What Is Bitcoin?

Bitcoin is a digital currency that, in the words of its sponsors, “uses peer-to-peer technology to operate with no central authority or banks.” By its very definition Bitcoin seems well-positioned to kill off central banks. Could it? Would it? Should it? Like just about everything else involving finance, the topic of central banks and their potential replacements is complex with valid arguments for and against.

Key Takeaways

  • As a digital currency that uses peer-to-peer technology, Bitcoin may be poised to eliminate central banks.
  • Proponents of central banks say they are vital to the economy to maintain employment, stabilize prices, and help keep the financial system going in times of crisis.
  • Central banks use interest rates and alter a nation's money supply to react to economic changes.
  • Critics of central banks suggest that they have a negative impact on consumers, businesses, and the economy.
  • Some believe that central bank policies can deter consumers from borrowing and may create asset bubbles.

Arguments for Central Banks

The digital era may be taking aim at central banks, but it has not yet managed to kill off the trusty Encyclopedia Britannica, so we turn to the venerable reference to learn that central banking can be traced back to Barcelona, Spain, in 1401. The first central bank, and those that followed in its wake, often helped nations fund wars and other government-supported initiatives.

The History of Central Banks

The English refined the concept of central banking in 1844 with the Bank Charter Act, a legislative effort that laid the groundwork for an institution that had monopoly power to issue currency. The idea was that a bank with that level of power could help stabilize the financial system in times of crisis. It’s a concept that many experts agree helped stave off disaster during the 2007-2008 financial crisis and the Great Recession that followed.

Central banks have evolved over time. The U.S. Federal Reserve, for example, is tasked with using monetary policy as a tool to do the following:

  • Maintain full employment and stable prices
  • Ensure the safety and soundness of the nation's banking and financial system and enable consumers to access credit
  • Stabilize the financial system in times of crisis
  • Help to oversee the nation’s payment systems

What Central Banks Do

To achieve these objectives, the Federal Reserve and other central banks can increase or decrease interest rates and create or destroy money. For example, if the economy seems to be growing too quickly and causing prices for goods and services to rise so rapidly that they become unaffordable, a central bank can increase interest rates to make it more expensive for borrowers to access money.

A central bank can also remove money from the economy by reducing the amount of money the central bank makes available to other banks for borrowing purposes. Since money largely exists on electronic balance sheets, simply hitting delete can make it disappear. Doing so reduces the amount of money available to purchase goods, theoretically causing prices to fall.

Of course, every action has a reaction. While reducing the amount of money in circulation may cause prices to fall, it also makes it more difficult for businesses to borrow money. In turn, these businesses may become cautious, unwilling to invest, and unwilling to hire new workers.

If an economy is not growing quickly enough, central banks can reduce interest rates or create money. Reducing interest rates make it less expensive, and therefore easier and more appealing, for business and consumers to borrow money. Similarly, central banks can increase the amount of money that banks have available to lend.

Central banks can also engage in additional efforts to manipulate economies. These efforts can include the purchase of securities (bonds) on the open market in an effort to generate demand for them. Increased demand leads to lower interest rates, as borrowers do not need to offer a higher rate because the central bank offers a ready and willing buyer.

Central Bank Policy Risks

Central bank-led efforts to steer economies on to the path to prosperity are fraught with peril. If interest rates are too low, inflation can become a problem. As prices rise and consumers can no longer afford to buy the items they wish to purchase, the economy can slow. If rates are too high, borrowing is stifled and the economy is hobbled.

Low-interest rates (relative to other nations) cause investors to pull money out of one country and send it to another country that offers a greater return in the form of higher interest rates. Consider the plight of retirees who rely on high-interest rates to generate income. If rates are low, these people suffer a direct hit to their purchasing power and ability to pay their bills. Sending cash to a country that offers better returns is a logical decision.

Manipulation of interest rates and/or the money supply also has a direct effect on the value of a nation’s currency. A strong dollar makes it more expensive for domestic firms to sell goods abroad. This can lead to domestic unemployment. A weak dollar increases the price of imported goods, including oil and other commodities.

This can make it more expensive for consumers to purchase imports and for domestic companies to produce goods that rely on imported parts or materials. Arguably, a weak dollar is beneficial for a slow economy that needs to pick up steam while a strong dollar is good for consumers.

Because there is a lag between the time a central bank begins to implement a policy change and that change actually having an impact on a nation’s economy, central banks are always looking to the future. They want to make policy changes today that will enable them to achieve future goals. 

Arguments Against Central Banks

The very complexities associated with national and global economies set the stage for an argument that these economies are too unpredictable to be successfully managed by the type of manipulation central banks engage in. This argument, made by proponents of the Austrian School of Economics, can be used to support the implementation of Bitcoin-style peer-to-peer currency that eliminates central banks and their complex schemes.

Negative Impact on Citizens and the Economy

Modern central banks have been the subject of controversy since their inception. And the reasons for discontent are wide and varied. On one hand, the concept of monopoly power is profoundly disturbing to many people. On another, the existence of an independent, opaque entity that has the power to manipulate an economy is even more disturbing.

Many people (including economists and politicians) believe that central banks make mistakes that have enormous ramifications in the lives of citizens. These mistakes include:

  • Increases in the monetary supply (creating inflation and hurting consumers by raising prices for the goods and services they purchase)
  • The implementation of interest rate increases (hurting consumers who wish to borrow money)
  • The formulation of policies that keep inflation too low (resulting in unemployment)
  • The implementation of unnaturally low-interest rates (creating asset bubbles in real estate, stocks, or bonds)

Along these lines, no less an authority than former Chair of the Federal Reserve Ben Bernanke blames manipulation by the central bank (which raised interest rates) for the Great Depression of 1929.

The Impact of Technology

In an era when technology has enabled consumers to engage in commerce without the need for a central authority, an argument can be made that central banks are no longer necessary. A broader examination of the banking system extends this argument.

Corruption associated with the banking system resulted in the Great Recession and a host of scandals. Bankers have caused great angst in Greece and other nations. Organizations such as the International Monetary Fund have been cited for fostering profits over people. And at the more local level, bankers make billions of dollars by serving as the middlemen in transactions between individuals. In this environment, the elimination of the entire banking system is an appealing concept to many people.

The Bottom Line

Central banks are currently the dominant structure nations use to manage their economies. They have monopoly power and are not going to give up that power without a fight. While Bitcoin and other digital currencies have generated significant interest, their adoption rates are minuscule and government support for them is virtually nonexistent.

Until and unless governments recognize Bitcoin as a legitimate currency, it has little hope of killing off central banks any time soon. That noted, central banks across the globe are watching and studying Bitcoin. Based on the fact that metal coins are expensive to manufacture (often costing more than their face value), it is more likely than not that central banks will one day issue digital currencies of their win.

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author does not own Bitcoin.