Mass Adoption Stifling The Bitcoin Network Evolution — Part II
By Mr Barkers on ALTCOIN MAGAZINE
History & Overview: Central Banks and Open Market Activities
This Article Has Been Broken Down Into 11 Sub-Sections:
- Brief History of Central Banking
2. The Beginning of the Monetary System
3.The Classical Gold Standard 1870–1914
4.Bretton Woods System 1945- 1971
5.The Demise of Bretton Woods System & Nixon Shock (1971–73)
6.The Washington Consensus 1973 — Present
7.Fractional Reserve Banking System
8.Open Market Activities
9.Financial Crises since 1997
10. The Current State of the World Economy
11. The Appeal of Bitcoin, Cryptocurrency & Blockchain Technology
Brief History of Central Banking
Most economists state that central banking dates back to the 17th century with the establishment of Sveriges Riksbank (the Bank of Sweden) in 1668. Twenty-six years later, the Bank of England (BOE) was founded in 1694. The BOE was originally a private bank, which originally engaged in trade finance and merchant banking for wealthy Aristocrats. However, traces of central banking predate this era and evidence shows it existed long before in ancient times.
Before the emergence of the first global monetary system, earlier primitive civilizations engaged in trade and issued a credit in several forms different from the west. Early Pacific civilizations used a string of beads or cowries as a ledger to record debt even before they started engaging in economic activity with other parties. The first form of paper money, made from stag skin, was discovered in China during the reign of Emperor Wu Ti of the Han Dynasty as far back as 140 BC. However paper money was officially documented during the Tang Dynasty between 618–907AD(around 800AD).
The strong demand for extensive international trade across the ancient world and civilizations was a catalyst for building the first banking systems. The Greek, Roman and Babylonian civilizations engaged in money lending, and also exchanged money and kept deposits during their travels to foreign lands to participate in burgeoning international trade. The Greek banking system was adopted in Egypt in 332 BC. Their run lasted 300 years, after which the Romans took over.
Usury was prohibited by the Roman Catholic Church the 4th century (AD) forbidding Christians from lending money or capital to other Christians while charging interest on the initial principal. In the 8th century Charlemagne pressed further making it a criminal offence. In 1311, Pope Clement V went even further and introduced the strictest usury laws in Europe. This opened up an economic opportunity for the Jews to become the primary money lenders and essentially central bankers of this era from the 7th century. Jews became the dominant money lenders in England during the era of William the Conqueror. They eventually became very wealthy, performing the role as the Exchequer, and were physically protected by the King’s troops. However, their lending service to the King ended in 1290 when their protection was withdrawn to appease popular demand of the people. The Jews were driven out of England and did not return until Hanoverian times.
The Beginning of the Monetary System
History illustrates that every 30–40 years a new monetary system is born. The failure of an existing monetary system is a result of information asymmetry, bubbles that develop in asset classes, global financial crises, more efficient IT systems, flawed financial models, globalization, artificial intelligence, business intelligence, machine learning, advance biological algorithms, cloud computing and ultimately the evolution of trade and economic activity across various civilizations and economies.
The Classical Gold Standard 1870–1914
The gold standard is a monetary system where a nation’s currency is pegged to the value of gold. This essentially means a country cannot increase its money supply without increasing its gold reserves; this creates monetary discipline by central banks and governments.
Until the 1870s, the world monetary system was centered on a bimetallic standard based on silver and gold. Sir Isaac Newton, Britain’s Master of the Mint accidentally created the gold standard by setting an outdated exchange rate that essentially killed the silver market and drove it out of circulation. Britain had become a powerhouse by 1870 at the peak of the Industrial Revolution with most of its supply chain of cheap raw materials and labor coming from its former colonies across the globe. It also controlled most lucrative trading and commercial routes on the seas with the military power of its Navy making it a formidable force. Its trading partners and allies were forced to adapt its mono-metallic standard. Germany and the U.S. moved onto the gold standard in 1871 and 1873, respectively. However, countries such as China decided to remain on the silver standard.
The beginning of World War I brought an end to the Classical Gold Standard era in 1914. The beginning of the war saw a decline in trade and gold exports across Europe. To finance the war, most European countries resorted to issuing bonds and printing money, which led to different interest rates across Europe, particularly in the U.K, France, and Germany. After the war ended in 1918, many European countries tried to move their economies back to the Gold Standard; unfortunately, it came with its own set of challenges for their individual economies. Britain decided to restore the Gold standard in 1925 at pre-war parity. The main aim was to please and meet the obligation of the U.K.’s creditors. This caused the pound to be 10% over-valued against the U.S. dollar due to inflation that had piled up since the beginning of the war in 1914. France did not follow the U.K and decided to seek a lower parity making its exports more competitive.
The U.K. could not increase its money supply to stimulate its economy because it was pegged to gold. Due to these constraints, it decided to abandon the Gold Standard once more in 1931. Other countries followed suit. This led to an age of economic growth and prosperity. The U.S., however, decided to cling to the Gold Standard. President Roosevelt increased the gold price from $20 per ounce to $35 per ounce in 1933. This effectively devalued the dollar by more that 40%. Most countries did not accommodate the failure of the stock market crash in 1929. This led to a period of protectionism and trading blocs among developed countries, which created a domino effect causing a fall and major contraction in world trade and growth.
Bretton Woods System 1945- 1971
A new monetary system was birthed in 1945 after the end of the Second World War. Under the Bretton Woods system, countries pegged their respective currencies to the U.S. dollar, which was comparatively exceptionally strong at the end of the war. Countries that had signed up to the international gold standard could then convert their U.S. dollars to gold at an exchange rate of $35 per ounce. The U.S. provided price stability but did not get involved in any type of currency intervention. Any currency intervention was manipulated by the respective central banks for countries. This system was meant to address speculative attacks on currencies and give central banks some form of independence and leeway. This was one of the major flaws of the Classical Gold Standard.
One of the major weaknesses of the Bretton Woods system was that it allowed the U.S. to run huge chronic trade deficits, effectively allowing Americans to live beyond their means and disincentivizing the government from strengthening their current account position. President De Gaulle of France threatened to fully liquidate France’s dollar position on suspicion that the U.S. was spending beyond their means and exceeding their gold reserves. The U.S. was also fighting the Vietnam War during the 1960s, which lead to an increase in deficit spending not backed by Gold.
The Demise of Bretton Woods System & Nixon Shock (1971–73)
In spring 1971, Germany suspended the peg of its Deutschmark to the dollar, allowing it to float freely. There were rumors that France and U.K would follow suit by liquidating their dollar reserves into gold. To avoid the negative ripple effects on the dollar and the wider economy, President Nixon took the U.S. off the gold standard in August 1971. This was known as the Nixon Shock. Nixon also introduced a 10% import surcharge that would force other countries to revalue their respective currencies as opposed to devaluing the dollar. This opened up the system of free-floating exchange rates.
The Washington Consensus 1973 — Present
After the Nixon Shock, the dollar continued to depreciate. Inflation was a major problem during this period and this led to a hike in interest rates to unprecedented levels. The U.S. dollar recovered its purchasing power in the 1980s; however, in 1985 the dollar threatened its international competitiveness by becoming too strong. The U.S., Japan, Germany, and France signed the Plaza Accord, which stipulated that each country would jointly intervene to lower the US dollar.
Fractional Reserve Banking System
In this system, only a fraction of bank deposits are backed by real cash and readily available for withdrawals. For example, the Federal Reserve in the U.S. allows commercial banks to lend up to 90% of bank deposits. This process leads to the creation and supply of loans to households and firms in the wider macroeconomy. The major flaw in fractional reserve banking is in times of financial crises (e.g. the Mortgage Meltdown in 2008), it leads to a run on the banks. A run on the bank occurs when there is financial panic in an economy forcing depositors to rush to banks to withdraw all funds or assets at the same time. Many U.S banks shut down during the Great Depression of 1929 because of run on the banks. This usually ends with the banks collapsing unless the central banks step in to lend funds as the Lender of Last Resort.
Open Market Activities
Open market activities refer to the buying and selling of government securities in an open market with the sole aim of expanding or contracting the money supply in the banking system. The Federal Reserve uses the same technique to adjust and manipulate the federal funds rate, the rate used by banks to borrow money from each other. Open market activity is a key tool used by central banks to control monetary policy. Central banks around the world (the FED, BOE, Bank of Japan (BOJ) began a more unconventional form of open market activity in 2008 at the height of the mortgage crises known as Quantitative Easing (Q.E.). Q.E increases the supply of money to an economy by buying up government or corporate securities. In 2008, $4 trillion worth of assets were bought by the FED that included corporate bonds, mortgage-backed securities, and commercial paper, instantly increasing the FED’s balance sheets.
QE sounds great on paper except it leads to severe asset bubbles in the real economy. If extra liquidity or money supply increases in an economy, the money is moved into different asset classes, e.g. the stock exchange, real estate, bonds, art. These asset classes ultimately over-inflate and send a false illusion to the greater population that the economy has moved into a boom cycle and a time of economic prosperity. This psychologically has an effect on society by igniting “animal spirits”. Animal spirits describe the psychological and emotional factors that drive investors to take certain financial decisions. People take on more credit card debt, rely on loans, borrow to fund holidays and buy over-inflated real estate lent at 50–100 their base salaries.
Financial Crises since 1997
In 2001, the FED set interest rates low in response to the dotcom crash and aftershocks of the 1997 Asian currency crises in order to jump-start the U.S. economy. The low rates sparked demand in the U.S. economy but led to a bubble in the real estate market. This triggered the global mortgage crisis of 2008, leading to a credit freeze in western economies, runs on banks, and a deep recession. After the global mortgage meltdown of 2008, the FED lowered interest rates, at one point setting them close to zero. This introduced a new concept into the economics of negative interest rates, theoretically not possible before 2008, which meant savers now had to pay banks interest for holding their assets. The snowballing effect of global interest rates being set close to zero by the FED from 2009 to 2015 has once more created bubbles and artificial increases in asset prices in the stock, real estate, and bond markets. The ripple effect of keeping interest rates so low over this time period is a promise of deeper recessions, a fall in the purchasing power of fiat currencies, a decline in living standards of the low and middle classes, and ultimately asset prices such as real estate bursting and falling into negative equity.
The Current State of the World Economy
14 trillion dollars’ worth of bonds are currently at negative yields in the current world market. The current bond market valuation (sovereign and corporate debt) sits over $100 trillion as of 2019. Ironically, the yield curve for bond markets is inverted, which is great for any business or government who wants to borrow but a huge red flag for a bondholder or an investor. Individuals who purchase and hold long-term (10–30yrs) bonds are compensated with less interest compared to individuals that hold short-term bonds (2–5yrs). Why would anyone accept a lower interest rate for holding a 30-year bond compared to a 2-year bond? This is a critical indicator that there is going to be a significant slowdown in the market and/or a major recession just around the corner.
Sweden, Denmark, Switzerland, and the European Central Bank are currently pursuing a regressive policy of negative interest rates in 2019. The International Monetary Fund (IMF) has also championed this mechanism and is touting it as a feasible tool to help control the monetary policy of Central banks. The idea behind this unconventional policy of negative interest rate is to disincentivize households and firms from saving. They believe if savings continue to fall due to negative rates, households will either result in borrowing and increasing their debt or spending cash that they have saved in the bank. Individuals could decide to withdraw all their funds from the bank and keep it in a safe at home if they are unhappy with this new negative rate policy. To stop run on the banks, Switzerland, Sweden and Denmark are all moving towards a cashless society where all of your transactions can easily be frozen or limited to daily minimum withdrawal amounts.
The Appeal of Bitcoin, Cryptocurrency & Blockchain Technology
Bitcoin provides a solution to this current irrational policy of negative interest rates and an escape route to the turmoil and flawed world monetary system. It provides a good store of value. Investors who are concerned with price swings and volatility of Bitcoin can find solace in “stable coins” like Dai or Gemini USD. A stable coin is a type of cryptocurrency that is designed to maintained stable value and avoid price volatility. It can be pegged to a fiat currency (USD, Euro, Pound), a commodity (normally a precious metal such gold or silver) or another cryptocurrency e.g a decentralized autonomous organisation. Stable coins are collateralized which means the number of coins in circulation are usually backed by a reserve asset.These coins provide a solution to fractional reserve banking as all stable coins are backed by an equivalent amount of dollars (1:1) ratio or precious metals . These stable coins have introduced stability and transparency into the current financial system thus returning society to the age of full reserve banking. Bitcoin and stable coins cannot be frozen by Central banks or commercial banks giving individuals sovereignty and absolute control over their assets and finances. The beauty of Bitcoin, Blockchain technology is as long as an individual holds and controls their private keys (passwords) they control and have total autonomy over their money, assets and financial destiny.
Disclaimer: The views and opinions expressed by the author in this article are for informational purposes only. The author makes no representations or warranties of any kind, express or implied about the accuracy, completeness, correctness, suitability or validity of the information contained in this article and shall not be liable for any errors, omissions or any loss or damage including without limitation, direct, indirect or any further consequential loss or damage arising from the use of the information contained in this article.
Any reliance you shall place on the information contained in this article is therefore strictly at your own risk.
Big thanks to Stephanie Amarteifio, Valerie Findlay & Seliana Kaguamba for your invaluable insights and objective feedback!!
