Is Money Dying? The Inflation Debate

It’s been called the most important yet most controversial question, on Wall Street, Crypto Twitter, Bitcoin Podcasts and even among economists and economic historians. With this week’s Consumer Price Index coming in at 6.2% annualized, the highest this century, we ask, what are the prospects for US dollar inflation?

The current inflation debate has been brewing for some time, and we’re not going to even pretend that we know anything about the future price path for the US economy. Economist JK Galbraith has said,

There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.

A recent spike in the price level in the US has rekindled fears of higher and persistent inflation, lower real yields and even the possibility of hyperinflation. For years, the lack of price inflation in the US given the so-called Fed “money printing” cycle has puzzled believers in “hard” (non-inflationary) money.

The US money stock is generally measured by M2 – currency (M0) in circulation plus demand deposits and other checkable deposits (together, M1) plus savings deposits, time deposits less than $100,000, and money-market deposit accounts for individuals. Certainly the money printer has been active. M2 looks to have gone vertical this decade.

Yet, for some time, officially-measured inflation in the US has been close to zero.

Recent price data, horror stories about tight supply chains and empty shelves along with a sudden rise in vacancies in lower-wage jobs have all suddenly renewed inflation fears, however. Shortages of workers, raw materials and finished goods have even caught the attention of the general public.

Energy prices have been skyrocketing, with natural gas users in Europe taking the worst hit. All of these factors have contributed to higher inflation globally. Eurozone price increases are nearing post-2008 highs, while US inflation is approaching its highest levels this century.

On cue, some of the most famous investors and founders have been weighing in on the issue, revealing a complete lack of consensus. Jack Dorsey of Twitter and Square sounded the alarm first, tweeting that hyperinflation is coming.

He later specified that this was both a US and global phenomenon: “it will happen in the US soon, and so the world.”

A belief in hyperinflation is quite an aggressive prediction, but Jack’s panic obviously appeals to the Bitcoin maxis. After all, the Bitcoin thesis has transitioned from disrupting payments (as per Satoshi 2008) to being a sound money in the face of the inevitable failure of fiat currencies.

Elon Musk for a change was the moderate voice on the subject, tweeting that he’s identified strong short-term inflationary pressure. Elon of course is exposed to the auto chip shortages and surely other supply chain issues.

Echoing the feelings of much of the space, Bitcoin hero Michael Saylor responded to both Jack and Elon, suggesting that inflation was already worse than the numbers show. There is lots of anecdotal evidence that price changes are hiding other secular shifts, such as skimpflation (prices remaining the same but quality worsening, especially in serviced) and tech and labor inflation diverging. Pressure on energy prices as the world moves towards renewables may also be here to stay for some time.

For over a decade, Bitcoin has been marketed as the only hedge for the upcoming hyperinflation. Gold isn’t going to do it: It’s a boomer investment. Saylor didn’t miss a beat asserting that “Bitocin solves this”.

Others, too, fear higher inflation though not hyperinflation. Hedge fund manager Paul Tudor Jones believes that inflation is not transitory, and is “probably the single biggest threat to certainly financial markets and I think to society just in general.”

Hold on though. Master tech investor Cathie Wood of ARK Invest disagrees. For some time her prediction of low inflation caused by exponential tech innovation, from artificial intelligence to better solar panels, has been correct. Her view is that the velocity of money has fallen dramatically.

To put it simply, money is believed to follow an identity: Money supply times the “Velocity of money” must equal the Price level times Economic Activity, MV = PY. That is, as the economy is using less money, increases in money supply have not translated into price rises.

Another equally simple yet likely more correct way to think about the lack of inflation is that increasing the money supply won’t impact the real economy if banks don’t lend it to businesses and consumers. It will, however, increase asset prices in a sort of Cantillon effect if it used to leverage investments and housing. The effect on financial assets is likely significant: As of this writing US stock markets, for example, have hit all-time highs.

Monetary economist George Selgin has a slightly different view of the recent low inflationary environment. When rates are low and interest is paid on reserves, banks have no incentive to lend. When rates are zero, according to Paul Krugman, quantitative easing can’t work.

In any event, zero interest rates – and therefore negative real rates – and high securities prices are inflation taxes of sorts for those that have yet to save for their future purchases – houses, retirement.

Hyperinflation

The bible of hyperinflation is When Money Dies, the economic history of the interwar Weimar Republic, though many also have in mind the former Yugoslavia, Zimbabwe, North Korea, Venezuela and several other countries. Some readers of this and monetarist and Austrian School economic doctrines have been brainwashed into seeing hyperinflation everywhere there is fiat money. Even where it’s not.

Turkey doesn’t need 000s for its notes due to recent hyperinflation. In fact, inflation has been just under 11% on average over the last 18 years. (Though, like many countries, it had a bout of pretty serious price increases in the 1970s).

Hyperinflation. It can’t happen here

Hyperinflation is very rare. There have been many studies investigating the causes of the various hyperinflations throughout history, and there remains some controversy. What can be said is that hyperinflation most often occurs during a period of tremendous upheaval, such as a war, a major political event (e.g. violent regime change), a balance of payments problem or a currency/debt crisis. Generally, governments become unable or unwilling to finance spending through taxes or borrowing.

What is likely happening during a hyperinflation is that both sides of the monetary equation, money supply and velocity, are rising at the same time, as now untrustworthy money is spent as fast as it’s received. If M and V are skyrocketing with economic output unchanged (or even falling), the price level, P, must rise to compensate (MV = PY).

War- and regime change-related hyperinflation is perhaps the most common. In Weimar Germany it is very likely that the hyperinflation began as a (self-sabotaging) exercise in frustrating Allied creditors without raising taxes, which would have collapsed the weak government.

It’s very hard to imagine the US in any situation resembling those of North Korea, the former Yugoslavia, Zimbabwe or Weimar Germany. The US has no foreign denominated debt (the issue in Zimbabwe and Germany), and is not facing any societal collapse or other exogenous calamity. Does Jack Dorsey really believe 50% per month inflation is coming? On what grounds?

The modern US has never experienced hyperinflation. Even during the oil shocks of the 1970s, inflation never rose above 15%.

Of course hyperinflations can and do occur elsewhere. But for those in smaller nations there are many effective hedges: Dollars, Swiss Francs, even USD stablecoins. Bitcoin was a great hedge against Venezuelan inflation. But so was the US dollar.

Permissionless decentralized currencies may have less chance of being seized, and may be used to send wealth out of a country in economic chaos. However a max exodus from the local fiat to crypto would be very difficult to effect on the ground.

Many commentators rightly point out that inflation is bad even if below the oft-cited 50% per month per hurdle. For one thing it erodes purchasing power, creating a government tax on fiat holdings.

Staked USD returns

A popular tool for visualizing the fall of USD as a store of value is the apparent erosion of dollar purchasing power since the Fed was established in 1913. Armed with this view, inflation looks to be a fatal characteristic of the US fiat dollar.

However, the USD has actually retained its purchasing power quite well. Staking in Defi or as a PoS node validator is now well-understood – thanks OHM – as a way of earning income as well as offsetting token inflation. If one “staked” their USD with the US government or in a bank, the returns offset all of the decline in US purchasing power.

In general, short term risk-free interest rates were high when inflation was high - high enough to compensate for the reduced purchasing power. Another way to say this is that, if you put your money in risk-free short-term t-bills, over the very long term you could still buy what you could in 1934.

Inflation

OK, hyperinflation is unlikely, pace Jack Dorsey, and the dollar has actually been a good store of value. Let’s turn to the prospects for “high” inflation. Why does this perfect storm of inflationary forces matter? Well, as we know from the 1970s in the US, and more recently in other countries, inflation appears to take hold when expected. The longer inflation hangs around, the more likely it will affect consumer and labor behavior, leading to a possible feedback loop: higher prices beget higher prices. Indeed, consumers currently expect more inflation in the near term.

Labor is becoming more expensive, with compensation costs for private industry workers in the US increasing 4.1 percent over the year, almost double last year’s rate.

And what about rates today? There is some fear that the Fed is too scared to raise rates this time around, as the economy and the asset markets are being artificially supported by Fed policy.

As hedge funder David Einhorn complained:

It’s not like [Fed Chair Powell] has done his best to fight inflation without success; he hasn’t lifted a finger to fight inflation. Instead, he has maintained a policy designed to create inflation. As a result, inflation is here and it appears poised to worsen.

Indeed, on November 3, Fed Chair Powell admitted that inflation might last a little longer than ideal and that he was not likely to act in the near term, saying

certainly we should see inflation moving down by the second or third quarter.

Matt King from Citi believes that inflation is here to stay, and that the Fed may be forced to raise rates, plunging the economy into a recession. At the same time, many, including Goldman Sachs, expect inflation to taper off. Supply shortages may be temporary, while energy prices are notoriously volatile. Gasoline prices have risen almost 50% this year in the US. Will that continue every year? Permanent adjustment is the big fear. Price increases would drive wage increases that would drive price increases. Experts dismiss such “wage push” inflation, however.

Higher inflation and low interest rates erodes the “staked” value of the USD, and is terribly regressive: Those with assets win, while the losers are those saving, working for flat nominal wages or holding only fiat.

As Yogi Berra said, however, “it’s tough to make predictions, especially about the future”. Yet we can say that hyperinflation is unlikely. High inflation is possible, certainly. Hopefully we don’t end up in anything resembling the stagflation of the 1970s.

Does Crypto “Need” Inflation?

One investment thesis for Bitcoin is that upcoming fiat collapse will send BTC to all-time high nominal price many times the current level while also opening the door for the adoption of the original cryptocurrency as the reserve asset of the world. Indeed, JPMorgan believes that the expectation that Bitcoin will be a more effective inflation hedge than gold is what sent BTC to all time highs a week or so ago.

Yet very high inflation and hyperinflation/currency collapse is associated with the kind of socio-political and economic changes nobody would wish on the US: War, violent regime change, foreign currency debt crisis, or export price collapse.

Many Bitcoiners, being generally right of center on economics, believe that deficit spending and money printing must lead inevitably to the failure of any fiat currency, and that their coins will function as the only solid store of value. Starwood Capital’s CEO Barry Sternlicht, who runs $95 billion, believes that Bitcoin will be that optimal inflation hedge. As real values erode, Bitcoin should stay strong, appreciating in dollar terms.

But the major crypto assets have outperformed any inflation measure. ETH for example is up 2300x more than US CPI since 2015.

It’s clear we don’t need hyperinflation to attract new converts to crypto investing.

What about crypto markets? Gaming, metaverses, Web3, decentralized finance do not rely on inflation for their use case. Paul Tudor Jones holds his crypto “for the technology,” even if, when pushed, he admitted that Bitcoin might be better than gold as an inflation hedge.

Inflation may be here to stay, and that might benefit the major crypto “currencies” as potential stores of value, but good crypto projects throughout the growing ecosystem will succeed regardless of whether or not the USD loses some of its allure.

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