Money might seem straight forward most of the times… I mean, we see dollars since we are kids, right? Well, currencies generally have a lot of hidden features. I thought it might be interesting to look into monetary phenomenons, in order to get to understand Bitcoin. Cryptocurrencies are called this way because of what they resemble: actual currency.
The most common monetary phenomenon is inflation. It is perhaps the most frequent of all and the one that affects everyone the most. It occurs when the general price level of goods is in an uptrend during a certain timespan. This basically translates to decrease in money power.
I guess you can see how it affects you during longer periods. In order to measure it, you determine the percentage change. Say, if $2 has now the buying power of a $1 from 36 years ago, that is a 2% annual inflation (which is actually what we are currently getting with the US dollar).
The first and most common cause is excessive money printing.
In order to understand what really happens, let’s understand the concept of money, then and now. Up to 1971, the gold price was fixed in USD and you could change at any point your dollars in the equivalent gold value. President Nixon removed this, meaning that authorities were able to print more money than the total gold reserves of the US.
This means the dollar started losing value. If there is created more of it, supply and demand dictates that the currency’s value goes down. What does our beloved government in order to avoid (or actually postpone) a crisis? It starts printing money. And that creates inflation.
Another cause of inflation could be the human expectations mechanism. If everyone expects that money will lose its value, they will, most likely, spend it. It is the easiest way to get rid of money fast and get something in exchange. Let’s take an example: John buys something from Kate. Kate does not want to keep the money, so she buys something from Todd. Todd doesn’t want to keep his money so he buys something from Dylan. This continues going on, and makes prices to rise. This is where the circle closes (the expectations meet the reality).
These are also known as hyperinflation. Venezuela is currently experiencing it. Also, at the apogee, hyperinflation in Zimbabwe in mid-2008 manifested in prices doubling every day. In order to put into perspective, if that were to happen to the USD it would mean that the buying power of $1 on the 1st of January would be equivalent to $1,073,741,824 on the 31st of January. That is a lot and people holding cash seem instant loss in value.
Another story I recall about hyperinflation is from Robert Kiyosaki’s book (link here). It is about a man in Zimbabwe who was coming close to retirement. In theory, he should’ve had enough money in order to live decently from the private retirement fund pension. Apparently, the fund had to pay all of his savings once, because they were having trouble with all of the hyperinflation. The only thing this man could buy with the money he earned in a lifetime from working was an oil barrel. This is what hyperinflation does and why it is so bad.
Deflation, in a few words, is negative inflation. What does this mean? Well, basically keeping cash (not in assets/liabilities) is good for you because the money you hold gets more buying power as time goes by.
Prices go down. Things get cheaper. By definition, deflation cannot occur when money is printed. Even though it would sound good at first, it is actually much worse than inflation and that is why it is more rare.
The last time the US had a period of significant deflation was during the Great Depression (early 1930s). In order to get a little bit of context, the 1920s was a period of massive general economic expansion for the country. This, of course, created an increase in stock levels (together with the fact that everyone was encouraged to buy on margin — you could put as little as 10% in order to buy stocks, the rest consisting of a bank loan), so it all had to finish with a dramatic crash. By 1933, the stock market went down as much as 90% and the unemployment rate soared at 25%.
Because people were unemployed, any remaining cash would be very carefully spent. This resulted in less spending, less demand so: prices going down. People started valuing more, so this caused deflation. If you want to read more about what happened, check this out: link.
There have not been many historical cases of deflation, so there is not too much to say. It can be worse than inflation in the sense that it brings unemployment to high rates and your assets start losing value fast.
Gold has been one of the most valuable assets over time, known for the fact that it does not lose its value when inflation appears. Basically, you are inflation-proof if you have gold. Why does gold lack inflation? Because it is a natural resource, meaning that there is a limited supply. People can print as much currency as they want – so its potential is infinite.
Bitcoin is very similar to gold. Mining creates more currency, which makes the system automatically manage inflation. How to lower the inflation though? Through block reward halving: that changes the reward miners receive upon mining a block by making it half. This means inflation is also going down at an exponential rate. When all Bitcoin will be mined, the inflation will become null. Which is a sweet dream for any currency.
Let’s see how the inflation of Bitcoin went over time. We can see the following graphic:
Even though Bitcoin has inflation, its tendency of going up in price makes it a “deflationary” currency. This means that its buying power increases.
It is not easy to see how Bitcoin respects the monetary phenomenons. The main problem is that Bitcoin is not currently engaging in so many transactions as an established currency such as the US Dollar or the Euro. People still currently see it as an asset, similar to how gold has become after the introduction of paper currency. When Bitcoin will actually be a currency, it will be similar to how people in the old times used gold as a transaction medium. At that moment, monetary phenomenons will be essential in getting to understand Bitcoin and they will apply very similarly to the other currencies.
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