The Story of Inflation and Hyperinflation
People don’t think much about currency; they just use it. They don’t notice a currency holding its value; they only notice when it doesn’t. Historically, the most frequent cause of a currency losing its value is: governments printing money.
To illustrate the effect, let’s consider a very simple example. There are 100 pencils for sale, and there is demand for exactly 100 pencils. If there is $100 available to buy the pencils, the price will tend towards $1 per pencil. Increase the supply of dollars to $200, and the price moves towards $2. The supply of pencils and the demand for them did not change, but the supply of money did, and it pushed up the price.
In a big America-size economy with millions of people and millions of things to buy, the same thing happens. If the economy remains the same, but you increase the supply of money, the prices rise — which means that the value of the dollar falls.
If the change in value becomes noticeable, people will spend the dollars as fast as they can, because the value of the dollar is falling. If they don’t need to buy with their dollars, they will buy something that will keep its value (gold, silver or whatever). The currency has become “debased.”
Such inflation occurs when a government prints money like it’s going out of style, and naturally, it does go out of style.
How does the Fed print money?
In truth it doesn’t print anything. You may picture the Federal Reserve commanding printing presses to spew out vast numbers of pristine 100 dollar bills. But that isn’t the mechanism “for money printing.” Paper dollars account for only about one tenth of the dollar money supply.
The full dollar money supply includes sources of money that are rarely converted into dollar bills, but could be: money in checking accounts, savings accounts, money orders, 24-hour money market funds, certificates of deposit, and so on.
When the Fed prints money, it does so by extending credit to (i.e., loaning money to) the banks and managing the interest rate they have to pay. The banks can then, if they so choose, lend that money to people or businesses and it will find its way into those various sources of money. That’s how the game is played.
Does This Mean the Fed Can Print as Much Money As It Pleases?
Not really. If you listen to the financial news once in a while, you’ll hear reports about the regular monthly meeting held by the Fed, what the Fed chose to do and how the financial markets reacted. If the Fed starts printing money in a big way, the markets will react negatively. The Fed prefers not to roil the markets unless it has no choice. If theFed wants to mess with the money supply it has to explain itself.
If The Fed Lends Money to the Banks, Do The Banks Have To Lend It Out?
No. In fact, they don’t have to accept the money at all. But lending is how banks make money. Typically, banks lend out more than they borrow from the Fed. They could lend out, say, ten times what they borrowed. This is called “fractional reserve banking.”
If the banks make good lending decisions and the borrowers pay back, then everything is hunky dory. Problems arise when the banks make too many bad loans. That’s when banking collapses occur. That’s why banks are regulated.
So How Does That Compare To Cryptocurrencies?
Cryptocurrencies are not like that at all. Not even close.
With a cryptocurrency, there is no Fed. And there is no fractional reserve banking.
Software controls the money supply and people never have a say in it.
With Bitcoin, for example, the money supply grows gradually — currently at about 3.85% per annum. It is slowing down. It will eventually come to a stop when 21,000,000 Bitcoin have been created.
The supply grows because (and only because) Bitcoin miners are paid in Bitcoin for mining blocks. The increase in the supply of Bitcoin is the payments made to miners.
Miners are also paid the transaction fees from each block. Eventually, when all the 21,000,000 Bitcoin have been created, the Bitcoin miners will make a living from transaction fees alone.
Different cryptos have different money supply growth rates. Most (like Litecoin and Ethereum) imitate Bitcoin and have a declining growth rate. Others, like the Permission (ticker: ASK) and XRP (Ripple), have zero growth rates.
In each case, the blockchain ensures either that no new crypto can be created or enforces the rate at which the new crypto is created. The only currency in existence there is the cryptocurrency recorded on the blockchain.
Is It Possible to Have “Fractional-Reserve Banking” with a Cryptocurrency?
No. This needs to be well understood, because — aside from the automated nature of the crypto money supply — it is the critical difference between fait currency and crypto.
With fractional-reserve banking, a bank borrows, say $1 million from the Fed. It then loans out, say, $10 million. $9 million are thus “created from nowhere.” Yes they are recorded in bank accounts, and they circulate around, and eventually, most of those dollars are paid back. So they exist, “sort of.”
But do you know what happens if the borrower cannot pay the bank back and instead goes bankrupt?
Those dollars disappear. They vanish, as if they never existed.
That’s what happens in a banking crash. Too many loans go bad, and the bank itself goes bankrupt — unless the Fed lends it some money to stay afloat.
None of that can happen with a cryptocurrency, because the amount of currency created is always there on the blockchain. It may pass from one owner to another, but it is always right there.
Would It Be Different If The Dollar Was Backed By Gold?
The dollar was backed by Gold once. And so were other currencies. The Gold standard was first abandoned when the First World War broke out. The countries involved in the war could not afford the war, so they printed money to pay for it.
If your currency is backed by gold, it is exchangeable for gold. If you print money like a drunken sailor, people buy gold with it, your gold reserves are quickly exhausted and the currency collapses.
And that’s the whole story, right there. If you back a currency with gold, you just cannot afford to print money. With crypto it’s quite similar, you simply can’t print money.