The gold standard. It dominated monetary theory for most of the 20th century before the United States formally abandoned it in 1971. Even today, however, gold remains in many people’s minds the backstop for world economies, even if that view simply isn’t accurate. You need to look no farther than the extremely popular Netflix series Money Heist to see the power gold still holds over popular imagination and countries’ financial institutions.

Gold has also traditionally acted as one of the primary hedges against inflation. Why? Because its value varies inversely with the value of the U.S. dollar. During strong inflationary periods, like the past year, the purchasing power of the dollar falls. The price of gold in dollars, in turn, increases, preserving the value of investments in gold. And this is why, throughout the years, gold has been a popular investment choice.

But gold’s power to defeat inflationary pressure may be as illusory as the gold-plated brass ingots in Money Heist. Other financial instruments may offer investors better overall protection while also generating consistent returns. 

Recently, attention has turned towards cryptocurrencies as an alternative inflationary hedge. However, cryptocurrencies have a long way to go before being generally accepted as an investment vehicle, much less a valid hedge against inflation.

Free Stock photos by Vecteezy

Why isn’t gold an effective hedge?

The general theory of gold holding value during periods of inflation is sound in isolation. But it has rarely proved true in the past half-century, largely because other forces are at play in the markets. 

Since the 1970s, gold simply hasn’t generated positive returns during periods of sustained inflation. In the 1980s, when there were two significant inflationary periods (1980-1984, 1988-1991), gold experienced large declines in value. And over the past year, when inflation reached rates not seen since the 1980s, gold again fell slightly.

So why do theory and practice diverge so drastically? Today’s environment provides a perfect object lesson. Every day there is another news story predicting that the Federal Reserve will raise interest rates several times this year to combat rising inflation. When rates rise, yield-bearing instruments become more valuable because the yields will typically increase with interest rates. As a result, gold, which generates no returns prior to sale, loses value compared to these other investments.

Why won’t crypto take gold’s place?

As cryptocurrencies increased in public popularity, often due to stories about the fortunes being made by early Bitcoin (BTC) investors, crypto entered the discussion as a potential alternative to gold for combating inflation. 

Initially, it looked as if 2021 would prove the case for crypto. In early 2021, inflation began to soar, going from 1.4% in January to 4.2% in April. Over the same period, Bitcoin was also rapidly increasing in price, reaching an all-time high above $63,000 by mid-April. 

But the rest of the year put the theory to the test. By July, inflation plateaued just below 5.5%. Bitcoin, however, plummeted during this time, losing more than half its value by mid-July. It then seemed to regain its footing, reaching another all-time high in early November as inflation pushed towards 7%.

As we moved into 2022, inflation continued its upward trek. But Bitcoin, and cryptocurrencies in general, fell precipitously. The market capitalization of the entire cryptocurrency market shed half a trillion dollars (over 20%) in January alone, spawning discussion of a “crypto winter.” It is this extreme volatility and unpredictability that makes cryptocurrency’s value as an inflationary hedge questionable at best.

There are other factors in addition to volatility that makes cryptocurrency much less attractive as a hedge than gold. Gold is a physical object with fixed reserves. While there may come a time when scientists find the alchemist’s stone that can efficiently and cost-effectively convert other elements into gold, that time is not yet here. And limited supply is a driver of value.

Bitcoin at least resembles gold in this respect. The Bitcoin protocol set 21 million BTC as the limit - no more can ever be minted. Nearly 19 million BTC already are in active circulation, a third of which have been lost. BTC investors need to understand how to use their options for storage of cryptocurrencies or are in long-term storage. And the limited supply has caused large increases in BTC prices.

Other cryptocurrencies, however, do not have limited supplies. And unlike the limited number of precious metals, new cryptocurrencies launch every day. Crypto market data provider CoinMarketCap currently tracks 17,296 cryptocurrencies and 4576 exchanges. The vast majority of cryptocurrencies have little or no value that can help position them as hedges.

Cryptocurrencies also seem to be far more vulnerable to reactionary price movements based on events that have nothing to do with their intrinsic value, particularly social media comments. The Robinhood/ GameStop/ Reddit scandal in 2021 proved that other investments like stocks are also susceptible to social media manipulation, but examples have been far less frequent than for crypto.

Meme coin DOGE is a perfect example. Created as a joke to poke fun at the popularity of Bitcoin, DOGE quickly became popular with crypto enthusiasts, not because of its value, but because of its message. Lately, it seems that DOGE relies almost exclusively on tweets from Elon Musk to generate value. In periods where DOGE does not rank highly in social media discussions, its value falls quickly, awaiting another Musk endorsement to drive prices back upward.

Without some better ties between price and value, crypto has limited utility as an inflationary hedge. There is little to no certainty that crypto prices will move inversely to inflation. Indeed, there is little to no correlation between crypto prices and inflation at all.

Another unique feature of the crypto markets that heightens their volatility is the effects of so-called crypto whales. These are investors who have vast holdings of any given cryptocurrency, and whose trades can significantly affect the market. Because of the size of their investments, they can intentionally manipulate prices.

This leads to another criticism of cryptocurrency, both generally and as an inflation hedge - the lack of regulation. Many critics suggest that until there is some degree of effective regulation of cryptocurrencies, they will continue to be an overly risky and volatile investment for most members of the public. Others, however, suggest that regulation will destroy the very heart of cryptocurrency, its decentralized nature, and thus its value.

Will cryptocurrency ever become an effective inflation hedge? It is certainly possible. Indeed, as cryptocurrencies mature and become regulated, it is even probable. But crypto’s very nature makes it unlikely that it will ever surpass gold.  

Conclusion

Cryptocurrency has led a very exciting, if short, life, quickly transitioning from an upstart alternative to traditional currencies to a popular investment for even large financial institutions and mainstream corporations. But it remains a product in its infancy, in transition. And until the markets develop effective ties between the value and price of cryptocurrencies, as well as correlations between the price of cryptocurrencies and overall consumer prices, gold will remain the instrument of choice to defeat inflation.