December, 2017

Cryptocurrency and central banking

Gold stored at the Federal Reserve Bank of New York.

Several people have questioned my criticism of cryptocurrency especially in the face of the Bitcoin’s recent run up and pull back. I am not ordained, consecrated, or even dedicated to money matters and my opinions are just that—opinions. So don’t take any of what follows as investment advice.

Cryptocurrencies lack two things that enable them to provide the vital services to modern economies—something of value backing them up and central banking to regulate them. We can debate the first point though recent wild valuation swings substantiate the value question.

Central banking is shrouded in mystery largely because most people can lead their lives oblivious to what central banks do to safeguard the4 global economy. Ironically, it seems that the rules and regulations put in place by central banks to provide stability are the ones disputed by advocates of cryptocurrency who see them as needless impediments to commerce rather than the defenses they are.

So the central question about cryptocurrencies revolves around central banking and an important additional question follows: Why do we need to reinvent the currency-central banking wheel? A question for later, and for a broader audience, is how can we further evolve the current central banking paradigm to address the needs that cryptocurrencies seem to expose? Central banking has evolved over hundreds of years and it can still evolve more given logical needs.

Central bank functions

First, let’s get some terms right. Cryptocurrencies such as Bitcoin have been described as a value store as well as a currency. Many people describe it as a better alternative than conventional currencies sponsored by governments because BTC has no regulations to clog up commerce and it therefore reduces economic friction and makes for more efficient business. That efficiency often comes from not having structures that manage the money supply, functions that evolved from hard experience in economic crashes over centuries.

So for any cryptocurrency to succeed their advocates must be engaged—consciously or not—in developing a central bank that will compete with other central banks such as the US Federal Reserve, the Bank of England, or the European Central Bank.

A central bank issues banknotes and controls interest and exchange rates thereby managing the money supply and maintaining the value of money in circulation. If a central bank issues too many notes thereby creating money, the result can be inflation because the value of each note represents a smaller amount of value. For example, paper money backed by gold or some other precious metal represents a call on a specific amount of metal. Increasing the amount of paper money in circulation without increasing the amount of precious metal means each note represents a smaller amount of value. The problem is the same for currencies not backed by metals as we’ll see.

A central bank also manages interest rates and has a monopoly on increasing the monetary base. Without such a monopoly anyone could flood the market with bank notes whose value would be close to nothing. Central banks are also the lenders of last resort able to maintain liquidity during a financial crisis when other lenders stop lending or raise interest rates to prohibitive levels or when buyers stop making purchases. In both cases, economic activity slows and a recession ensues.

Bitcoin and its miners, dealers, and brokers are not a central bank and lack many of the attributes of a central bank on which modern finance is based. Lacking a central bank function, cryptocurrencies act more like stocks. In an ICO (initial coin offering) cryptocurrencies’ promoters are attempting to have the advantages of a currency without providing a central bank’s key functions. So the markets treat cryptocurrencies as securities whose value is extrinsic and subject to the whims of the marketplace.

Value store

Money is generally considered a store of value. They are fungible, able to be easily converted from one thing of value to another. They enable people to take the fruits of their labor to the marketplace where they can acquire goods and services without the hassle of bartering a dozen eggs for a quart of milk, for instance. Exchange media can vary according to the tastes of the users. For example, in New France, in the 17^th century, now part of Canada, a beaver pelt was an accepted medium of exchange. Money can also be saved for future use, something that eggs or milk or pelts are not good for. Milk and eggs can spoil and money can still lose value due to inflation.

Money is able to supply this service because there is something “behind it” some form of tangible or intrinsic value. Critics will note that the money circulated by central banks today is fiat money meaning it has no value other than what is assigned to it. But while it is true that value is assigned, the assignment is not arbitrary.

Money was initially made out of a valuable thing, a commodity such as gold or silver. This is also called commodity money because the money is made of a valuable commodity. It evolved into a system with artificial placeholders, such as paper money, to represent the precious commodity and early on, you could exchange your paper money for the commodity, hence it was also called representative money.

In 1971, Richard Nixon decoupled the US Dollar from the gold standard—the ability to get real gold for your paper money—and thereafter the value of the dollar has floated on the markets as a fiat currency having a value assigned to it by a government. Other nations followed suit so that today the paper money in circulation is largely not backed by precious metal.

But that’s not to say that all of our money is without value. The US dollar is backed by “the full faith and credit” of the United States. This means, among other things, the ability to tax the citizenry to collect value with which to pay government debts. We should pause here to understand that money is a government creation used to pay government debts. We use money in the same way but as an after thought.

This government use of money necessarily puts a limit on the amount of money that any government can simply print, which brings us back to the importance of managing the money supply. The assurance of value management is enough to convince most people that a US dollar has intrinsic value and is a suitable means of value exchange.

In contrast, Monopoly money from the popular board game is a pure fiat money, its value is set by whatever the game players believe it to be though you can’t buy a cup of coffee in the real world with it.

So the question about cryptocurrency is what value does a currency represent? There are two answers. First, cryptocurrency represents the cost and effort that goes into mining it—intrinsic value. Second, cryptocurrency represents the value that traders are willing to assign to it when they buy and sell it—extrinsic value.

Mining value

There are costs associated with making a cryptocurrency but mining begs the question of why one would mine it at all instead of simply working with existing currencies? In the real world of tangible assets like buildings, (and this is not to slight cryptocurrency mining) constructing a building involves real costs that include land, materials, labor, design and a lot more. When the building is complete its value often exceeds the construction costs because tenants or buyers see intrinsic value in having the asset in the precise location and being able to use it for commerce or living.

The building has intrinsic value principally because other people see ways to profit from owning it or renting space there and they bid for access. A cryptocurrency has a small amount of intrinsic value as well but a lot of extrinsic value assigned by the marketplace by people who believe they can sell it for more than they paid for it.

Neither cryptocurrency nor a building are perfect stores of value. A building is only as valuable as what a buyer is willing to spend to acquire all or part of it. The same is true of cryptocurrency. Neither is terribly liquid or able to be exchanged for other value quickly though cryptocurrency exchanges are coming on stream.

A prospective buyer can purchase a building, but usually only after a good deal of diligence to determine its value. Value can be manipulated. It is therefore in the interest of the seller to control the flow of information to the buyer highlighting the building’s assets and downplaying its liabilities. For example the location may be an asset while the heating system might be getting old and in need of replacement.

When one party to an exchange can withhold or obfuscate information, the market is said to be inefficient. The opposite of an inefficient market is one with a high degree of transparency. So for instance, a regulation that requires a building owner to disclose the condition of its heating system would be said to promote transparency. Such a regulation would help to reduce transactional friction and aid in setting a fair price for the building.

Building owners might chafe at such “regulations” as interference with the free market but what they essentially oppose is the loss of ability to manipulate information for their own good. The Romans understood this and “Caveat Emptor” or “Let the buyer beware” stems from all of this.

Cryptocurrencies use blockchain or distributed ledger technology to assist in providing transparency for trading. Blockchain is highly useful in this regard but proponents of blockchain often forget that the ledger system does not add any value to the underlying currency whose value is specious. Worse, there are documented instances of hacking cryptocurrencies resulting in the loss, for the owner, of all value. An important function of central banks is to safeguard the integrity of a currency and to secure deposits. Without those safeguards markets could not operate and economic activity would slow considerably. When activity slows an economy goes into recession; how severe the recession is determined by how deftly central banks do their jobs. Without a central bank in the middle, all bets are off.

Macro stuff

Currency is used to operate an economy and there are conditions that cause an economy to operate more or less well. When economic efficiency is threatened, it’s the job of central banks to make things work again.

As we’ve seen, inflation occurs when there is an imbalance in the supply of circulating currency and the amount of goods available. Too many dollars in the hands of the public chasing too few goods and services results in bidding up the price of those goods and that’s inflation. A certain amount of inflation is good. Most of the world operates on the expectation of 2 percent inflation, which is mildly stimulative.

Recession happens when there are too many goods available and insufficient demand represented by owners of currency deciding not to use it in transactions. This is a form of hoarding different from savings. When an individual saves money in a bank for instance, the bank lends the money at interest to others who wish to buy or build and therefore spend it and stimulate the economy. In a recession, lenders raise interest rates making it harder for borrowers because repayment terms are higher, so economic activity slows.

So far, cryptocurrencies lack any macroeconomic structures for managing things like inflation and recession and on exchanges they behave much like stocks. As we’ve seen in many mergers and acquisitions company stock can be used in part or in lieu of cash to enable the transaction provided both sides agree on the value represented by the stocks. But as an everyday currency that one might use to purchase groceries or pay a utility bill, cryptocurrencies are still way behind the curve.

What happens in a recession when interest rates are cut to near zero as was the case over the last ten years post recession, could happen in cryptocurrency. With interest rates at or near zero if consumers refused to spend their money or use it to pay down debt rather than make new purchases, a recession would persist. That’s called a liquidity trap. When a liquidity trap threatened the US economy, in the last recession, the Federal Reserve stepped in with quantitative easing to purchase assets, which effectively increase the money supply when consumers and corporations can’t or won’t use the money in their hands. Cryptocurrencies have no such mechanism or central bank to operate it.

Why cryptocurrency?

So we come back to the core question, why would anyone decide to use a cryptocurrency instead of a conventional currency? Certainly there is the allure of significant and rapid price increases but that’s an attribute of a security not a currency. Sudden and rapid declines are also part of securities as well as cryptocurrency as we have seen. But high volatility is not desirable in a currency which is supposed to be a store of value.

What’s missing from the cryptocurrency boom is any form of a central banking function. Some people have estimated there are more than one thousand cryptocurrencies and most of them are convertible into US dollars or other established currencies. But this only begs the question of why have cryptocurrencies at all? Convertibility into standard currencies does not convey any protection against inflation in the currency, for example, or recession in the broader economy dependent on the currency. On the other hand, credit cards represent the purchasing power of conventional currency and offer benefits like increased fluidity suggested as an asset of cryptocurrencies and interoperability in regions denominated by other currencies. It would seem that “plastic” already supplies the benefits sought by cryptocurrencies while enabling use of central banking’s real advantages.

My 2 bits: Disintegration of the nation-state?

There are several attributes or functions that a nation-state provides its citizens and in so doing define a state. Nation-states provide security to citizens by preventing as much as possible random violence against them and providing a judicial system capable of administering justice evenly and fairly. This enables private property to exist, which, according to the late economist Angus Maddison, is a prerequisite for modern democracy. Maddison’s other requisites include transparent markets, acceptance of scientific rationalism, and good communications in both information transmission and transportation infrastructures.

Promoting a currency that is safe, liquid, and not given to huge swings in value is also essential to most of Maddison’s four pillars. A nation-state that can’t help its citizens preserve their wealth and provide for other security needs offers little to the individual. Rich individuals and corporations can circumvent some of the problems of security by arming themselves including hiring small armies to secure their persons. But the natural outcome of this self-arming is chaos because private armies look out only for what their employer wants. The result can easily become tribal warfare. We tried this once and the result was the Middle Ages.

The rise of cryptocurrencies parallels the rise of multi-national corporations, stateless warriors sowing chaos and terrorism, and its backlash is nationalism and tribalism. We are not yet at a doomsday point where civilization is collapsing, but there are many worrying signs that the norms and standards that shaped our international systems are beginning to wobble. Those systems were instituted as needed in simpler times and our international order grew up around them. That’s why destabilizing them is a concern. The international order can’t simply or easily revert to earlier times when kings and the rich could issue currencies any more than we can postulate the city-state or benevolent despotism as ideal forms of government.

Cryptocurrencies are a big deal because they upend the existing economic and financial order without necessarily replacing it with anything that improves on that order. In fact, absent a central banking system to help economies ride out inevitable rough spots and upheavals, cryptocurrencies pose a significant danger to the world economic system and ought to be avoided.