As the US escalates its military intervention in Somalia and drought and disease continue to decimate the country, a surprisingly resilient and resourceful currency system teeters on the verge of an overhaul. And in the process, it teaches us a lesson about cryptocurrencies.
JP Koning’s piece from last week on the Somali shilling is an excellent read, touching on the history, economics, philosophy and sociology of currency. He takes a deep look into the monetary system of a country without a government and without a central bank.
In the Somali economy, the old shilling notes have continued to circulate for the past 20 years, along with new, counterfeit notes. The interesting part is that the counterfeit notes are easily distinguishable from the old ones, but are generally accepted anyway. They became part of the currency, although they were not issued by any central bank. Counterfeiters created currency.
This shines a light on the tenuous nature of central bank-issued paper. Currency is what we say it is. In the absence of a central bank to enforce acceptance, we can designate something else as our coin if we wish.
It also underlines the resilience of money. With no central bank, why were the shilling notes accepted at all? JP presents some theories, all of them compelling: while inertia probably played a big part (might as well continue doing what we’ve always been doing, no reason not to), the one that I find most intriguing is that Somalis always assumed that a central bank would one day re-emerge and grant validity to the old (and the counterfeit) notes.
That is what is happening. A central bank formed in 2009, and, with the help of the IMF, is planning to buy the counterfeit notes from the public. It remains to be seen at what price, but the concept of validating whatever currency is currently in circulation (because hey, we weren’t here, so whatever) highlights the philosophy that money is whatever the central bank says it is.
Or maybe not. US dollars are also accepted as currency, especially in the cities. In fact, dollars are the most common medium of exchange. So, again, money is what the people say it is.
Counterfeit dollars are also in wide circulation. They, obviously, won’t be tolerated (since that’s not up to the central bank, they have no sovereignty over the US currency). According to CNBC, the US Secret Service has been brought in to help weed them out.
The case also highlights the need for some sort of monetary control. The enthusiasm of the printers of fake shilling notes led to inflation in the double digits and a currency in which over 95% of the notes in circulation are “unauthorized”.
Although, if there was no central bank, who’s to say the new notes were “fakes”? They weren’t treated as such by the users. There was no official authority to say that they weren’t real. So, why are we calling them “counterfeit” rather than “alternative”?
Perhaps because of the legacy of central bank power. Perhaps because the idea of anyone printing currency is too chaotic for us to process. Perhaps because experience has shown us that the “common good” requires a central authority.
This could go some way toward explaining the psychological resistance to bitcoin and other cryptocurrencies. We are so used to money being authorized by official institutions, and so averse to the idea that anyone can come in and complicate things, that we instinctively reject the idea of a viable alternative.
You’ll have heard the old adage that to really understand how something works, you need to break it. Thus a society ravaged by violence, famine and a lack of public infrastructure ends up revealing what money is and how it works. It can also teach us all that, while the current system is faulty, it is better than no system at all.
In addition, it shows that bitcoin is unlikely to replace national currencies. Governments, even fragile ones, like to exert some control over monetary policy. However, just as the US dollar ended up circulating along with the Somalian shilling, bitcoin can co-exist. In the end, the market will decide which currency it prefers.
The idea of bitcoin and central banks joining forces is not quite as farfetched as it seems. True, bitcoin is a decentralized global currency system, and regional central banks are, well, centralized and regional. So, on the surface they have nothing in common, except for the objective of a fast, efficient, low-cost method of payment and settlement. The main difference between bitcoin and the central banks is in how they think that should be governed and executed.
What do central banks want? They want an efficient way of settling interbank trades. They want a healthy banking system. And they want to influence the economy by controlling both the money supply and the interest rates.
What does bitcoin want? It wants to empower individual users to control the use of their own money, free from intervention, manipulation and censure, and totally open to market forces.
Could central banks use bitcoin’s technology to achieve their goals? In theory, yes. Would this end up being the irony of ironies? No, not really.
Central banks would not so much be interested in bitcoin as in its underlying technology of the blockchain. More efficient settlement, increased transparency, less economic vulnerability and a greater control over the money supply would have a significant impact on the Bank’s power and usefulness. It could be positive, or it could be negative. We could see a consolidation of central banks’ influence. Or, we could see them blockchained out of existence.
One of central banks’ main functions is to act as a clearing house for interbank trades. A vast amount of money is electronically transferred between banks at the end of each business day, to make sure that the net positions reflect that day’s financial activity. The central banks coordinate and settle this, using a variety of transfer platforms. It’s efficient. But it could be more so, especially if the need for a central clearing house was eliminated. What if the network of commercial banks and other financial institutions could settle directly on the blockchain? The central banks’ obligations could be reduced to that of regulation and monetary policy.
Another main function of central banks is that of issuing the currency. What if, instead of fiat currency, they issued a blockchain-based digital currency? (Which would, technically, also be fiat in that it is backed not by gold or similar, but by faith in the central bank.) That way we could all hold money directly issued by the central bank. Right now the only way to do that is with cash. If we could all effectively “open an account” with the central bank, there wouldn’t be much point in also having commercial bank deposits. Apart from the additional unnecessary costs, commercial banks are not as secure. They do not hold enough liquid assets to offset the client deposits, which leaves clients at the (remote, but still) risk of not being able to take their money out when they want to. With the central bank, that’s not a problem.
But with no retail deposits, commercial banks couldn’t lend as much as they do. Now, they take their retail deposits and lend them out to other individuals and business, thus making money more efficient and giving the economy a boost (not to mention making a profit in the process). This has the added effect of increasing the money supply, by effectively “re-using” money. It’s good for the economy (at least on the surface), but it’s difficult to control. The startling reality is that we don’t actually know what the money supply is at any given time. Central bank deposits at commercial banks can be used to back loans, but the scope is obviously more limited.
So, with commercial deposits replaced by central bank digital currency, lending would dry up (unless we can come up with a way to leverage central bank deposits). But some economists argue that it wouldn’t be a bad thing at all. Either way, the central bank would have a much tighter control on the money supply, and a much greater influence on the economic performance of the country. In theory, anyway – we all know that when it comes to economics, that is rarely the same as reality. The idea is a radical departure from the current economic system that we know. But, coming full circle, that is the point of bitcoin, the reason technologists have been searching for decades for a solution to the persistent problem of decentralized trust. Yet while bitcoin wants to be an alternative to central bank hegemony, the central banks themselves want to get in front of the inevitable change that this new technology will most likely force on the traditional system.
And all of this is not as farfetched as it sounds. Central banks are looking into these ideas, and the past few months have seen a slew of pronouncements from central banks all over the world. Just last week the Bank of England released a report that claims that a central bank-issued digital currency would permanently increase GDP by 3%. In March, Bank of England Deputy Governor Ben Broadbent gave a speech in which he outlined what such a system of central bank digital currency and blockchain settlements could look like. In January of this year the Bank announced that it was looking into the possibility of using the blockchain for the UK interbank settlement system. Last September the Bank of England’s top economist, Andrew Haldane, proposed the idea of issuing a state-backed cryptocurrency while simultaneously applying a negative interest rate on paper currency, or even banning paper currency outright.
Also in March of this year, researchers from the University College of London (not affiliated with the Bank of England) proposed the RSCoin framework for cryptocurrencies issued by central banks. This would allow the central banks to centralize the money supply, allow direct access to payments, and give an exact figure for the money supply at any given time. The cryptocurrencies would run on nodes validated by authorized “mintettes” (I think they’re being serious, I’m not sure).
Just last month it emerged at a conference of 90 central banks from around the world, hosted by the World Bank, the IMF and the Federal Reserve, that several of them have been investigating the blockchain for some time. Earlier this year the Dutch central bank revealed the development of an internal digital currency prototype called DNBCoin, for experimental purposes. And the following month the French central bank announced that it has been actively looking into bitcoin, digital currencies and distributed ledgers. Even Russia’s central bank has expressed an interest in the possibility of a central bank-issued digital currency.
A few weeks ago the Bank of Canada revealed that it has been experimenting with how to apply the blockchain to interbank payments. In May, the Deputy Governor of the Bank of Japan urged central bankers around the world to consider the implications of this technology. India’s central bank is investigating how to use the blockchain to reduce the dependence on cash and improve tax collection. China’s central bank is looking into issuing its own digital currency. The central bank of South Korea is researching distributed ledger applications. Barbados, Kazakhstan, the list goes on. And we can expect many more similar announcements in the coming months.
Cryptocurrencies are a reality, and with technological improvements and increased opportunity, they will become a more widely spread mechanism of financial transaction. Central banks can watch while their power to control the money supply is whittled away by the increased use of money outside their influence. Or, they could try to compete by incorporating cryptocurrencies into their national spheres. This obviously is not a simple proposition, and the ripple effects will need to be seriously considered. And no-one likes the idea of “experimenting” with something as fundamental as national and global economics. But change is inevitable, cryptocurrencies offer significant advantages, and the demands of the market are evolving. Calling for the disruption of the central banks is at this stage irresponsible, especially since we don’t yet have a viable alternative. However, if the central banks start to disrupt themselves, we could gradually move into a new economic order, with potential and promise that reach far beyond lower costs, faster transactions and enhanced transparency.
Bitcoin’s future as an alternative currency is generating heated debate and in-depth analysis of its potential effect on the money supply. Just in the past week, the Bank for International Settlements (owned by the world’s central banks) and a senior official from the Central Bank of Canada have both issued public statements on the potential impact. Just over a month ago, the Bank of England did the same. The attention that this is getting is good for headlines, perhaps, and no doubt makes for interesting intellectual debate. The debate may be intellectual, but it is also hypothetical, beside the point, and not particularly helpful, for three main reasons.
First, we lost control of the money supply years ago, when we left the gold standard. Central banks can in theory expand and contract national money supply by printing money, buying securities, tweaking banking regulations, etc. More money means lower interest rates, less money means that interest rates go up, and that is how central banks hope to influence economic growth. Yet they have much less control over the result than we generally believe. The actual amount of money in circulation is actually up to the banks, individual users, foreign investors and a long list of players each of whom has a different agenda.
Since so much of the money that we spend and save doesn’t even have physical form any more, it’s even harder to count, let alone control. Even the Federal Reserve itself admits that “over recent decades… the relationships between various measures of the money supply and variables such as GDP growth and inflation in the United States have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time.” And that’s just the US figures. Trying to get a feeling for the global money supply is a challenge, to say the least.
So, if we don’t know what the money supply is, how are earth are we going to know to what extent Bitcoin affects the final amount? And if the “official” money supply figures are not important anyway, as the Fed itself admits, what does it matter?
Second, a further layer to the irrelevance of this debate is that, while Bitcoin in many ways is a superior currency to the current fiat options, it won’t replace the dollar, the Euro, the Yuan or any other well-established local currency. Bitcoin is an ideal complement to local currencies, and is much better at trans-border payments and transfers. But the physical, practical, psychological and even emotional hurdles that need to be overcome before a culture relinquishes the comfort of the familiar and the convenience of the physical, outweigh the advantages of insisting on a blanket, society-wide adoption.
As Bitcoin takes over the international payments space, which is where its advantages really shine, it may end up surpassing major local currencies in terms of transaction volume, especially as trade becomes ever more international. But realistically, that won’t happen for many years yet. And even if (= when) it does, it won’t imply the elimination of other forms of payment. We will not end up with a bitcoin-dominated world.
Although it’s virtually impossible to have a reasonable idea of the global money supply, one figure that I saw earlier this year put the total at $43 trillion. The market capitalization of Bitcoin currently stands at under $5 billion. About 0.01%. Even when all the latent bitcoins have been mined and the supply stands at its potential maximum of 21 million, at current prices the Bitcoin market capitalization will only be $7.6 billion. Still not nearly enough to make a difference. Even if the price shot up (or gradually increased, if you prefer) to $1,000, and the world money supply stayed more or less the same, the total Bitcoin supply would still be less than 0.05% of the world money supply. In the year 2140. I don’t really see why central banks would tremble at that.
And third, this type of headline, while interesting, does little other than stoke the fear of this unknown financial concept that is going to bring about more change than we are comfortable with. I’m sure that if you asked a room full of anyone, even bankers who are supposed to understand the nuances, if they would like to see central banks lose control of the money supply, most would say no (even though, as I pointed out earlier, they don’t really have control of it anyway). No, we don’t want central banks to lose control of the economy. No, we don’t want Bitcoin to make our economy even more unstable.
And the headlines are actually misleading. In all three examples cited in the first paragraph (and there are many more), the word “unlikely” was prominently used. What the Senior Deputy Governor of the Central Bank of Canada actually said was: “In the unlikely situation in which cryptocurrencies were used broadly, a significant proportion of economic transactions would not be denominated in Canadian dollars.” We need to give more emphasis to the word unlikely. And we need to think about what level of “significant” is needed to wrest influence from the Central Bank. And with that we will realise that the Central Bank of Canada, the US, Europe and many other economic powers will most probably encounter greater dangers to their hegemony than Bitcoin. Which does not mean, of course, that Bitcoin won’t end up being powerful.