Examining the Crypt in Crypto

Crypto currency appears to be a new development and a step beyond traditional banking as we know it. However, when you take a closer look it will be clear that this is not the case. In fact, crypto currency is in a way a full circle back to the day of gold and silver coins.

In the olden days, coins were the medium of exchange, and a store of value as well as a unit of account. As the global population and economic activity grew shortages and practical issues ensued. As a result physical precious metals were replaced initially by receipts from the safekeepers, then by currency. Initially that currency was 100% backed by precious metals (“PM”s) then, over time less and less. The reason for this is not necessarily nefarious. If the quantity of currency is determined by the quantity of precious metals, the amount of gold/silver etc. has to keep exact pace with the amount of currency required by the economy. Yet, as currencies were more and more diluted, at least vs PMs, currencies seemed to work just fine except for the occasional bank failure, either local or national. The supply of currencies was primarily determined by governments and their agents, and secondarily by (private) banks.

In the current US system, money is primarily created not by miners who dig the stuff out of the ground but by loans that are made by commercial banks. Every time a bank makes a loan, whether it is a credit card charge or a mortgage, they create deposits (money) at the same time. This is why if we want our quantity of money to grow, our debt has to grow too.

Until recently (March 26th, 2020 to be exact) banks had to hold reserves (equity) against their loan portfolio but on March 26th, 2020 that requirement was set to zero. This means that banks now are allowed to create deposits (and therefore debt) without external restrictions. Credit risk / default risk has become the governing limit. What this practically means is that as long as the risk adjusted return of loans exceeds the cost of capital (which includes the operation costs and loss reserves) loans will be made / currency will be created. With reserve rates at zero even the concept of fractional lending has become moot.

The system as it currently is set up seems to work ok, with an emphasis is on “ok” in a “business as usual” environment.

Then there is chronic problem of inflation. Although the rate of inflation may appear low – often below the stated goal of 2% over time, currency is losing it purchasing power at a significant rate. Over the last 10 years the dollar has lost over 18% of its value.[i] But the minimum wage has not changed from $7.25 since 2009. Those who are stuck in that income bracket enjoyed an 18% cut in real income, all due to monetary considerations, not because of their own actions.

Government free money

There always have been believers in the gold standard as a way to remove political incentives to print money and debase the currency from the financial system. Gold, or any other (static)commodity for that matter, as a basis for a dynamic monetary system, makes no sense. One of the points made by believers in the gold standard is that when things get rough gold will save the day. On a micro scale there has been some truth to it. In various crisis physical currencies like (gold) coins have been a saving grace. But that doesn’t mean that it makes sense for it to be the basis of a monetary system.

The overarching motive for alternative currency/monetary systems is the idea that the current model debases currency out of existence and that something more permanent like PMs or crypto currencies somehow will fix this. Take away from banks the ability to create currency and all will be good and just.

In addition to age old PMs more recently crypto currencies have come onto the scene. Crypto currencies are fundamentally different from payment systems like DigiCash, PayPal etc. These systems are modern interfaces to the traditional banking system, not actual alternative currencies.

The Digital Age

Bitcoin / crypto is different. On the one hand bitcoin makes a lot of sense but a huge aspect of it makes no sense whatsoever.

Let us briefly touch on some of the parts that make no sense.

When bitcoin was designed somebody decided that only 21 million bitcoins would ever see the light of day. To have a static quantity of currency in a dynamic economy makes no sense. One argument that I have heard a number of times is that this doesn’t matter because bitcoins can be divided. This is obviously nonsensical. Gold and currency like dollars can be divided too. That doesn’t change the total quantity of currency units available.

The second aspect that makes no sense is that one has to use computer power to mine/create bitcoins. Even the term “mine” gives you a sense of what the creator(s) of bitcoin thought of when they came up with it. To mine means to extract something valuable, using other resources to do so. Bitcoin miners are using various sources of energy, likely including a quantity of non-renewables, to solve riddles to liberate bitcoins. The puzzles don’t appear to solve any pressing human issues like protein folding questions or looking for ET – they solve a riddle for riddle’s sake.

There are many more issues that bitcoin has but we’ll cover those in the expanded version of this essay.

So then what part of bitcoin does make sense?

To sum it up in one phrase: The one-sidedness.

Asset=Liability

Currencies used in the past like gold and other (precious) metals and materials as well as coins are one-sided. What that means is that when you own it, it isn’t someone else’s liability. Effectively, even dollar bills, although technically liabilities of the treasury) are one sided (and this is because you can’t cash it in for anything except for another dollar – read the fine print – which makes it a one way street). Once you have a dollar bill in hand you own it and effectively can do whatever you want to do with it. It is that ability to do what you want with it which is one of the reasons why the financial system is so aggressively trying to get rid of physical cash.

Any deposit you have anywhere is someone’s liability. If you find a dollar on the sidewalk, walk into a bank and deposit it, the bank now owes you one dollar. Your asset is the bank’s liability. When the order of transaction is reversed it is the same: get a mortgage from a bank and the bank now has an asset (an IOU secured by your house) and they put numbers in your bank account (deposit) which is money they now owe to you – your asset.

This dichotomy between physical currency and deposits is why there are so many restrictions on cash. In theory you can bring the entire banking system down by going to the bank, asking for your bank balance in cash and then putting it into a deposit box (at that same bank if you really want to rub it in).

Depending on your view of cause and effect, if everybody did this the deposit base used to justify the loans would be gone and the bank would be out of business.

The modern banking system is two sided but bitcoin is not. If you mined (or somehow obtained) a bitcoin) you now own it. It does not represent a liability of somebody else. You just own it. Nobody has any right to use it for any reason.

And this the complete anthesis of the modern banking system where asset and liabilities are just two different sides of the same coin.

In our traditional monetary system, the number of dollars in circulation is determined by the loans which are created by banks. Banks make loans based on their assessment of credit.

If a house is deemed to be worth 100,000 the bank may lend 80,000. That act of lending just created 80,000 new dollars but at the same time the global pool of unencumbered assets has been reduced by 100,000 because the bank puts a lien on the entire house, not just the loan amount.

Ultimately the aggressiveness of the bank’s lending standards are determined by the amount of (bankruptcy) risk the equity holders, the owners of the bank, are willing to take. Self-interest is the final governor on currency creation.

In a way this manner of lending (secured lending) isn’t so much currency creation as it is asset liquification. What used to be an illiquid asset (the house) has effectively been taken out of the asset pool and part of it has now been transformed into a liquid asset – dollars.

This mechanism doesn’t exist in crypto world. The quantity of currency units has been arbitrarily determined and there is no encumbrance of real assets. Crypto currency doesn’t liquify real assets, they are an addition to real assets. Even if the quantity of bitcoin could somehow be increased there is no offsetting encumbrance of assets – the quantity of assets remains the same and the quantity of bitcoin would also increase, which clearly makes no sense. This is no different than the discovery of a new gold mine that all of a sudden increases the quantity of gold available, with the predictable and historically proven effect of inflation.

As you can see crypto currency then isn’t so different from gold coins because gold coins don’t encumber assets either and the quantity of gold is determined by the amount that has been dug out of the ground. There is no relationship between the quantity of gold and real (productive) assets or the amount of economic activity. And how exactly is that smart?