US economy

Wonking Out: Wasn’t Bitcoin Supposed to Be a Hedge Against Inflation?


There’s a financial joke, whose origin I don’t know, that has been making the rounds lately. It goes like this: If inflation continues at current rates, the purchasing power of wealth held in dollars will be cut in half over the next eight years. But cryptocurrencies can beat that: They can lose half their value in just a few months.

Haha. But crypto enthusiasts have indeed marketed their products as an inflation hedge. Coinbase, the biggest United States crypto exchange, declares that cryptocurrencies are appealing because “they’re more resistant to inflation than fiat currencies like the U.S. dollar.” This is, not incidentally, the same argument people used to make for holding gold.

But a funny thing happened as fears of inflation grew, as seen in this chart showing Bitcoin’s price in U.S. dollars over the past year:

So why have crypto prices crashed at exactly the moment inflation has taken off? To some extent it may be a coincidence: If you believe, as I do, that crypto is to a large extent a Ponzi scheme, this may just happen to be the moment when the scheme has run out of new suckers.

But there’s also a more fundamental issue: People who touted cryptocurrencies as a hedge against fiat-currency inflation — sort of a digital equivalent of gold — fundamentally misunderstood how fiat currency systems work, and also, for what it’s worth, misunderstand what has historically driven the price of gold. It was, in fact, predictable that an upsurge in inflation would drive the price of Bitcoin down — although maybe not that it would produce such an epic crash.

The key point to understand is that while the dollar is indeed a fiat currency — that is, the authorities can issue more dollars at will, without the need to back those additional dollars with some kind of collateral — America isn’t Venezuela or the Weimar Republic, a nation that prints money to pay the government’s bills. Our money supply is a policy tool used by the Federal Reserve to help keep prices fairly stable — actually, rising around 2 percent a year — while avoiding recessions. Sometimes the Fed gets it wrong, as it did over the past year, when it (and I) failed to see the inflation surge coming. But when it does, it tries to correct the mistake.

What this means, in turn, is that an inflationary outbreak doesn’t presage a spiral of ever-rising prices, which you can avoid by buying crypto. On the contrary, markets believe that the Fed will do whatever it takes to bring inflation back down to normal levels: The five-year, five-year forward inflation expectation rate, a measure derived from spreads between regular U.S. bonds and bonds indexed to the Consumer Price Index, has barely moved through this whole episode:

And saying that the Fed will do “whatever it takes” means that it will raise interest rates until there are clear signs that inflation is cooling off. The Fed only has direct control over short-term rates, but long-term rates have already soared in anticipation of continued Fed tightening:

What does this mean for crypto? Well, the rate of return investors can get by buying bonds is up, which makes buying other assets, like stocks and, yes, cryptocurrency less attractive. So cryptocurrency isn’t a hedge against inflation, it’s the opposite: When inflation goes up, the Fed responds by raising interest rates, which makes cryptocurrencies go down.

The thing is, we should have learned all about this from what happened to gold after the 2008 financial crisis. Gold prices soared, which quite a few people saw as a harbinger of runaway inflation:

But the expected inflation never came. What was happening instead was that the Fed reacted to persistent economic weakness by keeping interest rates low, and low returns on bonds pushed people to invest in other things, including gold. Whatever purpose holding gold serves — something that, to be honest, remains somewhat mysterious — one thing gold definitely isn’t is an inflation hedge. And the same is true for cryptocurrency.

So another crypto myth bites the dust. And it’s hard to avoid wondering what myths are left.

Recently the legendary short-seller Jim Chanos gave Bloomberg a wide-ranging interview in which, speaking of cryptocurrency, he pointed out that “a lot of the concepts behind its adoption early on have proven to basically be, you know, not there or wanting. You know, it was going to be a replacement currency. Well, no, it’s not. Well, it’s going to be a diversifying asset. Well, no, it hasn’t been.” And now we know it isn’t an inflation hedge either.

Chanos went on to call crypto a “predatory junkyard.” Well, I wouldn’t go that far. Actually, on second thought, I would.


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