The cryptocurrency market is volatile , nonetheless, it is supposed to protect its holders against fiat money debasement. For many, cryptocurrency is a hedge against inflation . Moreover, it’s a safety net in an era when old conceptions about economics are being questioned.
But what happens when this safety net is tested by inflation? How does the inflationary spiral affect the cryptocurrency market? And is crypto the best inflation hedge?
Let’s dive into more depth.
What is Inflation?
One of the driving reasons behind the skyrocketing popularity of cryptocurrency – especially Bitcoin – is its lower susceptibility to inflation in comparison with fiat currencies like US Dollar.
But what is inflation?
Inflation is the loss of value of currencies over time, which causes the prices of consumer goods to rise. Many economists believe a certain level of inflation is good for the economy, which is why the U.S. government has printed more currency than is needed for decades. That’s why a nickel-priced Coke costs a few dollars today.
By contrast, the value of Bitcoin has grown significantly faster than the value of the U.S. dollar – rising from nearly nothing in 2010 to over $35,000 by late 2021. Because Bitcoin is a volatile market, it’s also seen sharp spikes and drops, but the overall trend has been up. This makes Bitcoin a valuable hedge against inflation in fiat currencies.
The Race to Beat Inflation
According to famous economist John Maynard Keynes, inflation isn’t always a bad thing, and it can aid the economy and create jobs during recessions.
As a whole, a low inflation rate stimulates spending, borrowing, and investing-all important for economic growth. The other extreme is hyperinflation when the price of goods and services increases rapidly, wages stagnate, currency value decreases, and living costs rise.
Low inflation slows the economy as a whole, while higher inflation erodes your savings. For example, citizens must prioritize spending in hyperinflationary economies like Venezuela, Argentina, and Zimbabwe. Otherwise, their savings will devalue as prices rise rapidly.
Is Inflation Important for Cryptocurrency?
A high inflation rate for fiat currencies may encourage individuals to invest more in digital currencies because the dollars and Euros in savings accounts are losing value. Bitcoin and thousands of other cryptocurrency options, like Ethereum, provide investors with an alternative. Bitcoin’s economics are complex, but the digital currency may resist inflation with some features built into it.
Some of the reasons that draw investors towards the crypto market during inflation are:
- The government cannot manipulate Bitcoin with interest rate changes or money printing to achieve policy goals.
- The ability of a store of value to resist inflation is based on scarcity. Bitcoin will never exceed its 21 million units limit. As of now, there is approximately 19 million bitcoin available. However, miners add 6.25 bitcoin to the blockchain every ten minutes by processing a new “block.”
- Conventional wisdom around Bitcoin is that it will rise in price in uncertain times, like gold and another scarce store of value. Moreover, it makes storing and sending value over the internet much easier than gold.
The Mythological Zero-Inflation Currency
In theory, using a currency that is stable in value – like the gold standard – would prevent continuously rising prices. This will lead to the benefit of ten dollars buying the same quantity of goods, whether today or twenty years later.
However, a system of this nature has a number of ill effects, including suppressing economic growth and trade in goods. That is why only assets and investments are now entrusted with the job of retaining value.
Cryptocurrency and Bitcoin’s Role in Inflation
The value of fiat has always been threatened by inflation, so people often invest in assets that remain valuable over time. Over the last few years, crypto has become a more popular alternative to gold as a hedge against inflation.
The Questionable Volatility of the Market
Critics argue that cryptocurrencies have appreciated over time, thus driving institutional money into the market. Even though Bitcoin suffered a massive drop from its all-time high in July to around $30,000, the price was still up 2% for the year. Whereas the yearly gain reached 300% in August.
In the wake of Bitcoin’s 45% drop in May, many investors returned to gold, considering cryptocurrency a young sector that hasn’t established itself as a stable asset class or a safe haven store of value. In order for an asset to serve as a store of value and a hedge against inflation, it must be stable and trustworthy.
The gold standard has been firmly established in this realm throughout history, even if it no longer underpins national currencies. As a result, the short-term volatility of cryptocurrencies makes them less trustworthy than gold for investors.
Bitcoin and Inflation
As the most valuable cryptocurrency in the world, Bitcoins has a reputation as the best anti-inflation investment.
Bitcoin is often cited as an inflation hedge. Still, the fact is the currency is prone to extreme gyrations and market jitters: Bitcoin’s value dropped almost 80% during December 2017, by 50% in March 2020, and by another 53% in May 2021.
In the long run, bitcoin has yet to be proven as an effective tool for improving user returns and reducing volatility. For example, the U.S. during the 1970s demonstrated the effectiveness of traditional hedges like gold in stabilizing purchasing power during periods of high inflation, something that bitcoin has not been proven to be effective. Consequently, returns are susceptible to the drastic short-term swings that occasionally affect the currency.
Bitcoins or Gold: Which one is a Better Anti-Inflation Investment?
Bitcoins are not connected with a single economy or currency
Bitcoin is independent of any specific money or economy, similar to gold. Furthermore, it isn’t dominated by a small group of companies or stakeholders. Instead, the escalating global demand is reflected in its emergence as an international asset class.
As inflation rises, investors are forced to take on more risk to offset the decline in the value of existing assets. For instance, dividend yields of 3% may serve as a supplement to retirement income. However, if inflation is 6%, it is simply not good enough.
As an alternative to stocks, bitcoins are a better choice since it largely avoids the econominc or political risks associated with the stock market. Moreover, for many, Bitcoin is one of the most practical and simple methods of diversifying away from gold and other fixed-income assets.
Fixed Supply
Bitcoin is considered a good inflation hedge because of its fixed supply of 21 million coins, almost 19 million of which have already been mined. A fixed supply ensures that new coins cannot enter circulation, so there is no inflation risk.
On the other hand, countries can simply increase the money supply by spending and buying government bonds, which lowers interest rates, reduces the effectiveness of the dollar, and inadvertently causes inflation.
Easy to Store and Transfer
Bitcoin is durable, easy to exchange, secure, and scarce, just like gold. Bitcoin, however, is also portable, transferable, and arguably more decentralized than gold. The supply of gold is mostly controlled by sovereign nations like the United States, China, Germany, and other European countries. In theory, anyone in the world can easily and safely store and protect their bitcoins, unlike gold.
Many gold bugs believe Bitcoin to be just a fake currency, and gold is a precious metal. But the blockchain technology behind Bitcoin has practical applications. Developing nations with stale fiat currencies have limited practical use cases for Bitcoin as a currency. Nonetheless, Bitcoin is better suited to countries experiencing hyperinflation or political turmoil.
Cryptocurrency as an Inflation Hedge: The Down Side
In essence, being ahead of the curve in acquiring Bitcoin could help – until enough people become Bitcoin holders that they can use it as a currency to buy and sell goods and services. After that point, it could be used as a normal currency for transactions, possibly stabilizing its value.
Currently, the value of Bitcoin fluctuates wildly, varying by three percent between the morning and evening hours of the same day. However, it could be a risk if you are selling the currency or an opportunity if you are buying it.
Cryptocurrency can be equated with the 17th-century tulip mania bubble by some titans of the conventional financial system.
Crypto enthusiasts can learn from current real-world conditions. For example, despite having almost zero inflation for over two decades now – an ideal for cryptocurrency enthusiasts – the Japanese economy hasn’t been significantly helped.
Even some enthusiasts believe Bitcoin is deflationary, meaning goods cost less when denominated in Bitcoin. Such a cycle would prevent prices, wages, and production from increasing, resulting in catastrophic consequences for people. Therefore, most economists today recommend against such a path of intentional deflation, although it could still have unforeseen, innovative effects.
The Stablecoin Alternatives
For many, cryptocurrency’s price fluctuations make the currency an unattractive store of value. Despite the fact that a 30% drop in price over 24-48 hours is rare and devastating in traditional markets like stocks, these events are fairly common in the crypto market.
However, if you’re hesitant about crypto’s volatile nature, you can consider using stable coins like:
The Bottom Line
Inflation can be good or bad, but most experts believe it to be disastrous when it grows too high and spirals out of control. Unfortunately, inflation is expected to rise in the near future as spending increases and economies expand, despite the fact that inflation remained stable over the last year due to the Coronavirus pandemic.
Due to this, businesses and individuals invest in gold, real estate, and other investments to protect themselves from future inflation. Like these assets, Bitcoin and cryptocurrencies will also have to play a vital role during inflationary periods over the coming decades.