Ethereum's Deflationary Impact: What Investors Need to Know

The Ethereum Merge brought a raft of significant changes to the world's second-largest cryptocurrency. The biggest among these was a switch from the type of proof-of-work crypto mining mechanism pioneered by Bitcoin to a new proof-of-stake system that incentivizes holding Ethereum tokens.

Included within Ethereum's proof-of-stake system is a mechanism that means some ETH is destroyed every time a transaction is verified on the network. Bitcoin's proof-of-work protocol sees new bitcoins created and distributed to miners verifying transactions on the network, with the supply of circulating BTC increasing over time. The changes brought by the Ethereum Merge differentiate Ethereum further from Bitcoin by making it deflationary.

So what exactly does becoming a deflationary cryptocurrency mean for Ethereum? And why is this important?

Proof of Work vs Proof of Stake

Ethereum's switch to proof of stake after the Merge on September 15, 2022, marked a major change in the way Ethereum operates. When Ethereum was launched in 2015, Vitalik Buterin and others involved in its creation envisioned it as an advanced blockchain network that would allow more complex transactions than Bitcoin. Ethereum's introduction of smart contracts has made it possible for applications such as decentralized finance (DeFi) and non-fungible tokens (NFTs) to exist on its blockchain network. But under the hood, Ethereum operated in the same way as Bitcoin.

One of the fundamental issues that had to be solved for cryptocurrencies to exist was ensuring that transactions were recorded correctly across a blockchain network and that users could not send the same token twice. Bitcoin solved this problem with a proof-of-work consensus mechanism that incentivizes miners to verify transactions by rewarding them with newly created BTC.

Proof of work provided an elegant solution to validating transactions, but it also had unexpected environmental consequences. The computers used to mine bitcoin and other cryptocurrencies use large amounts of energy to solve complex equations. As cryptocurrencies have grown in popularity, their energy demands have also grown exponentially. Figures are regularly touted in the media that show Bitcoin mining requires more energy consumption than power supply for some countries.

Ethereum co-founder Vitalik Buterin has said this resulted in a 0.2% reduction in total global emissions, making it one of the largest decarbonization events in human history.

Proof of stake eliminates the mining mechanism and instead allows users to verify transactions by simply holding a sufficient amount of ETH. The switch to proof of stake immediately saw Ethereum's energy consumption fall by 99.988%. Ethereum co-founder Vitalik Buterin has said this resulted in a 0.2% reduction in total global emissions, making it one of the largest decarbonization events in human history.

Along with the environmental impact, the switch to proof of stake creates deflationary pressure in the flow of ETH. Because users are now incentivized to hold onto their Ethereum, the amount of Ethereum in circulation is almost certain to be reduced. On top of this, a small amount of ETH is burned every time gas fees are sent to those holding enough ETH to verify transactions. The result is an immensely more energy-efficient cryptocurrency that has become deflationary in nature.

Inflationary vs Deflationary Currencies

The Ethereum Merge on September 15, 2022, brought the main Ethereum blockchain network in sync with the parallel Beacon Chain, which had been trialing the proof-of-stake upgrade since 2020. Within a month, Ethereum creation had been reduced by 90% and more than 4,000 ETH had been destroyed. Ethereum had passed a milestone in becoming a deflationary cryptocurrency for the first time.

Ethereum's move to being deflationary after the Merge coincided with much global debate surrounding increasing inflation. US Bureau of Labor Statistics showed that inflation in the United States hit 9.1% in June 2022. Other major economies have seen similar, or even higher, levels of inflation in 2022.

Inflation simply means that the value of a currency is falling in relation to the goods or services it can buy. Bitcoin's whitepaper was published in 2009, while the world was still reeling from the fallout of the 2008 financial crash. In response to the crash, governments across the globe began printing money to shore up their economies. This tactic of quantitative easing has been returned to repeatedly in the years since 2008, further intensifying in response to the economic tumult caused by the fallout from COVID-19.

One of the most frequently cited arguments against quantitative easing is that increasing the volume of a currency in circulation directly leads to the devaluation of that currency. One of history's most extreme examples of this comes from Germany's Weimar Republic in the years after World War One. Mass printing of new banknotes had already brought the value of German Papiermarks from 4.2 to 7.9 marks per dollar as the First World War neared its conclusion. As the Weimar Republic increased the velocity of money printing to pay off steep reparations imposed on the country by the war's victors in the Treaty of Versailles, the value of the Papiermark collapsed. By December 1922, one US dollar was worth a staggering 17,000 marks. More recent examples of countries experiencing hyperinflation include Venezuela, Zimbabwe, and Argentina. In all cases, runaway inflation has had ruinous consequences for the country involved.

Deflation is a less common phenomenon, but it can also bring negative economic consequences. In the 1980s, Japan's economy was enjoying a major boom. By 1989, 32 of the world's 50 largest companies by market capitalization were Japanese. When the economic bubble surrounding the boom burst in 1991, decades of deflation followed. A fall in the value of goods saw consumers hold onto their money, knowing that goods would likely be cheaper in the future. This downturn in economic activity compounded spiraling deflation and saw Japan stagnate while other economies grew. Between 1995 and 2007, Japan's GDP dropped by close to $1 trillion while wages fell by around 5%. By 2018, Toyota was the only Japanese company that remained among the world's 50 largest companies.

Inflation essentially means that a currency is becoming less valuable; deflation means it is becoming more valuable. With the Ethereum Merge making the cryptocurrency deflationary, basic economic theory suggests that the value of Ethereum should rise.

The Effect on Ethereum's Value

Immediately following the Merge, Ethereum's value actually fell. In the month following the Merge on September 15, 2022, Ethereum fell from a high above $1,638 to a low below $1,218.

Of course, there are many other factors influencing Ethereum's value following the Merge. The wider crypto market had been in constant decline from the heights of late 2021, when Bitcoin peaked at close to $67,500 and Ethereum reached its all-time high above $4,810. The wider macroeconomic climate at the time of the Ethereum Merge may also have played a part amid the economic chaos of rising inflation, falling stock markets, surging energy prices, and other turmoil related to the aftermath of the COVID-19 pandemic and fallout from Russia's invasion of Ukraine.

Ethereum dropped to a low below $2,000 in June 2021 but rebounded strongly in the run-up to the Merge, hitting close to $1,982 on August 15, 2022. The Ethereum Merge had been talked about for years before it became a reality, and those in the crypto space were well aware of the transition's timing. A fall in the US Dollar value of ETH value after the Ethereum Merge could simply be a classic example of the old investing truism "buy the rumor, sell the news." Deflationary pressures on the supply of ETH would be expected by many to lead to a longer-term rise in its price.

There are other issues that will play a part in Ethereum's future trajectory. Gas prices charged for transactions broadcast on the network remained stubbornly high following the Merge. Decrypt reported that Ethereum gas prices spiked by 218% a month after the Merge. Higher gas prices mean it's more costly to carry out activity on the Ethereum network, potentially leading to less activity and less demand for ETH.

However, Ethereum's move to become deflationary following the Merge has set it on an opposite trajectory to the narrative of rising inflation surrounding the discussion of the wider economy. Many who have staked ETH after the Merge will be hoping it proves a sound economic move amid the wider post-pandemic turmoil.