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Inflation and digital assets

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While the absence of inflation does provide protection for holders of their own currency, this proposition must be supplemented by the condition that an economy based on digital money is very different from ours today

Original title: "Inflation and Digital Assets"

Original author: First class

In the more than a decade since bitcoin was created, the term inflation has cropped up frequently in the digital asset community, with the completion of its third halving. In essence, the absence of inflation is seen as a guarantee of stability. It's an interesting point, but it's pretty much true. So let's talk about inflation.

What is inflation?

The dictionary says, "Inflation is the loss of the purchasing power of money, leading to a generally sustained increase in prices." In other words, a package of goods and services worth €100 today would be worth more later. Inflation is not a good thing for consumers: all else being equal, their purchasing power declines mechanically.

Inflation is an important psychological factor in consumption. The fear that prices will rise tomorrow is what drives many consumers to buy today. Falling prices (" deflation ") should therefore be avoided, as it suppresses consumption.

Inflation is a tax

Inflation is a tax without a name. It is both extremely fair, because all economic actors are equally affected, and extremely unfair, because the people most affected are those on low incomes, whose purchasing power has fallen without a corresponding increase in income. But if inflation is indeed a tax, is the state the beneficiary? Yes and no. Here's why.

Inflation stems from two main factors

Broadly speaking, inflation stems from two factors:

The first is demand-led growth. The principle is simple: the demand for a good gradually raises its price. In a period of strong growth in the size of the economy, all prices rise. Then wages rose, either because corporate profitability allowed or because unemployment fell and the Labour market tightened. This is the inflation everyone dreams of.

Another form of inflation is an increase in the money supply. Literally, if reserves were to increase by 10 percent tomorrow, the prices of goods and services in the economy would also rise by 10 percent mechanically. This inflation is more insidious, its effects are not always beneficial, and it can exist without economic growth. In such cases, wages struggle to match prices because firms see no steady demand for their products.

So to understand inflation, you need to look at the money supply, the amount of money in circulation. So what are the pillars of money creation? Is the credit. So talk of inflation must talk of credit.

Inflation and credit

Loose monetary policy, which promotes credit creation (such as keeping interest rates low), is inflationary. This is one of the biggest contradictions facing consumers: abundant low-cost credit and low inflation do not co-exist.

The link between inflation and credit is so strong that central Banks are charged with maintaining price stability.

The Federal Reserve and the European Central Bank often comment on this: they agree that a healthy inflation rate should be around 2%. Therefore, the central bank must guide monetary policy to avoid negative effects: authorizing the creation of money (in the form of credit) to promote economic development, avoiding inflation and undermining purchasing power.

Inflation and wealth transfer

If inflation is a tax, who collects it? Governments benefit from moderate inflation (not least because it dilutes debt (see article), but it is not a tax in the traditional sense (that is, a large amount of money is collected by the authorities). In effect, inflation organises the transfer of wealth between economic agents.

On one side are the holders of funds (notes, COINS, demand accounts, etc.), that is, each individual. On the other side are a large number of borrowers (regardless of their type of debt, public or private). Inflation is a transfer from holders of funds to borrowers. The first group of wealth, expressed in monetary units, loses value every year because of inflation. By the same token, the second group of debt loses value each year because of inflation. But the devaluation was a good thing: if I paid back €1,000 a month for 15 years, the purchasing power of that €1,000 would decline over time. Today the monthly payment of €1,000 is the same €1,000, but after 15 years of inflation it has less buying power.

In essence, this is another curse for consumers: high inflation reduces purchasing power but also greatly increases their debt affordability, especially for the type of debt (mortgages) that dominate in terms of volume and maturity.

The same is true for households, countries or companies: reasonable inflation digests debt more quickly. So central Banks face a dilemma: let inflation run its course, with fiscal policy to dilute debt, or fight inflation aggressively to protect purchasing power but keep interest rates on a tight leash.

Inflation and interest rates

So is there an easy way to regulate the transfer of wealth through the economy through inflation? There must be, through interest rates. In the same example above, let's say I have a total loan of 240,000 euros and Pay 1,000 euros a month at an annual interest rate of 5%. Now let's say that my payments are indexed to inflation, which means that the payments are adjusted every year for the rate of inflation. For example, if inflation reaches 2.5 per cent, I pay 7.5 per cent a year, or €1,500 a month instead of €1,000. This protects lenders, who can compensate by reducing their purchasing power at any time.

A sound monetary policy also involves controlling the general level of interest rates to regulate credit, the money supply, and ultimately inflation. During periods of high inflation, the central bank raises interest rates, and the immediate effects are slower credit and higher pay for lenders. But raising interest rates and restricting credit will also have a negative impact on the economy, as businesses (and individuals) find it harder to raise money.

These observations explain why many loans are tied to variable rates. But instead of using a variable rate, government bonds mostly use a fixed rate. In other words, government (fixed-rate) lending is far less resistant to inflation than variable rate lending, especially in the long run. In France, for example, property loans are mostly at fixed rates, in effect protecting borrowers at the expense of Banks. In the US or UK, a mortgage is an "adjustable rate mortgage", meaning that the interest rate on the loan is adjustable and the financial institution is protected from inflation (at least to some extent).

Bretton Woods system

So does a world without monetary inflation exist? It did exist, during the Bretton Woods agreement (1944-1976). At the end of The second world war, the great powers wanted a monetary system that promoted stability, in particular to avoid the hyperinflation that occurred in Germany during the interwar period. The Bretton Woods framework pegged currencies to the dollar, which was pegged to gold ($35 an ounce). This fixed exchange rate linked to gold avoided the uncontrolled creation of the dollar and other currencies.

In the Bretton Woods system, strict controls on money creation meant strict limits on credit creation. Tight restrictions on credit creation have led to an unprecedented period of stability.

The chart below shows the percentage of countries in a state of financial crisis between 1900 and 2008:

Image courtesy of the Article banking Crisis: The Threat of Equal Opportunity

It is clear that the Bretton Woods system brought a period of calm unprecedented even in a period of lasting peace. It follows that uncontrolled, credit-linked money creation causes as many problems as it solves, and is only a step away. After Bretton Woods, most financial crises have their roots in a collision between huge debts and erratic economic activity.

Inflation and digital assets

Most agreements on digital assets have a "hard-coded" inflation character. This is true of Bitcoin, Ethereum and many other cryptocurrencies. This inflation is a monetary inflation, that is, it does not correspond to a rise in prices, but to money creation. Since there is no central bank to oversee the amount of money, other inflation is unlikely, so these agreements cannot create credit. So if you want to borrow, you have to see if someone is willing to lend their assets. Similarly, commercial Banks are not suitable for this system, because their main function in real life is not to keep accounts, but to create credit.

It is absolutely true that digital assets are inflation-proof. But this comes at the cost of a lack of credit. In an economy based on digital money, consumers might find that inflation is not associated with money creation (except for the "code" in the agreement). They may find that no bank charges for an account, but they may also realise that getting credit to buy a house is a miracle. In a world with a limited money supply, getting credit is like persuading someone to lend you their savings. All borrowers are competing for limited resources. Moreover, the absence of monetary inflation does not mean the absence of inflation at all; it simply means that the second inflation mechanism has disappeared. If digital money can be used to buy oranges, manufacturers are likely to raise the price of oranges if demand is strong.

conclusion

While the absence of inflation does provide protection for holders of their own currency, this proposition must be supplemented by the condition that an economy based on digital money is very different from ours today. Without credit, the ability of governments (and companies and individuals) to borrow would be severely eroded. What monetary unit suits borrowing money most? The car? The factory? Or the public deficit? What's the price of it? What interest rate must be paid to the unit holder to accept the borrower's credit risk?

Such economies have existed throughout human history, including the period of industrialization. So, in theory, they cannot be repeated. But the world today is so overburdened with debt that it is hard to imagine such a return.