Central banks played a key role in creating the 2008 financial crisis through policymaking. One of the responses to that crisis was Bitcoin (BTCUSD). With its decentralized system and peer-to-peer technology, Bitcoin has the potential to dismantle a banking system in which a central authority is responsible for decisions that affect economic activity in entire countries. But the cryptocurrency has its own disadvantages that make it difficult to represent a decentralized system consisting of the cryptocurrency.
The central theses
- Bitcoin’s peer-to-peer technology and decentralized system have the potential to turn the role of central banks on its head in modern financial infrastructure.
- Central bank advocates say they are vital to the economy, to maintain jobs, stabilize prices, and keep the financial system running in times of crisis. Critics believe that central banks have a negative impact on consumers and the economy and are responsible for weakening recessions.
- While it has the potential to replace central banks, Bitcoin itself suffers from several disadvantages, including limited supply and a lack of legal status in most economies.
- Central banks borrow elements of Bitcoin’s design and technology to explore the use of central bank digital currencies (CBDCs) in their economies.
Role of central banks in an economy
Before studying the impact of Bitcoin on central banks, it is important to understand the role central banks play in an economy. Central bank policies underpin the global financial system. The mandates for central banks vary between countries. For example, in the United States, the Federal Reserve is responsible for controlling inflation and maintaining full employment. The Bank of England ensures the stability and solvency of the UK financial system.
Central banks use a variety of tactics known as monetary policy to carry out their mandates. Above all, however, they manipulate the money supply and interest rates. For example, a central bank could increase or decrease the amount of money that circulates in an economy. More money in an economy means more consumer spending and, consequently, economic growth. The opposite situation – that is, less money in an economy – leads to a situation in which consumers spend less and a recession sets in.
The actions of a central bank also affect imports, exports and foreign investment. For example, high interest rates can discourage foreign companies from investing in real estate, while low interest rates can encourage investment.
Central banks use a network of banks to distribute money in an economic system. In that sense, they are the linchpin of the financial infrastructure of an economy made up of banks and financial institutions, and central bank policies lead to economic booms and failures.
Commissioning a central body with the functioning of an economy has its advantages and disadvantages. Perhaps the biggest benefit is that it creates trust in the system. A currency issued by a central bank is secured by a trusted authority and can be exchanged for universal value. If each party in a monetary transaction were to issue their own coins, there would be competition between currencies and chaos would ensue.
Such a situation already existed in the days leading up to the creation of the Federal Reserve. Money spent by non-banks such as merchants and municipal corporations spread throughout the US monetary system. The exchange rates for each of these currencies varied, and many were scams that were not backed by enough gold reserves to justify their valuations. Bank runs and panics regularly shake the US economy.
In the immediate aftermath of the Civil War, the National Currency Act of 1863 and the National Bank Act of 1864 helped lay the foundation for a centralized and federal monetary system. A single national banknote was issued that was redeemable at face value in trading centers across the country. In addition, the creation of the Federal Reserve in 1913 brought monetary and financial stability to the economy.
A central decision-making body for recessions
The problem with the structure described above is that it places far too much trust and responsibility on the decisions of a central body. Debilitating recessions are the result of inadequate monetary policies by central banks.
The Great Depression, the largest economic recession in the history of the United States, was due to poorly managed economic policies and a number of bad decisions by local Federal Reserve banks, said former Fed chairman Ben Bernanke. The financial crisis and the Great Recession of 2008 were another example of the economy stagnating due to the Fed easing the economy and loosing interest rates.
The complexity of modern financial infrastructure has also made the role of central banks in an economy difficult. As money takes digital forms, the speed of its circulation through the global economy has increased. Financial transactions and products have become more abstract and difficult to understand.
Again, the Great Recession of 2008 is an example of this complexity. Various academic papers and articles have attributed the recession to an exotic derivatives trade, repackaging insolvent borrowers’ home loans into complex products to make them appear attractive. Attracted by the profits from these deals, banks sold the products to unsuspecting buyers, who resold the tranches to buyers around the world.
The entire financial system made fat profits. “As long as the music is playing, you have to get up and dance. We’re still dancing, ”Citigroup CEO at the time, Chuck Prince, told journalists notoriously. All of these deals were held up by money in the Federal Reserve.
The interconnected nature of the world economy means that political decisions (and mistakes) of a central bank are carried over to many countries. For example, it did not take long for the contagion of the Great Recession to spread from the United States to other economies, leading to global impotence in the stock markets.
A central bank’s potential fault in creating and triggering crises provided the seed for the invention of Bitcoin.
Can Bitcoin Kill Central Banks?
The case for Bitcoin as an alternative to central banks is based on both economics and technology. Satoshi Nakamoto, the inventor of Bitcoin, defined the cryptocurrency as a “peer-to-peer version of electronic cash” that enables “online payments to be sent directly from one party to another without going through a financial institution” .
In the context of a financial infrastructure system dominated by central banks, Bitcoin solves three problems:
First, it eliminates the double spending problem. Each bitcoin is unique and cryptographically secured, meaning it cannot be hacked or replicated. Hence, you cannot spend or fake Bitcoin twice.
Second, although Bitcoin’s network is decentralized, it is still a trustworthy system. In this case, trust is an algorithmic construct. Transactions on the Bitcoin network must be approved by nodes around the world in order to be included in its ledger. Even a single disagreement on the part of a node can render the transaction unsuitable for inclusion on Bitcoin’s ledger.
Third, Bitcoin’s network eliminates the need for centralized infrastructure by streamlining the process of making and distributing the currency. Anyone with a full node can generate Bitcoin at home. No intermediaries are required for peer-to-peer transfer between two addresses in Bitcoin’s blockchain. Therefore, a banking network chartered by a central authority is not required for the distribution of the cryptocurrency.
However, the economic independence Bitcoin promises has several catches:
The first of these is the status of Bitcoin as a transaction medium. There have been very few legally recorded uses for Bitcoin since it was released to the public. The cryptocurrency has gained notoriety as a favorite for criminal transactions and as a tool for speculation.
Second, the status of Bitcoin as a medium for legal transfers is unknown. The cryptocurrency has become legal tender in El Salvador, but that remains the only country that allows the cryptocurrency for transactions. Other nations around the world, including the United States and China, have cracked down on Bitcoin’s infrastructure and users.
After all, Bitcoin is volatile and limited in its supply. Only 21 million Bitcoin will be mined. An upper limit for the number of existing Bitcoins severely restricts their use. The scarcity has also made the cryptocurrency an attractive asset for speculation. Its price fluctuates between extremes, making it difficult to use in daily transactions.
The problems with using Bitcoin have not stopped central banks from adapting elements of the cryptocurrency to design their own digital currencies. Central Bank Digital Currencies (CBDCs), as the currencies are called, are being studied by several central banks for use in their economies. A digital currency issued by central banks can potentially remove intermediaries such as retail banks and use cryptography to ensure that it is not replicated or hacked. It can also prove to be cheaper to manufacture compared to metal coins.
The bottom line
Central banks are at the forefront of modern global financial infrastructure in the current economic system. An overwhelming majority of countries around the world use central banks to manage their economies. While offering several advantages, this form of centralized structure transfers excessive power to a single agency and has led to severe economic recessions.
Bitcoin’s technology is based on algorithmic trust, and its decentralized system offers an alternative to the current system. But the cryptocurrency has tiny adoption rates and its legal status is still in a cloud. Meanwhile, central banks have adopted elements of Bitcoin’s design and technology to investigate the case of a central bank-issued digital currency.