This is a guest post by Chris Pardo and the opinions expressed are those of the author and don't represent the views of Bitcoin Magazine or BTC Media.
Inflation is one of those read-the-small-print kind of taxes that people don’t often think about even though it can have a major impact on their finances and, thereby, on their lives.
Rising long-term inflation is more insidious than you might think because it can steadily and most assuredly decrease the value of your earnings/savings – especially, if your taxes aren’t indexed to compensate you for the cost of inflation. Inflation has always been the bane of many businesses and individuals alike.
One thing is clear: something needs to be done.
If cryptocurrency, perhaps Bitcoin, was globally accepted as the world’s reserve currency, how well could it manage inflation and provide transparency compared to the U.S. dollar, arguably the world’s primary reserve currency?
The world of fiat currency seems straightforward enough: Delegate monetary policy to those elected officials most capable of keeping a standardized and stable medium of exchange going.
In practice, however, things get complicated, and often the policies and the mechanisms to carry out the policies are convoluted and not as transparent as they could be.
For example, the Federal Reserve System (the Fed) attempts to manage inflation by using open market operations, the discount rate, and reserve requirements, but this monetary system has not been able to reduce long-term inflation.
Much of this instability in the money supply is due largely to the practice of fractional-reserve banking/lending by commercial banks and lenders and the Fed's imprecise, volatile way of increasing and decreasing the money supply by using bond transactions, discount rates and reserve requirements, which ultimately swings the economy and the money supply exponentially upwards or downwards.
With the current monetary system, regardless of how well the Fed tries to plan bond transactions, discount rates and reserve requirements to regulate the money supply, the practice of fractional-reserve banking/lending exponentially compounds the effects produced in response to even the slightest changes made to the money supply using the Fed's three primary monetary tools.
Currently the Fed’s policy on fractional-reserves requires banks and lenders only to keep meager reserves ranging from 0 to 10 percent, which allows banks to create upwards of 90 percent of their money out of thin air.
Think back to the movie “Dumb and Dumber” with the suitcase once flush full of cash that Lloyd and Harry plan on returning to its owner – but they later ended up spending most of the money – leaving behind a pile of napkin IOUs instead.
Our current situation is similar to this, but worse; the banks/lenders create upwards of 90 percent of their money by printing digital bank IOUs without there being any cash, “special” Treasury Department/Federal Reserve IOUs, to back up all of the commercial banks’/lenders’ funds to begin with.
Also, the fact that banks can charge interest on monies created through this process and often require people to pledge real, tangible assets as collateral for these bank IOUs is another issue altogether. But for the purposes of this discussion, the volatility created through managing money in this way seems to ultimately result in rising long-term inflation.
In addition, considering the dollar is the primary world-reserve currency, this status creates a unique situation that allows the United States to print excess reserves beyond its domestic needs to help supply the international demand. The excess reserves created in this process can, in turn, potentially distort the very indexes used by the Fed to help manage the money supply, thereby creating a fairly unstable system for managing inflation in the long run.
Perhaps it is time to transition to an alternative medium of exchange that is more transparent and effectively manages short- and long-term inflation.
Cryptocurrency may be a solution to regain the value of our savings/earnings on a global scale.
If Bitcoin were accepted as the world’s reserve currency, this could potentially create an environment that could curb inflation and introduce a moderate amount of favorable deflation until all 21 million bitcoin are eventually minted.
In fact, a small amount of deflation can actually be a good thing – as suggested by the Friedman rule – and bitcoin would be deflationary until the fixed number of coins are finally minted over the course of time.
Because Bitcoin is gradually minted at decreasing fixed rates determined every four years, it creates a deflationary effect, despite there actually being an increase in the money supply during this time which most traditional economists would recognize as a condition of inflation.
But it is this fixed money supply that has the potential to move society forward as quickly as the original token system did that moved us out of the barter economy to something more efficient.
After all the bitcoins are created, the only way for the deflationary effect to continue is if bitcoins are lost or destroyed, but the amount of bitcoins removed in this way would likely be minimal.
Again, with our Bitcoin example, the Bitcoin cryptocurrency approaches the currency distribution and management problem by codifying the rules in a mandatory consensus manner; the rules cannot be changed unless the majority of people decide to voluntarily run the new version of the Bitcoin protocol.
Put simply, the people who secure the Bitcoin network, the “miners,” and use bitcoin to exchange goods and services, can each decide which version of the Bitcoin program they want to run. If people decide they don’t agree with the latest changes made to the Bitcoin protocol, they can run the version of the protocol that has the features they agree with, and the world will continue to do business as usual.
In a sense, it’s a form of direct democracy: Votes are cast through the sheer action of choosing which version of the Bitcoin program to run.
In Bitcoin and other open-source cryptocurrencies, zero will never equal one; the software code can be audited at any time, creating an unrivaled level of transparency on the mechanisms of monetary policy.
Cryptocurrencies that have a finite money supply have the potential to become a safe haven that staves off long-term inflation for good, offering a new alternative to how people actually do savings and business.