April 17, 2020

Bitcoin and Inflation

Update: As this crisis progresses, my views on this subject have changed. Strong arguments can be made that this crisis will extremely deflationary in nature for the US economy. Given that the USD is the world reserve currency, there is a significant shortage of dollars. Everybody worldwide is chasing these dollars the dollar-denominated debt which vastly outsizes the amount of dollars in circulation. This gives the US the liberty to print huge amounts of money and run large fiscal deficits while keeping the risk of inflation low. One of the requirements for a bout of inflation is a drop in demand for money. However, with the world scrambling to get dollars, the risk remains low of inflation in the USD. The same can’t be said for other economies who run a higher risk. Nonetheless, the US is the largest economy and represents the biggest pool of capital which could potentially transition into BTC.

An extremely bearish outlook can be painted for the global economy as the spread of COVID-19 surfaces major fragilities. Central bankers are taking extreme actions by turning to the money spigot. Such actions increase the likelihood of an era of inflation that the majority of the world population will never have experienced in their adult lifetimes. Bitcoin’s predetermined inflation schedule may shine in such circumstances as the public becomes aware of putting their capital in BTC as a valid alternative to observing their wealth erode through inflation.

Bankers Turn To Stimulus But Bitcoin Underperforms

“There’s an infinite amount of cash at the Federal Reserve” Neel Kashkari

Combined assets of the Federal Reserve, ECB, and Bank of Japan.

-Combined Assets of Federal Reserve, BoJ, and ECB

Central bank balance sheets are ballooning. The combined assets of the Federal Reserve, ECB, BoJ, and PBOC is currently over $20 trillion.

Over $1 trillion has been added to the Federal Reserve balance sheet in the past month. This is only the beginning of the expansion with $6 trillion in fiscal stimulus recently approved by the US Senate.

Such extraordinary stimulus and monetary expansion would seem to logically strengthen the value proposition for a digital money native to a network with a predetermined inflation schedule. But the valuation of Bitcoin has not drastically increased under the circumstances. On the contrary, BTC price recently plummeted by over half in the course of two days in March.

Year-to-date percentage performance of Bitcoin, Gold, 20+ year Treasury Bonds, S&P500, and Oil

Gold has outperformed in recent conditions, consistent with market expectations of gold as an asset which outperforms in times of economic turbulence. Bitcoin, which many expected to outperform and is widely touted as digital gold, was sold off in the race for liquidity.

Does Bitcoin’s poor performance in current circumstances undermine its value proposition as an asset independent from state control? Aren’t times of global economic distress and wild monetary policies the moments when Bitcoin should thrive the most?

It would have been easy to build an argument that Bitcoin will outperform in times of economic distress beforehand. But the market is the ultimate price setter and it was a clear no from Mister Market that Bitcoin should outperform in the early phases of the economic crisis we have currently entered.

Many netizens will care little about Bitcoin when bills need to be paid, bellies need to be fed, and debt obligations mount. At this point, it is widely circulated information that the citizens of the country with the largest GDP have little savings and struggle to meet expenses.

Percentage of US adults who have no emergency savings

But how Bitcoin performs as this economic crisis continues to unfold is still an open question. Some blockchain analysis by CoinMetrics highlighted that those who moved their BTC prior to the phenomenal dump from March 12-13 were mostly shorter-term Bitcoin holders.

By analysing revived supply, a metric which partitions the amount of BTC transacted on a given day into time frames based on the time spanned since the BTC last moved, CoinMetrics uncovered that very little BTC that was unmoved for at least one year was transacted on the 11th of March. Only 4,131 BTC that was untouched for at least one year was transacted whereas 281k BTC that was untouched for at least 30 days was transacted.

BTC revived supply

More BTC Selling to Come?

But does this mean that the BTC price decline was just an initial onslaught of selling by those who are laden with debt or simply entered Bitcoin as a speculative bet? Is it a cleansing of the weak hands to keep the strongest?

Maybe. But we may be just after experiencing the first wave. The weakest may be removed. But what about the semi-weak? What about those who are okay to hold BTC now but will be forced to sell if economic conditions continue to exacerbate?

S&P500 adjusted for M2 money supply

An extremely bearish picture can certainly be painted for the global economy. Conditions will likely get far worse before they get better. As illustrated above, when the S&P500 performance is adjusted for M2 money supply growth, the current drop in equities is very small compared to what took place in 2008. 2008 was largely driven by an unwinding of a leveraged real estate market which had become overly intertwined with the financial system. Since then, the global economy has become even more driven by debt with debt-to-GDP ratios for all leading economies reaching record highs. In this crisis, everything is unwinding. We have observed recent asset price increases after the actions taken by central bankers but this is not a new phenomenon.

“During the Great Depression there were six big rallies in the stock market (of between 16 percent and 48 percent) in a bear market that declined a total of 89 percent. All of those rallies were triggered by government actions…

Principles for Navigating Big Debt Crises, Ray Dalio

Furthermore, there are huge vulnerabilities present in the economic data. James O’Beirne gave an overview in his newsletter of the myriad of fragilities in the American economy – the public struggling to meet expenses even before unemployment figures had a 30-sigma increase, mass foreclosures anticipated in the mortgage market, struggles facing small-business lenders etc.

“I’m so short that the prospect of making a small investment in 9mm ammo as a store of value is starting to sound increasingly less crazy. Still crazy. Just less crazy.”

James O’Beirne

What About Bitcoin Fundamentals?

From a valuation analysis perspective, it can also be argued that the fundamental pillars upholding Bitcoins value have weakened. The investment made by miners can be considered to be the security budget for the Bitcoin network. How much is a sufficient security budget is unknown.

Miners make multi-billion dollar investments in specialized hardware and infrastructure. Leaving any hash rate concentration arguments to the side (see here for a discussion on hash rate centralization), a miner coming online is beneficial for the security of the network. But Bitcoin miners are fragile to price declines and upward difficulty adjustments. The recent price decline pushed many miners to the point of capitulation, resulting in the largest  downward difficulty adjustment in Bitcoin since ASICs started mining on the network.With the upcoming halving, many more miners are expected to drop below their breakeven levels and be forced offline. Miners capitulating means the costliness allocated to network security is declining, resulting in BTC being a less valuable asset.

Another valuation analysis perspective is the number of users on the network. It would be delusional to argue that Bitcoin doesn’t in some way benefit from its vast network of stakeholders. Power laws such as Metcalfe’s Law highlight the nonlinear increases in value for every additional user on a network. Of all those BTC holders who converted to fiat in March, it can be expected that some of those have liquidated their entire BTC holdings. Some may never return. Momentarily, we have fewer stakeholders on the Bitcoin network, further justifying a decline in Bitcoin value.

Several arguments can be made that macroeconomic conditions will continue to exacerbate and put pressure on BTC holders while the Bitcoin network itself remains weaker from a valuation perspective. But this tells us little about the propensity of Bitcoin holders to sell. I reached out to Bitcoin holders with this survey to try and assess this question. While only a small number of responses were received, those that did respond showed a low propensity towards liquidating their holdings and a higher amount of savings than the general population. Over 70% of respondents indicated that they would not liquidate their BTC holdings at any point during a price decline. Over 50% of respondents indicated that they would not liquidate their BTC holdings at any point during a price decline in the scenario that they had less than three months living expenses. It should be noted that there were not sufficient responses for the results to be considered statistically significant. It should also be noted that the survey was simply distributed on Twitter and Telegram with no way to gauge the truthfulness of responses.

Inflation – The Killer App of The Current Monetary System?

Given how central banks are currently responding to the economic crisis, there’s at least one macroeconomic reason why the long-term prospects for Bitcoin could be extremely bullish. Inflation. Analysis by BitMEX Research argues that the actions being taken now by central banks and policymakers will set the foundation for an extraordinary bout of inflation. With such inflation will come an erosion of wealth which any generation after baby boomers will not have experienced in their adulthood. It can then be argued that Bitcoin will become an increasingly attractive option. Imagine a world where the majority of the planet see the value of their hard-earned savings decline in a fashion which they have never experienced during their lifetime. Here’s a recent comment from Nic Carter noting how inflation could bolster Bitcoins value.

“[Central bank] measures may well result in inflation — as policymakers have a hard time giving up their newfound ability to turn on the money spigot. Both a devaluation of sovereign currencies and a compromise of their neutrality (already underway) would render Bitcoin more attractive by comparison.”

In the short-term, Bitcoin holders may be put to the test. The spread of COVID-19 catalyzed a crisis which brought to the surface several fragilities present in the global economy. As the crisis unfolds, a strong case can be made for further asset price declines and further economic turbulence. As market participants worldwide rush for liquidity, some will be forced to sell BTC.

Nonetheless, Bitcoin has maintained its fixed supply and predetermined inflation schedule since inception despite several significant price declines lowering the security budget for the network. As central banks take extreme measures, the prospects for an era of inflation become more likely. In such circumstances, as the public observes the purchasing power of their hard-earned wealth eroding, Bitcoins ability to maintain its inflation schedule in light of external shocks should serve to increase its value as an alternative.