Inflation
It is easy to become confused when learning about inflation.
Inflation is often used in the media to discuss the increase in the prices of everyday goods, a phenomenon many of us are witnessing right now.
Wikipedia references inflation to mean the increase in prices over time.
Our politicians measure inflation based on the increase in the price of a basket of goods.
When economists discuss inflation, however, they often mean something entirely different. The definition will usually vary depending on the school of thought they are referencing (see here), so the subject can become quite confusing.
Much of the confusion arises from the fact that the world has been operating with a fiat currency for over one hundred years now. So, other dynamics, such as supply, demand, and employment, have entered the conversation when describing inflation.
I recently gave a talk on why Bitcoin solves the problem of poverty (see below) at our recent event in Nottingham – The Bitcoin Fest.
During that talk, I needed to explain the difference between inflation & deflation.
To be more explicit on this subject, we need to go back to when bank notes represented the amount of gold held on our behalf by a bank.
Banking
Many consider Adam Smith to be the father of economics. He authored the book The Wealth of Nations, published in 1776. In it, he praised the banks for managing the exchange of gold and silver via bank notes. Smith argued that by doing so, the banks eased significant friction in the ability to trade, given that metals were difficult to store and move around. He concluded that their role ought to be encouraged.
In Bitcoin & Banking, I argue that the introduction of the banking network in the UK following the establishment of the Bank of England in 1694 was responsible for the First and Second Industrial Revolutions.
The availability of banks significantly improved the comparative ease with which businesses could conduct trade. Even today, historians puzzle over why England appeared ahead of everyone else in industry at this time – their banking network gave them this advantage.
The trust in the banking system became the secret to the success of the British Empire. With a currency people could trust, business transactions were reliable, and business relationships at home and abroad could flourish.
Trusting the banks to issue bank notes became necessary for successful business transactions. As is often the way with such things, it rapidly became impossible to transact in any other way, and not doing so was incredibly inconvenient.
Currencies
On the other hand, around the same time in France, their currency was in serious trouble following poor management due to the collapse of their central bank and the Mississippi Bubble in 1720. Ultimately leading to the French Revolution a few decades later, as I discuss here:
Once the French Revolution was over, Napoleon rose to power.
Napoleon made a point of paying his soldiers with gold coins, which inspired great loyalty in them. Before the re-establishment of a metallic standard for their money in France in 1797, the soldiers were used to being paid with worthless inflated paper Assignats.
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Britain was hugely challenged by this, as up until this time, they could rely on the best reputation for their currency. As Napoleon’s fighting prowess and loyalty to the French population wowed Europe, Britain’s confidence in its strength began to wane, and they needed more resources to prevail. As parliament debated this, the solution veered towards suspending their Gold Standard through the Bank Restriction Act of 1797 (the same year France restored its metallic standard). The British Public were rightly disconcerted, and the political discussions of the time were parodied, as seen in some of the cartoons below and presented by Amanda Lahikainen, courtesy of the Library of Congress, in this video from 2013.
Britain gained an edge over Napoleon in the Napoleonic Wars by manipulating its currency. They managed this by creating additional currency units compared to the amount of gold held in the bank vaults and temporarily preventing customers from claiming their gold. Wikipedia reports that in 1797, £10,865,050 of notes circulated in Britain compared to £5,322,0120 in bullion.
To illustrate the effects of this, imagine you have a house worth 10oz of gold. Then imagine that the bank would typically issue £10 banknotes for these 10 ounces. With the outbreak of war, the government needs more money, so the bank creates £20 banknotes to represent the 10oz of gold they hold on your behalf in the bank. The extra currency units circulating in the economy now make your house worth 20oz of gold.
Deflation
When Britain finally won the Napoleonic Wars, they were able to claim an indemnity from France (a common practice of the time to provide restitution for damage from war, similar to damages paid in legal courts today) of 2 billion francs, equivalent to approximately £14 million in gold.
This amount was enough to refill Britain’s coffers. With the corresponding removal of the additional currency units they had added to circulation during the war, they could return to the Gold Standard and restore convertibility in 1821. By then, the Bank of England had £2,295,360 notes in circulation backed by £11,233,390 of bullion.
Sadly, even though the Bank of England was now happy, this intervention brought the 20-oz gold-value house back down to less than its normalised value of 10oz in my simplified example of the British economy above. The equivalent effect on the British economy in the early 1800s was the banking panic of 1825.
Humans tend to be happy when the prices of their assets increase, but they are not so happy when they go down.
The ‘shock’ to the system caused by this excessive withdrawal of currency units also disrupted businesses and their ability to take out loans. Imagine you had taken out a mortgage with the bank for the inflated price of a house worth 20oz of gold, and then the reduction in currency units brought the price back to below 10oz. The house owner would immediately be in negative equity.
A business owner who loses the value of his assets may be unable to pay staff and suppliers, so chaos ensues. In this way, the banking panic of 1825 brought about the end of the first Industrial Revolution. The country’s liquidity was decimated.
Economics
In economics, the process of creating additional currency units is recognised as the Quantity Theory of Money. It is where the concept of inflation originates. The increase in the price of assets is not always directly linear because other factors come into play. Economists extensively research such factors when understanding inflation, but it helps to know where the problem arises.
It is possible to endlessly analyse supply and demand curves, interest rates and employment figures, but the problem with inflation begins with the money supply. Conversely, deflation is when these currency units disappear from the economy.
The creation of these currency units has the additional effect of raising prices in the general economy (somewhat easier to manipulate) in addition to assets. So, the media talks about inflation in terms of its impact rather than as its cause, hence the confusion.
It is hard to blame the media, though; these misunderstandings have been developing for a long time.
War Reparations
A similar scenario with currency units in the Napoleonic Wars played out the same way one hundred years later regarding the First World War. This time, though, the loser was Germany, and the indemnity at the war’s end was so huge that they had no hope of paying it.
Indeed, Germany’s economy went into hyperinflation as it attempted to manipulate its currency to meet indemnity demands. As a result, Britain, still in charge of the finances of the British Empire, struggled to return to a Gold Standard.
Losing The Gold Standard
Winston Churchill, as Chancellor of the Exchequer, tried in 1925 by introducing the Gold Exchange Standard; see here: It was a compromise solution though, and the deflationary effect of attempting to return to a Gold Standard without the necessary resources ended disastrously, leading to banking failures in Europe, then the 1929 Stock Market Crash in America. In this way, the British Empire began to lose its last connection of currency units circulated by the bank, referencing gold.
Economists developed new strategies to handle currency no longer fully on a Gold Standard to deal with this situation. The process was gradual, but eventually, The Bretton Woods Agreement of 1944 passed the responsibility of managing the world’s currency on a similar Gold Exchange standard to America. Who then dropped it altogether in 1971 when Nixon ‘temporarily’ suspended the convertibility of the Dollar to Gold, just as William Pitt had done during the Napoleonic Wars in 1797. This time, though, there was no going back.
Economic Stimulation
Modern economists came into their own at this point, flexing their skills and attempting to manage ‘the business cycle’ by analysing the economic drivers influencing inflation and deflation using tools such as fiscal stimulation, interest rates, and quantitative easing, to name just a few.
Their results have been variable though. Each time they take small steps to calm inflation by removing currency units or raising interest rates, their methods go awry before long, and we experience another financial crisis, such as the 1987 stock market crash, the dot-com boom and bust of 2001, and the Great Financial Crisis of 2008.
Many economists argue that we are still recovering from the Great Financial Crisis. Others surmise we will never recover, so Central Bank Digital Currencies are the next logical step. I maintain that we still need to heal from separating from the Gold Standard in 1914 if the world is ever to use sound money again.
Such an outcome seems unlikely, though, given that early attempts to resolve the problem by insisting on an unreasonable indemnity bill to Germany resulted in the Weimar Hyperinflation. Other mismanagements have led to increasingly poor results ever since.
Centralised Planning
Although inflation is out of control and worsening by the day, modern economists have had some success in preventing inflation from becoming too out of hand. Experimenting with fiat currency has allowed governments to try centralised projects, such as welfare systems like the New Deal in the US and the NHS established in 1948 in the UK. These schemes improved conditions for many for a time. As the currency becomes worth less and less, though, these services start to deteriorate in quality as the value from the currency drains away and such schemes deplete resources
In my book Truth Decay – How Bitcoin Fixes This, I share my story of working within such systems and the disillusionment this entails.
I also speculate that we are nearing the endgame in that Central Banks cannot hold off the issues with fiat currency forever and that hyperinflation will likely be the result. I specifically address how Bitcoin can support independent businesses in this situation, given that I was a business owner running my small dental practice for many years before discovering exactly how inflation was likely to be a danger to the success of my business and, therefore, my own welfare.
Deflationary Crisis
In 2019, as I was writing my book, I understood hyperinflation to be our heading – a position I still hold. However, I am now mindful of the deflationary crisis that could be brewing as central banks such as the Federal Reserve in the US and the Bank of England in the UK use raising interest rates to cool the wheels of inflation.
While additional currency units can still be created behind the scenes using tools such as further sales of government debt in the form of bonds, raising interest rates creates a deflationary impact for ordinary people in the real economy—even though that is what many are currently hoping for at the moment.
However, as I explained with the deflationary crisis of 1825, if you have taken out a loan against an asset that has increased in value due to inflation, then there is a deflationary crisis in the economy. It has the potential to create chaos in our existing financial paradigms. Many businesses and family homes have loans secured against the value of their main asset.
In addition, interest rate rises have a lag effect—meaning that although interest rates began to rise in the final quarter of 2021, it takes time for the impact to seep through to the everyday economy.
Although some businesses may have savings to cover short-term emergencies, the slow pressure of higher interest rates and costs as they wait for the deflationary effect to take hold can eventually become too much. Business owners struggle to support the payments on their debts, and their businesses start to collapse, as was seen in the Great Financial Crisis of 2008.
An extreme example of the sudden loss of excess currency units is clear in Zimbabwe. The country has just lost 99% of the value of its stock market after announcing in the last few weeks that it is issuing a new form of gold-backed currency known as the Zig. Such announcements demonstrate that asset values can be lost literally overnight.
So, while inflation is in danger of leading us to hyperinflation, don’t discount the possibility of a sudden deflation, which could also hit the price of Bitcoin. Bitcoin is a great tool, but until things resolve in the broader financial system, it is wise to be cautious and prepared for anything.
Until next time, enthusiasts!
Victoria
The Bitcoin Group #405
In my latest appearance on ‘The World Crypto Network’, we discussed the recent arrest of the Samurai wallet developers, the hacking of El Salvador’s Chivo Wallet, and the approaching supply shock for Bitcoin.
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