Central Banks and Bitcoin: Setting the Fox to Guard the Henhouse?

“The past instability of the market economy is the consequence of excluding its most important regulator, money, from being itself regulated by the market process.” – Friedrich A. Hayek

Currently, almost unnoticed by the media mainstream, one of the most interesting developments in economic history since the invention of paper money in ancient China is unfolding: so-called cryptocurrencies are appearing in ever-growing variety and changing everything we thought we knew about money and monetary systems. At first glance, they merely improve payment processing, but on closer inspection, they suddenly bring potential solutions for economic problems like hyperinflation, depression, balance-of-payments imbalances, bank failures, and currency crises within reach, promising an end to the recurring social and economic catastrophes we have seen throughout history.

Military Origins #

Like the internet itself, cryptocurrencies spring from an originally military technology: cryptography. Cryptocurrency systems leverage the high level of technical progress in data encryption to distribute tamper-proof ledger entries across the entire internet, thereby creating a massive, decentralized account system that no single party can control or censor. The best-known representative of these technologies is of course Bitcoin. By now, there is also a growing number of “altcoins” seeking to improve upon the famous original.

Strategies for Central Banks #

This rapid development cannot be ignored by the traditional paper-based money providers, the state central banks. How they individually respond to this challenge will be decisive not only for their own fate but also for the future prosperity of their respective nations. Central banks can choose one of two basic strategies: they can fight to preserve their monopoly, or they can open themselves to market competition.

China Tries Strategy 1 #

The People’s Bank of China (PBC) has visibly chosen the first option. Alarmed by a Bitcoin boom in China, it promptly prohibited all financial institutions from conducting Bitcoin-related transactions last December. In April, it then instructed its system banks to also close all accounts of private companies involved with Bitcoin. The Bitcoin economy in China has suffered a substantial setback as a result. Whether it can actually be suppressed in the long run, however, is doubtful. A draconian stance on monetary matters has a long tradition in China: in the 13th century, merchants who refused to accept state paper money, for instance due to inflation, were threatened with the death penalty. Until four years ago, China still had the death penalty for nonviolent economic offenses such as gold smuggling.

The Right Strategy for the West #

In Europe and the USA, it remains open whether the Chinese path will be followed or whether the door will be opened for innovation-friendly competition among technologies and providers. So far, Western central banks have largely confined themselves to “warning” the banks in their system against contact with the young competitors, citing certain disadvantages or teething problems. Before this situation escalates, parliaments, as democratically superior authorities over central banks, should urgently take up the issue. The central banks themselves are caught in a dilemma. In their macroeconomic role, they should actually take an enlightened position and represent the interests of citizens. But since the future of their own product is at stake, existential self-interest works against impartial consideration. Leaving it to central banks to decide between preserving (their) monopoly or abolishing it would be the proverbial case of setting the fox to guard the henhouse.

The Telecom Industry as a Model #

The successful development of competition in the telecommunications sector could serve as a guide for parliaments. It is almost unimaginable today that not so long ago, the right to offer telephone and mobile services was solely in the hands of the state. Probably few remember that a landline call from Vienna to Innsbruck used to cost more than a mobile call abroad does today. Consumers’ choices were limited to ordering the standard plastic telephone in eggshell white, rust red, or olive green. And instead of the internet, there was Bildschirmtext (teletext) at exorbitant per-minute and even per-page rates. The opening of the telecom industry to competition from the late 1980s onward then enabled an ever-accelerating pace of innovation: today there is an almost unbelievable number and quality of new services from alternative providers, at costs that are affordable for the general public.

Identical Strategy Menu for Telecom Incumbents #

Back then too there were two alternatives: The leadership of some postal and telegraph administrations swiftly transformed their operations into competitive enterprises. Many established dedicated subsidiaries for mobile telephony and internet, using focus and flexibility to accelerate their ability to adapt to new competitors. Despite initial resistance to these ventures, they are today among the most successful and largest companies in the world. The state postal and telegraph administrations of the second type instead fought a defensive battle, conjuring up visions of the imminent collapse of the telephone network, the economy, and national security if private providers were allowed to operate such sensitive services and compete with them.

Strategy 2 Worked #

As everyone knows today, exactly the opposite is true. If parliament today tried to take away citizens’ mobile phones or cut off their internet access by law, it would meet with total incomprehension. It would also be the wrong economic and social policy. If telecom liberalization were reversed or the entry barriers for new providers were no longer lowered through pro-competitive regulation, we would all soon have to wait for new services and pay monopoly prices again.

Advantages of the New Technology #

Central bankers’ fear of change is quite understandable, because the advantages of the new type of money are compelling: cryptocurrencies are virtually counterfeit-proof, payments happen in seconds rather than days, and they reach every point on the planet in exactly the same way. All of this around the clock, without bank opening hours, with 100% reliability, and at negligible cost. But above all: the money supply of the leading alternative currency systems is technically fixed, hardcoded in the openly viewable base software. For instance, a maximum of 21 million bitcoins can ever be produced. The “customers” of central banks, by contrast, must live in constant fear of the printing press and rising inflation. Central banks can be encouraged or even ordered by politicians to print money, but private individuals will only voluntarily buy government bonds with their hard-earned bitcoins if a state’s debt level stands in a healthy relation to its tax revenue and the offered interest rate.

Muted Defensive Reactions #

Whether any central banks are currently implementing the enlightened strategy is not known. But the history of the telecom industry is a case of deja vu when you hear the arguments of the other type of central bank trying to nip potential competition from alternative currencies in the bud. Their lobbyists’ efforts will likely intensify, as Bitcoin’s market capitalization already exceeds 8 billion US dollars, signaling the steadily growing importance of the young competitor. The “warnings” currently being directed with increasing frequency at banks and their employees, and especially at parliamentarians, politicians, and government decision-makers, are in principle based on facts. Bitcoins can be stolen, we hear, and their exchange rate fluctuates widely. You can even buy weapons and drugs with bitcoins. But with all of these arguments, one has to ask: Where is the difference from many paper currencies?

Parts of the Regulatory Framework Made Obsolete #

Legal arguments are also being brought to bear. Many Bitcoin companies are said to operate outside today’s state regulation, which is supposed to make the banking system safe and prevent financial crises. The last two arguments in particular display a remarkable blindness to recent history since 2007. The opposite is the case. Foreseeably, an alternative financial and credit system based on cryptocurrencies and their hard-coded principles would make most of today’s regulations with their distorting liquidity and reserve requirements obsolete. The debt crises and bank collapses resulting from regulatory failures would become a thing of the past. When multiple private currencies compete, governments would never again need to perform emergency bailouts of the (one) monopoly currency or systemically critical banks. Never again would scarce budgets need to be diverted at the expense of other government functions, or entire future generations of taxpayers burdened, just to maintain a flawed and outdated monetary system, foreseeably only in the medium term anyway.

New Framework Conditions Required #

The prompt creation of fair competition now requires measures at the supranational level, in individual states, and at the central banks themselves as quickly as possible. The priority is separating sovereign from corporate functions. For the former, banking supervision must be expanded into a banking and currency supervision authority and given appropriate macroeconomic and political objectives (such as price stability). All legal foundations, including the Euro Act, the Coinage Act, the National Bank Act, and tax laws, must be stripped of any provisions that stand in the way of alternative currencies, favor a specific currency, or imply a monopoly position for any currency. Within the framework of the World Trade Organization (WTO), corresponding agreements must be negotiated to secure mutual market access for new currencies among participating states.

Strategy Implementation at Central Banks #

Central banks of the first type should prepare for future competition through a series of strategic measures. Analogous to the mobile subsidiaries of telecom corporations, the rapid establishment of specialized subsidiaries is recommended in order to house and develop their own cryptocurrency activities. This spreads technological risk, enables a better understanding of the new competitors, and structurally ensures the high level of strategic attention that the topic would otherwise not receive due to its (initially) small volume. This important step has several variations that are not necessarily mutually exclusive. The subsidiary could launch its own cryptocurrency to bring an optimal monetary product to market. The option of backing Bitcoin itself, operating a major node in the Bitcoin network, mining it, and contributing to its further development also deserves serious consideration. The central bank subsidiary could also peg its cryptocurrency to the central bank’s own paper money as a reserve currency, for instance creating a BitMark, a BitSchilling, or a BitEuro. They could form strategic alliances with other established or new money issuers to build critical mass within the largest possible currency zone. These alliances could also be secured through capital interlocking. After establishing an effective new regulatory framework, an IPO of the reformed central banks could, as in the telecom sector, round off the normalization of the industry structure within the economy.

Feedback Effects on Paper Money #

But even regarding the old technology of “paper,” the monopolistic structures must be broken up to enable individual product decisions and thus better paper money once again. The individual national banks of EU member states should be allowed to issue their own national currency alongside the franchise product “Euro,” in order to use the strategic advantages of their original currency zone or, in the case of poor product management (i.e., currency management) by the ECB, to be able to produce better money of their own. Should the ECB as franchisor prohibit this within the framework of legitimate freedom of contract, the next step would be to split the current institutions into an ECB branch and an independent national bank.

Parliaments Must Act #

Breaking up monopolies that hinder innovation and cause social and economic harm has always required enlightened politicians supported by democratic pressure from voters, clear positions from independent economists, consumer advocates, and business representatives. This applies no less to the urgently needed reorganization of the monetary system, one of the last problematic state monopolies. Political decision-makers and parliament should seize this historic opportunity to set the course for a more stable monetary and economic system through greater competition. But even central banks can actually benefit from this development: since they must hold their own against the new competitors, they will in the future, to the benefit of the general public, pay more attention to the stability of their currency, reorganize, become competitive, more efficient, and leaner. Time to trim the fat.

About the author: Mag. Hubertus Hofkirchner M.B.A. is an independent entrepreneur and economist in Vienna. From 2001 to 2005 he was CEO and supervisory board member of mobile and fixed-line operator Tele.ring; previously he was Director of Creditanstalt Investment Bank and a part-time lecturer at the Vienna University of Economics and Business.