Banks create currency. Central banks print it, or commercial banks type it into our economy. It isn't backed by any physical commodity. It's backed by faith. Faith of credit on the economy.
Creating currency also causes inflation. No matter whether it's the US Dollar, Bitcoin, or Japanese Yen. Consider an example with the imaginary currency, ExampleCoin (EC):
- There are 10,000 EC's, they are worth $1 each. In total, EC's are worth $10,000.
- The central bank print's 10,000 more EC's.
- EC's are still worth $10,000 in total. But now each EC is worth $0.50.
- Each EC coin has gone being worth $1, to $0.50. The EC currency has inflated by 100%.
There is a misconception that cryptocurrencies are deflationary. This is not exactly true. It depends on time horizons. Most cryptocurrencies have a cap. So, once they reach their cap, they will be deflationary. However, whilst new coins continue to be 'minted', they are in inflation.
The cryptocurrency cap is a selling point to the community. There is no one who can create money out of thin air. This anti-inflation sentiment is understandable. Especially given the failures of our monetary system. But, having a currency cap also creates problems. A deflationary currency is a disincentive to spend. It's unlikely you'll have a vibrant economy, when currency-holders gain by saving.
Inflation is not a bad thing. It can stimulate an economy. It's my opinion that cryptocurrency's have a better inflation mechanism than normal currencies. This is down to two key differences. The first is interest. The second is decision-making power.
In our everyday economy, central and commercial banks create money. This is fine. What they then do with the money is not.
Banks use new money to buy or create debt. Central banks buy government or corporate bonds. Commercial banks hand out loans.
These debt vehicles contain two components: principle and interest. Principle is the original amount lent. Interest is extra money promised to be paid back to the lender.
Reflecting on this, new money funds people who promise to pay back more than the original amount. So, there is always more debt in our economy then there is money.
In finance, this is concealed by the use of discount rates. A discount rate is a percentage determined by a risk free rate, expected inflation rate premium, and a risk premium of an investment. Investors use it to work out the present value of future interest payments.
Interest rates create pressure to make money. No one wants to default on a loan. But it's a vicious cycle, because it's never ending. By design, this is unsustainable. Our level of national debt, and size of corporate debt is proof of this.
Cryptocurrencies have a significant advantage in that there is no interest. But, to be a superior form of currency, cryptocurrencies need to work on how they spend the inflation.
Most crypto-currencies use the new coins to reward miners. This is great, until you consider it from the perspective of intrinsic value.
A currency grows in value if the amount of inflation is less than the amount of value created with the new money. With mining alone, I do not think this is possible. Returning to the EC coin example:
- There are 10,000 EC coins, worth $10,000 in total
- The network creates 1000 extra EC. A miner receives the 1000 EC for solving the Proof-of-Work algorithm. The blockchain continues.
- Now there are 11,000 EC coins in total.
Does the miner's role in sustaining the network mean the 11,000 EC coins are worth $11,000? Long term, the answer is no.
Yet, other cryptocurrencies are offering superior models. They can do more with inflation. Cryptocurrencies such as Dash have an advantage here. This is due to their masternode network and treasury.
In these currencies, the community presents a proposal to improve the network. They state a project description, and the amount of financing required. Proposals range from back-end development, to marketing ideas. Following a proposal, masternodes vote yes, or no, or abstain. If the proposal passes, the project receives funding from the inflation. You can see Dash's for yourself here, https://dashvotetracker.com/.
To recap, the key differences between crypto-currencies and normal currencies are two-fold. First, there is no interest associated with inflationary money. Second, the community decides where the money goes.
The incentive schemes also work differently. In our economy, bond and loan receivers face pressure to repay. They must pay principle, plus interest. If a project goes askew, they go bust. Under certain conditions, they lose assets such as their house. In the crypto-world, if a project does not deliver on it's promise, the funding gets withdrawn. The community monitors projects and withdraws funding should they see no added value.
So, cryptocurrencies with masternodes networks can grow in value from inflation alone. Returning to the EC coin example again:
- You have 10,000 EC coins, worth £10,000 in total
- Each EC coin is worth £1 each.
- The network creates an extra 1000 EC coins
- The miners receive 200 EC. The masternodes receive 100 EC. A developer receives 700 EC to speed up the transaction network.
Now, is the network worth more than $11,000? It could quite well be.
Long term, this form of financing is healthier and more sustainable. Far more than how our economy currently works.