Bubbles, Banks and Bitcoin


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Bubbles, Banks and Bitcoin

  1. 1. Bubbles, Banks And Bitcoin
  2. 2. We are used to money being created by the state. Or rather, we are used to money being created by banks on behalf of the state. The state has no direct control over the quantity of money created by the private sector on its behalf, though it does influence that quantity through monetary policy and, in these days of near-zero interest rates, fiscal policy. But it does guarantee it. Or rather, it used to.
  3. 3. Money created by the private sector on behalf of the state always ends up in a bank, and once it is there it is indistinguishable from money actually created by the state (bank reserves and physical currency). Private sector money and state money are “fungible”, or as Izabella Kaminska puts it, “entangled“. Trying to disentangle them is like unscrambling an omelet. So we don’t try to. We simply accept that all of it is equally valuable. Anything called a “dollar” and sporting the symbol $ is fully backed by the US government, however it was created – even actual counterfeits if they escape detection.
  4. 4. But the implied cost to the state of guaranteeing the value of all the money created by private sector lending activity is enormous,as we discovered when Lehman fell. So governments have been attempting to limit that guarantee – for example by capping the amount of private sector money that can be converted to safe government money (that’s what the depositor haircuts in Cyprus did), or limiting the types of institution whose moneycreating they will guarantee. The trouble is that far from making the system stronger and safer, it’s actually making it riskier.
  5. 5. Since private-sector-created money is indistinguishable from state-created money once it gets into a bank, limiting the state guarantee makes state-created money less safe. Saying “I’ll guarantee this but I won’t guarantee that” when “this” and “that” can’t be clearly distinguished means that “this” can’t be trusted because it might actually be “that”. It’s not unlike the UK’s ridiculous legislation banning “dangerous dogs”, which relies on identifying certain breeds of dog by means of their physical characteristics.
  6. 6. This has resulted in the rescue centres being full of Staffordshire bull terriers, which are not classified as “dangerous” but look very much like the banned American pit bull terriers. Trust in safe dogs has been diminished because they look like dangerous ones. So it is when the state removes the guarantee from some forms of money: trust is diminished in other forms that are still guaranteed.
  7. 7. This is where Bitcoin comes in. As state-guaranteed money becomes less safe, the private sector is trying to create alternatives. Bitcoin is gaining credibility as a future currency because the state is perceived as reneging on its implied pledge to guarantee the safety of money. Zero interest rate policy and QE, particularly, are seen as “theft”: people blame the state, not the banks, for negative returns because they believe the state sets the price of money. If the state can’t be trusted to honor its pledges, it is no surprise that people look for alternatives outside the state currency system.
  8. 8. Currencies have three functions: store of value, medium of exchange and accounting unit. At the moment, Bitcoin is principally a store of value. I disagree with those who think that Bitcoin cannot be a store of value because it has nothing physical backing it. Anything that is intrinsically scarce and doesn’t decay can be a store of value. Bitcoin, consisting as it does of digital information with a hard limit on the number of units that can be created, certainly meets these criteria. The deliberate scarcity of Bitcoin makes it good for people who want to invest in it as a store of value, because (bubbles aside) it will appreciate over time, so they will get richer simply by hanging on to it.
  9. 9. But it makes it much less satisfactory as a medium of exchange. When money is deliberately kept scarce in order to preserve the value of money savings over time, the general price level in the economy tends to fall, which is deflation. For the economy to grow, people have to spend, which is more likely if they expect prices to rise in the future – obviously we don’t want them rising too much, but a little bit of inflation does keep the economy moving. A safe asset which gradually appreciates, so makes a good longterm investment, is not a good medium of exchange. The design of Bitcoin therefore makes it more suitable as an investment rather than a medium of exchange.
  10. 10. Sources: http://www.coinsetter.com http://www.forbes.com/sites/francescoppola/2013/12/30/bubblesbanks-and-bitcoin/