The guest commentary below was written by Stephan Lubka of Swan.com. This piece does not necessarily reflect the opinion of Hedgeye.
Bitcoin is commonly presented as a hedge against inflation. Since Bitcoin has a fixed supply of 21 million, and fiat is a mind-numbing bacchanalia of printing and excess, it simply makes intuitive sense that Bitcoin would protect people, investors, and portfolios from the ravages of inflation.
So, why hasn't it?
This is a fantastic opportunity to untangle one of the most pernicious myths that have ever beset modern economic dialogues.
It starts with defining inflation. Inflation is the price of things going up, right?
Wrong, do not pass go. Do not collect two hundred continuously inflating US dollars!
When the term inflation was used for the first time it referred to an increase of paper currency against the supply of fixed collateral (gold, silver) that backed the paper notes. It meant that each paper note was worth less in terms of it's actual backing. However, there is no backing for our contemporary currencies.
Today, people use inflation to refer to two separate things, and whenever you hear someone saying inflation it's not always clear which definition they are referring to.
One definition is “the prices of consumer goods increasing” and the other is “dilution of the money supply”. So which is it?
Let's see if we can determine the answer to that question using two examples. Which of these scenarios should we expect Bitcoin to protect investors from?
Example 1) The made-up country Randia produces 40% of global copper production. One day, their government is overthrown by anti-industrial rebels who believe that humankind can only achieve salvation by returning to a pre-industrial lifestyle.
Overnight, all of the copper mines are shut down outside of a few that humans continue to operate with picks and shovels.
The price of copper soars on global markets since 40% of supply went offline within 24 hours. Consumer electronics increase rapidly in price. Electrification becomes exorbitantly expensive. Countries panic and increase fossil fuel-driven energy production. Manufacturing and construction are all impacted.
CPI in the US goes above 15%.
Example 2) The United State government is overthrown by Modern Monetary Theory rebels who believe humankind can only achieve salvation by giving every man, woman, and child $5,000 of freshly printed dollars every month.
Because this rapid increase in the supply of money is not accompanied by an increase in the supply of goods that people actually want, (e.g. food, energy, houses, electronics) there is just more money in a system chasing the same amount of goods.
Consumer goods increase rapidly in price. Electrification becomes exorbitantly expensive. Countries panic and increase fossil fuel-driven energy production. Manufacturing and construction are all impacted.
CPI in the US goes above 15%.
Which of these scenarios should Bitcoin protect investors from? A disruption in the actual supply of goods and commodities or a rapid increase in the money supply?
The answer is clearly scenario 2. The first example represents a tangible disruption to the non-abstract world of real goods and things. The abstract world of financial assets is subordinate to this real world, it does not have primacy over it.
(We will explore later on which financial tools if any, stand to benefit from disruptions to the real world).
The second example is a crisis on the level of the abstract world of finance. It is a manipulation of abstract instruments, which can itself be hedged against with other abstract instruments.
Asking for a financial instrument to appreciate in value against real-world non-abstract disruptions is asking to own something which makes you wealthier in a world that just became dramatically poorer.
Outside of directly owning the production and sale of those disrupted commodities, this isn't a realistic goal. You don't suddenly gain a larger percentage of the wealth of the world solely by holding hard money when copper mines go offline.
Bitcoin exists to provide users an alternative to irresponsible and fatalistic central bank monetary policy. After all, the headline cited in Bitcoin’s genesis block is “Chancellor on Brink of Second Bailout for Banks,” not “Supply Chains Face New Obstacles.”
So, is a dilution of the money supply the definition of inflation? Milton Friedman thought so and famously said “ Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. ”
Analyzing True Inflation
Inflation is solely the dilution of the money supply, the creation of more money. Consumer price increases are either caused by supply factors that no “inflation hedge” can or should protect investors from, or they are a lagging indicator of money printing.
Measuring monetary dilution via increases in the prices of goods is a fool's errand.
Why should we monitor the price of bread and cars to try to determine how much money has been created? Aren’t there countless factors that influence those prices?
Couldn’t advances in bread-making cover up actual inflation by driving prices down while monetary dilution drives them up?
And doesn’t newly printed money spread through the economy in an obfuscated and uneven way? Depending on how the money is printed, where it is spent, and who received it monetary dilution can have radically different influences on consumer prices.
Eventually, we will see an impact on consumer prices, but it will be asymmetric (generally affecting the goods the Cantillion class desires more) and will manifest itself on an uneven time scale as the newly printed money interacts with the wide variety of real market forces.
All of this comes together to suggest, that measuring inflation via consumer price increases is like determining if you got punched in the face by how many teeth you have left. No lost teeth? No punch to the face!
If we are only concerned with monetary dilution and not consumer price increases, isn't it a simple matter to determine the “real” rate of inflation, i.e how much money supply was added into the system?
Actually, it turns out not to be easy at all. To understand why we need to first explore what counts as “Money”.
We clearly agree as a society that currency is money, and creating more currency is clearly adding more money to the system. What about Treasury Bills? High-quality short-dated corporate bonds?
These are actually commonly referred to as “cash equivalents”. Most financial institutions and corporations don’t literally hold dollars, they hold these cash equivalents.
In essence, bonds are claims on future dollars. Investors spend real dollars today to buy future dollars. This scenario is effectively net neutral on increasing the money supply (unless those dollars were printed from thin air via a Central Bank). However, if those bonds get utilized as collateral for future borrowing, and if they get infinitely rolled over and never extinguished, they do in fact represent an expansion of the total amount of money in the system.
A bond is essentially an abstract legal promise to make certain payments. I give a company $10,000 dollars today and they pay me back $10,500 in two years.
There is no expansion of the money supply in this deal. However, if we now treat the abstract legal promise of the bond as an "asset" it can then be used as collateral.
We now have two things: $10,000 which was transferred from party A to party B (net neutral) and an abstract asset we are valuing at roughly $10,500!
This is pure alchemy! Newton would be proud (if he wasn't rendered penniless from financial speculation ).
By valuing the bond in today dollars at its value in future dollars, we have literally created more collateral (money) from thin air! This IS expansion of the money supply.
Anything which can function as indefinite collateral is in essence money. Any money substitute which is close enough in function to money is itself money. It is money because it can function in the exact same way as actual money.
So in specific circumstances, it's clear that bonds can expand the total amount of “money” in the system. But what about other assets?
Are assets (stocks, housing, etc) “money”? More importantly, do assets increasing in value represent an expansion of the “money” supply?
Traditional economists say “absolutely not!” In fact, traditional economists say the only way money is created is when commercial banks engage in lending because that actually puts more currency into the economy.
However, if we define money as money plus any close-enough substitute then we are faced with a different predicament. What money and money substitutes have in common is they both represent a form of abstract value which is distinct from the tangible value that, for example, a barrel of oil intrinsically possesses.
Stocks increasing in value clearly means there is more abstract value in the system. In classic economic theory, this occurs because those stocks have actually added more real tangible value to the system.
Is this classic theory actually true? Is every dollar that stocks increase representative of more real, tangible value added to the system? More cars? More oil? More computers? More efficiency in producing these?
Absolutely not, stocks can be driven up purely by monetary dilution. Welcome to QE baby!
I would make the argument that most growth in stocks over the last few decades is driven by monetary expansion, not an increase in tangible value. And because the growth in stocks is driven by monetary expansion, the growth in stock prices IS monetary expansion.
It is the expansion of the total monetary value in the system against the supply of real, tangible, value which has in fact not grown in proportion.
This is a fundamental truth of assets functioning as monetary substitutes, but it doesn’t include the fact that people can borrow against the current market price of the stocks/homes and that owning appreciating assets increases consumer spending of actual dollars. People spend more currency when their assets are worth more, mimicking a scenario where they simply have more currency. These both create the same effects as “more money in the system”.
Measuring the expansion of the money supply is no simple affair. It can be expanded in multiple ways, some hidden, some obvious. The end result of all monetary expansion is an increase in the total monetary value that people can possess.
As a result, the total dollar value in the world massively exceeds the total number of dollars by orders of magnitude.
This endless monetary expansion is a fundamental reality of our fiat system and is particularly needed in a system that is highly levered.
Let's be clear, in theory, we could operate a fiat system without expansion. However, this only works if everyone is willing to pay their debts in full!
It is not an inherent quality of fiat that the money supply must constantly be expanded. It is an inherent quality of governments that want to constantly issue more debt to finance spending, and who have no intention of or plan as to how to actually pay back those debts.
When the system reaches a sufficient level of indebtedness, the only way out is monetary expansion. This is compounded by the amount of leverage in the system.
Bitcoin and True Inflation
Does the increase in the price of bread, cars, oil, or Netflix adequately capture this broad growth of money? Absolutely not. CPI is a useless tool for measuring monetary expansion in anything but an extremely noisy way.
If CPI doesn’t actually reflect monetary expansion (which is inflation) why should Bitcoin provide a hedge against rising CPI?
It shouldn’t, and it doesn’t.
What Bitcoin does do is provide a hedge against actual inflation, i.e- monetary expansion.
- When the Fed engages in QE – Bitcoin goes up
- When the Fed tightens – Bitcoin goes down
- When the government engages in fiscal spending via stimulus checks – Bitcoin goes up
- When the government reduces fiscal spending – Bitcoin goes down
- When assets go up expanding the money supply – Bitcoin goes up
- When assets fall sharply, contracting the money supply – Bitcoin goes down
Bitcoin responds consistently and predictably to actual inflation. It is a true-inflation hedge when we define inflation correctly.
Now some readers may complain that this means Bitcoin behaves similarly to all other assets which respond similarly to expansion and contraction of the money supply.
I understand that critique but think it has two major flaws.
The first is that while Bitcoin is directionally similar to most other assets when the money supply is expanded or contracted, it outperforms all other major assets in environments of monetary expansion.
Bitcoin is the purest inflation hedge because it is just money. Yes, tech stocks go up as liquidity floods the system. Yes, houses go up as interest rates drop. But stocks have idiosyncratic risks like debt loads, bad product decisions, competition, risks of obsolescence, and other real-world challenges. The same is true for real estate which suffers sufficient maintenance costs, jurisdictional risks, and illiquidity.
These assets function as indirect liquidity proxies in a system so awash with money it doesn’t know where to put it.
Tokenized picture of a monkey? Why not!
Bitcoin is pristine, pure, and un-impacted by the idiosyncratic risks other assets face. The value of Bitcoin is theoretically infinite because money has no ceiling (it is obviously practically limited).
Additionally, why should the dollar-denominated price of any asset go up when liquidity is rapidly removed from the system? Monetary expansion is an alteration of the unit in which everything is priced.
If you removed 50% of all dollars from existence in one day, is there any asset that would actually go up in such a liquidity contraction? No.
The second critique of this complaint lies in the very asking of what sort of asset would actually purely hedge against CPI increases and not monetary expansion.
It would need to be an asset that buys more things when there are fewer of those things.
How could any asset, besides those raw goods and their producers, ever go up because the actual real stuff in an economy becomes suddenly more expensive in real terms? How could such events ever be good for any asset?
Only two assets can reliably increase in this environment:
The actual price of commodities, which can be speculated on via derivatives, and any company that is involved in the actual production or sale of those commodities or goods.
Is that what we want Bitcoin to be? A strange defensive asset that only works during times of supply disruption and dysfunction?
Or do we want Bitcoin to be an asset that can pull our financial livelihoods, out of the swirling complexity of a system awash with liquidity, a system that is trying to cram that money into every money substitute available even though none of them are perfect?
Do we want a defense from central bank policy or do we want something which trades cyclically during commodity disruptions?
The goal of Bitcoin is clearly something that stands in opposition to central banks and their policy errors. We have to accept that bitcoin will not provide a hedge against CPI increases and that to hedge against central bank actions is to be in a directional relationship with those actions.
Bitcoin is money. The value of money is in direct proportion to a given money's acceptance as money. Money lacks any fundamental value, it is a virtuous bubble. It just so happens that our preferred money, Bitcoin, is in a tug of war with all of the other money in the world.
For now, the performance of Bitcoin is intimately tied to central bank decisions, it is not uncorrelated to them. For some, this is perhaps disappointing, but I think that disappointment falls away upon closer inspection.
It has always been exactly this. Bitcoin has always been a tool for the end game. An escape hatch for the inevitable dysfunction and failure of central bank monetary policy.
In order to do that, it must possess a consistent relationship to the actions of central banks.
Inflation is monetary expansion. Bitcoin protects us from losing value due to monetary expansion.
At the end of the day, you either believe central banks will be forced to continuously expand the money supply or that they won't.
If that is the inevitable fate of this debt-driven, overly-financialized world we inhabit, then all Bitcoin needs to do is respond to that monetary expansion better than any other asset.
And that my dear friends, is what Bitcoin does better than any other asset known to man.
Steven is the Managing Director of Swan’s Private Client department with concierge services for HNWI interested in buying >$100k in Bitcoin. His mission is to make Bitcoin easy for investors in the US and internationally, and enabling Bitcoin purchases in IRA, 401k, and Trust accounts.