Bitcoin Is No Inflation Hedge

If you're myopic or impatient

This article represents the author’s opinion and doesn’t constitute financial advice.

Introduction

Bitcoin is often called "digital gold," a revolutionary asset meant to preserve wealth during economic uncertainty and excessive money printing. Skeptics argue that Bitcoin isn't an effective inflation hedge because it frequently moves with traditional markets, rising and falling alongside stocks and other assets. If you're judging Bitcoin based on its performance over a volatile week or month, it's easy to see why doubt surrounds its ability to hedge against inflation.

But is this criticism fair, or is it the result of a short-term perspective?

Low Time Preference is rare these days. Financial markets are watched minute by minute, and assets are often judged on immediate returns rather than long-term value. Shortsightedness overlooks the properties that make Bitcoin a strong hedge against inflation over time.

Bitcoin operates on a unique four-year cycle, marked by "halving" events that reduce the rate at which new bitcoins are created. This built-in scarcity is a feature that has historically driven significant price increases over extended periods.

If you've ever doubted Bitcoin's ability to protect your wealth from the eroding effects of inflation, it might be time to take a step back and consider the bigger picture. Bitcoin is one of the most effective inflation hedges available, IF you're willing to be patient and think long-term.

What Is an Inflation Hedge?

An inflation hedge is an investment that protects your purchasing power against the eroding effects of inflation (mostly money printing). When the Central Banks (Federal Reserve, Bank of England, European Central Bank etc) creates more money via quantitative easing (QE) or other methods, each unit of currency becomes less valuable and buys fewer goods and services. Assets like gold, real estate, and commodities have traditionally been used to hedge against inflation because they tend to retain or increase their value as inflation rises.

Investors seek out inflation hedges to preserve their wealth over time. If an asset's value increases at a rate equal to or greater than inflation, it protects the investor's purchasing power. Understanding what makes an effective inflation hedge is crucial for anyone looking to safeguard their assets in an inflationary environment. For example, over the past 20 years, the U.S. dollar has lost almost 50% of its purchasing power due to inflation. This means that something that cost $100 in 2003 would cost around $160 today. In other words, $100 today buys you only what about $63 could buy two decades ago. This is using official inflation figures, which are often manipulated to tell a story that we'll address later.

Understanding Bitcoin's Four-Year Cycle

Bitcoin operates on a unique four-year cycle, marked by "halving" events that reduce the rate at which new bitcoins are created. Approximately every four years, the reward miners receive for adding new blocks to the blockchain is cut in half. This built-in scarcity is a crucial feature that has historically driven significant price increases over extended periods.

By reducing the supply of new bitcoins, the halving events create upward pressure on price, assuming demand remains the same or increases. Looking at Bitcoin through a four-year window, its performance consistently grows against inflation rates and outperforms traditional hedges like gold.

Bitcoin's monetary policy directly opposes central banks monetary philosophy and that of Modern Monetary Theory (MMT). Central banks can increase the money supply with the stroke of a keyboard through quantitative easing, leading to currency devaluation and inflation. In contrast, Bitcoin acts as a deflationary asset rather than a traditional inflationary asset. Its fixed supply and decreasing issuance mean that each bitcoin becomes more scarce and potentially more valuable. This fundamental difference positions Bitcoin as a potential hedge against the inflationary effects of traditional monetary policies.

Bitcoin's Market Correlation

Skeptics argue that Bitcoin can't be an effective inflation hedge because it often moves in sync with traditional markets. They point out that Bitcoin has experienced significant drops during market downturns, suggesting it's too correlated with other assets to provide true diversification.

However, this criticism stems from a short-term or high time preference perspective, and a background in traditional finance (see my article on why tradfi has such a hard time understanding Bitcoin). While Bitcoin does experience volatility and can move with traditional markets over days or weeks, its long-term trajectory shows us the truth. Over multi-year periods, Bitcoin's performance diverges from traditional assets, showing strong growth even when other markets stagnate.

Short-term correlations can be misleading because they often reflect temporary market sentiments or reactions to immediate events. When we zoom out and look at the bigger picture, Bitcoin's unique properties like its fixed supply and decentralization set it apart from other assets. Short-term fluctuations in Bitcoin's price often reflect its unparalleled liquidity, making it one of the most liquid assets globally. In the event of a geopolitical crisis occurring outside of traditional market hours, investors have few options to access liquidity. Bitcoin's 24/7/365 trading capability makes it a powerful addition to any portfolio, providing investors with the ability to react to events in real-time.

If in doubt, zoom out

Bitcoin's Historical Outperformance

When we analyze Bitcoin's performance over various four-year periods, a pattern emerges: long-term holders have been rewarded with substantial returns despite short-term volatility. This growth highlights Bitcoin's potential as an effective hedge against inflation for those willing to adopt a low-time preference.

If you look back to any point in Bitcoin's history and compare its price to where it was four years later, you'll notice significant appreciation. Even accounting for market corrections and periods of decline, Bitcoin's overall trajectory has been upward. This long-term growth has not only outpaced inflation but has also outperformed traditional inflation hedges like gold.

Including a small allocation of Bitcoin in a diversified portfolio can enhance overall returns over time. This isn't about making speculative bets or chasing quick profits. It's about recognizing Bitcoin's unique properties, its fixed supply, decreasing issuance due to halving events; and increasing global adoption—that contribute to its long-term value appreciation.

By maintaining a low time preference and focusing on the bigger picture, investors can potentially safeguard and grow their wealth with Bitcoin, despite its short-term price fluctuations. This reinforces the idea that patience and a long-term perspective are the most important factor when considering Bitcoin as an inflation hedge.

Bitcoin in Daily, Weekly, and Monthly Perspectives

It's important to acknowledge that Bitcoin is volatile in the short term. Price swings over days, weeks, or even months can be significant. For those with a high time preference, and looking for quick gains, this volatility can be off-putting.

However, for investors willing to adopt a low time preference and think in terms of years rather than months, Bitcoin's volatility becomes less concerning. The short-term fluctuations tend to even out over longer periods, revealing an overall upward trend.

The M2 Money Supply Relationship

The M2 money supply measures the total amount of currency in circulation, including cash, checking accounts, savings deposits, and easily accessible funds. When central banks increase the M2 supply through actions like quantitative easing, more money enters the economy. This often leads to inflation because more dollars are chasing the same amount of goods and services.

Bitcoin's Strong Correlation with M2

Research by Lyn Alden and Sam Callahan, has shown that Bitcoin's price movements closely track changes in global liquidity, as measured by the M2 money supply. Bitcoin moves in the same direction as global liquidity about 83% of the time over any given 12-month period, making it a strong barometer of liquidity conditions.

This high correlation suggests that Bitcoin is more sensitive to changes in the money supply than traditional assets like stocks or bonds. Unlike stocks, which can be influenced by earnings and dividends, or bonds, which are considered safe-haven assets, Bitcoin's price is primarily driven by liquidity conditions and investor demand.

Real Estate: Not Gaining Value, Just Tracking Inflation

Similarly, real estate prices have surged in recent years, but this doesn't necessarily mean your property is gaining real value. In many cases, real estate is simply keeping pace with inflation driven by the expanding money supply. As the M2 supply increases, more money is available for lending and investing, which can drive up property prices. However, this rise in prices often reflects the devaluation of currency rather than an increase in the intrinsic value of the properties.

Limitations of the CPI

The Consumer Price Index (CPI) is commonly used to measure inflation, but it doesn't fully capture the actual increase in the cost of living. CPI focuses on a basket of consumer goods and services but largely excludes asset prices like real estate and investments. This means that while CPI might indicate low inflation, the actual costs of significant expenses like housing have risen much more dramatically.

By comparing M2 growth with real estate prices, we see a strong correlation, suggesting that M2 is a better indicator of real-world inflation than CPI. This is important because it highlights how traditional measures of inflation may understate the true erosion of purchasing power experienced by individuals.

Implications for Bitcoin as an Inflation Hedge

Given Bitcoin's strong correlation with the M2 money supply, it serves as an effective hedge against the type of inflation that isn't fully captured by CPI figures. As central banks continue to expand the money supply, Bitcoin's fixed supply becomes increasingly valuable. Investors seeking to preserve their wealth from the eroding effects of an expanding money supply are drawn to Bitcoin because of its scarcity and resistance to inflationary pressures.

Supply, Demand, and the Continuation of Trends

Bitcoin's finite supply of 21 million coins means that, over time, new supply will diminish until it eventually stops altogether. Meanwhile, demand for Bitcoin has been increasing, driven by growing adoption, institutional interest, and recognition of its potential as a store of value.

With decreasing supply and increasing demand, there's a strong case to be made that Bitcoin's long-term price appreciation will continue. Unless there's a fundamental change in Bitcoin's underlying principles or a significant shift in market dynamics, these trends will likely persist.

Conclusion

Judging Bitcoin solely on short-term price movements can lead to misconceptions about its effectiveness as an inflation hedge. While it's true that Bitcoin experiences volatility and can sometimes move with traditional markets, a longer-term perspective reveals its true potential.

By understanding Bitcoin's four-year cycle, built-in scarcity, and historical performance, it has consistently outperformed inflation and even traditional hedges like gold over extended periods. Adopting a low-time preference and focusing on long-term value can make Bitcoin a powerful tool for preserving and growing wealth in an inflationary environment.

For those interested in exploring Bitcoin as a potential inflation hedge, consider the following:

1. Educate yourself on Bitcoin's fundamentals, including its fixed supply, halving cycles, and decentralized nature. Never stop learning about Bitcoin.

2. Adopt a long-term perspective and avoid getting caught up in short-term price fluctuations.

3. Monitor the growth of the M2 money supply and other indicators of inflation to better understand Bitcoin's potential as a hedge.

Remember, investing in Bitcoin requires patience and a willingness to weather short-term volatility. But for those who believe in its long-term potential and are prepared to hold for the long haul, Bitcoin may prove to be the ultimate inflation hedge.