Bitcoin: A Paradigm Shift of the Global Monetary System? (Part 3/3)

In the third and final part of this series, I’m going to run through what inflation is and why we should care. Lastly, I’ll posit that bitcoin is not a panacea to the world’s economic or political problems, but it is a significant step forward in the right direction. To begin with, I won’t give you the standard economic textbook definition of inflation, I’ll instead summarise its impact through a short story.

Imagine that there are two islands left in the entire world. Each are inhabited by a few hundred people, just two kilometres across the warm Caribbean Sea from each other. Each island is rich in natural resources, however, neither island has the same resources as the other. On Island A, the topography is mainly comprised of sand, with limited trees and forest for mammals to shelter. It is a sparsely populated desert island, idyllic but barren. However, the west coast of the island enjoys a secret wealth of fish, as the best coral in the Caribbean attracts all manner of species to its shores. Two kilometers off the east coast of Island A is Island B, where the surface is dense with rainforest and all manner of flora and fauna that decorate the island. Deer and small mammals wander its forests, cut off from the mainland of North America thousands of years ago as the sea levels rose. In stark contrast to its plush rainforests are black volcanic rocks that surround its coastline. Regularly battered by large waves due to its position next to the colder currents of the Atlantic. Island B has more severe weather patterns and limited amounts of edible fish and coral.

About once a month, the inhabitants of both islands sail across the two kilometre stretch of water to trade goods with each other. Rare limestones were used as a medium of exchange to avoid barter and were found in equally scarce supplies on both islands. As a result, the price for lumber, fish, meat and herbs was stable over time. All was well on the last two islands on earth.

Late one afternoon, the inhabitants of Island A who were better adept at navigating the less turbulent Western Caribbean waters came across an unexplored cave to the south-west side of their island. Deep within the cave they stumbled across a substantial supply of limestone that was many multiples larger than the total supply of limestones across both islands. Realising the significance of what they had found, the sailors of island A spent the next month loading their ships with the new limestones ready for the next month’s trade with Island B.

The following month, as the fleet of boats from each island left their shores to do trade, Island A’s trading request was so large, that it would strip all of Island B’s trees, plants and animals from its surface. Island B thought that they were getting a great deal of limestone in return, and so agreed to sell all their resources in exchange for all the limestone they could imagine. After many days, weeks and months of trade taking place to transport the limestone to Island B and resources to Island A, the inhabitants of B began to realise a significant amount of limestone piling up in the centre of the island. Island B had become a desert-like barren place to live, with no resources but lots of limestone. Island A relished their new abundance in resources and began planting the new trees and plants across their island. New shelters were created and the wildlife and mammals from island B now began to thrive on island A.

Realising their terrible mistake, the inhabitants of Island B prepared for the next month’s trade by bringing back all the limestone they had been sold, ready to trade it all to get their island back to how it used to be. The following month, the two fleets of trade boats from each island met once again. Island B requested for all of its resources back, in return for all the limestone they had been sold by Island A. The tradesman of Island A agreed to sell some resources back to Island B but said that the price in limestone had now gone up one-hundred times. The inhabitants of Island B could now only afford to buy one percent of the resources they had sold before. The people of Island B reluctantly agreed as they could not eat the limestones or build shelters from them. For the next several years, the inhabitants of Island B experienced a torrid existence as famine and civil unrest broke out. The lack of valuable resources to construct shelter and provide nutrition eventually led to their population collapsing until just a few islanders remained.

This story is of course an oversimplification of inflation, but it is in essence what occurs between many countries across the world to this day. Countries around the world use fiat currency to trade with one another and to acquire a variety scarce assets and resources that are essential to the prosperity of an economy and its people. Much like the islands, the use of a currency is essential so that we are not reduced to barter, however, instead of discovering caves of limestone, or mines filled with gold, central banks and governments are able to inflate the currency supply at scale. Also known as quantitative easing, this increase in currency is synonymous with driving asset prices higher and consequently, pushing purchasing power of cash lower.

How can bitcoin help with this?

Bitcoin is a digital money that was created in 2009 and does not require the normal payment rails of the global banking system or a third-party bank to validate transactions. Perhaps most importantly. the bitcoin supply is finite at twenty-one million coins, and meets the key criteria of a sound money:

1. A medium of exchange – bitcoin is transacted and settled across hundreds of countries and with the lightning network, bitcoin can be transacted 25 million times per second.
2. A unit of account – bitcoin can either be used to value goods directly, or valued in fiat currencies, which in turn measure the value of a product or service.
3. A store of value – bitcoin is both scarce and incorruptible by design of its blockchain network.

Never in history has a money been created that fulfils all the key criteria of money so well. Perhaps for the first time since the gold standard ended in 1971, people around the world have an option to adopt a hard money that is decentralised, trustworthy, scarce, divisible and easily transferrable across space and time. The economic value of this technology is still in its nascent stages of adoption. It is estimated that about 46 million Americans alone own bitcoin.

Back to today’s inflation discussion, as a global response to the COVID-19 pandemic, governments around the world increased the m2 money supply (money which directly enters the hands of the public from government via stimulus) by >25%. This means there are 25% more dollars in circulation than there was just a year ago. Consequently, prices for things go up. Inflation is the average price increase in the cost of goods and services. While you may have heard of CPI and thought of it as the same as inflation, it is only a small and often misleading measure of inflation. CPI accounts for a basket of goods and services that are consumed by households and breaks it down into 87 categories and 11 groups. Importantly, CPI does not factor in more volatile assets such as house prices, commodities like lumber, stocks, bonds, or life insurance. Fairly important things you might think.

Assuming the need for cash stimulus to prop up the economy slows down post pandemic, and we revert to a more reasonable 5% p.a. average money supply increase, $100,000 saved would be worth the following thirty-years from today from the impacts of inflation:

$100,000 x 95% (^30 years) = $21, 463

Put another way, an asset worth $100,000 today that inflates in price by 5% per year would be worth:

$100,000 x 1.05 (^30 years) = $432, 194

Meaning, you would lose almost 80% of the value of your money over that time. With an additional 5% of your currency in supply each year, the price of goods, especially scarce and valuable goods go up and your purchasing power goes down. This is inflation. Shouldn’t a dollar today be worth a dollar tomorrow? The ability for central banks and governments to continually increase the supply of money and generate false growth through inflation is the biggest invisible tax on your money. Ask your parents or grandparents what they used to be able to buy for $100,000 thirty years ago and compare that to today.

Is Inflation Necessary?

Some might argue that inflation is the grease that moves the wheels of the economy forward, and that a little inflation is good. There is some truth in that. If you’re losing money by holding it, then spending makes more sense than saving and losing value. Many central banks around the world target a 2-3% inflation rate to encourage spending in the economy. Afterall, if a dollar was worth the same or potentially more tomorrow (deflation), then people might reduce their spending and GDP may stagnate. To further encourage lending by banks and borrowing by investors and consumers, some banks can even resort to the use of negative interest. What is negative interest I hear you say?

Negative interest means that if you deposit $100,000 in a bank, and the bank has a negative rate of (-5%) you will be charged $5,000 to simply hold your money in savings account. That’s right, you lose money. Better go and spend it then. Equally, if you borrow $100,000 and the rate is (-5%), after the first year, the amount outstanding will be $95,000 deducting any repayments you also make. In this kind of environment, we are essentially entering the Alice in Wonderland of economics. Rewarding risk taking and leverage and punishing diligent savers and those living within their means. Negative rates have already been seen in Australia, Switzerland, Germany and other European countries.

The main premise of this article series is that we should have the choice to save and protect our wealth if we want to. We shouldn’t have to pretend to become the next Warren Buffet or a technical analyst, trying to find the next Tesla or Amazon stock just to preserve our wealth and keep pace with inflation.

While gold had previously served this important store of value function over time (which I covered in my previous article), the price of gold has not protected investors against inflation in recent years. Bitcoin is the new digital gold of our generation and perhaps future generations to come. Building an added layer of security on top of gold as it is faster, cheaper and more efficient to transport and infinitely more secure to hold. Bitcoin is hope for millions of people around the world to buy and asset in quantities they can afford, without any entity having the ability to physically confiscate through corruption or to tax through inflation.