This article is describing deflation and its consequences while also exploring Bitcoin’s scarcity and the utilization of BCH as a replacement to fiat.
As Adam Smith puts it in the “Wealth of Nation”, an invisible hand is pushing prices in a free market. Lending creates bubbles and bubbles reach a tipping point and burst. Depending on the effect of the bubble, it can create spiral events that will lead to a recession and deflation.
Most economies when suffering high inflation will most probably have very low unemployment. However, deflation always means high unemployment and is usually associated with the recession of an economy.
Inflation and deflation are usually adjusted through actions of governments with Central banks like the FED and the ECB. Also the government interference with money supply is usually the common suspect that creates them in the first place.
I write about Bitcoin Cash. The title of this post is a reference to Bitcoin Cash, not to BTC. Due to high fees and inability to scale BTC has no property to be used as cash. It takes time but eventually everybody understands this fact.
Deflation
Image from: FT
Value of the government backed currencies (fiat) is decreasing with time due to inflation, we already know that and it is the main reason we are investing and hold only a small percentage in our cash reserves.
Satoshi designed Bitcoin having scarcity in mind. While the limit is 21 million since the beginning, there have also been discussions to increase this number. The code is not locked and developers can change anything as long as there is support from the overwhelming part of the community.
Of course I’m not making a case here for introduction of increasing the total supply of “fixed supply” cryptocurrencies. I’m interested in scarcity as an investor however this post is not about individual investors, but expands into macroeconomic scale.
Deflation is also an outcome of government and Central Bank intervention .
There are huge problems deflation creates in economies which is usually associated with a recession.
Inflation means that the national currency is losing value, and deflation is basically increasing this. Deflation means the average price of the basket of goods economists use to measure price changes is dropping.
It may be great to find prices being lower with time, however, this means our assets and investments also lose value since all prices are going lower and not just consumer goods.
Deflation is great when holding lots of cash in the bank. Money doesn’t lose its value but it is also increasing. Looks great at first glance, since this means that we are now able to buy goods with less money.
However there are many downturns that make deflation not working in any economy.
Our asset prices are also dropping and usually rapidly.
Wages also drop, cancelling the household advantage of buying at lower prices
Deinvestment appears, funds move out of big investments and exit the national economy to better options.
New investments stall and production is reduced due to falling prices and reduced demand.
GDP drops consequently and significantly.
Unemployment is rising.
Government debt value is increased (because of deflation). The same debt now costs more to serve, and will cost even more until deflation is over.
Less consumption since there is an anticipation of lower prices in the future.
Even less production since there is less consumption.
Even higher unemployment since there is less production.
All the above have happened before in countries struck by recession. The spiral of negative events will eventually fade away on its own, having first affected the population of this economies in many negative ways. However, governments will always try to intervene to create the illusion of having saved the economy, while probably having even worsen the effects.
Deflation is equally bad to very high inflation.
US and the EU
The European Union has a big problem that still does not correctly process. Europe is not a solid economy at the likes of the US, China, Russia.
It is a Union of economies that were each following different models for decades. After 2008 the decisions taken by just Germany affected the Union negatively, introducing strict supervision of many economies. The problem then was the high debt of countries like Spain, Italy, Portugal, Ireland, Greece, Cyprus.
Belgium also had a very high debt/GDP ratio (more than 100%) in 2008, however nobody ever discussed this, since Brussels was selected to be the central point of command for the European Union.
But the above is beyond the scope of this article, I just felt necessary to add as debt is an important factor to keep in mind.
These two charts give a good indication of deflationary concerns in the EU, which are caused by fears of recession due to the Covid effect.
The European Union has hit deflation levels for the third time since 2009. From my perspective and knowledge, this time, the EU did correct to not substantially increase the money supply, and currently, inflation returns to the expected levels of ~2%.
ECB didn't follow the logic of the FED and the money supply (M1, M2) wasn't increased dramatically. This fact also pushed the EUR pair to a higher USD price (~$1,22) a price that still looks suppressed. To combat deflation money supply was increased by ECB since the beginning of 2021 and reached higher levels in March.
Europe doesn't have an inflation problem, and won't have one during the current covid-crisis. The real danger is prolonged deflation that reduces production, investments, developments, research, and innovation.
Meanwhile, the United States treats money differently and money supply M1 almost quadrupled from the beginning of 2021.
When observing the two charts, higher inflation in the US is to be expected for 12-24 months. (Find more about the relation of M1 supply and inflation on inflationdata.com).
"We have to remember that there is a time lag as the increase in the money supply floats around the system. Typically the time lag is considered to be from 12 -18 months. So if we introduce a time lag into the money supply chart this is what we get."
Generally speaking, small inflation levels between 1-5% are necessary and important as it was proven by the EU for 20 years now. It is a viable way for economies to work. Higher than 5% (reported) inflation is dangerous and can overheat an economy, creating adverse effects.
Edit 20/6/2021
[EDIT]: I am deeply sorry for my analysis of the M1 supply in the US as I have made an error. It seems that this chart is correct, and the M1 supply changed rapidly, but this is not because of the FED actions.
Money M1 didn't just increase by 350% in the US and I should have tried to do more research when a chart behaves like that.
Of the $14 trillion increase in M1, $11.2 trillion (80%) came from an accounting rule change that shifted money from savings accounts to checking accounts.
Source: Collaborativefund
Saving accounts that are depicted in M2 are now also treated as checking accounts in the US. It is an accounting rule that changed and not that the FED printed an insane amount of dollars.
I have no excuse and will not try to find one. It is my fault and no matter if others also adressed this change in M1 as inflative, it is actually not.
M2 chart is this one:
Source: Fred Economic Data
Scarcity
Conventional FIAT currencies allow governments or banks to print money and cause inflation. In Bitcoin Cash's case, the total supply will be maxed out at 21,000,000 BCH. Printing extra money causes inflation, if there is no extra money printed, the value of the Bitcoin Cash should increase as the demand will rise (more people will start to use Bitcoin Cash) and supply will lower or stay flat (no more Bitcoin Cash is "printed"). This makes Bitcoin Cash similar to gold, which has limited supply and cannot be "printed" or artificially created.
Bitcoin Cash is an asset that maintains what Bitcoin abandoned. The digital cash aspect of a cryptocurrency.
As an asset, having a limited supply is great for investing, and while the user base keeps increasing the fair value of the asset will also keep doing so.
However, when it comes to a macroeconomic scale there are major differences between an asset and a currency. It will not be possible to have Bitcoin as a monetary value to compare prices and inflation.
Perhaps there will be a need for a fiat standard, at least for a few decades, before completely replacing a fiat currency in terms of valuating goods, services and assets.
Replacing fiat with Bitcoin means that Bitcoin will be the standard and prices will be in $BCH.
The inflation level for Bitcoin Cash currently is 1,8% which is a fair inflation level and for 3 more years until the next halving, it will stay this way. I think that the model of Bitcoin's scarcity can work better as no government will be able to abuse the monetary system to temporarily increase money in circulation and create fake wealth for electoral purposes and populism.
With the next halving, it will be reduced to 0,9%, which is a low inflation level and advancing lower as each four years new supply will be halved.
Cryptocurrencies however are universal. A fixed and decreasing rate of money inflation is meant for all economies, not just one where a cryptocurrency may be used massively as cash, instead of fiat.
For cryptocurrencies or any digital currency, I'm in favor of scarcity, as the fixed supply creates a better store of value.
On a macro scale, it will be impossible for a cryptocurrency (with fixed scarcity) to replace a national fiat currency, permanently, but this will probably rewrite economics completely.
There can be something else too. A basket of cryptocurrencies can be adopted as legal tender. Anything adopted will still not affect one economy alone. However, there are implications on the value of each unit, and as with forex and fiat currency wars, the same could happen with Crypto.
What are the most efficient we have today that can be used for everyday transactions?
Those that are cheap to use and the networks validate transactions instantly. Bitcoin Cash is certainly the top choice, Dash next, maybe LTC, maybe XRP, maybe Monero, whatever works and doesn't have legal or centralization issues in order to be accepted by populations.
A single cryptocurrency with a fixed supply will not be possible to completely replace a national fiat currency though.
El Salvador is one of the economies considering accepting cryptocurrencies as legal tender. I haven't read a lot about its strategy on this yet, but I find it funny reading news with headlines like: "El Salvador Bitcoin Legal Tender" (source), since this is just about adopting $BTC which has long abandoned its currency properties.
I've also read this news was announced by the CEO of payments processing app "Strike" so this will require some research to find how exactly it processes cryptocurrency transactions and if it actually benefits crypto or puts it under restrictions similar to Paypal.
Anyone having a different view on this, I am willing to discuss, since everything was put in a very loose and informal way in this post. It is just some thoughts and ideas and I’m open to discussion.
I am in favor of small inflation in a national currency, yet, one cryptocurrency or more with a fixed supply could also run in parallel with a fiat currency.
Certainly, the economies suffering from hyperinflation will find a great use case in doing so. In case of a national currency failure, the adoption of a cryptocurrency together with fiat, could be a sustainable solution and help in stabilizing the economy.
The point I wanted to make with this post is that only one cryptocurrency with a fixed supply may not be able to completely replace a fiat currency. Scarcity will not create inflation, however, possibly it could create deflationary concerns and in order to deal with those, maybe a fiat system should always exist in parallel.
A small percentage of inflation seems necessary for every economy.
Unquestionably, when a cryptocurrency will be considered instead of fiat it will require all the properties of cash.
While no cryptocurrency is perfect to reach this kind of adoption, a basket of cryptocurrencies that have efficient, decentralized networks could be a better solution.
Lead Images from: FT and Britannica
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