In this post we talk about how Bitcoin is reshaping the architecture of debt-based economies and monetary systems.
Let us explore how money is created in the modern economy. As John Kenneth Galbraith famously remarked, "The process by which money is created is so simple, the mind is repelled."
Essentially, the Federal Reserve Act of 2013, which directed the Comptroller General (GAO) to audit the Board of Governor of the Federal Reserve System and the Federal Reserve Banks, created the Central Banking system in the US that has since been adopted by most major market economies. According to this paradigm, Banks operate by accepting deposits from customers and issuing loans to borrowers. The reason that they are able to lend most of their deposits at any point of time is that not every depositor needs his or her money every day.
By offering depositors an interest rate on their deposits, banks can incentivise depositors to leave their deposits untouched for longer periods of time. This allows banks to lend out some of their deposits, while keeping a small fraction of total deposits on hand to meet daily withdrawal requests by depositors. This forms the basis of the fractional reserve banking system.
The way in which Central banks influence and shape monetary policies is by fixing the fraction (or) percentage of total deposits that banks must hold as reserves to satisfy daily withdrawals. This amount can, by definition, not be lent. This is called the Reserve ratio. The assets that make up the Reserve ratio are typically held in the form of cash stored in a bank vault and in deposits with the central bank. The Reserve ratio is the mandated minimum; banks can choose to hold more as reserves but cannot hold less.
This is the process by which money is created and transported in the modern global economy. As banks are allowed to loan out the bulk of their deposits, they are able create money supply in the economy. If a customer deposits $1000 in a bank, the bank may hold $100 in the form of Reserves and lend out the remaining $900 into the economy. The amount lent represents new money that has literally been created out of thin air. Most, if not all, money in the global economy today has been thus created out of loans (read: debt) issued by banks.
Fractional Reserve banking therefore encapsulates and conceives of money as a debt based system, where banks offer depositors an interest rate to deposit their money which they in turn use to provide loans or debts to borrowers. Money is literally lent into creation. Money creation is therefore based on a deceptively simple process of chain lending but, upon closer, inspection invites the following question: if all new money created is the product of borrowed principal, where does the money to pay the interest on said principal come from. That is, how does the bank fulfil the interest obligations to its depositors when it is creating money by lending out the deposited money.
We can frame this as the genesis problem of all debt-based money systems. Put differently, since fractional banking only creates enough money to satisfy the principal (equaling total money lent by the banking system) but not the interest on the principal, the economy is stuck in an eternal debt spiral wherein it needs the banking system to create more money just to pay the interest and so forth.
Both money supply and debt are therefore conjoined in a continuous, never-ending growth loop. In summary, debt-based money systems model economies wherein every debt crisis followed by a deleveraging cycle must necessarily be followed by yet another debt reflation cycle as the demand for money (capital) increases in an economic recovery. In essence, every economic recovery carries within itself the seeds of the next financial crisis.The only way that the mathematical and logical certainty of this cycle would seem to be able to be broken is if the borrower (bank) “spends” the interest earned back into economic circulation thereby enabling the borrower to pay it back.
Bitcoin and the blockchain offer the unique opportunity to sovereign governments to pivot to an equity-based money paradigm that allows the provably fair distribution of “currency tokens” into the economy. The value of these tokens can neither be inflated away by monetary policy decisions nor can the tokens be demonetized or cease to carry value due to cryptographic encryption.
The sovereign, rather than lose control as is often claimed by crypto critics, regains control over money supply by explicitly delinking it from the overall debt level (and the level of economic activity) in the economy. The ability to link currency or the money supply in the economy to a finite, a priori knowable number of unique equity tokens that can, by design, not be cloned or duplicated also implicitly solves the double-spending problem that in the existing debt based money paradigm is addressed imperfectly via the notion of a trusted 3rd party (a.k.a banking systems) at astronomical cost.
Also, these money tokens will be transacted and validated on blockchains that are, by definition, auditable by the sovereign and its affiliated agencies. The ability of the blockchain to serve as a complete, high fidelity repository of all real-time economic activity has the potential to profoundly enhance the ability of economic policymakers to frame better policies than they have ever been able to before.
In summary, we would like to advance the thesis that sovereigns should embrace blockchain not because it is fashionable to do so but because it will enable the best amongst them to exercise their powers with deeper and more lasting impact on the economic lives of their citizens.
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