We’re seeing first hand why inflation is a destructive force. It erodes the buying power of the dollars you have, effectively acting like an invisible tax. And as many crypto and tech investors are experiencing, also takes a wrecking ball to risk assets.
When inflation goes up, interest rates usually go up as well. Higher rates mean a higher discount rate in the valuation of an asset; if an asset’s cashflows are expected to come mostly in the future, increasing that discount rate reduces the present values of those cashflows substantially. High-growth tech and crypto are not being valued off what they earn now, but what they will earn eventually.
So inflation hurts the dollars in your pocket because they can’t buy as much, and destroys the tech and crypto assets in your portfolio by taking a sledge hammer to their valuations.
But why can deflation be just as bad?
Deflation has less of a negative consumer impact, however can be considerably more destructive to economic activity because of what it does to credit and labor markets. With inflation, costs can be passed to consumers or margins compressed for the seller. With deflation, debt burdens can destroy companies and slows spending, here’s how
1. Prices fall, and the value of the currency increases. These seem like positives, but they’re actually a major spending deterrent. In an economy, my spending is your income; and in one like the US that is highly dependent on consumer spending, this presents a major growth slowdown. Holding cash turns into an actual investment. Couple that with prices of goods and services declining and it’s likely you’ll delay a lot of spending you’d otherwise do.
2. It crushes credit markets. With inflation, those with higher debt actually benefit; every year that debt is inflated away, reducing your repayment burden. It’s exactly the opposite with deflation, as your debt load actually gets more expensive via having to earn and repay dollars that are increasingly more valuable. This increases the likelihood of defaults and makes debt more expensive to come by. This also makes borrowers less likely to seek out loans, which is how a majority of economic activity occurs. So you have debtors being burdened by more expensive servicing costs, and borrowers deterred by all of this. People default more and borrow less: a recipe for a growth implosion.
3. Wages and employment take a hit. If your dollars are worth more, it stands to reason your nominal pay should decline a bit to represent that deflation right? I’m sure you’d say your income certainly deserves to go up during inflation, so the inverse applies here too. However it doesn’t happen this way.
Employers tend not to lower the pay of employees, they simply fire batches of them to bring down collective costs. A concept referred to as Downward Nominal Wage Rigidity explains this phenomena. Because employers are reluctant to reduce nominal wages, they opt for layoffs to reduce expenses.
It would make more sense to simply give nominal pay decreases (that still have the same purchasing power) however the human component gets in the way here. We tend to get indignant at the prospect of a pay decrease, and doing this may cause higher value workers to quit. So to avoid this messiness, the workforce is reduced.
Deflation means the currency becomes a real investment just by holding it, debtors default at a higher rate, borrowers avoid economic investment, and people get laid off. Inflation and deflation are two different sides of the same unpleasant economic coin.
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