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28 September 2021

The Case Against Bitcoin’s Inflation Narrative

The Case Against Bitcoin’s Inflation Narrative

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Over the past few months, I have been collecting information related to the topic of inflation and would like to use this opportunity to share my findings with the Bitcoin audience in particular.

We will be looking at the effects that inflationary periods have had on areas such as interest rates and consumer behavior.

So we know what was happening to the Soviet ruble during this time, but how did interest rates respond.

According to”A History of Interest Rates,” deposit rates at the Gosbank were as high as 72% in 1923, but the text also indicates that these rates were not indicative of supply and demand, instead being determined by Soviet commissars, and thus would have likely been much higher.

In fact, the situation got so bad that producers and retailers couldn't, and didn't want to, part with their wares and responded by limiting the number of hours that their doors were open otherwise their inventory would be quickly cleaned out and the shopkeepers would have been stuck with the rapidly depreciating German mark.

Additionally, loans in excess of 10,000% were recorded in Germany during this period but due to the chaos of the hyperinflation, the occupation by the French of the Ruhr, and political extremism, true black market rates could have been much higher.

Figure 2 shows the rates of interest that banks have been paying their depositors over the last 25 years.

The quotes and charts from the section above provide consistent evidence that high rates of inflation lead to higher and higher rates of interest.

We will conclude this section with a quote from Milton Friedman regarding the relationship between interest rates and monetary policy:.

Now that we have a thorough understanding of what an inflationary environment looks like, we can more easily identify the types of attributes that would define a disinflationary or deflationary environment.

Inflation of the money supply leads to a "sustained, broad-based increase in consumer prices," as Jeffrey Snider likes to say, but that is not what we see here.

With four, technically five, QEs following the aftermath of the GFC, one would think that the value of the DXY (dollar index) would have decreased significantly but what we see is the exact opposite.

This low reading makes sense since it occurred just off the heels of a period of stellar commercial bank lending (true credit expansion) and within the context of a eurodollar system which had been free from hiccups.

We can use this chart to illustrate how interest rates respond to periods of both high and low inflation by using historic precedence in our analysis.

So how did interest rates react during a period which featured deflation, credit contraction and tight lending conditions.

It is counterintuitive based on what we are told but, when credit becomes scarce, interest rates will decrease and remain low until that condition changes.

The 1970s were essentially a continuation of the 1960s and credit continued to expand until, by the early 1980s, interest rates climbed so high that credit was forced to contract.

As credit was expanding during the 1960s and 1970s so, too, were interest rates rising.

At this point, you might say "that is all well and good, but how has the post-GFC world not been inflationary with the trillions of dollars being created by the Federal Reserve?" In order to answer this question, we will first need to explain what the difference is between a bank reserve and a banknote.

The Fed creates these bank reserves, which pay a tiny amount of interest, and exchange them for assets on the balance sheets of commercial banks, assets such as mortgage-backed securities or treasuries.

Common wisdom, along with support from the financial media and the Fed itself, would have you believe that those bank reserves are the same as the banknotes in your wallet, but they are not.

Bank reserves are an asset that cannot leave the banking system nor can these bank reserves function as banknotes since the two are non-fungible.

Without going into too much detail regarding the reserve requirements of commercial banks, what bank reserves essentially are is a credit that synthetically increases the amount of reserves a bank has with the idea being that increasing the amount of reserves on a bank's balance sheet will give the bank the confidence it needs to lend against those additional reserves during times of illiquidity and keep the economy afloat.

In summation, bank reserves are essentially an accounting credit issued by the Fed that cannot leave the banking system.

The key to remember is that bank reserves and banknotes are not fungible.

What is interesting to observe is that, despite there being virtually no bank reserves in the system prior to the GFC, the real GDP growth rate was, in fact, higher.

Due to the enormous amount of reserves being created by the Fed, we would have expected a sharp recovery right back to the trendline but that is not what we see.

The reduction in loan growth was so great following the GFC that its compounded rate, going back to 1982, was reduced from 9.1% to 7.8%; a reduction so large that it erased what would have been roughly $6.3 trillion from the economy.

In other words, the policy of QE and bank reserves has been a dismal failure at stoking inflation.

We have learned that bank reserves are not as inflationary as they are made out to be.

So, the next question we need to ask ourselves is who or what has been responsible for the various asset bubbles that have made themselves clearly evident over the past 13 years.

What happens frequently is that observers become enamored with the inflation narrative based on the rapid increase in a particular asset or commodity, such as we saw in stocks and lumber.

They proclaimed how great it was that the broken window created more work for the glazer, while neglecting the fact that the shopkeeper had fewer resources with which to purchase a suit that would have been a negative outcome for the tailor.

Bitcoin has been rising in a disinflationary, and sometimes even deflationary, environment which means that organic interest, speculation and industry growth are the primary drivers of the price.

The only area where credit expansion could at least partially explain increases in the price of bitcoin would be with the recent stimulus payments, assuming said payments were financed by debt issuance and not taxes.

Gold bugs have been screaming about inflation for well over a decade and yet the price of the yellow metal, long considered to be the inflation hedge, is below its 2011 high.

If inflation ever does truly arrive in the U.S., which I think it eventually will, my guess would be that the price of bitcoin would increase to levels only understood by the citizens of Argentina or perhaps Turkey.

Once you have a better understanding of how the plumbing of the monetary system works, as well as an understanding of how limited the transmission mechanisms available to the Fed to expand credit truly are, then you will see that there are currently no avenues whereby the Fed itself can just print money.

Once the stimulus has been exhausted, prices will begin to revert such as what we saw with lumber.

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