Recently I started investing in bitcoins and I’ve heard a great deal of talks about inflation and deflation however, not lots of people actually know and think about what inflation and deflation are. But let’s start with inflation.
We always needed ways to trade value and probably the most practical way to do it would be to link it with money. Before it worked quite well because the money that was issued was linked to gold. So every central bank needed enough gold to pay back all the money it issued. However, during the past century this changed and gold isn’t what is giving value to money but promises. As possible guess it’s very an easy task to abuse to such power and certainly the major central banks are not renouncing to do so. For this reason they’re printing money, so in other words they are “creating wealth” out of nothing without really having it. This technique not merely exposes us to risks of economic collapse nonetheless it results also with the de-valuation of money. Therefore, because money will probably be worth less, whoever is selling something has to raise the price of goods to reflect their real value, that is called inflation. But what’s behind the amount of money printing? Why are central banks doing this? Well the answer they might offer you is that by de-valuing their currency they are helping the exports.
In fairness, inside our global economy that is true. However, that’s not the only reason. By issuing fresh money we can afford to pay back the debts we had, 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’s why our countries love inflation. In inflationary environments it’s better to grow because debts are cheap. But what are the consequences of all this? It’s hard to store wealth. So if you keep carefully the money (you worked hard to get) in your money you’re actually losing wealth because your cash is de-valuing pretty quickly.
Because each central bank comes with 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, based on inflation and debts.
What about deflation? Well this is often the opposite of inflation and it is the biggest nightmare for the central banks, let’s see why. Basically, we have deflation when overall the costs of goods fall. This might be caused by an increase of value of money. Firstly, it could hurt spending as consumers will undoubtedly be incentivised to save lots of money because their value will increase overtime. Alternatively merchants will undoubtedly be under constant pressure. They will need to sell their goods quick otherwise they will lose money because the price they will charge for his or her services will drop as time passes. But if there is something we learned in these years is that central banks and governments usually do not care much about consumers or merchants, what they care probably the most is DEBT!!. In a deflationary environment debt can be a real burden since it will only get bigger as time passes. Because our economies derive from debt you can imagine exactly what will be the consequences of deflation.
So to conclude, inflation is growth friendly but is based on debt. Which means future generations will pay our debts. Deflation on the other hand makes growth harder but it implies that future generations won’t have much debt to cover (in such context it would be possible to afford slow growth).
OK so how all this fits with bitcoins?
Well, bitcoins are made to be an alternative for money also to be both a store of value and a mean for trading goods. They’re limited in number and we’ll never have more than 21 million bitcoins around. Therefore they’re designed to be deflationary. We now have all seen what the results of deflation are. However, in a bitcoin-based future it could still be easy for businesses to thrive. The way to go will be to switch from the debt-based economy to a share-based economy. In fact, because contracting debts in bitcoins will be very expensive business can still obtain the capital they want by issuing shares of their company. This could be an interesting alternative as it will offer many investment opportunities and the wealth generated will undoubtedly be distributed more evenly among people. However, simply for clarity, I must say that the main costs of borrowing capital will be reduced under bitcoins as the fees will be extremely low and there will not be intermediaries between transactions (banks rip people off, both borrowers and lenders). This would buffer a few of the negative sides of deflation. Nevertheless, bitcoin s will face many problems unfortunately, as governments still need fiat money to cover back the huge debts that we inherited from the past generations.