Inflation is a natural process, as it usually ebbs and flows between 1% and 2% for the western world. In Europe, the European Central Bank (ECB) aims to keep it steady around 2%, which is considered to be the optimal level for economic growth and prosperity. To be able to manage inflation and keep countries running smoothly, governments often have to intervene and manipulate market factors to keep inflation steady.
Sometimes the intervening parties may make a decision too late – or an incorrect decision – which could plunge a thriving economy into turmoil. Bitcoin could potentially solve this issue thanks to its decentralized nature and limited supply. In many ways Bitcoin could be used as a preventative measure against hyperinflation, but also as a form of financial escape for those who are already stuck within an economy plunging deeper into hyperinflation.
Managing Inflation in Fiat Currencies
If the inflation rate begins to rise above 2% in the Eurozone, the ECB imposes a series of credit restrictions – such as interest rate adjustments. By increasing interest rates, it makes the cost of borrowing money more expensive. This means mortgage rates will go up and credit card rates will also rise. This is designed to stop consumer spending and slow down the economic growth, which in turn will reduce the inflation rate.
Once the inflation rate goes back down to an acceptable level and remains there for a while, the ECB will most likely lower interest rates again. However, if inflation looks like it will fall below 1%, the ECB will implement what is known as quantitative easing. This essentially controls the rate at which new money is printed and reduction of interest rates.
This reduction of rates means consumers will have more spending power as loans are cheaper and credit card rates are lower. This, in turn, means more people can afford to spend freely, helping the economy to expand and grow. Once inflation is back at stable levels again and remains there, the ECB will most likely slightly increase inflation rates.
When it all Goes Wrong
These processes are in place to prevent economic collapses, but they rely on governments to control the supply of money and interest rates very carefully. When a government comes along that isn’t so good at managing the country’s finances, it all goes wrong very quickly.
This is the current situation in Venezuela, where inflation has climbed so high, it is now called hyperinflation. Venezuela’s economy relies solely on oil exports, and up until the oil price crash in 2014, it was a very prosperous and wealthy country. Poorly controlled responses to the crash in oil price lead to inflation spiralling out of control. Within 2 years, the Venezuelan GDP had fallen by 18.6% and inflation hit 800%.
How can Bitcoin Solve Hyperinflation?
The Venezuelan currency – the Bolivar – has been devalued to the extent of becoming virtually worthless. To buy simple items – such as a loaf of bread – people need to fill a wheelbarrow with cash. At the time of writing, to buy 1 BTC it would cost 51.8 billion bolivar. Even if Venezuelans had bought Bitcoin when it was at valued at $20,000, they would still be better off than if they had just held bolivars.
This is where Bitcoin steps in. A government – or Satoshi Nakamoto himself for that matter – can’t simply “print” more Bitcoin, so there is a limited supply. This practically prevents inflation from occurring, as there would be a steady stream of Bitcoin passing around the world. The price of goods would fall each year slightly because of increased production rate, whilst the price of Bitcoin fundamentally stays the same. Over time, this will effectively mean Bitcoin has more purchasing power and thus increase the value.
The more Bitcoin is worth, the more incentive miners have to run their mining rigs and mine more Bitcoin. This extra supply of Bitcoin would then devalue the Bitcoin slightly and things would balance themselves out. Inflation and deflation are naturally controlled by a decentralized network of miners and consumers, not a government.
Working out the Kinks in the System
Currently, Bitcoin is very volatile, and this instability means that prices are unpredictable. This isn’t good for a currency, and until the price becomes more stable, it’s impractical and unfeasible to use it as a solitary currency. For example, Laszlo Hanyecz bought two pizzas back in 2010 for 10,000 BTC. That same amount of Bitcoin today would have bought him 3,986,871 Large Ultimate Cheese Lover’s Pizzas, if you include a $1 tip per pizza.
Also, once the last Bitcoin has been mined – estimated to be in 122 years’ time – there is no more incentive for the miners to run their operations. This will essentially cause Bitcoin to not work as there will be nobody to verify the transactions.
The Bottom Line on Bitcoin
Bitcoin has all the ingredients to solve hyperinflation as a replacement currency. With new improvements and layers being added all the time – such as the Lighting Network – there is real potential for it to replace failed fiat currencies. Earlier this week, Jeremy Alliare (Circle CEO) stated that he believes that all fiat currencies will be replaced by cryptos, giving more weight to this possibility.
Once all the Bitcoins have been mined, there needs to be a system put in place that will still reward miners for completing blocks to ensure that Bitcoin still works. Whether that is a fee-based system for using Bitcoin whereby the miner gets a small cut of every transaction, or the maximum number of total coins is increased, still needs to be decided.
For now, Bitcoin represents a great way to mitigate risks from depreciating currencies like the bolivar through investing, rather than use as an everyday currency. However, if a nation is to test using Bitcoin as a currency, Venezuela stands a great candidate given its current economic state.