Ecoinometrics - October 19, 2020
Central banks have a problem...
… and no it isn’t Bitcoin. I mean, not yet.
The major central banks have similar mandates. Through their monetary policies they are supposed to:
Make sure that inflation stays around 2%.
Provide a high level of employment.
They have been failing on both counts, mostly because they don’t have the right tools. But things might be about to change.
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You know the expression: when you have a hammer every problem looks like a nail.
The US Federal Reserve does not have a hammer, but they can do two things:
Manipulate interest rates through the Fed funds rate (short term) and through yield curve control (long term).
Inject liquidity into the system.
When it comes to the Fed funds rate we are already virtually at 0%. Negative rates might come soon as we have seen in Europe and Japan but the problem is that clearly it doesn’t help.
The Fed funds rate was low for almost 10 years after the 2008 financial crisis but CPI inflation never came even close to 2%.
Yield curve control isn’t yet in full force but this is a tool for debt management more than anything else. Any effect this would have on CPI inflation and employment is at least twice removed.
What about pumping money into the system then? Is it working?
Once more it does not have the expected result.
Just take a look at the expansion of the money in the past 30 years.
Already before 2020 M2 had been on a spectacular growth trajectory.
But what happened since February is off the chart. Compared to 2020 the 2008 financial crisis just looks like a bump in the road.
But where is all this money going? Definitely not in the real economy…
The velocity of money is one way of measuring how the money supply moves around in the economy. You can think of it as answering the question: is the money added to the system resulting in an increase of the economic activity.
As you can see from the chart below the answer is a clear no.
Actually it seems to have the opposite effect. The more M2 is growing the less effective it is at increasing the economic activity.
The reason for that is the Cantillon effect. The point at which this newly created money enters the system matters. And the way things are currently designed most of that newly created money enters the system through the banks.
The problem with that is banks are not incentivized to distribute that money around.
The result isn’t CPI inflation but financial assets inflation which believe it or not isn’t the Fed mandate.
Can you spot the common theme?
The Federal Reserve tools are too far away from the action.
When the Fed prints money it goes to the US Treasury or the banking system in general. What happens afterwards is out of their control.
But what if there was another way?
What if every citizen and every business had an account directly at the Federal Reserve?
What if the Fed could distribute USD directly to those accounts?
What if the Fed could then track and control how these USD are used?
By removing the intermediaries that are the US government and the banks the Federal Reserve would have direct control over the flow of money in the economy.
For central planners this would be the dream.
For the free market this would be a disaster.
The thing is this is not going to stay a dream for long. Central Banks Digital Currencies are coming.
Now they might not realize it but with the introduction of Central Banks Digital Currencies the Feds of the world are playing a dangerous game.
On one hand they need them. There is no way Central Banks can achieve their mandate while the velocity of money is constantly decreasing.
They can’t rely on the banks to make money flow everywhere. They need to have direct access to businesses and individuals.
That’s achievable with CBDCs. Businesses and citizens can have an account directly at their central bank. This is simply a digital wallet. And the central bank can control exactly who gets what and on what terms.
In that system your money is completely controlled by your central bank.
On the other hand what if I told you that there is a similar system where you can keep your wealth in a digital currency using a digital wallet but instead of the central banks being in control:
The system is permissionless. You can do whatever you want with your savings.
The system is decentralized. No single entity is in control of the whole network.
The monetary policy is fixed and transparent. The currency creation is algorithmic and the total supply is fixed.
That is the promise of Bitcoin.
Clearly anyone who wants to stay in control will choose to go with Bitcoin over CBDCs.
And the irony is that the introduction of CBDCs by central banks will raise awareness of Bitcoin up to a point where it might be seen as a threat.
We aren’t there yet. Remember that Bitcoin is a tiny market:
10 times smaller than Apple.
50 times smaller than gold.
100 times smaller than the US M2 money stock.
But already the Bank of England is worried about Bitcoin…
At this point there might be two paths:
Bitcoin becomes a base layer used by individuals and central banks as a reserve currency.
CBDCs and Bitcoin work as parallel systems.
The more Bitcoin gets integrated to the global financial system the more likely it is that central banks will be forced into the first scenario.
That’s why it is important to see Bitcoin being adopted as a reserve asset by businesses or to witness the growth of the regulated derivatives market. My opinion is that for the long term we better embrace than fear those trends.
But in the meantime we’ll probably have to live with the second scenario for a while.
That’s it for today. If you have learned something please subscribe and share to help the newsletter grow.
Cheers,
Nick
The Ecoinometrics newsletter decrypts Bitcoin’s place in the global financial system. If you want to get an edge in understanding the future of finance you only have to do two things:
Click on the subscribe button right below.
Follow Ecoinometrics on Twitter at https://twitter.com/ecoinometrics.
Done? That’s great! Thank you and enjoy.