Crypto-Currency Inflation

More than Quantity

By Steven J. Grisafi, PhD.

Progress in any science makes great strides whenever instances of theoretical concepts can be found in actual practice. The phenomenon of the liquidity trap occurring within macroeconomic systems, whenever interest rates fall upon their lower limit of zero, is characterized by an inflation rate so deficient such that theory predicts it would be necessary to set interest rates below zero so as to hope to spur greater economic activity. While a central bank can seek to lower interest rates in the hope that cheaper capital may spur greater activity within an economy, it is the interaction of the inflation rate of the currency with the interest rate on capital that causes the phenomenon of a liquidity trap. No mere setting of an interest rate causes a liquidity trap. This complication of the interplay between saving and investment has some features that can been seen at work within the crypto-currency markets.

I have explained that there exists two distinct monetary systems operating with the crypto-currency phenomenon: the Proof of Work system initiated by the Bitcoin and the Proof of Stake system initiated by the Peercoin. In most Proof of Work systems a limit is placed upon the number of coins to be created. In most Proof of Stake systems there is no such limit placed and coin developers speak of an inflation rate as the rate of increase in the number of coins to be created in the process known as minting. Having pondered such remarks I have concluded than the growth rate of the money supply for such Proof of Stake crypto-currencies is not equivalent to the inflation rate experienced with sovereign currencies. The distinction lies within the population that use the currencies. The people of a nation-state that issues a sovereign currency are the population that must use that particular currency. Their growth rate has some effect upon the inflation rate of their currency because every individual has needs and must utilize currency to satisfy those needs. Hence the inflation rate of their currency is only greater than zero when the growth rate of the money supply for their currency exceeds the population growth rate. As the population of a people increases their money supply must also increase or their currency would grow more dear. For any crypto-currency there is no such fixed population that is compelled by law to use the coin so mere growth of the money supply of the coins is no indication of any changing value for the currency.

The Proof of Stake monetary system encourages hoarding because the more coins one has the greater the chances one has of obtaining new coins through the process of minting. The Proof of Stake process of minting new coins does not require any special computer hardware and can be undertaken by any computer user who owns some coins. Consequently, any such interested person is encouraged to buy an initial supply of coins and to keep them unspent with the hope of creating more. While most Proof of Work crypto-currencies have an upper limit upon the number of coins that will be obtained, through the process known as mining, some do not. The most conspicuous example is the Dogecoin. The developers of the Dogecoin have announced that there will be no limit to the supply of Dogecoins created. Regardless of how difficult it may be to create them, knowing that the supply of Dogecoins will grow without bound ought to have ramifications upon the willingness of users to buy and use Dogecoins. Having spent much time trading on the crypto-coin exchanges I can report that this news has not discouraged the use of the Dogecoin. It has enhanced its use.

Within the crypto-coin exchanges there are to be seen several theoretical concepts operating in practice. When first approaching a crypto-coin exchange one ought ponder: Why does anyone buy or sell these coins? For the active traders within these currency exchanges it may sometimes be the vain hope of accruing capital gains. However, for some it may be trading Proof of Work coins for Proof of Stake coins that are then to be hoarded. All of the three primary exchange coins, the Bitcoin, the Litecoin, and the Dogecoin are Proof of Work coins and bear no interest if held unspent within a wallet. Thus, one should expect to see within the coin exchanges the trading of Proof of Work coins for the acquiring of Proof of Stake coins. To some extent, from my experience, this is what I have seen. Yet, there are some curious anomalies also to be found. For example, the Pandacoin is a Proof of Stake coin. There are approximately thirty-two billion Pandacoins currently in existence. There are currently approximately ninety-seven billion Dogecoins in circulation. One might think that with three times as many Dogecoins in circulation that the Pandacoin would be valued more highly than the Dogecoin. But the Dogecoin has a value of sixteen Pandacoins. This curiosity is to be explained by the fact that the Dogecoin often serves as the vehicle of exchange on several currency exchanges while the Pandacoin, being a Proof of Stake coin, is often bought just to be hoarded.

The lesson to be learned upon the crypto-coin exchanges is that the quantity of money alone is no measure of the value of a currency. Proof of Work coins bear a higher frequency of trading, hence the velocity of their money supply is much greater than that of the Proof of Stake coins. Although the Proof of Stake coins bear interest, while the Proof of Work coins do not, their decreased money flow resulting from hoarding hurts their value ratings. All in all, one can say that a monetary system comprised of both Proof of Work coins and Proof of Stake coins works best because the Proof of Work coins operate as the media of exchange and the Proof of Stake coins operate as the media of investment.