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How would a deflationary economy work?

Published 7.3.2023

There will only be 45,000,000,000 ADA coins in the Cardano ecosystem. New ADA coins will gradually be released from the reserve and eventually, we will get to the point of having almost all coins in circulation. People believe that cryptocurrencies could serve as money that could hold value in the long term. Do you know how such an economy would work? Very differently than you know it today, and you might not like it. The price of goods could gradually decrease. Wages would gradually fall in nominal terms. It would be more difficult to repay debt. It might be impossible for governments to solve sudden serious problems economically. It is inconceivable for the present indebted governments to transform an inflationary economy into a deflationary one. Moreover, how can we create a new economy that is fair for all who want to join it? Algorithmic stablecoins may be the only possible way to create better money. ADA, like BTC and other similar coins, can be an amazing reserve currency, but it will probably never be a good medium of exchange.

TLDR

  • It was necessary to abandon the gold standard in order to stimulate the economy.
  • Are you ready to live debt-free? You may be, but governments are not.
  • It would be difficult for people to change their thinking if we switched to deflationary money.
  • Users can use DJED as a medium of exchange while holding ADA as a store of value. The Cardano ecosystem will provide both functions.
  • All assets in the world are volatile, including gold. There is no reason to think that ADA or BTC will be more stable than existing assets.
  • Cryptocurrencies can be a good store of value if we use their value for something useful. One of the most useful tools in the world is currency.

How would a currency with a fixed monetary policy work?

Deflationary money refers to a monetary system where the value of money increases over time, leading to a decrease in the general price level. In other words, with deflationary money, the purchasing power of money increases over time. Each unit of currency can buy more goods and services than before.

Cryptocurrency fans believe this is a desirable feature for a medium of exchange. Who wouldn't want to have more for not doing anything? Just keep the money and the individual would get rich. One of the current false narratives around cryptocurrencies is that such money is better than inflationary fiat currencies. However, one must see the difference between a medium of exchange and a store of value. These functions of money cannot be combined together to work well in the long term.

How does inflationary money work? The general price level increases over time, and each unit of currency can buy fewer goods and services than before. So by holding money, one becomes poorer. It's logical not to want that kind of money, isn't it?

Before you answer, you should know how deflationary money works and what problems are associated with it.

In a deflationary environment, people may be encouraged to save money instead of spending it, as the value of their savings will increase over time. This can have a dampening effect on economic growth, as businesses may see decreased demand for their products and services, leading to lower profits and potentially lower employment. Overall economic activity can decrease, as businesses struggle to sell their products and services.

On the other hand, there is a positive thing about incentivizing saving. Deflation can lead to a more financially responsible population, which is beneficial for individuals and the economy as a whole.

Deflation can have a negative impact on the ability to borrow money, hence on investment in new ventures and the development of new technologies. While deflation can benefit those who hold debt, it can be detrimental to those who owe money. Why is that? The real value of their debt increases over time, making it harder for them to pay it off. In other words, more effort is required to repay a given amount of monetary units.

It can be very difficult for people to change their mindset and start thinking deflationary. Goods would have the same or decreasing value. Instead of negotiating with your employer for a wage increase, he would negotiate with you for a wage decrease. If you failed to repay the debt on time, it would become increasingly difficult as time went on and you could remain in debt for the rest of your life. It is preferable not to take on the debt at all and to save instead. In practice, this would mean buying your own home in retirement.

Deflationary monetary policy can have a negative impact on governments. In fact, if they do not have sufficient reserves to deal with a sudden crisis, they may have little or no way to solve the problem. If governments do not have sufficient reserves, they need to borrow. Solving problems through debt can be abused by governments and often is nowadays (with inflationary policy), but it is important to know that in some cases there may not be a better solution. Governments can balance between debt and protecting the health or life of citizens. In a deflationary economy, high government debt could lead to subsequent bankruptcy. Government bankruptcy would have negative effects on citizens. If the economy worked with a deflationary policy, the only solution might be to change the rules of the game and go back to an inflationary model. Indeed, that was one of the reasons why the gold standard was abandoned.

The gold standard created deflationary pressures during the Great Depression. As the US economy contracted and prices fell, the value of gold increased relative to other goods and services. This led to a decrease in the money supply, as the government had to remove money from circulation to maintain the gold standard. This deflationary pressure exacerbated the economic downturn, making it more difficult for businesses and individuals to repay their debts and stimulating a negative feedback loop.

As we know from the past, deflationary experiments have failed. It's often because deflation can be self-reinforcing. When prices are falling, consumers may delay purchases in anticipation of lower prices in the future, which can lead to lower economic activity and further price declines. This can create a vicious cycle that's difficult to break out of.

It is important to note that while deflation may seem like a desirable outcome in theory, it can be difficult to achieve in practice and can also have negative consequences for the economy, including increased debt burdens and decreased investment. Additionally, while some degree of deflation may be acceptable, sustained deflation can lead to a deflationary spiral, in which falling prices lead to decreased demand and investment, which in turn leads to lower prices and further decreased demand, and so on. Therefore, maintaining a stable general price level is an important goal for most modern economies.

Neither people nor governments are prepared for the transition from an inflationary to a deflationary economy. Current governments are in debt. Pension systems are not ready for such a transition. Many pensioners are dependent on what they get from governments. Many states are only able to pay pensions because they collect taxes. Entrepreneurs are used to borrowing money to start or expand their businesses. Technological innovation needs funding even though many attempts fail.

Deflationary money has some advantages. But they also have many disadvantages that must not be overlooked. Deflationary money might solve some of the current problems, but there would be many new problems to solve that we do not have as much experience with.

Algorithmic stablecoins and sound money

Cardano has an algorithmic overcollateralized stablecoin Djed. This is a way to create a currency with stable purchasing power and, at the same time, have digital assets as sound money. ADA is perfectly suited to be a reserve currency for Djed. Djed will have a real underlying asset with a fixed monetary policy while allowing the creation of a stablecoin that people can start using immediately.

The value of the ADA will be volatile for a long time to come. However, it may tend to rise if the Cardano ecosystem thrives. Users can use DJED as a medium of exchange while holding ADA as a store of value. The Cardano ecosystem will provide both functions.

Cryptocurrencies are still a very young industry and therefore coin prices will be very volatile. Although both Cardano and Bitcoin have a fixed monetary policy and a capped maximum number of coins, a drop in market capitalization of 50% or more is common. A rigid monetary policy for cryptocurrencies may not be a guarantee of value preservation.

The unstable economic environment is hindering the wider adoption of cryptocurrencies as a medium of exchange. In the case of the store of value, it is better as people are prepared for longer bear markets and believe in better times.

It can surprise you that there are few assets that are more price stable than gold. For example inflation-protected bonds, real estate indexes, blue-chip stocks, and commodity baskets.

U.S. Treasury Bonds are considered to be one of the safest investments in the world. They have a history of stability and provide a reliable source of income to investors. Blue-chip stocks are shares of large, well-established companies that have a history of stable earnings and dividend payments. While real estate and blue-chip stock prices can fluctuate in the short term, over a longer period of time, they tend to be more stable than gold. Commodity baskets are one way to deal with volatility. Investing in a basket of different commodities, such as food, metals, energy, etc., can reduce the impact of fluctuations in the price of individual assets.

Is the gold price or the USD more stable? Historically, gold has been considered a relatively stable asset compared to fiat currencies, including USD. This is because gold has a limited supply, and its value is not directly influenced by government policies or central bank decisions. However, this does not mean that gold is always more stable than USD, as gold prices can also be influenced by various factors.

There is no asset in our world that is stable for a long time and is a clear champion compared to other assets. The best we can do if we want to create stability is to create a basket of assets. There is no reason to think that ADA or BTC will be more stable in the long run than existing assets. It always depends on what the asset is used for. The more it is used, the more it can be affected by geopolitical influences, markets, government decisions, crises, etc.

If we want to have a truly stable currency, it might be the best idea to use the Djed algorithm and tie the value of the stablecoin to a basket of assets. Would such a currency be inflationary or deflationary? One might assume deflationary, but it would depend on the composition of the basket of assets. One can also assume that such a currency would be more stable than if we were to use cryptocurrencies themselves. And this is absolutely crucial.

Conclusion

Most economists agree that moderate inflation is ideal for the medium of exchange. For the store of value, a gradual increase in value is the best. The value should grow very slowly, perhaps only a few percent a year, but ideally, it should not decline too much. There is no ideal world and we are looking for the best suitable solution. Cryptocurrencies can be a good store of value if we use their value for something useful. One of the most useful tools in the world is currency (a medium of exchange) because we all use it every day. Unless, or until, we are able to use cryptocurrencies directly, and we may not be able to, the best solution seems to be to use volatile cryptocurrencies as the underlying asset for the creation of a stablecoin whose value will depend on a carefully chosen basket of assets.

By linking the values of multiple cryptocurrencies together, we can gain greater stability, as the value of the coins will impact the economic activity of each ecosystem. In addition, the system will be more resilient to shocks. For example, if one entire ecosystem were to collapse. If that were to happen, economic activity would naturally spill over into another ecosystem. Relying on a single blockchain can be risky for the world. It makes sense to create stablecoins and use multiple cryptocurrencies as the underlying asset.

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