Our Flawed Financial System is Reflected in Bitcoin

My Comments: What exactly is a bitcoin? I’ve been reading about them for many months now and I’ve yet to understand how I would spend one if it happened to show up in my change at Publix. Chances are it never will. But…


The image suggests they are made of metal. But that runs counter to the notion they are a digital invention. Yes, I know the $20 bill in my wallet is really just a piece of paper, allegedly backed by the full faith and credit of the US Government. For more years than I care to remember, I’ve used similar pieces of paper to buy breakfast and other things I need because the guy on the other side of the counter believes the same thing. So we all get along.

But some people have had their bitcoin companies go bankrupt, and gone to jail or committed suicide. Others have made a fortune (so far…). Maybe this is a timely article from the Financial Times. One key phrase used by the author is for us to… think of money as a social contract between the citizen and the state.

By Wolfgang Münchau / March 2, 2014 / The Financial Times

The degree to which economists have ignored Bitcoin is surpassed only by the extent to which Bitcoin enthusiasts have ignored economics. The divide between these groups is larger than that between analogue and digital.

If you were to ask what is the immediate economic importance of the artificial internet currency itself, then there is indeed really not much to say. Bitcoin is not macroeconomically relevant, and never will be. This explains why economists show so little interest. The entire stock of Bitcoins was worth less than $7bn last Friday. The monetary base of the US is $4tn.

This misses the point, however. The real importance of the technology behind Bitcoin is its future potential. Bitcoin itself may just end up playing the role of the useful idiot that is ultimately usurped by a worthy successor – call it Bitnote.

Properly constructed, Bitnote could mount a serious dual challenge to our established economic system: first to our currency-issuing monopolistic central banks, second to the global system of financial intermediation. Take the two together, and Bitnote becomes potential challenger to the entire system of global finance, in particular of fractional reserve banking – where a central bank channels money into the economy through the banks.

If that were to happen, it would be an act of huge macroeconomic, indeed geopolitical significance. Whether such a change would be benign, or not, is another matter. It would depend on the circumstances in which the challenge occurs and the features of the new money itself.

Bitcoin in its current form is not up to the job because of its limited monetary base. It may have a money creation algorithm, but the total number of bitcoins in circulation is capped at 21m. If Bitcoin were already our currency, it would at best operate similar to the gold standard. This is about the last thing you would want in today’s fragile global economy. But this is only an argument against Bitcoin specifically. It is not an argument against the principle of an economically more literate monetary system as such.

The monopoly of central banks is enshrined in law – but the law will not guarantee the status quo indefinitely. It would be hard to discriminate against Bitcoin and its successors through legal force alone.

Think of money as a social contract between the citizen and the state. Democracies have entrusted central banks with the task of money issuance because this is how we hope to ensure its core functions: as a universally accepted means of transaction, as a unit of account and as a store of value. The central bank has the tools to assure stable prices. It can use its monopoly to provide lender of last resort functions in a crisis. It can use monetary policy to reduce fluctuations in the economic cycle. And it can do all this much more securely than any private-sector competitor. Money printing plants and central banks are guarded by people with guns. Internet security is not quite the same. And while a fiat money system can go broke in theory, the Mt Gox Bitcoin exchange went broke in practice.

These advantages are important but possibly ephemeral. The current system exists only because society decided that the previous one did not work. It was the accumulation of financial crises in industrial societies that brought us the fiat-currency issuing monopolistic central bank.

But while economic and political change gave rise to our current system, it will also end it. It was the internet and advances in cryptography that made Bitcoin technically feasible. But whether a hypothetical Bitnote will grow to macroeconomically relevant scale will depend less on technology than on the new system’s perceived usefulness relative to our current system.

Those perceptions may be changing. The combination of financial deregulation and globalisation, national economic policies and a lack of global co-ordination is unsustainable. Something that is unsustainable either ends, or is made sustainable.

The experience of our handling of the global financial crisis and its various regional cousins would suggest that big-system change is unlikely. The G20 and other international debating clubs have achieved little in terms of financial sector reforms and monetary policy co-ordination. The financial lobbies are stronger than ever. Just as 10 years ago, the policy establishment has no clue how to control financial bubbles. Whatever the priorities are of the advanced countries, making the financial system sustainable is not at the top of the list.

If global instability persists it will produce more crises. Whether the next Bitcoin or its successors can succeed is impossible to forecast. But the environment is one in which an alternative decentralised system could flourish.
For those running such a system and especially those who advocate its development into a global monetary unit, it would be a good idea to develop at least a cursory interest in monetary economics. I suspect the challenge for the economics profession would be incomparably larger.