Central Banks and the Bitcoin Experiment

Money has gone digital

Money has gone digital.  Less than 3% of currency these days is in the form of cash (coins or paper bills).  I still struggle to understand bitcoin, but I have slowly come to realize that what I don't fully understand are the technological aspects of bitcoin.  To understand bitcoin, you must first understand blockchain. To understand blockchain, you need to know about open-source coding, algorithms and cryptography, then you need to know about hashing and CPUs in order to understand what "mining for bitcoins" means (although I get that "mining" means solving a math puzzle and allowing transactions to use your computer).  However, these lacunae in our technological knowledge notwithstanding, bitcoin is just like any other digital currency (keeping in mind that the US dollar, for example, is already 97% digital) with only one truly significant difference.  Every example of money that we accept without much thought is managed and manipulated by a central bank--bitcoin is not.

Countries and companies preparing their own digital currency

Most countries have their own currencies--197 countries use 164 different national currencies worldwide--but there are only eight [small] countries without a central bank.  The Financial Post reported a few days ago that  last year Stephen Murchison did a presentation to the Bank of Canada on "whether or not the bank should issue its own digital money."  China is preparing the launch of its own digital currency.  Facebook is planning the release of Libra, its own digital money.  The FP article reports that :

 Switzerland’s central bank started exploring the use of digital currencies for trading. Sweden and Singapore both have research efforts underway. [ . . . .]  JPMorgan is already using a digital coin and Vanguard is testing a blockchain-based currency trading system.

Although these reports create the impression of a definite distinction between digital and non-digital currencies; to reiterate, most of the money we use today is already digital.  Since this currency must be encrypted in order to transit over the internet, it can also be described as cryptocurrency.  What distinguishes bitcoin from the crypto, digital money that we accept unquestioningly into our lives is that bitcoin has no central bank.

Facebook, China and even JPMorgan provide a central bank to manage their digital currencies.  We Canadians who have been accepting Canadian Tire money since the 1950s should be at ease with corporations' producing their own money, and recognize that a company (the Canadian Tire Corporation in this case) can be a central bank.  The question bitcoin raises is:  "Do we need central banks?"

Central Banks:  God or the Devil?

Central banks are either God or the Devil depending on your perspective.  Few issues are more likely to spur conspiracy theories than discussions of central banks.  The claim that the Rothchild family has slowly taken over the central banks of the world regularly gets viral play.  Depending on your perspective the US Federal Reserve (the US central bank) either saved the American economy from total collapse in 2008 with 100s of billions in bailouts, or it protected the interests of wealthy bankers at the expense of American sub-prime mortgage holders.  Central banks are either a cabal of fat-cat bankers taking care of themselves, or they are altruistic, public-spirited individuals dedicated to serving the interests and welfare of their countries' citizens.  Individuals with connections to a central bank have insider knowledge not only of monetary policy but of the financial systems and decisions of their home countries.  These financial gurus tend to be in the wealthiest 1% of the 1%--which arouses suspicion.  On the other hand, they help to control inflation and unemployment by decreasing or increasing the money supply, cooling down or heating up the economy.  We barely note their existence until there is a major screw up, as there was in 2008.

What's the difference between the new money and the old money?

The average citizen doesn't understand bitcoin because the average citizen doesn't understand money.  I speak from the perspective of an average citizen.  Even though I have done two posts on the subject (What Is Money?  & How Is Money Created)  and I am an accredited professional in understanding works of imagination, I still struggle to grasp that money, that thing which hard-core realists consider the bedrock of modern existence and survival, what we get up and go to work for, and worry about going to bed, can be such an airy-fairy, shrouded-in-mystery product of imagination.

How the Bank of Canada creates money

I credit this Parliament of Canada website with providing a clear and succinct description of "how the Bank of Canada creates money for the federal government." The article also provides "Information about how private commercial banks create money." The first step is perhaps the most confusing.  The Government of Canada produces bonds and treasury bills, which the Bank of Canada sells to private banks and other financial institutions, but the Bank of Canada also buys 20% of the bonds produced by the Government. This first step is confusing because to the uninitiated (like me) the assumption is that the Bank of Canada is part of the Government of Canada, so it sounds like Canada is buying and selling to itself.  The process would seem to make more sense if the Bank of Canada was a private company, separate from the Government.  In fact, the Royal Bank of Canada was first created as a private enterprise in 1934 but was nationalized in 1938.

However, in the current Canadian case:

Since the Bank of Canada is a Crown corporation wholly owned by the federal government, the Bank's purchase of newly issued securities from the federal government can be considered an internal transaction. By recording new and equal amounts on the asset and liability sides of its balance sheet, the Bank of Canada creates money through a few keystrokes. The federal government can spend the newly created bank deposits in the Canadian economy if it wishes.

The entire process seems like a game of "let's pretend."  "Let's pretend" you are a bank and I borrow some money from you, then I deposit the money I borrowed from you in your bank.  There is no limit to how much money I can borrow from you, and it doesn't matter if you think I'm a good, reliable client or not.  When I spend the money I have deposited in your bank, you take the money out of my account.  Of course, you will never ask me to repay the money I've borrowed from your bank. Later, when I have depleted my account, I will just borrow some more money from you.  In more adult language:

 . . . the Bank of Canada's purchase of government securities at auction means that the Bank records the value of the securities as a new asset on its balance sheet, and it simultaneously records the proceeds of sale of the securities as a deposit in the Government of Canada's account at the Bank [. . . ]. No paper evidence of a bond, treasury bill or cash is exchanged between the Government of Canada and the Bank of Canada in these transactions. Rather, the transactions consist entirely of digital accounting entries.

Most of the Money in the Economy is Created by Private Banks

In the game of "let's pretend," the Bank of Canada only buys 20% of the Canadian government's loans, the other 80% is purchased by private banks and investment firms.

Private commercial banks also create money – when they purchase newly issued government securities as primary dealers at auctions – by making digital accounting entries on their own balance sheets. The asset side is augmented to reflect the purchase of new securities, and the liability side is augmented to reflect a new deposit in the federal government's account with the bank. However, it is important to note that money is also created within the private banking system every time the banks extend a new loan, such as a home mortgage or a business loan. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money [. . .]. Most of the money in the economy is, in fact, created within the private banking system.

As just described, with a click of the mouse, private banks have an asset (money in their accounts) and an equal debt owed to the Bank of Canada.  Why do private banks buy or even want Canadian government debt?  The answer has many names (some of which I have dealt with in What Is Money?  & How Is Money Created) such as "leverage" or "the fractal banking system."  The parliamentary website describes the system as "[t]he limiting rules, known as 'capital constraints,' [ . . .]."  What each of these expressions is telling us is that when you go to a bank to take out a mortgage, or a car loan, or an education loan, or if you use your bank's credit card to buy a cup of coffee, you are creating money.  The money does not exist until you spend it, and when you spend it you have created an asset--money in the bank's bank account.

The Ontology of money

What we are talking about here, in big words, is the ontology of money.  With most things that are borrowed, there is an assumption that they must exist in order to be borrowed--not so with money.  It's as if you go to the bank to borrow a cup of sugar, the bank has sugar, but the sugar they lend you doesn't exist--except that you still owe the bank a cup of sugar.  Guess what?  Now the bank is considered to have even more sugar because the sugar you borrowed is added to the bank's supply. What "leverage," "the fractal banking system," and "capital constraints" all indicate is that the bank is allowed to lend you 10, 25 or even 40 times the amount of money it actually has, depending on the "limiting rules" in place.  For a period of time, the banks in Iceland had no limit on the amount they could lend out and thereby created so much money for themselves that they had more money on their books than the entire GDP of the country.  Imagine you were a bank and the "capital constraint" leverage ratio was 4% and you had a hundred dollars in your pocket.  You could lend your friend $2500 (without touching the $100 in your pocket).  Once you had your first friend's IOU for $2500, you could lend a second friend 25 X 2500 = $625,000.  If you could find a third friend, you could lend him $625,000 X 25!  You'd be a multimillionaire.  Kinda makes you want to be a banker, doesn't it?

The Bitcoin experiment

I call bitcoin an experiment because it attempts to test (prove or disprove) a hypothesis in an empirical fashion.  The hypothesis is that it is possible to create money without a central bank, without a private banking system, in fact, without any of the middlemen who run the financial system.  The mere fact that bitcoin still exists (despite constant rumours of its demise) is proof that it is possible to have a monetary system, to buy and sell, lend and borrow, carry out transactions of every sort on a person-to-person basis, without a central bank and accompanying private banking system.

What's wrong with bitcoin?

As I have taken note, here and there, of what is said to be wrong with bitcoin, I have found the only substantially negative feature of bitcoin relative to other currencies is its volatility.  The value of a bitcoin can change dramatically because its price is based entirely on supply and demand.  The total supply of bitcoins has, by design, been limited to 21 million.  Bitcoin is comparable to gold in terms of its limited supply and consequent fluctuating value. Fluctuations in the value of bitcoins can be unnerving as you are trying to decide if you should save, spend or exchange them.  This forex volatility calculator rates bitcoin (BTC) at least four times more volatile than most currencies.  Today's financial news is full of references to bitcoin's dramatic fall to below $10,000 Canadian.  Of course, if you bought, mined or were paid in bitcoins six years ago, you would still be up over $9000 per coin.  Central banks generally work to reduce the volatility of their countries' currencies, but they can also manipulate them to serve national economic interests in the global market place.

Much is made of the potential use of bitcoin to avoid taxes or for criminal activity.  As such bitcoin is a more technological, efficient replacement for cash, gold, jewelry, and artwork--all common currencies for tax-evading criminal activity (not to mention offshore banking, of course).  The real risk to and of bitcoins is that countries will and have been moving to protect their own central banks and banking systems by banning the use of bitcoin.  China is a leading example.  The second bitcoin risk, and perhaps this is the greatest one, is the competition from countries--like Canada, as the Murchison presentation suggests--when they create their own versions of bitcoin using the blockchain technology which would allow the government to track how every Canadian digital dollar is spent. 

Addendum

Royal Bank of Canada launching new cryptocurrency trading platform: Report

Why Are the Poor Always with Us? "Moral Hazard."

The Poor Are Always with Us

“The poor are always with us.”  What a discouraging declaration!  More disturbing still, it is attributed to Jesus Christ.  Although the details vary from one gospel to another, Mary of Bethany (some say Mary Magdalene) was pouring expensive oil on Jesus’s feet (in some versions on his head) when his disciples complained  (some say Judas specifically) that the money could have been used to feed the poor.  (The Gospel of Matthew suggests that this incident is what caused Judas to betray Jesus.)

Moral Hazard

Why are the poor always with us?  Consider  “moral hazard.”  “Moral hazard,” according to Alan Blinder in After the Music Stopped:  The Financial Crisis, the Response, and the Work Ahead, “has nothing to do with morality.”  The concept originated in the 18th century in the insurance industry and suggests that having insurance might encourage risky (and therefore immoral?) behaviour.  

Today the concept is very much with us as insurers worry aloud  that house insurance will encourage us to smoke in bed, car insurance will promote real-life Gand Theft Auto, and medical insurance will cause all of the above.   In fact, “moral hazard” is pervasive because it underpins all the “self reliance,” “free market” arguments of, in particular, American capitalism.

The concept arose in Blinder’s book because “moral hazard” also applies to making risky investments.  In 2008, super wealthy financiers and bankers, who were typically the defenders and upholders of “moral hazard,” found themselves in a situation where they needed hundreds of billions of dollars in bailouts because they had made risky, losing investments.  To accept government money instead of facing the consequences of their behaviour was to repudiate “moral hazard”—which is what they ended up doing.  However, “moral hazard” when applied to the holders of underwater sub-prime mortgages was kept in tact when TARP (the bailout program) was implemented.

Ron Paul on "moral hazard" and "too big to fail" in 2008.

Social Spending and Moral Hazard

Though you may never before have heard of “moral hazard,” you have undoubtedly heard one or more of the “common sense” claims based on “moral hazard.”  “Moral hazard” is the idea behind arguments against the guaranteed income, free day care, tuition-free university education, family planning, and the decriminalization of drugs, to name but a few.  Despite arguing the case in favour of “enlightenment,” in  Enlightenment Now: The Case for Reason, Science, Humanism, and Progress, Steve Pinker claims that “Social spending, like everything, has downsides. As with all insurance, it can create a 'moral hazard' in which the insured slack off or take foolish risks, counting on the insurer to bail them out if they fail.”

Poverty Versus Wealth Inequality

If not through social spending how can poverty be addressed? Pinker argues, quite rightly I would say, that it is a  mistake to confuse poverty and wealth inequality.  Some Americans may be disgruntled, may even think of themselves as poor, not because they are poor in any real sense but because they are struggling to "keep up with the Joneses."

"The confusion of inequality with poverty comes straight out of the lump fallacy— the mindset in which wealth is a finite resource, like an antelope carcass, which has to be divvied up in zero-sum fashion, so that if some people end up with more, others must have less. As we just saw, wealth is not like that: since the Industrial Revolution, it has expanded exponentially."

True enough, but it takes a lot of poor people to create one billionaire.  Pinker's use of J.K. Rowling as his example of a billionaire is disingenuous.  Sure, it's hard to get a hate on for the welfare mom whose Harry Potter stories have made her the wealthiest writer on the planet, but even in her case if we consider the copy editors, bookstore clerks, theme-park employees and printers at the bottom of the pyramid we can begin to see signs of the poverty which supports her wealth.  Pinker's graph correlating wealth inequality with everyone getting richer is cutesy and confusing, but his conclusion that "the world’s poor have gotten richer in part at the expense of the American lower middle class" who would in turn elect Donald Trump President seems clear enough.

Does Wealth Inequality Make Us Richer or Poorer?

Much of the world may have been pulled out of dire poverty over the last 200 years, as Pinker claims, but extreme wealth inequality is a destabilizing force in any society.  Pinker's graph notwithstanding, wealth inequality also produces an inefficient and wasteful economy.  The purchasing power of the haves puts pressure on both the have-nots and those who have less. For example, London, England has some of the most expensive real estate in the world, but it is also known for the number of homes and mansions which are left empty by the super wealthy. Take note the next time you are watching a a premiere sports event on television:  how many of the best seats are left empty because someone is wealthy enough to buy them and then not bother to attend?  Is the economy really being served by one man owning a dozen houses or fifty cars or paying tens of millions of dollars for a painting?

The Financial System Depends on Moral Hazard ...

Money, as we have seen, is just a measuring system for debt (see What Is Money?) or what  Yuval Noah Harari, in Sapiens:  A Brief History of Humankind, calls "imaginary" and "a psychological construct." Money is created every time someone signs a mortgage, takes out a loan or uses a credit card.  It is therefore limitless and infinite--definitely not a a zero-sum game.  Since money is "imaginary," nothing real or tangible, why can't we put Santa Claus and Tinker Bell in charge and just give poor people the money they need?

And Moral Hazard Depends on Poverty

The answer is, of course, "moral hazard,"  . . . and I'l bet you're thinking "and the whole financial system would collapse."  Conclusion:  the whole financial system is based on moral hazard.  Why are the poor always with us?  Because without them "moral hazard" would disappear.

A billionaire asking for millions of dollars in subsidies, grants and tax breaks is so common that we hardly notice.  An indigent standing on a street corner asking for twenties would have to be out of his mind.  The richer you are the less moral hazard applies.  The burden of moral hazard falls most heavily on the poor; in fact, poverty and moral hazard are inseparable.  The threat of poverty is what keeps the rest of us from stepping out of line.