The return of the spectre?

„The question to be asked – the danger to be recognised – is how inflation, however caused, affects a nation: its government, its people, its officials, and its society. The more materialist a society, possibly, the more cruelly it hurts.”

– Adam Fergusson in ‘When Money Dies’

Besides the occasional coverage on (hyper-) inflation in Venezuela, Western spectators have been largely spared the phenomenon in recent years. Globalisation and technology have come to be seen as deflationary laws of nature. This led some to even ponder whether inflation is dead.

Yet after more than a decade of ultra-loose monetary policies and a pandemic later, has the spectre of inflation risen from the dead? Recent developments in the US seem to suggest so. The US consumer price index (CPI) showed a 5.4% annual jump, marking the fastest uptick since August 2008.

The latest developments have opened an interesting debate on the nature of inflation. Is it merely “transitory”, driven by short-term factors that will soon abate, as the FED continues to proclaim? Or, will it prove to be more “enduring” due to structural factors at play?

Jerome Powell, the Fed’s chair, continues to assure observers that the Fed is carefully monitoring inflation and that there is no need to worry. Joe Biden recently came to his side:

“The reality is you can’t flip the global economic light back on and not expect inflation to happen”

Powell continues to assert that the recent inflation increases can be attributed to a pretty narrow group of thingsthat will soon fade away. This group of things includes supply-chain shortages (wood, steel), price normalisations in COVID-hit domains (tourism, flights) and pent-up demand (now being unleashed).

The development of the price of lumber seems to favour Powell’s hypothesis – at least for now.

As a result, Powell’s modus operandi is “wait-and-see”. The rationale behind this approach is COVID-19. More specifically, the Delta variant. The Fed is cautious in managing the balancing act of the recovery: if it slams the brakes too early, it could it jeopardise the recovery at a critical stage. If it’s too late, inflation could spiral out of control. For now, Delta trumps inflation.

However, given the noisy nature of the debate, it’s crucial to look at what the other side of the argument is saying. Their hypothesis rests on the belief that inflation will prove to be more enduring due to “structural factors” at play.

Some point to the inherent gap between demand and supply, which we currently witness. As a result of the unprecedented stimuli and rapid growth in broad money supply, consumers have more money to spend. Mohamed El-Erian, Chief Economic Advisor to Allianz, warns that the production of certain goods may remain constrained far longer than expected.

Others note that the reopening of the US-economy has outpaced the capacity of companies to hire new people. Corporations ranging from Amazon over BlackRock to Chipotle have already increased wages. What’s more, a labour mismatch of skills might arise. As the economy continues to become more tech-savvy, not all people may come back to their old-jobs. Some jobs may have become ‘rationalised’, while others may require more technical qualifications. Parts of the workforce might find out they don’t have the right skills anymore, causing the overall labour force to shrink. In the short-term (with a lower supply of skilled labour), this could cause further upward wage pressure.

Last but not least, Warren Buffet alluded to third structural factor during Berkshire Hathaway’s recent AGM:

“We are raising prices. People are raising prices to us and it’s being accepted.”

Since the last financial crisis, whenever there were higher input costs, companies shrank their margins. Yet today companies with pricing power (e.g., from the tobacco, software, food retail and luxury goods sector) pass the higher input costs on to the consumers, which in turn gets reflected in the CPI.

So, what to expect in this noisy and at times ambivalent environment?

An interesting development could be witnessed on the other side of Atlantic. The ECB recently adjusted its inflation target to 2% over the medium-term giving it more room to keep rates “lower for longer”. The FT was quick to notice that this marks “an important break with the conservative monetary doctrine of Germany’s Bundesbank that formed the bedrock of the euro’s creation.”

In the US, the Fed’s dual mandate of full employment and stable prices provides insights. During last week’s Congressional hearings, Powell was adamant to notice that “there is still a long way to go” in the labour market. It’s still 7.5 million jobs away from its pre-pandemic level. Thus, expect the Fed’s monetary policy to remain in place for now.

What’s next for Bitcoin in an era of ‘helicopter money’, negative interest & big debt?

Searching for the roots of Bitcoin’s narrative

If we are to understand Bitcoin’s meteoric rise, we must return to 2008. After all, the world’s largest cryptocurrency is a child of the global financial crisis (GFC).  

Once Lehman Brothers went into bankruptcy, many banks and financial institutions across the globe followed. Governments all over the world soon stepped in, bailing them out.

Three days after Lehman went bust, Hank Paulson, Treasury Secretary, and Ben Bernanke, Head of the Fed, went to George W. Bush. They told him:

We need a trillion dollars in cash, and we need it by five o’clock.’

After Bush shrugged them away, Paulson and Bernanke went to Congress, where they repeated their plea:

If we don’t have a trillion dollars by today, the American financial system will melt down in 72 hours. The world financial system will melt down in two weeks, and there will be global anarchy.

While the global financial system didn’t slide into abyss, trust had been lost in a monetary system that ran on trust. Robert Shiller, Nobel Laureate in 2013, points out that the experiences surrounding the financial crisis wove the narrative for Bitcoin:

I think narrative is very important to the popularity of Bitcoin and other crypto-currency. Part of the reason that Bitcoin succeeded is that it fed into an anarchism narrative that government is unnecessary and untrustworthy. It fostered a narrative that young people have created a financial institution that is out of the government’s reach. That’s a powerful narrative.

what is Genesis Block and why Genesis Block is needed? | by TecraCoin |  Medium

Bitcoin’s Genesis Block’s Secret Message

Fast forward a decade – Welcome to a world of ‘helicopter money’, negative interest & big debt

Albeit the US & EU economies had been out of the woods for a while, neither the Fed nor the ECB could stop their addiction of expansionary monetary policies.

Then COVID-19 came, piling pressure on the Fed & ECB to open the financial floodgates another time. As the US government distributed $1,200 stimulus checks to its citizens, Milton Friedman’s “Helicopter Money” became reality.

Yet Friedman was prescient enough to know that „there ain’t no such thing as a free lunch“. In 2020, the US debt-to-GDP ratio skyrocketed to unprecedented levels.

Deflating national debt through inflation

With Modern Monetary Theory (MMT) en vogue, many economists believe that huge government debt is not a problem. Yet at some point the day of reckoning arrives. As of now, there are three main ways for governments to deal with debt:  

They can choose to (i) not pay some portion of their debt (i.e., “hard default”), (ii) adopt austerity measures in hopes of running a budget surplus, or (iii) reduce the value of the debt they owe through inflation (i.e., “soft default”).

With more than a fifth of all dollars in circulation being printed in 2020, the US government picked the path of a “soft default”. Cynics may point out that COVID-19 even provided the US government with a noble excuse for printing money; and thus, reducing their debt burden.

While we’ve witnessed inflation in various areas (incl. equity prices & real estate), the real inflation rate (measured by the CPI) remains low. Yet inflation doesn’t simply happen whenever more money is pumped into the system. The velocity of money matters.

For the velocity of money to rise, people need to stop hoarding money and spend it. This could either happen voluntarily or through a collapse in trust. The former scenario might happen when the virus is defeated, while the latter could happen if the people’s confidence in both the government and the future collapses – akin to what went down in the Weimar Republic.

The Pandora’s Box of Central Bank Digital Currencies

However, there is a third way that masquerades under the acronym of CBDC. The abbreviation conceals the ECB’s panacea: Central Bank Digital Currencies in the form of a digital euro.

The digital euro is nothing less than immaterial cash. Instead of carrying it in your purse, you have your own account at the ECB. Given the digital euro’s proposed use of blockchain technology, this might sound tempting.

Yet on the way are several red flags. One of them was pointed out by Jörg Krämer, Chief Economist of Commerzbank, who noted that it would unnecessarily “make the state more powerful at the expense of its citizens”. The heightened potential for citizen surveillance explains the allure for China’s government to experiment with a digital yuan. Any transaction could be tracked via the blockchain ledger.

Further, Bill Campbell, highlights another troubling aspect:

With CBDCs, the central banks would possess the necessary plumbing to directly deliver a digital currency to individuals’ bank accounts, ready to be spent via debit cards. Such a mechanism could open veritable floodgates of liquidity into the consumer economy and accelerate the rate of inflation.

But perhaps a hypothesis illustrates the most troubling aspect of a digital euro. Assuming that the digital euro gradually replaces cash, it would be impossible to evade negative interest rates.

Not willing to see their deposits deflate, people would stop hoarding money, looking for safe harbors, but also increase consumption. This would inevitably raise the velocity of money, pushing the rate of inflation higher.

The allure of digital gold: scarcity in an age of superabundance

When confronted with such scenarios in the past, people searched for safe harbors. They usually found them in gold. Yet with everything becoming digitized, it was only a matter of time until gold found its digital equivalent.

And Bitcoin wants to be that – or at least, that’s what the crypto community hopes for.

The brilliant Niall Ferguson succinctly captured Bitcoin’s allure:

Bitcoin is the only digital asset or token that has scarcity built in. Everything in the internet is defined by a superabundance; Bitcoin is the exception.

While gold’s supply continuously increased as demand rose over the years, Bitcoin’s supply is capped by default at 21 million bitcoins.

Towards Hayek’s ‘Denationalisation of Money’

As Bitcoin’s price reached record heights in recent weeks, some believe we are finally destined to witness Hayek’s “Denationalisation of Money”. In 1976, Hayek wrote:

I don’t believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we can’t take it violently out of the hands of government, all we can do is by some sly roundabout way introduce something that they can’t stop.

He also wrote:

I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.

Hayek believed that people – if given the opportunity – would punish producers of inflationary money by abandoning it. As governments would no longer be able to reduce their debt burdens through inflation, it would also enforce fiscal discipline. Thus, currency competition would serve as an effective debt brake.

Until the advent of the Internet, governments didn’t have to worry about competing currencies that were out of their reach. Yet with the decentralized structure of cryptocurrencies, currency competition in the spirit of Hayek has arrived.

Will Leviathan retaliate?

Looking ahead, the crucial question will be if governments decide to reign in on Bitcoin. Christine Lagarde’s comments last week served as a warning shot:

There has to be regulation. This has to be applied and agreed upon … at a global level because if there is an escape that escape will be used

A look at history provides another bleak reminder. During the Great Depression, Franklin D. Roosevelt enacted Executive Order 6102, banning gold ownership. The ban lasted for 41 years until 1974.                                               

As the crypto community experiences peerless euphoria, it might be worthwhile to revisit history. The time of governments as bystanders will come to an end – rather sooner than later.