Crypto Explained

Does Ethereum have an Inflation problem?

January 11, 2021
With the recent highs seen in the price of Ether (ETH), market validation of the smart-contract blockchain platform is strong. But as the price has risen, so has the question of ‘inflation’ on the platform.

Co-founder and CEO of Block.One Brendan Blumer took to Twitter to share some thought-provoking insights, claiming that for the ETH asset to maintain current prices, a substantial $9 billion of new capital would be needed on an annual basis to maintain the Ethereum network. This would make ETH inflation "on average much higher inflation than the USD" at 26,000 ETH per day.

Rising Ethereum Price

The Ethereum blockchain is powered by ETH. This can be used for several purposes such as to pay for computational services on the blockchain or transact and trade on a cryptocurrency exchange. Like all assets, ETH is affected by multiple macro and micro factors that shape market sentiment. 

The ETH price has been on a tear lately with the second-largest cryptocurrency by market cap blasting through $1,000, looking to test its 2018 all-time-high of $1,448, and posting staggering yearly gains of more than 745%.

There are several reasons for this run on ETH beyond the obvious spillover from rising institutional interest in Bitcoin trickling into other digital assets. The Ethereum network is not just a frontrunner in brand recognition after Bitcoin, it’s also made a name for itself as the platform of choice for many cryptocurrency projects and decentralized applications (dApps) to build on, as well as being the driving force behind the explosion of decentralized finance (DeFi) last year. 

Moreover, Ethereum has committed to transforming its energy-intensive Proof of Work consensus model to a more sustainable Proof of Stake system that is environmentally friendly and will allow the blockchain to scale. With the advent of DeFi and the move to ETH 2.0, Ethereum fundamentals are certainly looking bullish.

However, as Blumer points out, a rising Ethereum price is potentially an issue. 

Increasing Gas Prices

The increase in both on-chain activity and off-chain hype that positively influences the ETH price, also increases gas price inflation. This can have crippling effects on users of the network. Without getting too deep in the weeds, gas is used on Ethereum to pay for transaction fees and the computational resources required to execute a required action (such as run decentralized apps or smart contracts). 

This greatly impacts developers on the Ethereum blockchain as well as those who want to send simple transactions in ETH because they have to pay a gas fee (denominated in a unit called gwei). Users of the network can decide on the amount of gas that they pay per transaction. However, since it is the miners who decide which transactions to process first; if a user selects a lower gas fee, his or her transaction will take longer to process – and might not get processed at all. 

High gas prices result in skyrocketing transaction fees pricing some participants out of the market. They also lead to network congestion. In fact, Ethereum was first thrust into the mainstream limelight during the ICO boom of 2017-2018 when a popular collectible feline dApp CryptoKitties almost brought the network to a standstill. It simply could not keep pace with the high demand for provably scarce ERC-20-compatible digital kittens, resulting in high latency and high gas price inflation.

Pricing Out Experimentation

In 2020 and beyond with the acceleration of DeFi, Ethereum gas fees have hit new all-time-highs. In fact, as of September 2020, Ethereum gas prices had risen more than 20x from the start of the year. This may not be enough to dissuade investors chasing massive yields on DeFi protocols; but for many users attempting to maintain a sustainable decentralized application, gas fees have become prohibitively high.

Many businesses have been forced to shutter, including UniLogin, which started two years ago with a vision for a Universal Login standard for Ethereum. In a touching Medium post that begins "Unilogin is out of gas," its lead developer goes on to explain that because of the rise in DeFi and the state of the Ethereum gas market, the company simply couldn't "see a way forward." It had reached the point where Unilogin was paying as much as $130 to onboard new users. 

Another project to suffer the costs of rising gas prices is Publish0x, a platform that compensates writers in ETH. It announced in September 2020 that it had to delay payments for a week and even switch to a monthly payment model to avoid extortionate gas fees. While DeFi has been the overriding narrative of 2020, innovation in other areas has suffered the cost.

ETH Inflation Rate

The issue of inflation with Ethereum has come under scrutiny. Unlike Bitcoin, which has a capped supply of 21 million, ETH does not have an overall cap. Its rate of issuance was determined in its 2014 pre-sale in which some 60 million ETH were created for sale, 12 million ETH were designated to a development fund, and the annual issuance was capped at a rate of 12 million ETH per year.  

As pointed out in this detailed article here, that's approximately one-quarter of its initial supply every year (25%). On the surface, this inflation rate may appear high, but in fact, USD inflation is still higher, particularly this year in which the USD supply has increased by about 33% – around 20% of that in the first seven months. 

There are also several other factors to consider about ETH inflation – not least the built-in reduced size in block rewards for miners. This is an effort to reduce ETH inflation in terms of basic supply and demand – just as BTC halves its block reward every four years. 

While the total supply of Ether does not have an established limit, reducing the inflation rate is an essential tool to ensure scarcity. In fact, if you study the long-term trajectory of ETH projects, you can see that Ethereum was designed to decrease ETH inflation over the long term. With a capped annual issuance, inflation decreases every year.

As one Twitter commenter pointed out, with ETH, the annual inflation per year will eventually trend to zero. This is graphically represented in the below chart taken from the Ethereum whitepaper.

IN addition, not all ETH that is mined is sold by miners since many of them HODL them out of circulation. Many more tokens are permanently lost due to various reasons, from security breaches to human error, or even death. 

Solutions to ETH Inflation

All these valid arguments for increasing ETH scarcity and ETH inflation trending to zero in the long-term do little though to help those struggling dApps on the network today. Yet this problem has not gone unnoticed by the Ethereum community. With the transition to Proof of Stake allowing for greater performance and reduced gas fees, this problem will eventually be circumvented.  

According to CoinDesk, the transition to ETH 2.0’s staking mechanism is set to reduce the inflation rate of ETH to 0.5%-2.0%. This would place it "in the same company as BTC and gold in terms of supply inflation."

Moreover, Ethereum continues to discuss the implementation of a proposal in the meantime that would tackle the issue and make its network sustainable to all users, called the EIP 1559 change

Among its advantages comes a solution to increase transaction speed, lower prices, and burn a portion of ether with every transaction. This would add scarcity to the crypto asset and eventually make ETH a deflationary cryptocurrency.

ETH inflation may be pricing out experimentation in some areas today, however, looking at the long-term picture, there is a sustainable path ahead. 

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