The British pound is teetering.
The US Fed is hiking at a record pace.
Credit Suisse is wobbling.
As Ryan Dinse pointed out yesterday, cockroaches are appearing as the global economy festers.
But what struck me most in Ryan’s piece is his lament at a financial system stressed by central bank incompetence.
As Ryan wrote:
‘If the great fiat experiment is indeed doomed, no matter how central banks try and fix it, where do you turn?
‘Step one is getting out of centralised finance…and instead, getting into the world of decentralisation. It’s becoming more and more clear that this is the only way forward for our monetary system…
‘The story is so much larger than the price of bitcoin, although that is sure to increase over time as more and more people realise this.
‘It’s about the idea that anyone (anywhere) can participate in a financial ecosystem without fear or favour.
‘Something we all desperately need right now.’
Can cryptocurrencies provide a cure? And if they can, what does that mean for central banks?
Is Bitcoin [BTC] their existential threat?
A world without central banks
There was a time before central banks. We didn’t always live under their auspice.
For instance, the US Federal Reserve was established by Congress in 1913. The Reserve Bank of Australia, as we know it, only commenced operations in 1960.
And developments in cryptocurrency may well usher us back to a central bank-free era once more.
The idea of obsoleting central banks isn’t new or particular to cryptocurrencies.
Prominent economists of a bygone era like John Nash and Milton Friedman both argued for the role of an ‘algorithmic currency’ that would supplant the role of central banks.
In a 1994 interview, Nobel laureate Friedman even went so far as to call for the abolition of the Fed.
Its record wasn’t much good, he thought.
Friedman wasn’t alone.
In Financial Stability without Central Banks, economist and historian George Selgin didn’t pull his punches when assessing the history of central banks.
Here’s an excerpt (emphasis added):
‘A banking system that is backed by a central bank has a tendency towards instability. This is because the creation of money by the central bank can inflate money and credit creation in the banking system as a whole. The mechanism of banks restraining the behaviour of each other is blunted. Financial instability and price instability are likely results.
‘Since the creation of the Federal Reserve, financial stability has worsened. The pre-Federal Reserve model was itself problematic. However, the history of other countries’ banking systems suggests that whatever the problem was, the solution was not a central bank. Financial stability is more likely in a system without central banks and that is not distorted by misguided regulation.’
Cryptocurrencies threaten the potency of central banks
Private cryptocurrencies are a threat to the way central banks operate because they blunt the financial instruments central banks wield.
Central banks use domestic currency to shape financial outcomes by nudging incentives to save, spend, or invest.
A rising cryptocurrency like bitcoin could weaken a central bank’s influence over the economy.
For instance, would the RBA’s interest rate policies have much impact if, hypothetically, most Australians transacted with bitcoin?
A domestic currency is the medium through which central banks operate. The currency is a conduit of monetary policy.
Privatise the currency, decentralise it, disperse the spheres of influence, and a central bank loses potency.
It becomes a craftsman bereft of his tools.
It sounds hyperbolic, but the question of what follows when a cryptocurrency reaches critical mass is serious.
As Cornell economist Eswar Prasad explained in a paper last year:
‘The major implications of such developments would not just be the reduction in the demand for central bank money as mediums of exchange or stores of value, but the consequences they would have for the business models of banks and other existing financial institutions…
‘While it is premature to speak of disruption of traditional concepts of central banking, it is worth considering if the looming changes to money, financial markets, and payments systems will have significant repercussions for the operation of central banks and their ability to deliver on key objectives such as low inflation and financial stability.
‘For many central banks, the responses are driven by concerns about the rapidly declining usage of currency and the implications for both financial and macroeconomic stability if decentralized, privately managed payment systems displace both cash and traditional payment systems managed by regulated financial institutions.’
Our own Reserve Bank of Australia (RBA) has admitted that the rise of private cryptocurrencies poses threats to central banks.
In a 2020 research note, the RBA noted:
‘Widespread substitution away from the domestic currency could threaten a country’s monetary sovereignty and reduce the ability of the central bank to influence domestic monetary conditions (including via changes to the structure of interest rates and the exchange rate) and to act as the lender of last resort if required.’
That’s why many central banks are considering rolling out their own central bank digital currencies (CBDCs) to pre-empt the rise of cryptocurrencies.
Can central banks and bitcoin coexist?
What does a world look like where central banks and bitcoin intermingle?
It might look something like El Salvador.
In September 2021, El Salvador made bitcoin legal tender. The country’s Bitcoin Law proclaimed:
‘The purpose of this law is to regulate bitcoin as unrestricted legal tender with liberating power, unlimited in any transaction, and to any title that public or private natural or legal persons require carrying out.’
The International Monetary Fund (IMF) was not pleased with El Salvador’s bitcoin adoption push, pausing negotiations for a US$1.3 billion assistance package.
A blog post published on the IMF’s site a few months before bitcoin became legal tender in El Salvador outlined some of the reasons why.
The post titled ‘Cryptoassets as National Currency? A Step Too Far’ distinguished crypto assets from digital money.
IMF classifies bitcoin as the former.
The blog post also worried about the influence of crypto assets on monetary policy:
‘Also, monetary policy would lose bite. Central banks cannot set interest rates on a foreign currency. Usually, when a country adopts a foreign currency as its own, it “imports” the credibility of the foreign monetary policy and hope to bring its economy–and interest rates–in line with the foreign business cycle. Neither of these is possible in the case of widespread cryptoasset adoption.
‘As a result, domestic prices could become highly unstable. Even if all prices were quoted in, say, Bitcoin, the prices of imported goods and services would still fluctuate massively, following the whims of market valuations.’
Bitcoin is yet to catch fire in El Salvador, and the nation’s central bank is a bit of an outlier.
El Salvador’s economy is dollarised — pegged to the USD — so technically, its central bank can’t set monetary policy.
El Salvador’s interest rates are set by market forces external to the central bank.
Bitcoin can’t make a central bank obsolete if the bank already made much of its role redundant by hitching its wagon to the USD.
The real test will be whether a cryptocurrency like bitcoin could replace much of the function of a major central bank.
Interestingly, the RBA pooh-poohed the idea of cryptocurrencies usurping the monetary sovereignty of ‘well-functioning’ economies:
‘In countries with well-functioning financial and payment systems and a history of low inflation, like Australia, the risk of widespread adoption of money denominated in some other currency seems very low. However, this would not, for example, preclude adoption of a global stablecoin for specific use cases, such as cross-border payments, particularly if it was lower cost and offered a better user experience than existing services.’
I guess time will tell.
Bitcoin: march to US$1 million?
Tomorrow, Ryan will host a special presentation where he will break down many of the concepts we discussed in today’s piece.
But Ryan will also make the case (controversial for some, I bet) for how bitcoin could be worth US$1 million by 2030.
Stay tuned — it will be a cracker!
Until next week,
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Kiryll Prakapenka,
For Money Morning
