It is and it isn’t
There has been a lot of debate on whether crypto is a hedge against inflation. Often statements that extol the virtue of crypto include terms and jargon that is bandied around with little regard to what they truly mean. It’s often unclear as to what a lot of the hubris translates to in real terms, and the impact to the rise and fall of cryptocurrency when correlated to economic conditions such as inflation.
Inflation is undoubtedly being experienced across many countries in the world at the moment. After excessive spending through the pandemic, supply chain disruption, quantitative easing, geopolitical discourse and war, inflation has reared its ugly head.
As a consequence, many have viewed cryptocurrency as the hedge against inflation.
But is this true?
Table of Contents
What is Inflation
Let’s start with explaining what inflation is. Rampant inflation is the economic death sentence that all governments want to prevent at all costs. It doesn’t matter whether the government is democratic, authoritarian, capitalist, socialist, left or right wing leaning, all types of government must manage and tackle inflation, because inflation is the reduction of real value in a country’s currency. No government, unless they choose not to have any form of currency, can escape the need to address inflation when it spirals out of control.
What is the Effect of Inflation
Inflation drives down the real purchasing power of wealth, causing an economy to regress. As inflation increases, it causes a snowball effect pushing up the cost of living, reducing real wages and subsequently currency depreciation.
To combat the reduction of real wages (income), businesses push up their costs of goods and services. This produces a circular effect, which contributes further to the fall of real wealth among individuals.
For example, if the price of a coffee increases by 100%, then your purchasing power has effectively halved, i.e. your real wealth is half of what it was, because now you can only afford to buy one coffee when previously you could buy two. In order to combat this, you request for a payrise which increases business expenses, which is then addressed by pushing up the price of coffee further.
What causes Inflation to rise
Inflation is the symptom of the economy getting sick and being unhealthy. Similar to us “humans” absorbing too much sugar, you may get super pumped and feel great in the short term, but you feel like shit in the long term.
One of the causes of inflation is the increased supply of a country’s supply of money i.e. their currency. There are many ways that this can be done. In the past, money was more commonly in the form of notes and coins, and therefore more money could be printed to increase supply.
In today’s world, money is effectively digital and with the backing of “promises”. Notionally, if everyone agrees that there is more money, and accepts and trades with the extra money, then supply has increased in the economy.
Increasing the supply of money is not necessarily always a bad thing. It’s often used to get an economy going if productivity is low and activity is subdued. Stimulating the economy in this manner, generates activity (albeit a sugar kick) by giving everyone a free lunch. Who doesn’t love a free lunch? It generates excitement, development, economic trade, innovation and many other broader macro benefits.
This may sound great for the short term, but in the long term the purchasing power of the currency devalues. Why? Because there is no such thing as a free lunch. Someone needs to make the lunch, hence with money creation out of thin air, the lunch needs to be made in the future, and if not, then an economic crash in the form of recession or depression is imminent.
How to Hedge Against Inflation with Crypto
To protect against a reduction of purchasing power of a currency, many people look to invest in assets that hold or even increase in value when inflation rises. This strategy is often referred to as “hedging”. To hedge against a potential economic impact means to buy an asset or investment that will appreciate (or depreciate) inversely to the effects of inflation.
Cryptocurrency has been touted as the hedge against inflation. It has been argued that neither governments, nor users of crypto have the ability to simply create extra crypto into the system unfettered. As a result, excessive inflationary symptoms will never occur in crypto. As fiat currencies devalue, a cryptocurrency will retain its purchasing power and appreciate against the fiat.
This is the theory that many crypto supporters/investors put forward as a benefit of cryptocurrencies.
Does Crypto Hedge against Inflation?
In theory, this all makes sense, if cryptocurrencies were backed by governments, and recognised world wide strongly embedded in the mainstream. But alas, they are not.
Many consider cryptocurrencies to be nothing, empty digital software coding with no intrinsic value. Though this may be true, the same can be said of Louis Vuitton bags, Ferraris and anything of high luxury wealth. What extra value do these “high end” products bring, yet consumers are willing to pay a high price for it. The value is what anyone is willing to pay for it.
But, if that day should ever come, when cryptocurrency is embedded in mainstream economic trade, and is truly backed and supported by the government then cryptocurrencies will become the hedge against inflation. When will that day come, and how embedded does the cryptocurrency need to be in economic activity is anyone’s guess.
Should I buy Crypto during times of High Inflation?
Therefore cryptocurrencies, at present, are more akin to a consumer product, than being a traditional form of fiat currency. In times of high inflation, cryptocurrency will fall just like any other high end good.
It therefore is not wise to buy into cryptocurrency during high inflationary periods unless you have excess fiat monies, can buy during the dip and play the long term game.
Cryptocurrencies are here to stay, but they are highly volatile and will remain so, until further regulations are implemented, and it becomes more mainstream.
As a result, cryptocurrency is NOT behaving as a hedge against inflation, but may in the future as cryptocurrency markets mature.
Bitcoin is Mainstream so it should be a Hedge against Inflation
Although bitcoin is the most popular cryptocurrency that is used and traded widely, bitcoin is nowhere near used enough across the world, nor sufficiently regulated, to be considered part of mainstream.
The false pretence that bitcoin is used everywhere is purported by the endless reporting in mainstream media, social media and extensive advertising by cryptocurrency exchanges. In addition, the investment by big banks and corporates into cryptocurrencies has fueled the notion that bitcoin is widely and commonly used.
At the time of writing, Bitcoin has a market valuation that is less than 1 trillion USD in the world. This is a drop in the ocean when compared to the combined investment market for shares, property and other financial assets when aggregated in the world.
Bitcoin still has a long way to go before it is universally considered part of mainstream
Bitcoin is like Gold and therefore is a hedge against inflation
Whilst it is often said that “gold is a hedge against inflation”, it actually isn’t. The price of gold has not moved inversely to the rise and fall of inflation, nor has the price followed the ups and downs of economic activity.
Therefore, bitcoin is similar to gold, in that it does not hedge against inflation. But bitcoin is it’s own market and will not follow the volatility of gold.
High inflation reduces the purchasing power and wealth of individuals. In recent times, high inflation has steered investors to search for investment assets that will not lose value due to inflation. Often gold has been linked as an asset to invest in, when inflation is high. Cryptocurrency advocates have also argued that digital currency is also a hedge against inflation, similar to gold, but this is not correct.
Cryptocurrency, if more widely accepted and used in the mainstream could become a hedge against inflation with its supply controlled. However, currently, cryptocurrency is far from being used as a mainstream investment asset. As a result, cryptocurrencies behave more like a high risk commodity, and will fall when other safer assets are available to give a less riskier return.
That day may come, when cryptocurrencies will become a hedge to inflation, but we are not there yet.