Headline: Can cryptocurrency be used as an inflation hedge?
Body: OK, this one seems pretty relevant, but it also seems pretty complicated. We might think we know what this means (gut feeling) but, your gut might be incorrect. Maybe.
So, what causes inflation?
In the broadest sense, inflation is an oversized number of dollars chasing an undersized flow of goods and services. Between September and November 20089 the number of U.S. dollar bills increased sharply, but the inflation rate went down. (The over-printing of currency makes inflation worse, but is not the proximate cause.) It seems much more important that there is distrust in the central monetary system. Throw in some supply chain disruptions, the war in Ukraine and some profiteering in the corporate world, and inflation was almost a fait’ acompli.
What is an inflation hedge?
A hedge is a smaller investment made in a different item than our main ones, on the theory that if we are wrong on the primary investment, the error will be partially made up on this other investment. For instance, in a period of rapidly rising prices (like we will ever see this?) a person might feel that the inflation rate is so high that the return earned on most investments will not keep up with the inflation. So, they buy something like gold which will likely rise in price faster then the rest of the market. Then, they can sell this investment when the price is significantly higher than their purchase price. This is the idea of an inflation hedge.
Why do many believe that Bitcoin (primarily) and other cryptocurrencies are great inflation hedges.
According to its proponents, Bitcoin was designed from the start with inflation in mind. There will always be a maximum of 21 million Bitcoin. In a process known as “halving” miners used to be paid 50 BTC to substantiate one block of transactions. As time went on, they were instead paid 25 BTC for the same type of substantiation. Because of this planned halving, it was anticipated that inflation would be worked against by the rules of mathematics. Furthermore, as there is no central authority, monetary maneuvers like quantitative easing, wouldn’t even be an option for cryptocurrency, and thus they would be protected from the consequent inflation. It’s easy to access 24/7 and there is no central authority to manipulate it. All in all, it makes for a good surface story.
But, as the Fed begins to remove liquidity from the market, this narrative is changing. (By raising key interest rates, the Fed can effectively remove liquidity by requiring a much higher interest rate to make a project go. So few projects qualify for this high standard that fewer projects are undertaken, and the economy re-stabilizes at a lower level. Or, so goes the textbook theory.) In both economic conditions, “risk-on” (high liquidity and “risk-off” (low liquidity), many different investments offer a more lucrative rate of return. Still, there were enough advocates of cryptocurrency as an effective inflation hedge, that it kind of became one. But, contrarians claim that given its price volatility, it cannot be seen as a “store” of value, and thus cannot be considered an inflation hedge. Add to this the insecurity of this cryptocurrency ‘ ($1.2 billion hacked just last year) and the whopping amount of electrical power needed to mine cryptocurrency, the hedge hypothesis develops some holes.
Might this be something else entirely?
I don’t know if anybody else has REALLY bad sinus problems. If you do, I’m sorry, but you’re in excellent company. Problem is, in the drugstore, decongestants and specialty sinus medications are in the exact same space, on the theory that they are related. It’s true: they are related, in symptoms addressed. But decongestants will not help your sinuses and your misery will continue. In a similar vein, we have inflation hedges and then hedges for a drop in the value of the dollar. They too are related, but it s quite possible that cryptocurrency could serve very well for one purpose and not so well for the other.
The Future’s so Bright… I gotta [be]-ware, shades!!
OK, the famous modern Western movie is called The Good, The Bad and The Ugly. We’ve observed the Good, seen the Bad, what of the Ugly? Or, in our case, crypto might be Ugly now, but it might ride glorious into the future. Well, maybe. The authors seem to argue here that cryptocurrency will become a more potent hedge against inflation as more and more people begin to treat it that way. Well, yeah, not really an earth-shaking prediction here. What is interesting here is the idea of blockchains “maturing.” What does that look like? I think this mainly revolves around sensible regulation and the large institutional investors seeing cryptocurrency as a valid investment. (I admit, these are NOT independent events.) But the major point being made remains the same: When enough people feel secure enough, enough people will buy enough to make people truly secure. As to timeline for this to happen, and how to kick-start this virtuous cycle, I have no idea
The Verdict
The more responsible and diligent the crypto community becomes, the more every sound protocol will benefit, and crypto will become a genuine hedge against inflation. Because cryptocurrencies currently follow growth stock patterns, they act as a good hedge against inflation during periods of stable growth but fail during times of financial crisis. As cryptocurrencies evolve, they’ll become an effective bulwark during these downturns too.
I ran into many sentiments like this one in my research. But I feel that I must ask, when do you NEED a hedge against inflation? Most likely it is during those times of fiscal and monetary stress. Given this, it seems most prudent to not assume cryptocurrency to be a good inflation hedge. This might force us to confront the inconvenient truth that we need to keep searching.
REFERENCES
https://cointelegraph.com/news/crypto-will-become-an-inflation-hedge-just-not-yet
https://www.yahoo.com/now/cryptocurrency-inflation-hedge-135115613.html
Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice. Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.