Is Crypto a Hedge Against Inflation?

The narratives have shifted and morphed rapidly. Bitcoin was initially held back by the widespread belief that it was strictly for hackers, money-launderers, and assorted criminals only. But it was kept alive by those who believed it would one day be the currency we all use everywhere and for everything.

Takeaways

• When did this idea first appear?

• Could Bitcoin replace gold?

• Why Bitcoin can be considered a good hedge against inflation

Why could crypto be a hedge against inflation?

As Bitcoin's limitations of speed and scale became clearer, the "you will use it to buy your coffee!" narrative gave way to a bold new dream, pushed hard by acolytes of Saifedean Ammous' bestselling book The Bitcoin Standard. 

The new narrative declared Bitcoin a store of value and 'digital gold'. With many other cryptos rising in price in Bitcoin's wake, a lot of people now consider crypto a hedge against inflation.

Hard Money, Soft Money

The new narrative caught fire at the start of the COVID-19 pandemic, as central banks started printing money in unprecedented quantities. What had begun as an emergency measure in the wake of the Great Financial Crash in 2008 had since become the go-to solution for any weakness in economic growth. It was feared that all the 'quantitative easing' would cause the US dollar to suffer from inflation.

Pump It Up

The theory is pretty simple. If a country's central bank creates lots of new money out of thin air and makes sure it makes its way into the 'real economy' (people buying goods and services) then naturally that gives a boost to many struggling businesses, it helps to keep people employed and corporate profits high.

That's what America did after the pandemic lockdowns began - trillions of dollars were printed and the government literally sent big checks to citizens, to spend or invest as they liked. Some of that money made its way into the stock and crypto markets, helping to push prices to all-time-highs. And a lot of it was spent in stores.

The inflation problem tends to arise if there are bottlenecks in the supply of goods and services or if there are labour shortages. All the new dollars in people's pockets are chasing too few goods. Sellers react by putting up their prices because there is so much demand for their limited goods.

Then workers respond to higher store prices by demanding higher wages. Firms then put up their prices even more, in order to pay for the higher wages and because the workers now have even more money to spend on goods. This is the 'wage-price spiral'.

Hyperinflation

Printing too much money - as Germany discovered in 1923 - can occasionally lead to disastrous hyperinflation. The wage-price spiral destroyed the value of people's savings, and the economy was severely damaged.

A German man uses his worthless banknotes as wallpaper, 1923 - Bundesarchiv, Bild 102-00104 / Pahl, Georg / CC-BY-SA 3.0

Old Gold, New Gold

In a 'hard money' system, unlimited money-printing is not possible. So-called 'gold bugs' have long championed a return to the gold standard, where the dollar and other currencies were pegged to the price of gold.

The main job of central banks was to maintain their currencies' worth, in terms of a particular quantity of gold per currency unit. They had to be very careful, because if they created too much new money, the value of their currency might move out of kilter with the price of gold.

Now hard money enthusiasts have something new and shiny to play with. A 'digital gold'. Bitcoin.

Invisible Cash

Maybe shiny isn't quite the right word... considering Bitcoin has no physical form. It's pure bits and bytes. But what it shares with gold is a cast-iron guarantee that it can't be 'printed' in huge quantities. When the demand for gold is high, gold miners can expand their output, but not by much. Bitcoin is even 'harder', as an algorithm ensures only a trickle of new bitcoins are created each year.

The narrative says that if governments are printing national 'fiat' currencies like crazy, and inflation takes off, then investors should transfer their money into 'hard' currencies like gold or Bitcoin to protect the value of their savings.

Even though many other cryptocurrencies don't have hard limits on their quantity in the way Bitcoin does, the whole sector tends to rise and fall together over the long term, hence the belief that we can consider the whole of crypto a hedge against inflation.

Ups and Downs

So it's all well and good in theory... but how about in practice? Is Crypto a hedge against inflation?

Well here's the actual statistical correlation between Bitcoin and the US Consumer Price Index:

This paints an interesting picture. The correlation between Bitcoin and inflation was weakly positive, but trending downwards for four years. Then, at the start of 2021, as cash-rich ordinary investors were piling into Bitcoin, the correlation started heading sharply upwards.

By the start of 2022, the correlation was looking pretty strong. This could be just an aberration, it's possibly just a coincidence that Bitcoin had one of its periodic booms just as inflation was taking off in the states.

But perhaps a critical mass of investors now consider crypto a hedge against inflation. And if that's the case, we can expect this correlation to strengthen further still.

Conclusion

Ultimately it comes down to belief. If enough investors truly consider crypto a hedge against inflation, then it can become a self-fulfilling prophecy because every time inflation rises, investors will buy Bitcoin and push the price up. Likewise, if the monthly inflation figures are unexpectedly low, investors will sell Bitcoin in anticipation of other investors doing exactly that.

So for now at least, we can consider Bitcoin and crypto a hedge against inflation. But sadly, we cannot simply rely on this correlation to continue. The trouble with strong narratives is that if/when a critical mass of people stop believing, the narrative can die. Just ask Ra, the sun god. He is not feeling the love these days. Maybe one day Bitcoin will feel the same.

Ra, god of the sun. By Jeff Dahl