There has been recent talk about Bitcoin and other cryptocurrencies gaining mainstream attention. Crypto enthusiasts claim that cryptocurrency could possibly replace the US dollar or even central banking as a whole. Although the creation of cryptocurrencies like Bitcoin can potentially change the way we transact and make payments, it is far away from mainstream use.
Bloggers, thought leaders, and other crypto enthusiasts are quick to point out how Bitcoin will be the future of global currency but they fail to mention that many structural hurdles exist which prevent Bitcoin from being anything other than a glorified PayPal.
This article will detail the reasons why cryptocurrencies like Bitcoin will not replace central banking, the U.S. dollar, or other centralized currencies. Fair warning, this article gets deep into the details and is a bit long for the casual reader. Although it’s trendy to post quick articles about how Bitcoin will take over the world or come to its ultimate demise there is a serious lack of content that details exactly how this will happen.
Why Bitcoin Won’t Replace Central Banking
Bitcoin advocates are quick to exclaim that Bitcoin will end central banking as we know it. No longer will you need to use centralized institutions to buy, sell, or exchange goods. You can simply click a few buttons on your smartphone and presto!
One example I heard from a FinTech blogger was how Bitcoin will make it dramatically easier to make major purchases like buying a car. They explained that the current way of buying a car involves going through several banks to find a loan and then negotiating with a dealer to make the ultimate purchase. This process is tedious and involves way too much paperwork and ruins the entire buying process. With Bitcoin, this blogger explained, you will no longer have to go through a bank to purchase a car – you can simply use Bitcoin, hit some buttons on your smartphone, and then grab the keys.
But wait, how can you buy a car with Bitcoin if you needed a bank loan to begin with? Bitcoin is impractical as a medium of exchange because it lacks the backing of financial institutions. How can Bitcoin replace centralized institutions if the everyday consumer can’t borrow Bitcoin to make major purchases like buying a car or purchasing their first home?
Simple solution, one might say – just don’t incur debt, don’t buy a car, and don’t buy a house. Obviously this would be devastating for the economy when most businesses and individuals rely on debt financing to stay afloat.
“Ok I got the answer, we make a system where individuals can transfer money to their Bitcoin savings accounts and other businesses and individuals can tap into these funds and pay interest. Win win right?”
But how is this possible without a centralized institution checking the credit worthiness of borrowers? Who is going to decide what interest rate to charge and what the maximum principal should be on the loan? What about debt covenants, capital requirements, and other measures to ensure timely payments are made? What happens when everyone decides they need their savings but there isn’t enough Bitcoin in the system? Cue this clip from “It’s a Wonderful Life.”
History of Central Banking
To fully understand why centralized institutions are so important for the widespread use of currencies we need to look back in history. Although the concept of banking dates back over thousands of years, the banking system as we know it today has its origins in Sweden during the late 1500’s and early 1600’s.
During this period Sweden gained prominence over other European countries through a heavy reliance on fishing, and iron and copper mining. In order for a flexible and vibrant commercial sector to exist, the Swedish government needed to establish a medium of exchange beyond the traditional barter system. In 1534 Sweden made the first step towards this goal by minting the first daler, the pronunciation of which should sound familiar.
Even though the daler had been minted, Swedes were having difficulty circulating the currency into the hands of those who wanted them. For this reason, the Swedes needed an institution that would act as an intermediary by storing, distributing, and loaning money. By the early 1600’s the Swedes had borrowed the Italian word banca and made it into the Swedish word bank. Although they had the concept of a central banking system, one did not formally exist until years later (Irwin 2013).
One of the World’s First Centralized Bank
The creation of the banking system in Sweden during the mid 1600’s can be attributed to Johan Palmstruch, a Latvian born, Dutch raised, Swedish banker; the destruction of the banking system and the subsequent collapse of Swedish economy is his responsibility to bear as well.
To begin, there were two major issues with currency circulation in the Swedish economy before the creation of a centralized banking system. Firstly, the daler was minted using copper and thus its value was subject to fluctuations irrelevant to the actual worth of the currency. Since the metal itself can be used for other purposes besides the exchange of goods or services, the value of the metal itself gives rise to deviations in the actual worth of the stated currency.
For example, if the copper coin had a printed value of 10 dalers but the actual worth of the copper was 11 dalers then the copper could just be melted down and sold for 11 dalers worth of goods or services. Conversely, if the printed value of the coin was 10 dalers but the value of the copper was 9 dalers then sellers would be hesitant to accept the currency as a means of exchange since it held less value. This deviation would ultimately be accounted for through changes in prices in the market leading to either inflation or deflation.
Secondly, in regards to practicality, “a ten-daler plate, the most common unit of currency, measured about twelve by twenty-four inches and weighed more than forty-three pounds. It was enough to buy sixty-six pounds of butter or thirty-three days of work from an unskilled laborer” (Irwin 2013). The actual weight and size of the daler was an actual impediment to commerce, therefore, a new system would have to be put in place.
The solution to the two problems that faced the currency was simple; create an institution that would hold the copper daler in exchange for paper notes. The paper note was in essence a receipt that would allow the holder to lay claim on a specified value of copper daler. Therefore, the holder would be able to exchange the paper notes for goods and services as if they were copper daler themselves.
History of Lending
Although this served as a financial innovation that would boost commerce, banks still lacked one important facet that is common among modern banks: practical lending practices. Bank officials and shareholders in the bank would come to realize that the reserves of daler on hand could be easily converted into loans. As long as all the depositors didn’t exchange their notes for copper daler all at once, the bank could theoretically issue more notes than actual copper daler on hand; this concept is known as fractional reserve banking.
The bank began lending money to businesses and merchants who would finance inventories and business investments. Living standards improved significantly for both the merchant and noble class and commerce expanded significantly (Irwin 2013). As we will see, the system worked for a while but it would face difficulty.
Since the value of paper money is not derived from the material on which it is printed, the value is then derived from the institution that prints said monies. Untimely, paper money holds value because the public has confidence in the institution that stands behind it. The currency can be given additional credibility by Governments if the currency is considered a valid means by which levied taxes may be paid.
As use of the currency spread to other financial centers and demand for the daler increased, the supply of paper currency in circulation dramatically increased in comparison to actual amount of copper daler in the economy. Soon there was far more paper currency in circulation than there was copper daler in reserves. As repayments to depositors slowed and banking operations became erratic, public confidence fell and a feedback loop of falling confidence threatened the banks solvency.
As confidence falls, sellers demand more and more paper currency for similar goods and services. This drives depositors to exchange their paper currency for copper daler in hopes to retain value of their depreciating monies. Since the bank cannot exchange all the notes for equal value of copper daler, due to the fractional reserve system, the bank must pay out reserves to depositors in a first come first served basis.
Given this, depositors run to the bank in hopes that they will be one of the few to pull out their deposits before the bank runs out of money; hence the phrase “bank run.” In 1667, the Swedish government liquidated the Stockholms Banco and Palmstruch was disallowed from running a bank ever again. Although the success and failures of the Stockholms Banco are almost 400 years old, the lessons and responses of the crisis in the 1600’s are still relevant and have been used as a case study for modern centralized institutions (Irwin 2013).
Centralized Banking In The Modern World
Every great modernized nation understands the importance of trade and commerce on the economy. More specifically, every great modernized nation understands the impact banking has on trade and commerce, and thus the economy as a whole. Large projects or business ventures are dependent upon large amounts of capital financing.
True, huge ventures can be undertaken with the savings of small groups or an individual person but the frequency of which would be relatively small. If an economy is to flourish, there needs to be an institution that centralizes the savings of its citizens in order to expand capital financing for large or even small projects.
Storing cash under a mattress only benefits future consumption for said person but if that money was instead deposited in a bank then those funds could be available for current and future investment and consumption. This system not only increases current investment but also increases future consumption and offers a higher standard of living (Mishkin 2013).
However, the centralization of savings can be quite dangerous if a bank run were to occur like it did in Sweden and in several other banks throughout history. Although this might be the case, central bankers learned from these mistakes and applied appropriate policy, specifically, the Bagehot’s Dictum.
The Bagehot’s Dictum
In his book Lombard Street, Walter Bagehot outlines the response of the Bank of England to the Overand-Gurney crisis and offers his advice. The three pillars of his arguments are that central banks should act as a lender of last resort by 1) lending freely 2) at a high interest rate 3) on good collateral (Madigan 2009).
If in good times the financial institution would otherwise be solvent and that the current insolvency is due to a systematic lack of confidence then a central bank can step in and act as a backstop to the banking industry.
For example, if a financial institution was experiencing a run on its deposits then the central bank would lend on a short-term basis on assets of the financial institution as collateral. This would prevent a fire sale on the banks assets which could decrease the value of similar assets in the market. If a fire sale were to occur it could decrease the valuation of assets of other financial institutions and cause a contagion effect. The repercussions of not preventing systematic bank failures are deep recessions or even a Great Depression. (Bernanke 2013)
The Gold Standard
The difference between any prior crisis and the Great Depression is the handling of monetary policy by monetary authorities; the cause is not so much important as the response. Most notably, the intellectual mindset during that time was that of hard money and liquidation. Hard money is defined as low or zero inflation with a focus on protectionist policy to the strength of a nation’s currency.
During this time period many countries tied their currencies to the value of gold. Countries would try to maintain the value of their currencies by holding massive amounts of gold reserves and buy and sell gold in order to adjust the supply of currency in circulation. If the value of the currency decreased lower than the targeted value the country would sell gold in order to decrease paper currency in circulation and thus increase its value. The opposite would be done if the valuation was above the targeted level.
Such policy not only impacts the value of the currency but also interest rates within the economy. As the money supply contracts interest rates increase, and as the money supply expands interest rates decrease. If a country is trying to maintain the strength of its currency it will decrease the supply of the money which causes an increase in interest rates which leads to a suppression in economic activity.
In normal times this would not be a problem but when the money supply is already contracting and the economy is suffering from deflation than this would be devastating to an economy. Eventually the country will be forced to leave the gold standard when it finds its gold reserves depleted. This is exactly what happened in the U.S., Britain, and many European countries during this period (Bernanke 2013).
The second and far more dangerous theory was the liquidationist theory. This theory was made famous by Herbert Hoover’s secretary of the Treasury at the time, Andrew Mellon: “Liquidate labor, liquidate stock, liquidate the farmers, liquidate real estate” (Bernanke 2013).
The thought was the economy expanded too quickly in the roaring twenties and that the current downturn was a way of getting rid of those excesses. Industries were allowed to collapse and bank runs were allowed to take their course. In the 1930’s during the peak of the crisis over 4,000 banks failed in a single year in the United States alone.
Learning From Their Mistakes
The difference between the crisis that resulted in The Great Depression and those in the past is the global impact of the Depressions and the financial panic. It was not only a crisis of confidence within one economy but the global economy as a whole. The mass failures of banks crippled the global economic system and led to years of deflation and crippling unemployment. Central bankers around the world were given a perfect case study on exactly what not to do during a financial crisis and they were poised for the next crisis to make sure the event leading up to the Great Depression would never happen again (Bernanke 2013).
In order to prevent future bank runs, governments and central banks developed deposit insurance. Most notably, in the United States congress created the Federal Deposit Insurance Corporation (FDIC) with the passage of the Banking act of 1933. Currently, the FDIC covers deposits of member banks up to $250,000.
Centralized Institutions Create Mainstream Use
In essence, the life blood of an economy is centered around lending and centralized institutions. In the U.S., businesses use dollars because that’s what is received when you get a bank loan. Businesses pay their employees in dollars because the IRS requires the remittance of withholding tax in dollars. Businesses collect revenue in dollars because state and local governments require the remittance of sales tax in dollars. When individuals pay their taxes to the IRS at the end of the year they need to do so using dollars.
Centralized banking creates stability and widespread use of currencies. These currencies in turn help governments manage and stabilize economic growth. To think that the U.S., or other governments for that matter, would willingly give up that control to currencies like Bitcoin is insane. Until Bitcoin is an acceptable method to pay taxes, used to get bank financing, and widely used to purchase goods and services it will continue to be a speculative investment.
I know what you’re thinking, what did any of that have to do with Bitcoin and the modern economy? Well, if Bitcoin is going to be used as a currency then it has to deal with those same issues. It is impossible to think that Bitcoin will replace centralized banking when debt financing is such an integral part of the modern economy.
Additionally, the instability of cryptocurrency and lack of centralized control allows the changes in valuation to upend the economy. Imagine trying to buy groceries when the value of Bitcoin changes a few hundred percentage points?
History has show that the technology surrounding currency has vastly improved but the fundamental principles remain. In order to have a functional widespread currency in the modern age you’ll need institutional lending practices, acceptance by Governments and major financial institutions, a central bank to act as the backstop to avert financial panics and proper use of monetary policy to maintain the stability of the currency.
Bitcoin and other cryptocurrency are simply too rigid, too underdeveloped and lack the backing of major governments and financial institutions to be considered a credible alternative. Until cryptocurrency can fundamentally change the underlying principles of what is means to be a currency in the modern age then it will have a difficult time disrupting financial institutions and economic thought that has been refined over hundreds of years.
Bernanke, B. (2013). The Federal Reserve and the financial crisis. Princeton, NJ: Princeton University Press.
Irwin, N. (2013). The alchemists: Three central bankers and a world on fire. New York, NY: The Penguin Press.
Madigan, B. F. (2009, August 21). Speech. FRB: Madigan, Bagehot’s Dictum in Practice: Formulating and Implementing Policies to Combat the Financial Crisis. Retrieved from http://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm
Mishkin, F. S., Matthews, K., Giuliodori, M., & Mishkin, F. S. (2013). The economics of money, banking, and financial markets. Harlow: Pearson.