Is Bitcoin a Hedge Against Inflation?

When it comes to the topic of inflation, most of us will readily agree that it has become a problem in the global economy. Where this agreement usually ends, however, is on the question of what causes inflation and the best method to safeguard one’s wealth from its effects. Whereas some are convinced that inflation is necessary for the economy, others maintain it is strictly damaging and that hard assets are necessary to protect oneself from its adverse effects. Although inflation may seem of concern to only finance or economics-oriented individuals, it should in fact concern anyone who cares about their well-being and the well-being of their friends and family. In this article, we will explore what inflation is, what causes it, and how Bitcoin presents itself as a unique solution to this pernicious economic phenomenon.

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What is Inflation?

Inflation refers to a general increase in the price of goods and services in the economy, resulting in a decrease in the overall purchasing power of money. In other words, Inflation means that things get more expensive over time, so each dollar you have buys less than it did before. Although this may seem counterintuitive, central banks worldwide have adopted a standard policy of targeting 2% inflation annually. The chart below illustrates the inflation rate of the US Consumer Price Index (CPI) from 1990 to 2024. As you can see inflation has stayed in the 2% range over the past 35 years, with occasional variance.

This means central banks target a 2% reduction in your purchasing power every year. However, inflation has recently become entrenched in the global economy and reached above 9% in the US in 2022 thanks to the COVID-19 pandemic and the massive stimulus response from governments around the world. This surge in inflation has fueled a global cost-of-living crisis, where citizens are struggling to pay bills, afford homes, and put food on the table due to the soaring prices of goods and services in the economy. This begs the question, what is causing inflation and what can I do to protect myself from it?

What Causes Inflation?

While inflation can be caused by supply or demand shocks in an economy, its root cause is the printing of money which results in an increase in the total supply of money in the economy. To illustrate this point, the chart below shows US M2 money supply growth since 1980 plotted alongside CPI Inflation using 1980 as the base index year. As evident from the chart, both the money supply (M2) and the price levels of goods have dramatically increased in tandem since the 1980s. 

In the modern economy, money is primarily printed through two methods: 

1. When commercial banks lend money into existence, it increases the total money in the system
2. When central banks buy securities on the open market, it increases the total money in the system (also known as quantitative easing).

While the method of money printing influences the degree of inflation experienced, the overall result remains the same; when the supply of money increases in the economy, but the amount of goods and services remains the same, you create a situation where too much money is chasing too few goods, causing prices to rise. In this way, inflation can be thought of as a simple function of supply and demand between the number of monetary units and the goods and services available to buy in the economy.

At its core, when governments and central banks print money, it increases the total money supply, diluting the existing supply of currency. By creating new units of money, all the other units of money in circulation become less valuable on a per-unit basis since there is now a greater total supply. The act of debasing the money supply is referred to as monetary debasement. To illustrate this point, consider the Mona Lisa as an example.

The Mona Lisa, renowned for its beauty and historical significance, holds immense value due to its scarcity; there is only one original painting. Its uniqueness drives people from all corners of the globe to the Louvre Museum in Paris to catch a glimpse of this masterpiece. However, if multiple exact replicas, all painted by Van Gogh, were widely distributed, the value of each individual painting would decline. 

With increased availability and copies, the exclusivity of the original diminishes, leading to a decrease in its value. In this way, the scarcity of the original Mona Lisa sustains its value, while an abundance of the replicas would diminish the individual worth of all paintings. This example showcases how scarcity, is a desirable characteristic of money if you want it to retain its value over long periods.

Essentially, the process of printing money and the resulting inflation drives a wedge between the real and nominal value of money. Nominally speaking, $1 from 1914 is the same as $1 in 2023, but the purchasing power (i.e. the real value of what that dollar can purchase) has decreased dramatically due to the massive expansion in the money supply that has taken place since the creation of the Federal Reserve (the US Central Bank) in 1914.

Fiat Currency Supply Dynamics

In our current monetary system, fiat currencies (i.e. government-issued money like the US Dollar or Canadian Dollar, etc.) have become the standard form of money available in the world today. Around the world, each government and central bank maintains a monopoly over the money used within their borders. In this system, they have the authority to dictate the supply of money and the cost of borrowing money (i.e. the interest rate) as they see fit.

This model results in a very fractured system, where each individual currency has little to no acceptance outside its borders, and where decisions over the supply of money (and thus inflation) are made by a small group of people, with no input from the public who are the predominant users of their currency.

Here we reach the crux of the issue — throughout history, no government or central bank has been able to resist the temptation of printing money. Whether it is to finance government spending, bail the economy out of a recession, or wage war with a foreign power, there is always a reason that proves too futile to not print money. This is in part why every fiat currency has eventually succumbed to monetary debasement and eventually failed in often spectacular ways. Because of this, inflation can be thought of as an inherent characteristic of fiat currencies. 

Although the extent of inflation may fluctuate, fiat currencies are consistently devalued due to the continual printing of money by governments and central banks. This is why prices go up indefinitely and why life continues getting more expensive. Because of the ease at which fiat currencies can be printed, they effectively have an unlimited supply, rendering them ineffective for preserving wealth in the long term. Due to this inflationary nature, the long-term viability of fiat currencies has come increasingly into question in recent times, especially in developing countries where inflation runs even more rampant.

Bitcoin’s Supply Dynamics

Bitcoin emerges on the opposite spectrum of fiat currencies. Instead of a central bank with monopoly power over the money, that enables them to print money as they see fit, Bitcoin operates in a decentralized manner, with no central authority, and a maximum supply of 21 million coins. This has prompted many to label Bitcoin as the money of the future.

By operating without a central authority, Bitcoin solves the problem of inflation as it relates to printing more money and increasing the money supply. No one can print more Bitcoin. Instead, Bitcoin is more accurately categorized as a deflationary currency. When measured against Bitcoin, prices and the cost of living fall over time. This stands in stark contrast to fiat currencies where prices and the cost of living continue to rise. 

If people were prompted to choose between an economy where prices rise gradually over time and life gets more expensive or an economy where prices fall gradually over time and life gets cheaper, most would hastily pick the latter.

At a time when inflation has become entrenched around the globe, Bitcoin emerges as a compelling store of value. A store of value refers to the ability of money or an asset to retain its purchasing power over time. Bitcoin’s supply cap of 21 million coins ensures scarcity, a fundamental driver of value in economics. Unlike fiat currencies, users of Bitcoin don't need to worry about currency debasement or inflation eroding their purchasing power over time. With a supply cap of 21 million coins, Bitcoin establishes itself as money free from inflation.

Is Bitcoin an Inflation Hedge?

Due to Bitcoin’s monetary properties, in particular its supply cap, many have praised it as a hedge against inflation. What they mean by this, is not that Bitcoin will necessarily perform well during periods of high inflation, but rather due to its hard-capped supply, you can avoid the debasement present in fiat currencies entirely by holding your savings in Bitcoin. Due to this, Bitcoin may be more accurately characterized as a hedge against monetary debasement. All things considered, when inflation runs hot, it is wise to protect your wealth and savings in hard assets, i.e. assets that cannot be debased or printed, such as gold or Bitcoin.

In conclusion, the phenomenon of inflation presents a significant challenge in today's global economy, affecting individuals' purchasing power and overall financial well-being. While traditional monetary systems have grappled with inflationary pressures and the debasement of fiat currencies, Bitcoin emerges as a unique solution.

By holding wealth in Bitcoin, individuals can safeguard their savings from the erosive effects of inflation, ensuring the preservation of purchasing power over time. As inflation continues to pose threats to economic stability and financial security, the importance of stores of value, such as Bitcoin, becomes increasingly apparent. Embracing Bitcoin in the face of inflation not only protects individuals' wealth but also signifies a shift towards a monetary system that works for the people, not against them.