What will Bitcoin look like in a deflationary economy?

What will Bitcoin look like in a deflationary economy?

Although the cryptocurrency community is concerned about hyperinflation, this is not the biggest threat of the global economy. The reality is exactly the opposite. With growing deflation due to isolation around the world, how will Bitcoin react in such an environment?

Bitcoin acts like a fence

Gold is the main barrier against inflation and Bitcoin is growing with similar properties.

Bitcoin's monetary inflation is currently higher than developed countries like the United States, making it a barrier against authoritarian governments.

According to the famous Bitcoin on-chain analyst Willy Woo, the BTC inflation rate is 3.69%. The U.S. inflation rate was 2.3% from February 2019 to February 2020.

However, due to fixed supply and reduced periodic issuance, Bitcoin is considered a hedge against hyperinflation. Argentina, for example, has a high level of bad debt and high inflation, which increases the demand for Bitcoin locally.

The South American country had an inflation rate of 4.42% in 2004. The figure has soared to more than 50% according to data released by Statista. 

"Argentines are selling record Pesos to buy Bitcoin on LocalBitcoins, because the government is going to default and the national money will be inflated."

But when global demand for goods and services shrinks due to the Corona virus, deflation is a much more realistic scenario than hyperinflation.

When deflation occurs, the purchasing power of fiat money is enhanced. Therefore, everyone including large investors will tend to stick with cash. During periods of inflation, stocks and other risky assets perform well thanks to constant capital inflows from those seeking to preserve assets.

During inflation, fiat money tends to lose value, leading to an increase in demand for other value-preserving assets. Conversely, during deflation, demand for fiat is higher due to the increase in the value of cash.

An expression of demand for fiat is in the buying behavior of the middle class and lower. During a period of deflation, this demographic group will delay consumption of non-essential goods and services if it is believed that similar products will be cheaper in the future. Current isolation is the catalyst that reduces this need.

Bitcoin is not a deflationary asset because the total supply does not decrease annually.

If deflation hits the United States today, it will actually be a bearish trend for Bitcoin, as capital inflows into risky assets will decline, causing prices to stall.

When debt debt comes with deflation

Each case of deflation in the past few decades is different.

Spain fought two deflationary events in 2009 and 2015-16. But despite falling commodity prices, GDP growth in Spain is still higher than the European average.

Sometimes deflation is not enough to delay consumption in a country.

Greece has been in debt crisis for nearly a decade and deflation has plagued the country from 2013 to 2017. Unable to make payments and on top of national defaults; A series of bailouts from the EU and the IMF have helped them avoid this situation.

The focus of the problem is a crisis of confidence, evidenced by increased borrowing costs for the Greek government. These costs were transferred to Greek citizens through 12 tax increases.

The cost of funding for the Greek government soared when the debt crisis appeared Source: CEIC.

Insofar as Bitcoin is a barrier against authority, a crisis of government confidence will create a thriving environment for decentralized cryptocurrencies.

Localism prevents national defaults

With a government debt to GDP ratio of 240%, Japan has the most debt per capita, even more than Greece. Japan has also been the offspring of a deflationary economy since the 1990s.

The Japanese stock index never recovered after deflation in the 1990s | Source: TradingView.

Japan's debt ballooned when deflation struck Asian powers. In an effort to boost economic growth, the government has pushed for heavy fiscal stimulus measures, resulting in a huge debt pile.

Government debt to GDP of Japan | Source: TradingEconomics.

However, Japan has never defaulted or missed any interest payments to lenders. The reason for this is simple: most of Japan's debt is owned by the Japanese.

More than 70% of the new national debt is bought by Bank of Japan - the national central bank. The remaining 30% is mainly bought by Japanese banks and the public.

When debt is owned within the borders of a country, it is much easier to postpone the maturity and process the debt for several years.

Although these measures have prevented the national debt crisis, the size of the government's obligations to lenders is unsustainable.

As of June 2019, nearly 30% of US national debt is owned by foreign investors, of which China and Japan hold large amounts.

Composition of US debt obligations | Source: Visual Capitalist

Foreign investors who have no interest in providing bailout for the government can promote debt maturity, force the country to accept more debt or default and cause a crisis of confidence.

Although the scenario is unlikely, because US Treasury bonds have the highest credit rating in the world, it is possible if the economic situation worsens.

Circumstances will determine the fate of Bitcoin

Deflation creates a negative environment for Bitcoin, but if potential financial tensions involve political collapse, then it will be the time when Bitcoin shines.

In situations like those of Greece, the value proposition of Bitcoin is highlighted. But the same does not happen in the case of Japan where deflation has not crippled the government.

At its core, Bitcoin will continue to be a barrier against the lust for power by the authorities. But it also serves as an alternative financial system if confidence in the dominant system collapses.