It has been said that some investors have flocked to bitcoin in order to protect their wealth from the impact of rampant inflation. But what does that mean, exactly?
With inflation hitting new highs, people are drawn to anything that they can flock to as a hedge against inflation.
Despite arguments to the contrary, cryptocurrency is often considered an inflation-resistant asset, and advocates often tout it as an asset class that’s uncorrelated with real-world assets. But things quickly become complicated when you learn that cryptocurrencies are unique, and some are inflationary by design.
What is inflation, anyway?
Inflation is an economic term that refers to periods when prices rise over time. Often, that’s because a currency devalues – when one unit of the same currency buys you less stuff than it used to. If you watch a documentary from the ’80s and see someone selling a burger for 50 cents, while that same joint charges you 10 bucks – that’s inflation in action.
You might have realized the pinch of inflation when prices rise faster than your wages. You’re worse off if your $50,000 salary paycheck buys you 10% fewer goods and services than the year before. But if your employer boosts your salary to $55,000, you won’t have to change your spending habits and won’t feel the effects of inflation.
Economists think that a little bit of inflation is helpful to keep people buying, thereby stimulating the economy. But in times of economic crisis, like the coronavirus pandemic, inflation can get out of hand.
Economists disagree about the causes of the current bout of inflation – the worst in decades – which measures about 8.5% in the U.S. Some people point their fingers at the Federal Reserve for printing too much money, which in turn was used to stimulate the economy and handle the pandemic.
Others say that the Fed’s not squarely to blame – supply shortages caused by lockdowns were the main problem.
Bitcoin and inflation
Crypto advocates think that allowing central bankers to influence the economy through monetary policies, namely quantitative easing, leads to disaster. Rampant money printing from the central banks of Venezuela, Turkey and Zimbabwe have ruined their respective economies.
Crypto advocates often say that cryptocurrencies like bitcoin (BTC) are resistant to the incompetence of central bankers and governments because they are decentralized, and cannot be shut down.
Another reason is that bitcoin’s issuance is determined by code – unlike the Fed, a central bank can’t just mint as much bitcoin as it wants.
While more bitcoin enters circulation over time, the rate at which new bitcoin is issued to miners is determined by the Bitcoin protocol. The supply is capped, and supplies of new coins are estimated to run dry around the year 2140. And unlike central banks, whose economists must respond to market events, the Bitcoin blockchain runs like clockwork.
Approximately every four years, the protocol cuts the issuance of new bitcoin by half – the phenomenon is known as the “halving”.
Bitcoin’s fixed supply has led some fans to consider it akin to “digital gold” – in reference to the yellow metal, another beloved inflation-resistant asset. So-called stores of value assets stand the test of time because they are uncorrelated with other assets and are resistant to entities that interfere with the market. But are cryptocurrencies like bitcoin really a hedge against inflation?
The argument against bitcoin being an inflation-resistant asset
While the U.S. dollar has fallen, bitcoin has far outpaced its value, rewarding early investors. But the cryptocurrency is highly volatile: Talk to recent investors who lost money when bitcoin cratered, and they might tell you that their investment has not outpaced inflation in the short term.
In the past few years, bitcoin has tracked the U.S. stock market, which performs well when the economy is stimulated and stutters when spending decreases – like in times of high inflation. When inflation reached 40-year highs in December 2021, bitcoin fell. The question of whether bitcoin is a long-term inflation hedge is difficult to answer without the benefit of hindsight.
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 the demand remained the same).
Other cryptocurrencies have dynamic supplies; the stablecoin TerraUSD (UST) mints and destroys tokens based on LUNA token swaps to keep its price at a steady $1.
And some tokens, like non-fungible tokens (NFTs), are one of a kind – like a piece of fine art, their value is dependent on their uniqueness.