With inflation reaching new heights, people are drawn to anything they can rush to for inflation protection.
Despite arguments to the contrary, cryptocurrency is often viewed as an inflation-proof asset, and proponents often present it as an asset class uncorrelated with real-world assets. But things quickly get complicated when you discover that cryptocurrencies are unique and some are inflationary in nature.
What is inflation?
Inflation is an economic term that refers to periods when prices rise over time. Often this is because a currency is depreciating – when a unit of the same currency buys you less stuff than before. If you watch a documentary from the 80s and see someone selling a hamburger for 50 cents and that same joint is charging you 10 bucks, that’s inflation in action.
You may have realized the pinch of inflation when prices rise faster than your wages. You’ll be worse off if you buy 10% fewer goods and services with your $50,000 salary than the year before. But if your employer increases your salary to $55,000, you don’t have to change your spending habits and you won’t feel the effects of inflation.
Economists believe that a little inflation helps people buy, thereby stimulating the economy. But in times of economic crisis, such as the coronavirus pandemic, inflation can spiral out of control.
Economists disagree on the causes of the current rise in inflation – the worst in decades – which is about 8.5% in the United States. Some people are pointing the finger at the Federal Reserve for printing too much money, which in turn has been used to stimulate the economy and contain the pandemic.
Others say the Fed is not entirely to blame – supply shortages caused by the lockdowns have been the biggest problem.
Proponents of crypto believe it will lead to disaster if central bankers can influence the economy through monetary policy, namely quantitative easing. Massive money printing by the central banks of Venezuela, Turkey and Zimbabwe has ruined their respective economies.
Crypto advocates often say that cryptocurrencies such as bitcoin (BTC) resist the incompetence of central bankers and governments because they are decentralized and cannot be shut down.
Another reason is that the issuance of bitcoins is determined by a code – unlike the Fed, a central bank cannot mint as many bitcoins as it wants.
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As more bitcoins come into circulation over time, the rate at which new bitcoins are issued to miners is determined by the bitcoin protocol. The supply is limited and the supply of new coins is expected to run out around the year 2140. And unlike central banks, whose economists have to react to market events, the Bitcoin blockchain runs like clockwork.
Every four years, the protocol halves the issuance of new bitcoins – the phenomenon is known as “halving”.
Bitcoin’s steady supply has led some fans to think of it as “digital gold” — a reference to the yellow metal, another much-loved, inflation-proof asset. So-called stores of value assets stand the test of time because they are uncorrelated with other assets and resistant to entities that disrupt the market. But are cryptocurrencies like bitcoin really an inflation hedge?
The argument that Bitcoin is an inflation-proof asset
When the US dollar fell, bitcoin rose well above its value, rewarding early investors. But cryptocurrency is highly volatile: Talk to recent investors who lost money when bitcoin crashed, and they could tell you their investment didn’t outperform short-term inflation.
In recent years, bitcoin has followed the US stock market, performing well when the economy is booming and stuttering when spending falls, such as during times of high inflation. When inflation hit its 40-year high in December 2021, bitcoin fell. Whether bitcoin is a long-term inflation hedge without the hindsight benefit is hard to answer.
However, not all cryptocurrencies work like bitcoin. Some cryptocurrencies are deflationary – meaning that the supply decreases over time, designed to increase the value of the coin over time (if demand stays the same).
And some tokens, such as non-fungible tokens (NFTs), are unique – like a work of art, their value depends on how unique they are.