Through their policymaking, central banks played a key role in manufacturing the 2008 financial crisis. 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 the economic fortunes of entire countries. But the cryptocurrency has its own set of drawbacks that make it difficult to make a case for a decentralized system consisting of the cryptocurrency.
- Bitcoin’s peer-to-peer technology and decentralized system has the potential to upend the role of central banks in modern financial infrastructure.
- 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. Critics suggest central banks have a negative impact on consumers and the economy and are responsible for debilitating recessions.
- While it has potential as a replacement to central banks, Bitcoin itself suffers from multiple drawbacks, including a limited supply and lack of legal status in most economies.
- Central banks are borrowing 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 exploring the effect of Bitcoin on central banks, it is important to understand the role that central banks play in an economy. Central bank policymaking underpins the global financial system. The mandates for central banks vary between countries. For example, the Federal Reserve in the United States is responsible for controlling inflation and maintaining full employment. The Bank of England ensures stability and solvency of the financial system in the United Kingdom.
Central banks use a variety of tactics, known as monetary policy, to achieve their mandates. Mainly, however, they manipulate money supply and interest rates. For example, a central bank might increase or decrease the quantity of money circulating in an economy. More money in an economy equals more spending by consumers and, consequently, economic growth. The opposite situation—i.e., less money in an economy—translates to one in which consumers spend less and a recession ensues.
A central bank’s actions also have an effect on imports, exports, and overseas investment. For example, high interest rates can deter investment by foreign entities in real estate, while low interest rates can promote investment.
Central banks use a network of banks to distribute money in an economic system. In that sense, they are the pivot of an economy’s financial infrastructure that consists of banks and financial institutions, and central bank policymaking results in economic booms and busts.
Tasking a central agency with an economy’s functioning has its advantages and disadvantages. Perhaps the biggest advantage is that it builds trust in the system. A central bank-issued currency is backstopped by a trusted authority and can be exchanged at a universal value. If each party in a monetary transaction issued its own coins, then there would be competition among the currencies, and chaos would ensue.
A situation like this already existed in the days before the Federal Reserve came into being. Money issued by nonbank entities like merchants and municipal corporations proliferated throughout the U.S. monetary system. The exchange rates for each of these currencies varied, and many were frauds, not backed by enough gold reserves to justify their valuations. Bank runs and panics periodically convulsed through the U.S. economy.
Immediately after the Civil War, the National Currency Act of 1863 and the National Bank Act of 1864 helped set the grounding for a centralized and federal system of money. A uniform national bank note that was redeemable at face value in commercial centers across the country was issued. Further to this, the Federal Reserve’s creation in 1913 brought monetary and financial stability to the economy.
A Central Decision-Making Authority 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 agency. Debilitating recessions have resulted from improper monetary policy measures pursued by central banks.
The Great Depression, the biggest economic recession in the history of the United States, occurred due to mismanaged economic policy and a series of wrong decisions by local Federal Reserve banks, according to former Fed Chairman Ben Bernanke. The Financial Crisis and the Great Recession of 2008 were another example of the economy tanking due to the Federal Reserve slackening its hold on the economy and pursuing a policy of loose interest rates.
The complexity of the modern financial infrastructure has also complicated the role of central banks in an economy. As money takes on digital forms, the velocity 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 ascribed the recession to exotic derivative trading in which housing loans of insolvent borrowers were repackaged into complex products to make them seem attractive. Attracted to profits from these trades, banks sold the products to unsuspecting buyers who resold the tranches to buyers across the world.
The entire financial system generated fat profits. “As long as the music’s playing, you’ve got to get up and dance. We are still dancing,” then-Citigroup CEO Chuck Prince infamously told journalists. All of these trades were backstopped by money at the Federal Reserve.
The interconnected nature of the global economy means that policymaking decisions (and errors) by one central bank are transmitted across many countries. For example, the contagion of the Great Recession did not take long to spread from the United States to other economies and led to a global swoon in stock markets.
The potential culpability of a central bank in manufacturing and precipitating crises provided the seed for Bitcoin’s invention.
Can Bitcoin Kill Central Banks?
The case for Bitcoin as an alternative to central banks is based both on economics and technology. Satoshi Nakamoto, Bitcoin’s inventor, defined the cryptocurrency as a “peer-to-peer version of electronic cash” that allows “online payments to be sent directly from one party to another without going through a financial institution.”
Within the context of a financial infrastructure system dominated by central banks, Bitcoin solves three problems:
First, it eliminates the problem of double spending. Each bitcoin is unique and cryptographically secured, meaning it cannot be hacked or replicated. Therefore, you cannot spend bitcoin twice or counterfeit it.
Second, even though it is decentralized, Bitcoin’s network is still a trustworthy system. In this case, trust is an algorithmic construct. Transactions on Bitcoin’s network have to be approved by nodes spread out across the world to be included in its ledger. Even a single disagreement by a node can make the transaction ineligible for inclusion in Bitcoin’s ledger.
Third, Bitcoin’s network eliminates the need for a centralized infrastructure by streamlining the process to produce and distribute the currency. Anyone with a full node can generate bitcoin at home. Intermediaries are not required for peer-to-peer transfer between two addresses on Bitcoin’s blockchain. Therefore, a network of banks chartered by a central authority is not necessary to distribute the cryptocurrency.
However, the economic independence promised by Bitcoin comes with several catches:
The first of these is Bitcoin’s status as a medium of transaction. Since it was released to the general public, there have been very few legitimately recorded uses for bitcoin. The cryptocurrency has gained notoriety as a favorite for criminal transactions and as an instrument for speculation.
Second, Bitcoin’s status as a medium for legal transfers is unknown. The cryptocurrency has become legal tender in El Salvador, but that remains the only country to allow the cryptocurrency for transactions. Other nations around the world, including the United States and China, have cracked down on Bitcoin’s infrastructure and users.
Finally, Bitcoin is volatile and restricted in its supply. There will only be 21 million bitcoin mined. A cap on the number of bitcoin in existence severely limits its use. Scarcity has also made the cryptocurrency an attractive asset for speculation. Its price swings between extremes, making it difficult for use in daily transactions.
The problems with Bitcoin’s use has not deterred central banks from adapting elements of the cryptocurrency to design their own digital currencies. Central bank digital currencies (CBDCs), as the currencies are known, are being explored by several central banks for use in their economy. A digital currency issued by central banks may possibly remove intermediaries, such as retail banks, and will use cryptography to ensure that it is not replicated or hacked. It may also work out to be cheaper to produce compared to metal coins.
The Bottom Line
Central banks are at the helm of the 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 it offers several advantages, this form of centralized structure vests excessive power on a single authority and has resulted in severe economic recessions.
Bitcoin’s technology relies on algorithmic trust, and its decentralized system offers an alternative to the current system. But the cryptocurrency has miniscule adoption rates, and its legal status is still under a cloud. Meanwhile, central banks have co-opted elements of Bitcoin’s design and technology to explore the case of a digital currency issued by central banks.