ESG Series - Social Part 5: Inflation & Series Conclusion

Learning Outcomes

This piece will discuss:

• The role of institutions in an economy
• The case for Bitcoin as a monetary rival, furthered by concerns of high inflation in many smaller or less developed countries
• Bitcoin’s potential to protect people’s wealth in the face of an unstable sovereign currency

Introduction

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Conceived in the wake of the 2008 global financial crisis, Bitcoin was created as an alternative to central bank-issued currencies. Years later, and the case for Bitcoin as a monetary rival has been furthered by concerns of high inflation in many smaller or less developed countries, which is devaluing citizens’ savings as the price of staple goods rise. Due to the fact that fiat currencies are tied to an economy and a central bank, they may be prone to unreliable monetary policy, unlike Bitcoin, whose value is driven by the invisible hand of the market and has a strictly fixed supply baked-in at the protocol level. Consequently, this article explores the potential that Bitcoin has to protect people’s wealth in the face of an unstable, and inflationary sovereign currency.

The Role of Institutions

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What is Inflation?

Inflation is the increase in the price of goods and services over a sustained period of time. It is synonymous with the consumer price index (CPI), which tracks the changes in price of a fixed basket of consumer goods and services.

Reserve Banks

One of the most important institutions in an economy is its central, or reserve bank. Central banks are responsible for implementing monetary policy and ideally operate independently of the government. One of the principal objectives of monetary policy is to control inflation and keep it within appropriate levels which, in Australia’s case, is between 2% to 3%, on average, over time. This is primarily done through open market operations which involves transacting domestic government securities on the secondary market to try to achieve a target cash rate. This cash rate flows through to many facets of the economy, including financial markets and bank lending, which ultimately influences aggregate demand. The interaction between aggregate demand and aggregate supply, amongst other factors such as the changes in import prices due to exchange rates, are the main determinants of inflation.

Implications of Poor Economic Management

Whilst inflation is inherent to the design of traditional financial systems, primarily fuelled by changes in aggregate demand, it can reach extremes when poor economic management is involved. In particular, monetary policy decisions that create excessive money supply have in the past exacerbated inflation, often resulting in hyper inflation which has been the case in countries such as Zimbabwe and Venezuela.

Bitcoin is Fundamentally Different

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‘Digital Gold’

Since inception, many have likened Bitcoin to gold and its investment properties. However, unlike gold, the number of bitcoins to ever be mined into existence is capped by its protocol at 21 million. This means that no one can arbitrarily create or destroy new bitcoins, therefore making it scarce. One could say that this is more of a hedge against debasement rather than macro-level inflation. Bitcoin is also difficult to mine/produce, and even more difficult to forge. However, proponents should be careful before claiming that Bitcoin provides a hedge against inflation for investors the same way gold traditionally has, as historical price movements show that this is not the case. It is important to note that there are key differences between the two assets' properties and their uses, particularly in the context of inflation.

Historically, during periods of recession or inflation, investors have turned to gold as a store of value. For the majority of investors, gaining such exposure is not accomplished through holding physical bullions, but rather by taking a long position in financial markets through gold-backed investment securities. Exposure to Bitcoin on the other hand, is not limited to investors in these markets, as its digital and decentralised features enable trade to occur at any time without physical or geographical restrictions.

Consequently, the comparison between Bitcoin and the precious metal is somewhat misplaced. Inflation is not just a concern for investors who wish to hedge, but as we have mentioned, is affecting many individuals across the globe. It is not very practical for small investors or individuals to carry around gold however, as it is to carry around a digital wallet on a smartphone or other suitable device. Bitcoin’s potential social impact is realised through everyday citizens, where the use case is particularly strong for those who live in countries with poor economic management that has led to hyperinflation of their sovereign currency.

No One in Charge

What is it about Bitcoin that makes it supposedly inflation resistant? Bitcoin is in direct opposition to fiat currency, as the risk of inflating money is not the same. Nobody is in charge of potentially inflationary decisions. At the same time, Bitcoin is controlled by its own protocol; despite countries banning the use of Bitcoin, the integrity of the Bitcoin network has remained unaffected since inception.

The same cannot be said for all fiat currencies however. There are three core considerations that determine a currency’s success: the ability to be used as a method of exchange (liquidity), a store of value, and a unit of account. For a floating currency, its value effectively boils down to whether it can sustain all three of these attributes into the future. It has no intrinsic value - it is trust-based. So, when trust in the currency, or in the institution backing the currency, is lost, many people turn to alternative currencies, even if they may be prohibited.

In the case of Bitcoin, one bitcoin will always represent the same percentage of total expected bitcoin supply (21 million bitcoins). Those who hold and trade Bitcoin are doing so voluntarily, essentially taking a risk on the network’s purchasing power. Whilst this is a relatively high risk in a stable country with a strong economy, currency and low inflation, the risk is considerably lower in the face of inflation of 50% per annum or greater.

When Institutions Fail

Throughout history, currencies have evolved, with the most dominant currency in the world now being the US Dollar (USD). However whilst the USD has been deemed as one of the safest stores of value, many currencies issued by central authorities have been to the detriment of its citizens.

One such case is ZImbabwe, which experienced decade-long hyperinflation and several currency changes due to poor monetary policy decisions. From 1998 to 2009, the inflation rate of the Zimbabwean dollar rose rapidly, peaking at 79,600,000,000% per month in mid-November of 2008. Several policy decisions and economic mismanagement were to blame, leading to the collapse of the banking sector due to economic sanctions imposed by the US, European Union and the IMF.

As banks were unable to mobilise funds for investments or loans due to increased risks and political looting, the economy suffered. Lack of confidence and trust in the government and currency due to corruption contributed to the severity of inflation. To exacerbate this issue, the Zimbabwean government also printed hefty sums of money, and underreported its printing activities.

Subsequent efforts to prevent further falls in the value of Zimbabwe’s currency did not address the underlying core issues. Instead, the reserve bank increased money printing, declared inflation illegal, redenominated its currencies, avoided updating its foreign exchange rates or inflation rates, and announced several new currency regimes. This ultimately led to a further deterioration in citizens’ confidence, and created black market exchanges which traded the USD, despite it being illegal.

In 2019, Zimbabwe suspended its multi-currency system and central authorities decided to convert all USD-denominated accounts into the RTGS (real-time gross settlement) dollar or ‘Zimdollar’ at par. Ever since, inflation has persisted, though not to the degree it once was, and difficulties moving money through the banking system remain. This has placed economic strain on citizens, who must pay significant costs to send money outside of the country, and cannot withdraw cash easily.

The use-case for bitcoin appears to be quite clear. Bitcoin’s absent need of a higher authority prevents this type of mismanagement. Though bitcoin’s price has historically been volatile over short-term periods, transactions through its network are immutable, and provide settlement finality that cannot be matched by any fiat currency. Indeed, the likelihood of Bitcoin’s adoption in countries like Zimbabwe relies primarily on increased education and accessibility.

Series Conclusion

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In this 5 part series, we discussed Bitcoin’s application as a tool for social impact, namely in the context of diversity and inclusion, the remittance market, foreign aid, and as we have just touched upon, inflation.

As one of the most principal pillars of the ‘S’ in ESG, we initially explored Bitcoin’s compatibility with diversity and inclusion and its potential to address the current hurdles facing the 1.7 billion unbanked and underbanked population. With only a basic smartphone and an internet connection, Bitcoin can be used by anyone around the globe, offering an inclusive digital payment method.

Moreover, we delved deep into the complexities of the global remittance market, and its presently high and variable cross-border costs and transfer times. With Bitcoin’s layer 2 solution, the Lightning Network, people are able to send remittances via the network with little to no cost, with many already doing so in countries like El Salvador.

The lack of intermediaries was the central focus in our following piece, foreign aid, where we highlighted the current system’s inefficiencies, and explored how the Ukrainian Government’s “Aid for Ukraine” initiative utilised Bitcoin to deliver aid during a crisis.

Finally, we end our series by unpacking the role Bitcoin may have in the face of unstable and inflationary sovereign currency. Unlike fiat currencies, Bitcoin’s supply is both fixed and known, meaning it cannot be subject to poor monetary policy under any individual or authority which has led to hyperinflation in many countries.

Together, we highlighted the ability that Bitcoin’s secure peer-to-peer network has to allow for social impact to be made. As we have established throughout - Bitcoin is simply a widely accessible technology that doesn’t necessarily do anything by itself. However, those willing to do so can utilise its power to promote social development across the financial system, especially when the status quo may be inefficient or inaccessible.