Recently I started investing in bitcoins and I’ve heard a lot of talks about inflation and deflation but not lots of people actually know and think about what inflation and deflation are. But let’s focus on inflation.
We always needed a way to trade value and the most practical way to take action is to link it with money. During the past it worked quite well as the money that was issued was linked to gold. So every central bank had to have enough gold to cover back all the money it issued. However, before century this changed and gold isn’t what’s giving value to money but promises. As you can guess it’s very easy to abuse to such power and certainly the major central banks are not renouncing to do so. For this reason they are printing money, so basically they are “creating wealth” out of thin air without really having it. This process not only exposes us to risks of economic collapse but it results also with the de-valuation of money. Therefore, because money will probably be worth less, whoever is selling something has to increase the price of goods to reflect their real value, that is called inflation. But what’s behind the money printing? Why are central banks doing this? Well the answer they might give you is that by de-valuing their currency they’re helping the exports.
In fairness, inside our global economy that is true. However, that is not the only reason. By issuing fresh money we can afford to pay back the debts we’d, quite simply we make new debts to cover the old ones. But that is not only it, by de-valuing our currencies we are de-facto de-valuing our debts. That is why our countries love inflation. In inflationary environments it’s simpler to grow because debts are cheap. But which are the consequences of most this? It’s hard to store wealth. If you keep carefully the money (you worked hard to obtain) in your money you are actually losing wealth because your money is de-valuing pretty quickly.
Because each central bank has an inflation target at around 2% we are able to well say that keeping money costs most of us at least 2% each year. This discourages savers and spur consumes. This is how our economies are working, predicated on inflation and debts.
What about deflation? Well this is exactly the opposite of inflation in fact it is the biggest nightmare for the central banks, let’s understand why. Basically, we’ve deflation when overall the prices of goods fall. This might be caused by an increase of value of money. To begin with, it could hurt spending as consumers will be incentivised to save lots of money because their value will increase overtime. On the other hand merchants will be under constant pressure. They will have to sell their goods quick otherwise they’ll lose money as the price they will charge for his or her services will drop as time passes. But when there is something we learned in these years is that central banks and governments do not care much about consumers or merchants, what they care the most is DEBT!!. In a deflationary environment debt can be a real burden as it will only get bigger over time. Because our economies are based on debt you can imagine what will function as consequences of deflation.
So in summary, inflation is growth friendly but is founded on debt. Therefore the future generations will pay our debts. Deflation however makes growth harder but it implies that future generations won’t have much debt to cover (in such context it could be possible to afford slow growth).
OK so how all this fits with bitcoins?
Well, bitcoins are designed to be an alternative for money and to be both a store of value and a mean for trading goods. They are limited in number and we’ll never have more than 21 million bitcoins around. Therefore they are designed to be deflationary. Now we have all seen what the results of deflation are. However, in a bitcoin-based future it could still be possible for businesses to thrive. The way to go will be to switch from the debt-based economy to a share-based economy. Actually, because contracting debts in bitcoins would be very expensive business can still obtain the capital they want by issuing shares of their company. This could be a fascinating alternative as it will offer many investment opportunities and the wealth generated will be distributed more evenly among people. However, just for clarity, I have to say that part of the costs of borrowing capital will be reduced under bitcoins as the fees would be extremely low and there won’t be intermediaries between transactions (banks rip people off, both borrowers and lenders). Bitcoin Revolution might buffer some of the negative sides of deflation. Nevertheless, bitcoins will face many problems unfortunately, as governments still need fiat money to cover back the huge debts that people inherited from days gone by generations.