When there is an increase in the general price of goods and services in an economy, it is known as inflation. Inflation results in the reduction of the purchasing power of a currency. A currency’s purchasing power refers to the value of a currency expressed in terms of the number of goods and services that can be purchased with a unit of that currency.
Many economists and policymakers believe that a low-to-moderate inflation rate of about 2% per year is acceptable and beneficial for the economy. However, when inflation exceeds 2%, it becomes detrimental to the economy.
There are cases when the general prices of goods and services increase rapidly, resulting in a type of inflation that spins out of control. When inflation spins out of control it is called hyperinflation. In hyperinflation, the rise in prices leads to an inflation rate that is greater than 50% per month. One of the typical causes of hyperinflation is the significant rise in the supply of money without corresponding economic growth. In other words, the central or reserve bank prints excessive money while the economic output remains the same. Instigators of economic turmoil, such as war, are oftentimes catalysts of hyperinflation.
A central or reserve bank can control inflation by applying traditional tools and monetary policies. The US Federal Reserve policymakers, for example, monitor several price indexes to evaluate changes in inflation. On the one hand, when inflation seems high the Federal Reserve effects a rise in interest rates to bring inflation down; on the other hand, when inflation is too low the Federal Reserve stimulates the economy by typically lowering interest rates.
Hyperinflation is very difficult to control. Only drastic measures such as “dollarization” – replacing the currency of a hyperinflation-ridden state with a foreign, more stable currency – can be employed to checkmate hyperinflation in an economy.
Hyperinflation leads to the hoarding of basic household goods such as food and groceries, leading to shortages. As the value of currency decreases rapidly, most consumers withdraw their funds from banks and convert them into other currencies or commodities. A hyperinflation-induced stampede for withdrawals is created, leading to bank runs.
Instances of Hyperinflation
Though hyperinflation is not a regular occurrence, especially in developed nations, there have been instances throughout history and the modern-day where hyperinflation ripped through economies. Germany’s Weimar republic was plagued with hyperinflation during its last years. Monthly inflation rates of up to 29,500% were recorded. Prices doubled every 3.7 days.
Another extreme case of hyperinflation was in Hungary just after the second world war. Prices doubled every 15 hours during the thirteen-month-long period of hyperinflation (July 1945 – August 1946).
The then Federal Republic of Yugoslavia experienced one of the longest and most severe hyperinflations, between the years 1992 and 1994. The daily inflation rate was around 62%. The government issued new and higher denomination bank notes every few days to cope with the hyperinflation. In September 1993, the highest denomination banknote was issued – a 500 billion Yugoslav dinar bank note.
Zimbabwe, a southern African country, experienced one of the most recent examples of hyperinflation, with an estimated monthly inflation rate of 79.6 billion percent at the peak of its hyperinflation. Prices almost doubled every twenty-four hours. Shop owners began rejecting the Zimbabwe dollar (Z$) and opted for the US dollar and South African rand as the acceptable medium of exchange.
In 2016, socioeconomic and political crises led to hyperinflation in Venezuela. By 2018, the Venezuelan hyperinflation rate increased to 10 million percent. In just two years, the bolivar, Venezuela’s national currency, lost 99.9% of its value.
Hedges Against Inflation and Hyperinflation
Traditionally, assets and investments such as gold and real estate have been the preferred methods of investing to hedge against inflation. Consumers also explore options such as moving funds into a high-yield savings account, buying stocks, and investing in commodities. In emerging markets, consumers are prone to the practice of purchasing stronger currencies, such as the US dollar, and hoarding them.
Despite their use as hedges against inflation, traditional assets and investments, especially fixed-income securities, can still be prone to interest rate risks (potential investment losses that can occur as a result of fluctuation in interest rates).
Digital Assets as a Hedge Against Inflation and Hyperinflation
Digital assets such as cryptocurrencies have inherent characteristics that make them a good hedge against inflation. The supply of Bitcoin, for example, is fixed at 21 million. After 21 million Bitcoins are mined, no further Bitcoin will be added to the supply. Some other crypto assets are inherently deflationary; these crypto assets are deflationary in the sense that the circulating supply is reduced on a per-transaction basis or periodically.
A percentage of the gas fees of some crypto assets are burned on every transaction that takes place on the blockchain. Hedging crypto assets against inflation is one of the vital aspects of the tokenomics of cryptocurrencies. Some coins that started without a deflationary mechanism have, along the way, made upgrades that integrate some form of deflation. Ethereum, for example, launched its EIP-1159 proposal which introduced a mechanism to burn a portion of the gas fee for every transaction carried out on the Ethereum blockchain.
Crypto assets with no inherent token burn mechanism undergo periodic, scheduled buybacks and burns carried out mostly by the project team. BNB, the native coin in the Binance ecosystem, undergoes a quarterly burn. The Binance team buys back some BNB with 20% of Binance’s profits; the team destroys the acquired BNB by sending them to a burn address. Binance says it will continue to buy back and burn BNB every quarter until 50% of the BNB supply (100 million BNB) is burned. Just like Ethereum’s EIP-1159, Binance also implemented an automatic, real-time burning mechanism of gas fees on the Binance Smart Chain (BSC), with the introduction of Binance Evolution Proposal 95 (BEP-95). These measures help cryptocurrencies maintain value.
From trading at less than $100 per BTC in 2012 to a value of over $60,000 per BTC in 2021, Bitcoin’s purchasing power increased tremendously within a decade.
When there is hyperinflation, wealthy families could see their wealth disappear in the twinkling of an eye, while poorer families are driven into dire desperation. In the case of Venezuela's hyperinflation, the utter failure of the government to curb hyperinflation and the subsequent lack of trust in the national currency at the peak of hyperinflation led most consumers to turn to Bitcoin and other cryptocurrencies. Venezuelan migrant workers also made use of Bitcoin and other cryptocurrencies, extensively, to send remittances back home.
A Chainalysis blog post published in 2020 reported that Venezuela had reached one of the highest rates of cryptocurrency usage in the world, ranking third on Chainalysis’ Global Crypto Adoption Index.
In a bid to curb inflation, the government in Venezuela proposed a central bank digital currency (CBDC) called petromoneda (petro). The digital currency is supposedly backed by the country's oil reserve. Petro has since launched but has failed to gain enough traction.
Cryptocurrencies in general are a good hedge against inflation. They can be inherently deflationary or capped at a certain total supply, giving them the ability to achieve 0% inflation.
To learn more about Bitcoin, visit our Investing in Bitcoin guide.
To learn more about Ethereum, visit our Investing in Ethereum guide.
To learn more about BNB, visit our Investing in BNB guide.