The role of cryptocurrency in a recession
The buzz around cryptocurrency and how it’ll be affected by economic inflation is ever-rising. Inflation is the general increase in prices of goods and services over time while the purchasing power of money reduces. As prices increase, the value of money decreases, and investments that don’t keep pace with inflation can lose value in real time.
To better understand how an economic slowdown can affect crypto, we must look back at the history and origin of cryptocurrency — dating back to the Great Recession (2008).
The history of cryptocurrency
In 2008, author Satoshi Nakamoto published a report called ‘Bitcoin: A Peer-to-Peer Electronic Cash System’, outlining the plan for a peer-to-peer internet-based currency. Nakamoto’s endeavour was born out of a frustrated response to several controversial government bailouts following the collapse of established firms. The creation of Bitcoin was primarily inspired by the ongoing global financial crisis at that time and the belief that traditional financial systems should make way for a new, decentralized alternative.
In the early days of Bitcoin, the cryptocurrency and blockchain industry was relatively small, and the technology was largely unknown to the broader public. With the launch of Ethereum in 2015, the industry began to gain more widespread attention thanks to its introduction of smart contracts and other innovative features.
What recessions mean for crypto
Although cryptocurrency was conceived amidst a significant economic crisis, it’s difficult to predict how a mature blockchain industry will respond to a period of rapid inflation. There’s not enough data for analysts to corroborate the relationship between crypto prices and macroeconomic factors.
However, based on the industry performance and stock market predictions, economists have come up with a general idea of what recession may mean for crypto:
- Depreciating Crypto Value: Cryptocurrencies are often viewed as more volatile and speculative and may be more likely to experience price swings during economic uncertainty. Suppose businesses and individuals experience financial hardship during a recession. In that case, they may be less likely to invest in cryptocurrencies or may need to sell their existing holdings, which could also put downward pressure on prices. Since Bitcoin has yet to grow into a global reserve currency, digital assets like several high-growth tech stocks can depreciate in value.
- Low-Risk Investments: If investors become more risk-averse, they may shift their investments away from smaller, more speculative cryptocurrencies towards safer assets, which could lead to a decrease in demand and a corresponding drop in prices.
Additionally, stablecoins — cryptocurrencies pegged to a stable asset such as the US dollar — may also see increased demand during economic uncertainty, as they provide a way for investors to hold a cryptocurrency without being exposed to the volatility of other cryptocurrencies.
- Layoffs At Crypto Companies: If digital assets depreciate, companies with crypto exposure might issue releases or stop hiring. This happened after the crypto selloff in 2022 when notable centralized crypto exchanges (CEXs) like Coinbase, Gemini, and Crypto.com issued massive layoffs.
- Low Trading Volume: Retail investors need to strongly believe in cryptocurrencies like Bitcoin and Ethereum to choose to allocate their capital to less volatile assets such as bonds. As a result, centralized exchanges may experience lower trading volumes and inactivity during a recession compared to a bullish market.
How crypto can be helpful in a recession
The significance of cryptocurrencies during a recession is a topic of debate among economists and investors. While some remain sceptical about crypto’s ability to mitigate the impacts of a recession, others are confident that crypto can provide a hedge against inflation.
Here are the features of crypto that can be useful in a period of economic turndown:
- Decentralized Alternative: Cryptocurrencies are not controlled by any central authority, such as a government or a central bank. As a result, they are not subject to the same inflationary pressures and government interventions as traditional currencies. While traditional financial systems will experience instability, accessibility to assets and transactions may become staggered as people rush to withdraw their assets. Crypto can offer an alternative way to transact without relying on affected financial institutions.
- Hedge Against Inflation: Some proponents argue that cryptocurrencies can hedge against inflation and other economic risks (more on that later). Since many cryptocurrencies have a limited supply, their value may not be subject to the same inflationary pressures as traditional currencies. This could provide a way for individuals and businesses to protect their assets from inflation and other economic risks, as many do with gold.
- Investment Diversification: Traditional investment opportunities will most likely be underperforming or unstable during a recession. Cryptocurrencies may offer an alternate way to diversify an investment portfolio and potentially generate returns.
Crypto’s role in helping economies beat inflation
According to Maulik Shah, co-founder and CEO at Almus Risk Consulting LLP, a forex treasury outsourcing company, “Cryptocurrency can help struggling economies beat inflation.” He adds, “Inflation is the function of demand and supply; monetary policy can influence the demand side in managing inflation and inflation expectations.”
He also explains how “loose monetary policy by central banks the world over has led to excessive liquidity (currency in circulation), which has led to demand and inflation”.
Most industry experts vouch for crypto challenging the basic framework of monetary policy — with the decentralised finance (DeFi) system eliminating the control held by a third party in the flow of the exchange instrument.
As Shah states, “There’s no printing of currency for stimulation or even control of currency in circulation by central banks or similar entities, and therefore a situation such as too much money chasing too little goods does not arise”.
The adoption of cryptocurrencies as a medium of exchange has been limited to only a few countries, such as El Salvador and the Central African Republic. As a result, the impact of cryptocurrencies on inflation control is likely to be limited as well. However, some investors may turn to stable cryptocurrencies like Bitcoin during periods of inflation. Bitcoin has a fixed supply, which makes it similar to gold and potentially valuable as a hedge against inflation.
According to Shah, it’s important to note that the relationship between cryptocurrencies and inflation can be complex and may only sometimes be straightforward. He lists factors such as investor psychology and market sentiment, as they can also play a role in determining the value and performance of cryptocurrencies during periods of inflation.
Is Bitcoin an inflation hedge?
Whether Bitcoin is genuinely a hedge against inflation has remained a hot topic among economists and investors. Some argue that Bitcoin has properties similar to traditional hedges against inflation, such as gold. To better understand these particular properties of Bitcoin, we must explore how hedges against inflation work.
How an inflation hedge functions
Hedges against inflation are assets or investments that can help protect an investor’s portfolio from the effects of inflation. One way hedges against inflation work are by providing a store of value that can keep up with or outpace inflation.
For example, gold is often considered a hedge against inflation because its value tends to rise during periods of inflation. Other assets that may be used as hedges against inflation include real estate, commodities, and inflation-linked bonds.
Hedges also generate income or cash flow that can help counter the consequences of inflation. For example, dividend-paying stocks or rental properties can generate income that increases over time and help investors maintain their purchasing power despite inflation.
What about Bitcoin?
Bitcoin is often considered a potential hedge against inflation due to its limited supply and decentralized nature. During the creation of Bitcoin, Satoshi Nakamoto embedded a hard cap into the source code that limited its circulation to 21 million bitcoins. Unlike fiat currencies that can be inflated through monetary policy decisions by central banks, Bitcoin has a finite supply of 21 million coins that can never be exceeded.
This scarcity means that Bitcoin’s value may hold up better during inflation than currencies that can be devalued through inflationary policies. Bitcoin’s decentralized nature also means independence from traditional financial systems — which may provide a degree of protection against inflation and other economic risks that can affect government-issued currencies.
However, Bitcoin has yet to prove itself as a viable inflation hedge.
Steven Lubka, managing director of private clients at Swan Bitcoin, says, “Bitcoin works well as a hedge against rising prices when inflation is caused by monetary expansion. It is less effective when the disruption of the food supply and energy causes inflation”.
He reasons that in a world where the price of goods is going up because there’s been a radical loss of abundance, Bitcoin isn’t going to protect investors. He, however, states that Bitcoin is a much better hedge against inflation than stocks or real estate, owing to a couple of factors — like interdependency on external factors, risk of obsolescence, bad product decisions, etc. Neither does Bitcoin need maintenance nor is it affected by the risk involved in stock-picking.
Thus, the effectiveness of cryptocurrencies as an inflation hedge depends on market conditions. Cryptocurrencies tend to fail as an inflation hedge during high volatility and market uncertainty. However, in stable growth environments, they can easily outperform the market and act as a good hedge against inflation.
According to Omid Malekan, a professor at Columbia Business School specializing in crypto and blockchain technology, “Once volatility smooths out, we will have a better picture of how it responds to macro developments, like the rate of inflation or what the Fed is doing,” he says, noting that current crypto prices could reflect inputs besides inflation as well — like overleveraged cryptocurrency lenders or a lack of regulation.
Proper protocols will provide benefits as the crypto community becomes more responsible and diligent, and cryptocurrencies will become a genuine hedge against inflation. However, it is currently wise to exercise caution when investing in cryptocurrencies during periods of market turmoil and not rely solely on them as a tool for shoring up investments against inflation. Over time, as blockchain protocols mature, we may see an increase in the adoption and stability of cryptocurrencies as inflation hedges..
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