Is crypto a good hedge against fiat inflation?

If you are (un)fortunate enough to ever find yourself in a crypto subreddit, you might come across this idealistic sentiment:

“Bitcoin is a hedge against inflation.”

This is the fiery battle cry of every Bitcoin Maximalist. But what does it mean? And why are some people so passionate about it? And what about the people that disagree? For one:

“Bitcoin is not a hedge against anything…”

-Nassim Nicholas Taleb, 2021

I personally consider Taleb to be one of the greatest thinkers extant, so him being the “contrarian” of this story makes it much more exciting. In 2019, Taleb publicly stated his support for crypto as an “excellent idea” and an “insurance policy against an Orwellian future”. Now only just two years later, he has done a 180 to become a vocal bitcoin critic.

So who is right here? A hoard of online neckbeards or one of the greatest thinkers alive?

Before we answer this, let me first guess a few things. I’m guessing you’re reading this because you want to know what this dang crypto technology is. You’re vaguely interested in economics. You have a vaguer interest in financial systems. You have a hazy idea that the global financial crisis ’08 did not end well, at least for the little guys. You want to know more about how inflation works and why it apparently sucks. You’ve seen a Pepe or wojak meme here and there. You’ve seen a candlestick chart, nodded, and thought to yourself, “hmm yes, stonks.”

Well I’m inviting you to explore this with me, because I want answers too, damnit.

Quick disclaimer: I am pro-bitcoin although I personally own almost no bitcoin. However I am more invested in other cryptocurrencies, especially those with smart contract functionality like Ethereum.

WHAT IS INFLATION? WHY IS IT BAD?

I once had a friend tell me this:

“Governments can end poverty and world hunger. Just print more money. It’s not that hard. Money is a made-up invention anyway!”

While I admired his idealism, it’s a little bit more complex than “print money and gift it to poor people”.

The truth is that money printing devalues our currency. The combined money we have in circulation holds a certain value. Printing more money increases supply of the dollar, but since the value of the combined money stays the same, the dollar devalues - each dollar is worth less to make up for increased supply. This is called inflation.

Think of it as this: let’s say there are only 3 gold Charizard Pokèmon cards in existence. They are extremely valuable because it’s rare (only 3 exist). If the card company decides to print more gold Charizard cards, the value of these cards will decline in proportion to the increase of cards. It’s not really valuable if everyone owns a card. We see something very important here: scarcity and value are closely linked.

It’s important that money supply is restricted, and thus scarce. Maintaining the money supply at a fixed rate of growth is what lets money retain a steady value. Steady value is a necessary feature for money to be a successful medium of exchange.

In the United States, inflation of monetary supply occurs at a small but steady rate. At least, that’s what the target is. The US Federal Reserve aims to keep inflation at 2% a year. Bank of Canada, The Bank of England, Sweden’s Riksbank, & Bank of Japan all of the same 2% target. Why 2%? Because a little bit of inflation makes sense as low inflation can “weaken the economy” - if the dollar devalues, then citizens are incentivised to spend and stimulate the economy, as opposed to hodling a deflationary asset that is growing in value.

This small 2% increase is why 2 litres of milk costs $1 in 1991, but now costs $2. Inflation decreases the purchasing power of our money.

Inflation can also be a side effect of the Fed decreasing interest rates in order to stimulate the economy:

Decreased interest rates —> more people borrowing —> more money to spend —> economy grows and inflation increases as more money is in circulation.

Wait a second, you might be wondering. Borrowing money is increasing the money supply? Banks are creating money? Yes, this is because US banks operate under a system of Fractional Reserve Banking. More on this another day.

HYPERINFLATION

Hyperinflation is when a local currency rapidly inflates at a rate above 50%. This quickly erodes the value of the currency as prices and goods increase. The dollar becomes worthless. Hyperinflation occurs when the monetary supply is increased dramatically, usually as a desperate response to a destabilising sociopolitical or natural circumstances. One of the most well-known cases of hyperinflation was the devaluation of the Zimbabwe dollar in 2007. At its peak month of currency instability, Zimbabwe was facing 79.6b% inflation. That’s right, BILLION. BILLION!

INFLATION TODAY

Now let’s look at inflation rates in the US right now. It was reported that the inflation rate rose to 6.8% in the last year (2021) which is disturbingly high, but the worse thing is this isn’t even the correct figure. It’s something closer to 16%. (Here is a good video explaining how this figure has been manipulated.) This is because of the shocking fact that 40% of the entire US money supply was printed in just the last year!!!

Inflation like this means that the cost of living for everyday citizens like you and me becomes more and more unaffordable. Anyone who has done any sort of grocery shopping pre-pandemic and post-pandemic is clearly aware that the price of a pack of chicken drumsticks ain’t what it used to be. On top of that, because of inflation, Millenials are being priced out of the housing market. People blame speculation in the markets now, which is pretty much the incongruence between intrinsic value and market price. They also blame boomers with their 50 investment properties. But these are just side effects of YOUR DOLLAR BEING DEVALUED. THE TL;DR = YOUR MONEY IS WORTH LESS SO OTHER ASSETS LIKE REAL ESTATE ARE WORTH MORE. I DON’T KNOW WHY I’M SHOUTING.

It’s no wonder why people are looking more and more into alternative forms of money.

BUT FIRST… WHAT IS MONEY, REALLY?

Why the hell is money? Can I just invent a KariCoin, print out some colourful rectangular paper and get people to use it to buy stuff?

No. Just no.

Let’s take a ride through the history of money. A very short ride. Otherwise we’d be here forever. I got shit to do man.

Imagine a time before paper bills and metal coins were used as money. How did people transact value back then? Well, some societies used stones and beads. Some used seashells. Yes, seashells were used as a form of currency. Why these random-ass objects you can find at the beach, you ask?

There are certain reasons why these natural resources became monetary mediums. First, in these societies these particular types of stones or seashells were hard to find, meaning it was scarce. Again, here’s the link between scarcity and value. Thus European settlers adopted seashells as legal tender in the 1600s - though this would soon be replaced by metals as soon as more seashells could be harvested and they quickly lost their scarcity and value.

Another form of money used was salt. This is actually where the word “salary” comes from - it is derived from sal, the latin word for salt! However, all these forms of money were extremely flawed in the same way: once societies found a way to produce them without restraint, then any value they held went out the window.

Eventually societies would start to adopt gold as a sound monetary medium. Gold is very attractive in many ways. Firstly, it is very shiny, ooh. Secondly it has many intrinsically valuable properties - gold is virtually impossible to destroy, impossible to synthesise/create, and is extremely rare (remember the link between scarcity and value? Remember???) It has a very steady supply flow of 1.5% (flow is the amount of new gold mined every year). Its supply is restricted at a constant rate, unlike seashells, stones, or salt.

But there is one big problem: it is very hard to just carry gold bars around if you want to make any financial transaction. I cannot say in truth that I own any item of clothing that can hold a decent-sized gold bar. It is just hard to transport, especially in large quantities.

So governments began to issue physical paper receipts, redeemable in gold or silver. This was the beginning of what would become The Gold Standard - fiat money backed by equivalent gold reserves. The problem with this is that it is easy for governments to inflate the supply of the dollar beyond gold reserves, disturbing the convertibility of gold to dollars… thereby engaging in money creation out of thin air…

So after WWII, something needed to change. A new monetary order called the Bretton Woods System was established amongst 44 participating member nations. The agreement was that the US would peg their dollar to gold at $35 an ounce, and the other allied nations would peg their dollars to the US dollar. Unfortunately this system proved too inflexible as all nations failed to maintain the discipline of fixed exchange rates. It was much more complex than this little blog post can document or my brain can comprehend.

In 1971, the Bretton Woods System was abolished when President Nixon got rid of the gold standard and ended the convertibility of US dollars to gold. What was said to be a temporary measure still endures today, proving Milton Friedman’s saying “nothing is so permanent as a temporary government program.”

Thus began the era of government-issued currencies: true fiat.

Hyperinflation is a problem very unique to fiat currencies. Government-issued money has an extremely low cost of production, and money printer go brrr is a very real and common response to an impending recession threat. And as I've talked about above, in the last year we've seen inflation rates soar to the highest its been in decades.

I know, this is all a quick and simplistic rundown, but we have other things to talk about. I just want to you note that things aren’t too good. Your liquid savings aren’t in a good place right about now :(

Enter: Cryptocurrency.

If you have ever had any serious conversation about crypto, you might have heard this particular concern:

BUT WHAT IS BITCOIN BACKED BY?

I happened into a conversation about bitcoin with a work colleague once. She exclaimed in a huff:

“My husband bought bitcoin and I was so mad. Luckily it wasn’t much, but still. I just don’t understand it. What is bitcoin even backed by?”

I asked her, “Ok, but what is fiat currency backed by?”

As we have already talked about, the US dollar is backed by shit-all. Remember that 50 years ago President Nixon nixed the Gold Standard. But she didn’t have an answer to my question. How can you question the intrinsic value of cryptocurrency without first understanding the integrity of the currency you currently use? It seemed so irrational to me.

Ok lady, so here is what bitcoin is backed by.

Bitcoin is backed by mathematical certainty and scarcity.

Think about why this is so valuable. We currently live in a world where confusion is rife, misinformation is a common political tactic, everything is polemicised, and you don’t really know who to trust.

Incorruptible certainty is gold in times like these. Gold, Jerry!

Bitcoin cannot be manipulated. It is all secured cryptographically through a proof-of-work consensus algorithm on a worldwide network of nodes. How do we know it’s secure? Not once in its 11 year lifespan has any hacker been able to successfully bring it down. Theoretically if hackers were able to secure 51% of the processing power then it may be able to falsify and manipulate transactions on the ledger, but due to the integrity and size of the system this has not happened.

On top of that it can ensure scarcity of stock by having a predetermined supply schedule that eventually caps the total supply at just 21 million bitcoin. Again, this steady supply schedule is something that is nearly impossible to corrupt.

Now we’ve talked about why scarcity is so important. It’s even more important to note that scarcity alone does not make an asset valuable! Remember the dumb Beanie Baby craze of the 90s, where people were paying $20k a pop for toy bear with a fucking blue hat? Or a monkey with a moustache or whatever it was? They’ve certainly not gone down in scarcity but their market price is close to zero. Which shows that even with low supply, if there’s low demand, a product is worthless.

This is what would make or break bitcoin: Demand.

ALL RIGHT, NOW ANSWER THE DAMN QUESTION. IS BITCOIN A HEDGE AGAINST INFLATION?

No, bitcoin is not a perfect hedge against inflation.

To “hedge your bets” is to adopt an opposite position to offset the risks of a particular investment. For example, let’s say I’m betting that my house isn’t going to spontaneously burst into flames. To hedge this bet I would take out fire insurance. That way, I’d offset the risks of this bet because I’m protected even in the eventuality of a house fire. Hedging a bet effectively means I’ve got my ass covered in either bull or bear outcomes — house doesn’t burst into flames, I win. House bursts into flames, I win.

A “perfect hedge” is one that is 100% inversely correlated with the asset in question.

If the asset plummets, the hedge rises.

The dollar devaluing does not perfectly correlate with price rises in Bitcoin. So bitcoin is not a perfect hedge against inflation.

Taleb argues it here:

“Basically, there’s no connection between inflation and Bitcoin. None. I mean, you can have hyperinflation and Bitcoin going to zero. There’s no link between them.”

Taleb cites the flash crash of 2020 in which all financial markets, including cryptocurrency, plummeted in response to the Covid-19 pandemic chaos. In fact, crypto crashed harder.

Taleb offers harsher anti-bitcoin words:

“Bitcoin has characteristics of an open Ponzi, everybody knows it’s a Ponzi.”

A Ponzi scheme is a fraudulent system in which early investors are paid profits using the money from newer investors. These early investors join the system under the guise that they are investing in some legitimate cash-flowing business, completely unaware that their profits are funnelled from other victims. A traditional Ponzi scheme involves a centralised entity running the fraudulent puppetshow, as was the case with the infamous Bernie Madoff scam. (It must be noted that some people (extremists?) consider fiat to be a Ponzi scheme too, due to its centralised nature.)

So is Bitcoin a ponzi?

The case supporting the idea that BTC is Ponzi is mainly that bitcoin is highly speculative. What makes an asset speculative? When the market price is spades higher than the intrinsic value of the asset. Now intrinsic value is sometimes hard to pinpoint — but generally an asset has intrinsic value if it has utility and yield… some benefit to society.

The case against is that Ponzi schemes are usually propped up by some facade - investors have no idea that their funds come from others in the system rather than a business yield. There is no such pretence with investing in Bitcoin — most people invest knowing wildly volatile cryptos like bitcoin are not used so much as currency or medium of exchange than a hopeful store of value.

CRYPTO IS ONLY VALUABLE IF IT IS USEFUL FOR SOCIETY.

For Bitcoin to become some sort of safe haven against inflation, it needs to produce some sort of utility. Taleb continues:

“If you want to hedge against inflation, buy a piece of land,” he advised, adding that one can “grow olives on it. You’ll have olive oil.” He continued, “Of course, the best strategy for investors is to own things that produce yields in the future.”

So then in what way can Bitcoin be useful? What is its metaphorical olive oil?

It can serve two traditional financial functions:

1) Bitcoin is a medium of Exchange (currency)

2) Bitcoin is a Store of Value (SoV)

BITCOIN AS CURRENCY

Let’s address the first one: quite truthfully, bitcoin fails as a currency. I’m as pro-bitcoin as they come and even I admit this. Sure, you can certainly use it as a currency, and a decent amount of people still do. But most users are afraid to spend their bitcoins for fear that the asset will moon and they will potentially miss out on gains. Extreme volatility is bitcoin’s Achilles’ heel. Everybody and their mum’s neighbour’s friend’s dog has heard of the famous bitcoin pizza story. Everybody and their mum’s neighbour’s friend’s dog is afraid of becoming that famous bitcoin pizza story. Not to mention that the UX for paying via crypto right now is still clunky and in its infancy. Let’s just say I recently bought a t-shirt with bitcoin, and although it wasn’t a challenging task, it wasn’t smooth or pleasant.

Now you can maybe use stablecoins which are pegged to another monetary asset, usually USD. But of course this is futile in the case of USD hyperinflation, because the value of the stable coin would crash alongside it. Alternatively you could invest in stablecoins pegged to gold, but why not just buy gold directly then? Sure, you could argue that gold-pegged stablecoins are better because crypto is decentralised and trustless, but upon closer examination stablecoins aren’t really that trustless. You need to place your trust in the third party that is holding the USD or gold in reserves that the corresponding crypto coins are pegged to. This is the controversy that faces stable coin Tether right now - we do not know if they hold the appropriate amount of USD in reserves. I’m digressing…

BITCOIN AS STORE OF VALUE

Okay okay okay so let’s look at bitcoin as a SoV. Is it wise to park your money in bitcoin in times of turbulence, so your net worth is protected and stable? The unsexy answer is that we don’t know. The value of bitcoin could for sure tank alongside the dollar. Whether bitcoin is good as a store of value depends on institutional and retail demand. Historically crypto has performed very well in its relatively short lifespan. The longer this trend continues, the stronger the probability that it will continue along this trajectory (this phenomena is called “The Lindy Effect”).

Traditionally, Gold has been the go-to store-of-value in times of financial turmoil. As we talked about before, this is because gold has a very steady flow rate of 1.5%. So, investing in crypto and investing in gold offer many similar benefits.

Whether you decide to invest in Bitcoin or invest in Gold depends on how much risk you’re willing to take on. It is safer to invest in Gold when you take volatility and the Lindy effect into consideration. If you wanna live a little, and you’re willing to tolerate insane dips, invest in bitcoin. It always seems to have a tendency to revert to the mean anyway.

ANOTHER USE FOR CRYPTO - THE BIRTH OF DECENTRALISED FINANCE

Only a few years after bitcoin was born, a lot of smart programmers wanted to improve on it. But altering the mechanisms behind bitcoin is very hard, for very good reason. So these genius nerds invented other cryptocurrencies - like Ethereum - that can be programmed to execute Smart Contracts. As such, these cryptos are more like platforms that can run decentralised applications, rather than being just durable financial ledgers. This opened us to the world of Decentralised Finance - not only can we now transact without a bank, but we can trade options, lend, borrow, and stake our money, all on the blockchain. And we don’t need to enrich a banker to do this!

So one big possible productive aspect of crypto is that we can leverage our wealth without needing to go through a central bank. Traditional finance should quiver at the thought. Though there are talks that central banks are developing their own blockchain-based digital currencies. There are good reasons why this is fucking horrifying, but that’s a blog post for another day.

We're coming to the end of this blog, so here's the obligatory practical take-away part:

4 THINGS YOU CAN DO TO PROTECT YOUR WEALTH IN PERIODS OF HIGH INFLATION

Here are the 4 things you can do in periods of high inflation:

RUN A SUCCESSFUL BUSINESS.

Successful business owners are somewhat protected because they can merely raise their prices alongside inflation in order to meet demand.

TAKE OUT A MORTGAGE PRE-INFLATION.

When you take out a mortgage, you are securing a piece of real estate. Then over the next ~30 years you pay off the mortgage, but you have locked in the asset at a pre-inflation price. Meaning that even as the price of your house appreciates wildly as the value of the dollar depreciates, you are still only paying off the debt you secured! On top of that you are gaining the value of asset appreciation on top of your equity! All wealthy people leverage debt this way - that’s why you never see a rich bastard purchase a home out-right, even when they have the means to do so. This is an attractive option as long as you are able to lock in a very low interest rate.

INVEST IN PRECIOUS METALS LIKE GOLD OR SILVER

Tech giant Palantir invested 50 million dollars to buy gold bars in a hedge against a possible incoming black swan event. If the dollar collapses, then they will have effectively stored their value in a stable asset.

INVEST IN CRYPTO

My take-home message is just this: Crypto isn’t a hard hedge against inflation. But overall I would recommend you have some position in it. Invest in bitcoin, but invest more into cryptos like Ethereum because it has a more tangible benefit to society.

In the end you want to have your tentacles in different asset classes. Yes, the traditional advice to diversify your portfolio still holds up. And if everything collapses, then everything collapses, there would have been nothing you could’ve done anyway.

Mark Cuban famously said: “Diversification is for idiots”.

And it’s true in some way - blind diversification might harm more than protect.

However you do not want to be holding only liquid assets in fiat if it crashes. You don’t want to be holding only properties if it crashes. At the end of the day, informed diversification is still the best position. And you must protect yourself - inflation is a covert tax on the poor, with wealth being redistributed to the wealthy asset-owning class.