Tackling the Inflation Misinformation Machine

The current bout of inflation is transitory, but it’s far better than deflation.

AccessTimeIconJun 10, 2022 at 9:04 p.m. UTC
Updated May 11, 2023 at 4:52 p.m. UTC
AccessTimeIconJun 10, 2022 at 9:04 p.m. UTCUpdated May 11, 2023 at 4:52 p.m. UTCLayer 2
AccessTimeIconJun 10, 2022 at 9:04 p.m. UTCUpdated May 11, 2023 at 4:52 p.m. UTCLayer 2

One of the most common memes and messages across crypto communities is that deflation is better than inflation, and the more deflationary the asset, the better. Fueling the message to buy these assets is a widespread argument that inflation is out of control and that the monetary expansion that took place during the coronavirus pandemic is directly to blame.

Let’s start with the most foundational error common across multiple crypto ecosystems: the idea that deflationary systems are better than inflationary ones. Bitcoin maximalists tend to hit on this the hardest, but the Ethereum community can be just as bad. Ultrasound.money touts the deflationary impact of EIP-1559 and the coming Ethereum Merge as a good thing as well.

Paul Brody is EY's global blockchain leader and a CoinDesk columnist.

The theory is appealing: If you have crypto and the rate at which new crypto is added goes to zero or starts to go negative, the value of your crypto should rise. The hidden assumption in there is that demand for said crypto remains the same or goes up. In reality, deflationary ecosystems don’t seem to work very well. And there’s lots of evidence for that, particularly from the Great Depression, when the sooner a country abandoned the gold standard, the faster its economy recovered.

World production and prices. (League of Nations)
World production and prices. (League of Nations)

The reason that deflationary systems cause economic collapse is that if people expect the value of their currency to increase, they avoid spending it and try to hold onto it. This leads to soaring savings (HODLing!) and plunging demand. Conversely, in highly inflationary systems, people rush to spend money. It’s no surprise that central banks aim for price stability overall.

It’s important to understand, however, that absolute price stability is an impossible and unreasonable target. Economies change over time, and prices have to as well. Manufacturing and technology have made buying things ever cheaper, but many services don’t benefit from the same productivity gains. Teachers still look after approximately the same number of kids as they did a century ago, while factory workers can use machinery to churn out a hundred times more stuff. It would be crazy for prices of TVs and education to be identical after all that time.

All things being equal, a little inflation is better than a little deflation. This allows central banks to set interest rates below the rate of inflation, if necessary. If you can borrow money at 1% and inflation is 3%, your effective “real” interest rate is actually -2%. It’s how central banks do airdrops. Unfortunately, there’s no easy way to set interest rates below zero.

The second big topic that’s worth addressing is the idea that inflation in Western democracies is some kind of major policy failure or that it’s out of control. It’s neither. Inflation and central banks seem to be performing exactly as intended. Vast fiscal and monetary stimulus saved the world from what might have been a devastating recession at the start of the pandemic. Now, central banks and governments are pulling back. But monetary and fiscal policy isn’t an exact science; the idea that you can perfectly steer the global economy through a massive plunge in services sales, an explosion in product sales as people stay home and buy stuff, and then back to a surging services sector is ludicrous.

A good benchmark of whether this is going well overall, or badly, would be to compare the current pandemic to the last time we had a global market transformation on such a scale with different levels of fiscal and monetary stimulus and huge shifts in demand. The only real prior example of that was the entry and exit from World War II. After the war, the U.S. also experienced a surge of inflation as demobilization shifted demand with great speed from tanks and guns to kitchen appliances and cars.

That burst of inflation was also transitory. Over a period of three years after WW II, inflation peaked at an 18% annual rate before falling back to normal levels. It did not signal the start of prolonged inflation, and nobody now looks back on that as some kind of major policy failure. It was a reasonable consequence of shifting the entire world’s production and demand plan. The fact that inflation in the U.S. seems to have peaked at around 8% makes this transitory adjustment look good by comparison.

When it comes to building our future economy in a blockchain ecosystem, we must not fail to learn the lessons from the past. If we want Ethereum to become the engine of a new global economy (and I do!), and we’d like its ether (ETH) token to become a basic unit of pricing, then price stability, not deflation, is a preferred target. Pushing for ever more deflationary architectures will certainly please the HODLers, but it won’t position Ethereum to become a global economy in its own right.

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Paul Brody

Paul Brody is Global Blockchain Leader for EY (Ernst & Young). Under his leadership, EY is established a global presence in the blockchain space with a particular focus on public blockchains, assurance, and business application development in the Ethereum ecosystem.