Inflation and Bitcoin: Why so much misunderstanding?

Inflation and Bitcoin: Why so much misunderstanding?

The term “inflation” means many things to many people. That explains, in part, the confusion. Because effective communication requires shared definitions. When we all begin to redefine terms on a whim, understanding becomes more difficult. On the other hand, we have the ideologies. A noisy minority fervently believe that deflation is the solution to all problems. But for the rest of the world, deflation is synonymous with crisis. Now, let’s talk about inflation and its (true) effect on the price of Bitcoin.

The first enemy of the concept of inflation is the anecdote. I am referring to Pedro Pérez who goes to the supermarket every day. Pedro, very observant, discovers a significant increase in many items of his consumption. Find out, for example, that apples have increased by 30%, orange juice by 10%, and gasoline by 100%. For him, it is clear that inflation is at 50%. Minimum! In addition, his daughter in New York tells him that the properties there are through the roof. Of course, he is outraged to hear on the news that inflation for that year does not exceed 7%. Lie! Pedro, who is characterized by having a high sense of justice, begins to suspect that the authorities are deceiving him. Why? Well, because what your eyes see profoundly contradicts the official data. Who to believe?

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Friend Pedro is alarmed by the increases. But you forget to consider the items that have registered drops in their prices. Your daughter is having trouble finding housing in New York. But in her case, the rent hasn’t gone up in years. Communications, services, clothing, household appliances, etc. Many things, in fact, have come down in price. But it is very rare for those items to participate in conversations about inflation. The world is full of Pedros. So-called inflation experts attacking official data.

In the United States, inflation is data published by a government entity using very specific criteria. The indicator includes many items and excludes many others. The last Picasso sold at auction, for example, is not part of the indicator. Neither are Apple stocks. In the same way, the indicator gives more importance to the price of rents than to the sale price of real estate, for example. It is a national average taken from some pre-established items. In other words, statistically speaking, the sample of friend Pedro is very limited and can lead him to erroneous conclusions. A supermarket in South Florida is not very representative. However, for him, it is the whole world. Anyway, he is right and says it everywhere.

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Now, we already talked about the anecdote as a very inadequate inflation indicator. Now let’s talk a bit about the conservative view of inflation. For conservatives, inflation is always a bad thing. It dilutes the value of the currency, lowers purchasing power, and discourages saving. According to conservatives, “inflation is always a monetary phenomenon.” The ideal is to have a hard coin. This implies that the United States Federal Reserve should not issue as much currency. That is, deflation is desirable.

For conservatives, the above is a matter of dogma. And here there is no valid argument. Those ideas are already articles of faith for them and are part of their identities. They are correct. And the others are deeply mistaken. But nevertheless, current economic practices are quite different from the conservative view. Inflation is not solely a monetary phenomenon. Deflation is crisis. And moderate inflation (2-3%) stimulates growth. This increases income, stimulates production and employment, encourages investment and raises the price of assets. The release and withdrawal of currency is a necessity for monetary stability. It is not the conservative practice, but it is the accepted practice.

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The coronavirus crisis was a deflationary crisis. Because of that historic deflation, historic amounts of liquidity were injected. The liquidity in circulation stimulated investment. In other words, a financial boom was created. And that mainly benefited technology and cryptocurrencies. In other words, deflation caused an abysmal fall and a loose monetary policy raised prices. After a start, the Federal Reserve warned that inflation would reach figures above those traditionally accepted in order to raise employment figures. In other words, exceptional times require exceptional measures.

Why the inflation? Production and distribution chain problems. Shutting down a machine is easy. But overcoming inertia and putting the machine back into operation as before is not so easy. Despite inflation at historical records, the Fed’s strategy has been to tolerate because withdrawing liquidity prematurely would turn off the machine again. That money is needed to revive production and distribution chains. What is the problem? Well, inflation got out of control. And the Reserve will be obliged to withdraw liquidity earlier than anticipated.

Moderate inflation is desirable. However, excessive inflation does not. 6% inflation is still tolerable in exceptional circumstances. For example, to raise the employment rate. But inflation of 6% can continue to rise, if no action is taken. That is exactly what it is intended to do. The Reserve will stop the purchase of bonds and next year it will raise interest rates. In this way, inflation is lowered. But the markets suffer.

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When it comes to the price of cryptocurrencies, inflation is not the most relevant data. The most relevant is monetary policy. Cryptocurrencies are speculative assets that benefit from liquidity. As simple as that. Now, how do investors behave in the face of this historic inflation? Investors most concerned about inflation withdraw from speculative / growth assets and take refuge in cash, T-bonds, corporate bonds, and stocks. That is, more Coca-Cola and less Bitcoin.

Market behavior right now directly contradicts what the most devoted bitcoiners have told us for years: Bitcoin is a hedge of inflation. That is something that arises from conservative (libertarian) ideas. It is more dogma than reality. They are aspirations of people who defend a creed. But when it comes to our finances, it is best to be pragmatic. It is important to put politics aside. And describe reality objectively. The misunderstandings around Bitcoin and inflation stem from ideological bias. There are many conservatives in this space and they always present a conservative view of the situation. But what does experience tell you? Why the latest falls? How does Bitcoin respond to monetary policy developments?