supply deflates over time. We haven’t seen much monetary deflation in Western economies in modern times — quite the opposite. The reason that a deflationary currency is theoretically attractive is that it becomes scarcer over time as its supply dwindles and possibly, as a result of that scarcity, more valuable over time.
As discussed, Bitcoin is likely not deflationary but, rather, slightly inflationary. One could argue that “slightly inflationary” is preferable to currencies like the dollar, which are potentially far more inflationary and have no guarantee of any supply controls other than trust in the Fed’s management of the money supply. Gold is also inflationary because mining companies keep pulling more of it out of the ground, adding to its supply, while relatively little is likely destroyed or lost. Interestingly, there is some discussion that ETH will be net deflationary after its full move to proof-of-stake but, due to a number of factors including usage rate, we can’t currently predict whether ETH will ultimately deflate.
In sum, the crypto community tends to intermingle discussions of price inflation and monetary inflation. The core arguments around Bitcoin, ETH, and other cryptocurrencies generally fall more correctly into the realm of monetary inflation. The interesting thing is that the U.S. and other Western economies are conducting an experiment in monetary inflation that is unprecedented and whose effects remain unpredictable. The rise of Bitcoin and other cryptocurrencies may be a symptom of this experiment and, as a result, they may indeed prove to be a solid hedge against both monetary and price inflation. Certainly, buying Bitcoin and ETH when they were first issued and holding them until today would have generated returns that far exceeded any reasonable measure of inflation, whether price or monetary.
