The Bear’s Lair: Cryptos are sounder than today’s currencies

Crypto-currencies are an entirely imaginary form of money, dreamed up by pimply nerds in basements. Or so it seemed. Yet examine the algorithms behind some of the better crypto-currencies, and look in contrast at the monetary policies that have devastated the last decade. You will recognize two things. First, fiat money is fiat money, whether or not it has a government stamp on it. And second, the best crypto-currencies, considered as a store of value, are much more solidly designed than the world’s major conventional currencies. The long-term implications of this for our economy are troubling, to say the least.

We must establish first what a sound currency consists of. To do so we must once again go back to the debates surrounding the 1819 return to the Gold Standard. In a House of Lords debate a year before that, Robert, Lord Liverpool, Britain’s prime minister with an especial expertise in economic policy said: “The best system of currency for any country, and particularly for a country such as this, is a paper circulation, measured by the precious metals as its standard, and supported in value by being convertible into cash at the pleasure of the holder.”

He then explained why he felt any paper currency issue should have statutory limits: “Unless some limit is adopted, property will become insecure, and the circulation will be subjected to repeated shocks, that might cause great public calamity and individual suffering. The evil of insecurity could not be a solitary evil. The repeated failures of banks would give a shock to public credit, and the character of all paper currency would be affected by that of the most insecure.” Presciently, Liverpool thus anticipated our present difficulties with unlimited expansion of credit.

Finally, Liverpool pointed out that “the tendency of an inconvertible paper money is to create fictitious wealth, bubbles, which by their bursting, produce inconvenience.”

Liverpool was thus not rigidly opposed to paper money; he had worked with a paper money system in 1797-1821. He also recognized that in a modern industrial economy, the vast majority of payments were made through paper instruments of one kind or another. However, he believed that the amount of paper issued should be strictly limited. In another speech a few years earlier, he had explained that Britain’s paper money system of the Napoleonic era differed from the French “assignats” or the U.S. “continentals” because the bank notes were issued by the Bank of England, then a private sector entity, so that normal banking prudence and avoidance of leverage would limit the amount of paper that was issued.

Excessive paper issues, whether by the “country banks” of his day or by the government itself could only to disaster, either a mass bankruptcy of the country banks as happened in 1825 or a hyperinflation, as had happened in Revolutionary America and France, and was to recur with added vigour in the 1923 Weimar Republic.

By Liverpool’s standards, a paper currency like the 1980s dollar managed by Paul Volcker would be an acceptable emergency measure, similar to the British paper money of 1797-1821, even though there was no store of value to which it was linked. The supply was strictly limited, in the Volcker dollar’s case by following strict rules of money supply growth. The result was a currency that was neither too inflationary, nor conducive to excessive speculation, nor prone to creating “fictitious capital.”

By contrast, Liverpool would regard the conventional monetary system of today with unmitigated horror. Not only is the amount of issue unlimited, but central banks, by buying government debt in vast quantities, have encouraged its expansion. He would be surprised by the lack of consumer price inflation, but would point out triumphantly that the level of fictitious capital was altogether excessive, so that in every sector we see bubbles, which, as he said with typical understatement “by their bursting, produce inconvenience.” He would see real estate, tech, art, share prices and more or less every asset price as buoyed by fictitious wealth with nothing behind it. (He would indeed probably regard shares that traded above their net asset value as being deeply suspect – his Victorian successors did.) He would thus expect a gigantic crash, and be very surprised we had not had it yet.

At first sight, crypto-currencies, which have exploded in value to some $160 billion from zero in 2009, are merely an extreme example of a bubble caused by loose money. After all, being created electronically out of nothing, they represent no value. But then as Liverpool would point out, a conventional modern currency with an aggressive public sector central bank entirely out of control from any commercial reality equally represents no real value.

Liverpool would be attracted by three central features of crypto-currencies, their anonymity, their creation by the private sector and their algorithms limiting the amount of currency created. Each of these features would appear to him more attractive than their analogues among today’s conventional currencies.

In Liverpool’s world, generally inaccurate memories of the Stuarts remained strong, as did a suspicion of foreign countries’ tendencies to produce a Louis XIV or a Napoleon. Hence, he would be deeply distrustful of the new capability created by modern technology for government to track everybody’s payments and wealth levels. He would rightly see that in the hands of a Louis XIV, a James II or a Napoleon, such a capability would lead to deep injustice, in which enemies of the regime were stripped of their wealth and payments to politically disapproved entities were disallowed.

Liverpool regarded strong property rights as a vital element in a free and civilized society, and so cyber-capabilities that allowed potentially tyrannical governments to abuse those rights, for example by imposing punitive taxation, would be anathema to him. To the extent that their payment systems and stores of wealth are truly anonymous, he would thus approve of crypto-currencies.

Liverpool would strongly approve of the private sector nature of crypto-currencies. He thought a government-issued money hopelessly unsound because of the danger of over-issue and inflation. He also recognized that a private sector note issuer would always want to restrict the supply of notes to maintain their value.

Liverpool would worry mainly about the proliferation of crypto-currencies and the lack of barriers to their creation. The scam level in the area is very high, as it was in the financial business in Liverpool’s day, but over time currencies with protections such as control by a broad group of investors would tend to dominate. Liverpool would recognize that over time, the stronger crypto-currencies would drive out the weaker, and that the best crypto-currencies are less vulnerable to subornation than fiat currencies blown by political whims.

Gresham’s Law, that bad money drives out good, only works when the bad money can be tendered at full face value; in the crypto-currency world, it cannot. Dogecoin, a crypto-currency that took a Bernankeist approach and issued an excessive 110 billion units, has been in existence several years, yet has not shared in the price rise of other crypto-currencies.

Finally, Liverpool would be greatly reassured by the crypto-currency algorithms preventing excessive money creation. He would recognize that the better crypto-currencies do not share the tendencies to over-issue of ordinary fiat currencies, and hence that over time their value in terms of those fiat currencies must tend to increase. He would however be very wary of profit-seeking artificial increases in circulation like the Bitcoin “split” of August 1, 2017, and would want protections against them.

Liverpool would recognize that the value of crypto-currencies in their current embryonic stage must be highly unstable, and that only when market forces have caused the best crypto-currencies to emerge from the herd, and fraudulent or unsound efforts to fail, would a truly conservative investor wish to store his wealth in them. He would also worry about the stability of the crypto-currency exchanges, which do not have the oligarchic controls of his own day’s City of London, and hence are prone to unexpected bankruptcy or fraud.

Nevertheless, as currency algorithms become better tested and understood, and as exchanges acquire scale and reputation, the level of fraud would decrease. Liverpool was aware of the scams perpetrated at the time of the South Sea Bubble in 1720. He also knew of the tendency of new markets in his own time to produce scams like the 1822 bond issue for the non-existent South American Republic of Poyais, complete with a prospectus waxing rhapsodic over the beauties of the non-existent cathedral in its non-existent capital’s main square.

Nevertheless, babies eventually stop teething, and markets eventually mature to the point where conservative and careful investors can enter them and achieve moderate, safe returns. By that time, the bonanza speculative profits will have ended, and a gigantic crash will have occurred, weeding out the weak and fraudulent entrants. However, short of a drastic reformation by the world’s conventional currency central banks and governments, the advantages of crypto-currencies as stores of value will remain, as will their convenience as means of exchange.

Crypto-currencies are thus likely in the long run to capture much of the wealth and exchange that is currently routed through conventional fiat currencies. To do so, the world will need a very much larger crypto-currency “money supply” perhaps of the order of $8 trillion, the current value of the global gold stock. That suggests that the growth of crypto-currencies may have very much further to go.

Lord Liverpool would still prefer that we adopt a Gold Standard, and think it very eccentric of us not to do so. But for him, crypto-currencies would remain far more attractive than their sadly degraded conventional-world politically-managed fiat alternatives.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)