OOne of the most common memes and messages in the crypto communities is that deflation is better than inflation, and the more deflationary the asset, the better. Fueling the message to buy these assets is a widespread argument that inflation is out of control and that the monetary expansion that has taken place during the coronavirus pandemic is directly to blame.
Let’s start with the most fundamental fallacy common to several crypto ecosystems: the idea that deflationary systems are better than inflationary systems. Bitcoin maximalists tend to hit the hardest, but the Ethereum community can be just as bad. Ultrasound.money is also touting the deflationary impact of EIP-1559 and the upcoming Ethereum meltdown.
Paul Brody is EY’s global blockchain leader and a CoinDesk columnist.
The theory is seductive: if you have a crypto and the rate at which new crypto is added drops to zero or starts to go negative, the value of your crypto should increase. The assumption hidden in there is that the demand for said crypto stays the same or increases. In reality, deflationary ecosystems don’t seem to be working very well. And there is ample evidence of this, especially since the Great Depression, when the sooner a country left the gold standard, the faster its economy recovered.
The reason deflationary systems cause economic collapse is that if people expect the value of their currency to rise, they avoid spending it and try to hold on to it. This leads to increased savings (HODLing!) and a drop in demand. Conversely, in highly inflationary systems, people rush to spend money. It is not surprising that central banks globally aim for price stability.
It is important to understand, however, that absolute price stability is an impossible and unreasonable goal. Savings change over time, and so do prices. Manufacturing and technology have made purchases increasingly cheaper, but many services are not enjoying the same productivity gains. Teachers still look after roughly the same number of children as they did a century ago, while factory workers can use machines to produce a hundred times more stuff. It would be crazy if the prices for televisions and education were the same after all this time.
All other things being equal, a little inflation is better than a little deflation. This allows central banks to set interest rates below the rate of inflation, if necessary. If you can borrow money at 1% and inflation is 3%, your effective “real” interest rate is actually -2%. That’s how central banks do airdrops. Unfortunately, there is no easy way to set interest rates below zero.
Read more: Inflation unexpectedly reaccelerated to 8.6% in May, hitting a new 4-decade high
The second big topic worth talking about is the idea that inflation in Western democracies is some kind of major political failure or is out of control. It’s neither. Inflation and central banks seem to be behaving exactly as expected. Extensive fiscal and monetary stimulus saved the world from what could have been a devastating recession at the start of the pandemic. Now central banks and governments are stepping back. But monetary and fiscal policy is not an exact science; the idea that you can perfectly steer the global economy through a massive drop in service sales, an explosion in product sales as people stay home and buy things, and then back to a full service sector boom is ridiculous.
A good benchmark for whether this is going well or badly overall would be to compare the current pandemic to the last time we had a global market transformation on such a scale with varying levels of fiscal and monetary stimulus and huge changes in demand. The only real prior example of this was the entry and exit of World War II. After the war, the United States also experienced a surge in inflation as demobilization shifted high-speed demand from tanks and guns to kitchen appliances and cars.
This surge in inflation was also transitory. Over a three-year period after World War II, inflation peaked at an annual rate of 18% before falling back to normal levels. It did not signal the start of prolonged inflation, and no one now sees this as some kind of major policy failure. It was a reasonable consequence of the change in production plan and worldwide demand. The fact that US inflation appears to have peaked at around 8% makes this transitional adjustment look good by comparison.
When it comes to building our future economy in a blockchain ecosystem, we must not fail to learn from the lessons of the past. If we want Ethereum to become the engine of a new global economy (and I am!), and we would like its ether token (ETH) to become a basic pricing unit, then price stability, and not deflation, is a prime target. . Pushing for ever more deflationary architectures will certainly appeal to HODLers, but it won’t position Ethereum to become a full-fledged global economy.
Read more: The Link Between Bitcoin and Inflation
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