Recently I started investing in bitcoins and I’ve heard a great deal of talks about inflation and deflation but not many people actually know and consider what inflation and deflation are. But let’s start with inflation.
We always needed a way to trade value and the most practical way to do it is to link it with money. In the past it worked quite well because the money that was issued was linked to gold. So every central bank had to have enough gold to pay back all the money it issued. However, in the past century this changed and gold is not what is 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 in other words 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 is worth less, whoever is selling something has to increase the price of goods to reflect their real value, this is called inflation. But what’s behind the money printing? Why are central banks doing so? Well the answer they would give you is that by de-valuing their currency they are helping the exports.
In fairness, in our global economy this is true. However, that is not the only reason. By issuing fresh money we can afford to pay back the debts we had, in other words we make new debts to pay 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 bitcoin mixer inflationary environments it’s easier to grow because debts are cheap. But what are the consequences of all this? It’s hard to store wealth. So if you keep the money (you worked hard to get) in your bank account 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 can well say that keeping money costs all of us at least 2% per 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 exactly the opposite of inflation and it is the biggest nightmare for our central banks, let’s see why. Basically, we have deflation when overall the prices of goods fall. This would be caused by an increase of value of money. First of all, it would hurt spending as consumers will be incentivised to save money because their value will increase overtime. On the other hand merchants will be under constant pressure. They will need to sell their goods quick otherwise they will lose money as the price they will charge for their services will drop over time. But if 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 will become a real burden as it will only get bigger over time. Because our economies are based on debt you can imagine what will be the consequences of deflation.
So to summarize, inflation is growth friendly but is based on debt. Therefore the 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 pay (in such context it would 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 will never have more than 21 million bitcoins around. Therefore they are designed to be deflationary. Now we have all seen what the consequences of deflation are. However, in a bitcoin-based future it would still be possible for businesses to thrive. The way to go will be to switch from a debt-based economy to a share-based economy. In fact, because contracting debts in bitcoins would be very expensive business can still obtain the capital they need by issuing shares of their company. This could be an interesting 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 because the fees would be extremely low and there won’t be intermediaries between transactions (banks rip people off, both borrowers and lenders). This would buffer some of the negative sides of deflation. Nevertheless, bitcoins will face many problems unfortunately, as governments still need fiat money to pay back the huge debts that we inherited from the past generations.