The biggest question we face today, from a macro economic standpoint, is whether the economic downturn brought on by COVID-19 is inflationary or deflationary. The reason the mechanism is so important is that it greatly influences the relative performance of assets during such times.

We have all beaten the ‘Bitcoin is an inflation hedge’ narrative to death due to it’s fixed supply and deterministic issuance schedule. But the question remains, how will it perform in a deflationary environment?

First, let’s define these terms and discuss what the drivers and signals are that point in either direction. Then we can look at which asset classes, and specifically cryptocurrency, we can expect to perform well during each process.

Just a quick reminder, I am not an economist so will likely have some concepts half-baked and perhaps not quite right. It is also a large and complex picture and there probably is no right or full answer, just likely and unlikely outcomes. What I will try to do, is aggregate and synthesise some of the ideas I’ve come across to help build a picture of what I see as the most likely outcome.

Definitions and drivers

Deflationary Economies

 A deflationary economy is one where prices fall or deflate. This means that holding a dollar today will buy more goods and services tomorrow as they become cheaper. In other words, in a deflationary economy, money gains purchasing power over time.

This is exactly the mindset we have in Bitcoin where we believe BTC will appreciate over time so we would rather spend fiat money and save scarce assets like Bitcoin.

The incentive in such an environment becomes to focus on saving and not spending. As a result, demand falls further pushing prices even lower to attract buyers creating a deflationary trajectory.

So what causes a deflation? Well the last major one which impacted the global economy was the Great Depression and the mechanism that precipitated the event was a Debt Deflation after a period of widespread  speculation on the stock market and lavish spending in the Roaring 20’s.

At this time, money was ‘paper money’ with a tangible claim against the gold that backed it. Since many people did not return the paper money to banks in exchange for gold, the banks utilised fractional reserve banking whereby more paper money (claims on gold) could be issued than there were gold reserves.

That paper money was lent out, borrowed and spent in the economy and most critically, was borrowed on margin and invested in the ‘infallible’ stock market. When the market fell, suddenly margin calls and debts were due but there was no longer any value behind the claims.

There was more debt than money and as debts started to be defaulted on, the money owed to the bank or broker was essentially destroyed. One person’s debt is another’s liability.

Thus a scramble for money and continual selling of assets created an unprecedented demand for dollars whilst at the same time, the ability for one to earn income was reduced as companies and businesses went out of business.

Money became a scarce asset and fears that banks would run out of money and gold in reserves commenced a bank-run as everyone sought to withdraw their money at once.

This deflationary mechanism due to increased scarcity and demand for money means that debts owed today will become harder to service in the future. The incentive is to pay back debts as soon as possible because it could be harder to come up with the cash at a later date. This also dis-incentives new borrowing which again, leads to a spiral of reduced spending demand.

Inflationary Economies

In contrast, an Inflationary economy is one where the money supply is expanding and money is becoming easier to come by. In modern times, this has been the result of credit expansion and central bank control over monetary and fiscal policy.

The commercial banks still lend out more money than they have in reserves as part of fractional reserve banking. Only nowadays, reserves are not measured in gold, but instead a form of IOU from the issuing central bank/government.

A simplified explanation of the process: commercial banks will borrow a reserve of money from the central bank at the current interest rate (currently 0%…). The commercial bank then turns to face the public and corporations and lends out 10x the amount borrowed (under a 10% fractional reserve system).

The interest rate they lend out to companies and retail borrowers is most often higher than the rate they borrow from the reserve bank, typically 1-5% higher than the reserve rate for large loans like home mortgages or corporate loans, and 10%+ higher for consumer loans like credit cards.

So immediately, you can see the inflationary impacts. Commercial bank borrows $1M at 0%, and then lends out 10M at anything between 2% to 20%, effectively 10x the original money supply.

Now this important part is that that $10M lent out, has a gravity, a magnet force pulling it back in, and that is the repayment schedule. If you borrow money, you need to pay it back with interest. When you pay it back, it allows the bank to repay its interest to the central bank (currently nil) AND/OR destroys the repaid money AND/OR allows more capacity for the bank to lend it out (including the interest you payed) to someone else.

Under this scheme, the economy should see an inflation of the money supply as the principle and interest you paid back is more than the amount the commercial bank owed the central bank. SO they make a profit and can then re-lend that money out and the cycle repeats.

More money, less scarce, prices should rise over time. Additionally, money is easier to come by in the future so borrowing today, is easier to pay back tomorrow. Therefore, demand and consumption increase which is again a feedback mechanism.

This is inflation in a nutshell.

The Central banks use monetary policy to set the reserve interest rate which controls how much the commercial banks need to repay and destroy. The other lever is Fiscal policy where the central bank prints money to inject into the economy by buying assets from commercial banks and other critical financial service providers.

The transition

Now where things get hairy is when the world has borrowed just a wee bit too much money…and by wee bit I mean Trillions in each country.

In a well-functioning inflationary economy, the debts will be repaid with a minority of defaults. If a handful of borrowers default, it isn’t a big problem because the bank lent out 10x their reserve and made more than the 0% interest they owed the Central bank. Gains from one loan cover losses on the few that defaulted.

But what happens when lots of defaults and ones of larger size start to occur, as a result of job losses, reduced productivity a global shutdown. Every default reduces spending which in turn reduces economic activity, and the cycle starts to turn around in a big way.

Ray Dalio covers this very well in his video on how the Economic Machine works. It occurs over the Short and Long term debt cycles where the latter is a result of accumulation over long periods of time.

https://www.youtube.com/watch?v=PHe0bXAIuk0

In this simplified model, this Deleveraging transition usually has four approaches that are deployed by central banks and governments:

In all previous deleveraging events, Central governments have deployed all four in sequence, only resorting to printing money as a final resort. With the current economic climate, around the world, governments have almost immediately moved to stimulus and money printing via QE. This is likely a result of the perceived successful deployment of QE in 2008-09 and also a probable recognition that they have no other choice.

In my view, it seems that debt levels have reached such astronomical levels, the 2008 deleveraging was perhaps arrested too soon by QE (leading to a V shape recovery) and zero interest rates and QE have essentially continued ever since. We never actually deleveraged properly in 2008 and have reinflated the bubble to be larger, angrier and further reaching.