What Is Inflation?
|— In the early 1900s, most currencies were backed by physical gold. But by the 1970s, every country in the world had abandoned the gold standard.|
— Not backed by anything, governments now became free to print as much currency as needed to keep the economy in check.
— This was the beginning of the rampant inflation problem, which we are all affected by to some degree.
— Cryptocurrencies like Bitcoin may represent a solution to the problem.
Inflation! If you’re like us, then just reading the word might have just sent a chill down your spine. But just what is inflation?
Why? Because it’s arguably one of the biggest drains on our wallets and makes everything much much more expensive over time—certainly not ideal! But did you know inflation wasn’t always a thing?
The Gold Standard
That’s right, there was a time way back when, when you didn’t have to worry about the effects of inflation on your finances. We’re talking about the late 19th and early 20th century—back when most national currencies were actually pegged to a specific quantity of gold.
Back in the day, the governments of most countries actually set a fixed exchange rate between their currencies and gold. This meant you could walk into a bank with a bunch of cash and walk out with a fixed allocation of gold, and you could do it again the next day, and the next, and get the exact same amount of gold each time—not like today, where you’d have to contend with a different exchange rate every day.
This system was effective for a couple of main reasons. For one, gold is difficult to come by. Not only is the supply limited to the number of known gold deposits, but it is also difficult to extract, refine and transport—meaning a lot of work had to be put in to make it usable. It also can’t be counterfeited, since it can’t be manufactured and it’s incredibly easy to check if gold is real or not.
This system was known as the gold standard—and it has been nixed for half a century now. Where currencies used to be backed by a fixed allocation of gold, they’re not anymore! Instead, they’re simply backed by the goodwill of the government that prints/mints it.
And as we’ll soon find out, changes in economic circumstances over the last century have forced governments to print more currency than ever before, resulting in something we all face, but many of us aren’t aware of just how damaging it is to our finances.
Know what we’re talking about? Yep, it’s our good old friend, inflation again.
The move away from gold
Before we get into the nitty-gritty of inflation and why it straight up sucks, we first need to take a look at how fiat money came about—that is the kind of money we have today, that isn’t backed by gold or anything else.
Back when countries needed to adhere to the gold standard, they had to maintain a significant gold reserve to match the amount of currency in circulation.
In other words, they couldn’t print money unless they had enough gold in reserves to back it up—that is, unless they changed the exchange rates (which they did, plenty of times).
But as countries needed to ramp up their spending due to World War I, they found that they were limited by the availability of gold. So they simply suspended the interconvertibility of gold or changed its exchange rate to increase cash flow.
But the gold standard didn’t completely die until the 1970s, which is when the United States dissolved something known as the Bretton Woods agreement, which saw other currencies pegged to the US dollar (USD) which was itself pegged to gold.
With this, the US dollar became what is now known as a ‘fiat currency’—that is, a currency that has its value enforced by the government that issues it and is reliant on the continued faith of its users.
This is the kind of money that we generally use today—it doesn’t have any intrinsic value like commodity money and there is no limit to how much of it can be printed, since it isn’t constrained by the availability of resources. In other words, governments can essentially print money as and when needed—and for any reason!
And boy have they been busy printing—with around one-fifth of all US dollars printed in 2020 alone.
The rapidly increasing money supply, in combination with other factors like rising wages and production costs, has caused the purchasing power of currencies to collapse over time. This means it costs more and more over time to buy the same things.
In other words, inflation is the reason everything seems to be getting more expensive over time!
How inflation affects you
Like most things, the value of a fiat currency is largely dependent on changes in supply and demand.
When supply goes up and demand decreases or stays the same, the value of that currency tends to drop—while the opposite is true if demand increases while supply drops or stays the same. That’s supply and demand in a nutshell.
But with fiat currencies, this balance is almost always skewed toward oversupply. This oversupply is where the problems start—there’s just too much currency in circulation.
You know where this is going.
With too much money in circulation, its value tends to diminish over time, making it less and less valuable.
This isn’t too noticeable when measured from day to day or even month to month, but when you compare it by the decade, the damage becomes clear.
If you’ve been around for several decades, you may have already noticed how money just doesn’t go as far as it used to—that’s due to inflation. Overall, the purchasing power of the US dollar (USD) has fallen by more than 90 percent in the last 100 years and more than 30 percent in the last twenty years.
To put this into perspective, $100 in 2021 will get you less than a tenth of what it would 100 years ago, or just two-thirds of what it would in 2001.
This is part of the reason why the price of a McDonald’s Big Mac has increased from $0.45 in the 1960s up to $5.66 in 2021. Talk about a tough number to chew!
Yep, things haven’t just been getting more expensive, your money is also losing value. Double whammy!
As you might imagine, keeping money in the bank or simply holding cash for long periods of time can result in a dramatic loss in purchasing power—this is certainly the case if the interest rate you receive (the money you earn for parking your money at the bank) doesn’t cover inflation.
And that’s if your bank is generous enough to even pay interest—many don’t. And some even enforce negative interest rates, meaning you actually lose money for holding your funds at a bank! Ouch.
This isn’t just a problem that affects the US dollar (USD), practically every modern currency suffers from inflation, while some even suffer from ‘hyperinflation’—due to extremely rapid increases in the cost of goods.
All in all, it’s not a pretty picture.
Why crypto hedges against inflation
In the last few years, cryptocurrencies have emerged as one of the most popular hedges against inflation, since some of their properties can make them resistant to the purchasing power decline that fiat currencies typically experience over time.
One of these properties is their finite supply.
Many cryptocurrencies, including Bitcoin (BTC), Litecoin (LTC), and Cardano (ADA) have a fixed maximum supply that cannot be easily exceeded—unlike most fiat currencies which have no maximum supply limit.
This means you can always be sure exactly how many units of a cryptocurrency will ever exist—whereas for fiat currencies, you’re essentially at the whim of the government. With cryptocurrencies, on the other hand, only the community can decide if any changes should be implemented—empowering the many rather than the few.
Moreover, they also have a known, predictable rate of inflation that isn’t dependent on the surrounding economic environment, but instead baked in at the protocol level. In many cases, this rate of inflation (new coins entering circulation each year) actually decreases over time, making the coin deflationary.
This means you can be safe in the knowledge that a ‘supply shock’—that is a sudden increase in the supply—is never looming.
Some would also argue that unlike fiat currencies which have no supply limit and are not backed by a commodity, the scarcity of many cryptocurrencies is what gives them at least part of their value.
They’re a bit like gold in that respect, which is why some people call Bitcoin ‘digital gold’.
As you have probably heard by now, most cryptocurrencies have seen their value skyrocket against fiat currencies like the US dollar (USD), Pound sterling (GBP), and Chinese yuan (CNY)—with Bitcoin alone climbing 340% against the USD in the last year.
This growth may be a simple byproduct of their increasing use as a hedge against inflation, as more and more people begin to recognize the damage done by inflation.
Inflation is a problem that we all face, but often don’t recognize how problematic it can be—particularly when measured over years and decades.
But thanks to cryptocurrencies, it’s now possible to retake control of our finances, and avoid seeing the value of our money gradually eroded over time.
As such, cryptocurrencies are often hailed as the potential ‘future of money’, since they empower the individual, protect against economic decline, and have seen meteoric growth in both value and adoption as people make the transition.
Knowledge is power – so keep on learning! If you enjoy getting to grips with crypto and blockchain, check out our School of Block video Get Rich Quickly In Crypto.