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The Gloom of Central Banking.pdf

The Gloom of Central Banking.pdf

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TheGloomofCentralBanking
TuurDemeester,november2012

1
TheGloomofCentralBanking
DoestheCB’stoolboxhavewhatittakestocontainaprivate,decentralisedcryptocurrency?Or:Bitcoinseenthroughtheeyesofacentralbanker.
Onoctober29th2012,theEuropeanCentralBankpublisheda55-pagereporttitled“
VirtualCurrencySchemes
”.
1
With183referencesinthetext,itseemsobviousthatspecificallythefastgrowingpeertopeercurrency
Bitcoin
isunderscrutiny.
2
Whyintheworld,onewonders,wouldanincreadiblypowerfulfinancialinstitutionbothertoinvestigatewhatseemstobenothingmorethanacomplexmathematicalpuzzlewithwhichabunchofwhippersnapperssendpackagesofbitsandbytesbackandforthtoeachother?Inwhatfollows,Isketchanevolutionofhowcentralbanks—themonopolistsofthecurrentfiatmoneyparadigm—havedealtwiththeexistenceofonlinefreemarketcompetitionsince1996,andhowtheyarenowreactingtothesuddenappearanceofanenigmaticrival.ItturnsoutnotonlytheECBbutalsoitsmorepowerfulandsophisticatedSwissgodfather,theBankforInternationalSettlements,findsthatithasgenuinereasonstobeonhighalert.Bewarnedthatthisisasubjectivetakeontheissue.Peoplefromcentralbankandgovernmentcircleswillnodoubtaccusemeofbeingunbalancedandunfairinmyinterpretationsandconclusions.Sobeit.MygoalhereistoscrapeofftheveneerofthesereportsandthuscatchaglimpseofwhatmayactuallybehappeningbehindthecloseddoorsofBaselandBrussels.
“…virtualcurrenciescouldhaveasubstitutioneffectoncentralbankmoneyiftheybecomewidelyaccepted.”
ECBReport,10.29.2012
Understandingcentralbankerpsychology
It’smybeliefthatthemostperceptivecentralbankerstodayareworriedaboutwhatishappeningintheworld,ormorespecifically,what’shappening
totheirworl
.Distrustandangerwiththeirpoliciesis
Bitcoin’sfixedmoneysupplyanddecentralizednaturemakesittoughcompetitionforcentralbanksaroundtheworld.
(srcimage:theeconomist)
“Theexpectationofageneralprogressiveupwardmovementofallpricesdoesnotbringaboutintensifiedproductionandimprovementinwell-being.Itresultsintheflighttorealvalues,”inthecrack-upboomandthecompletebreakdownofthemonetarysystem.”
LudwigvonMises,1949
“ButexactlywhichfireistheFedtryingtoputout?WhydoestheFedthinkitsactionscanputouttheseparticularflames?HowdoestheFedknowthatitsbalancesheetwillactaswaterratherthanoxygen?”
PeterR.Fisher,BlackRockmanagementdirectorandexcentralbanker,2009

1
http://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemes201210en.pdf .
2
TheonlyothercurrencythatreceivesmorethanasidewaysmentionisthestagnatingLindenDollaroftheonlinegameSecondLife,whichin2011hadamarketcapofsome$29million.Hereiswhatthetextsays:
“…ofparticularinterestaretheschemesdesignedtocompeteagainstrealcurrenciesasamediumofexchange.Forthetimebeing,themostprominentcaseisBitcoin…”
Src:“Virtualcurrencyschemes”,p.19.
 
TheGloomofCentralBanking
TuurDemeester,november2012

2somethingcentralbankershavealwayshadtodealwith.
Butnow,forthefirsttime,theyarefacedwithasolutionwhichposesanexistentialthreattotheirmonopolizedfiatcurrency:thearrivalofdecentralizedprivatecurrencies.
Beforewediveintothecentralbanks’reactionstothisnewdevelopment,letusfocusonwhatmakesthewheelsofcentralbankingspin,andhowtheyhavereactedtodigitalcurrenciesinthepast.
Theoriginalfunctionofcentralbanking
Centralbankshavehistoricallybeencreatedtoservethreegoals:1.
 
Defendingthemonopolyoffiatmoney2.
 
Institutionalizingfractionalreservebanking3.
 
Institutionalizingseigniorage
1.Defendingthemonopolyoffiatmoney
Historically,moneywasmintedbyprivateparties,givingthepublicthefreedomtochoosethebestmoneyavailableinthemarketplace.Thischangedwiththecomingofcentralbanking,whichimposedamonopolyonmoney,allowingthegovernmenttocontrolavastamountofwealthandmakingitmucheasiertoborrowfromthenextgenerations.Oftenanemptlytreasurywastheveryincentivetostartacentralbank,aswasthecasewiththeBankofEngland.FiatmoneyasdefinedintherecentECBreport:
“anylegaltenderdesignatedandissuedbyacentralauthority.Peoplearewillingtoacceptitinexchangeforgoodsandservicessimplybecausetheytrustthiscentralauthority.Trustisthereforeacrucialelementofanyfiatmoneysystem.” 
3
2.Institutionalizingfractionalreservebanking
Theroleofcentralbanksasthelenderoflastresortistomakewholethefractionalreservebanks(banksthatonlykeepafractionoftheirreservestrulyavailabletotheircustomers)whenevertheyrunintotrouble—inotherwords,tobailthemoutonasystematicbasis.It’simportanttonotehowthisroleoflenderoflastresortalsoforcescentralbankstosupportmassiveexpansionofgovernmentspending:ifprivatebanksareallowedtoplayaroundwithcustomerdeposits,itbecomesverytemptingforthesebankstoloadupongovernmentbondsattheexpenseofthesaver.
3.Institutionalizingseigniorage
Theeasiestwaytodefinemodernseigniorageis‘moneyprinting’,or
Thefirststeptowardsunderstandingthecomplexitiesofmodernfinancialinstitutionsandterminologyistofindoutwheretheycamefrom.Onlyunderstandtheoriginsofaninstitutionorinstrumentandyouwillfinditspresent-dayrolemucheasiertograsp.”
NiallFerguson,2008
“WhenyouorIwriteachecktheremustbesufficientfundsinouraccounttocoverthecheck,butwhentheFederalReservewritesacheckthereisnobankdepositonwhichthatcheckisdrawn.WhentheFederalReservewritesacheck,itiscreatingmoney.”
‘Puttingitsimply’,BostonFederalReserveBank
“J.P.Morgan’sfondnessforacentralbankwasheightenedbythememoryofthefactthatthebankofwhichisfatherJuniuswasjuniorpartner…wassavedfrombankruptcyinthePanicof1857byanemergencycreditfromtheBankofEngland.”
MurrayRothbard

3
“VirtualCurrencySchemes”
 
TheGloomofCentralBanking
TuurDemeester,november2012

3‘controlleddebasementofthecurrencyinfavoroftherulers’.Amoresophisticated/convoluteddefinitioncanbyfoundattheBIS:
“Inahistoricalcontextthetermseignioragewasusedtorefertothe
 share, feeortaxwhichtheseignior,orsovereign,tooktocovertheexpensesofcoinageandforprofit 
.Withtheintroductionofpapermoney,larger profitscouldbemadebecausebanknotescostmuchlesstoproducethantheirfacevalue.Whencentralbankscametobemonopolysuppliersofbanknotes,seignioragecametobereflectedintheprofitsmadebythemandultimatelyremittedtotheirmajororonlyshareholder,the government.” 
4
Nowthatmostfiatmoneyisdigital,thecostofmoneycreationisalsovirtuallyzero,makingseigniorageallthemoreeasyandprofitable.Seignioragecomesinespeciallyhandyifthegovernmentcannotlongerpayoffits’debtwiththerevenuesoftaxincome.ThiswastheprimaryreasonwhytheBankofEnglandwasfounded.Quotingfroma2011BISpaper:
“Atthelimit,ifgovernmentistoremainsolvent,monetarypolicyhasnoalternativebuttoprintmoneytogeneratetheseignioragerevenuesneededtomeetinterestpaymentsinthedebt.” 
Whatkeepsacentralbankerupatnight
ThereasonwhyItellallofthis,isthatitiscrucialtounderstandhowamoderncentralbank
bydesign
isforcedtoembracebothseigniorage(moneyprinting)anditsroleaslenderoflastresort(sponsoringfractionalreservebanking).Theformeristhesourceofprofitthatkeepsthedaytodaygovernmentwheelsturning,andthelatterisneededtokeepthestate’slongtermdebtmachinespinning.Andtwomechanismsonlyfunctionaslongasthegeneralpopulationispreparedtocooperate.Itisthecitizenswhoholdthepinintheproverbialgrenade,becauseitis
 fromthem
thatthegovernmentbuystheservicesitearnswithseigniorage,anditis
 fromthem
thatthebanksusedepositstolendmoneytothegovernment.Arunonthebanksorarefusaltoacceptthatthemonopolizedmoneyhasactualvaluewillcausethiscentralizedsystemtostopfunctioning,greatlydeminishingtheeconomicprivilegesofgovernments,banks,andcentralbanks.Bycontinuallybeinginvolvedinseigniorageandtheproppingupoffractionalreservebanks,acentralbankoperatesinanenvironmentthatintheblinkofaneyecanturnintoaneconomicwarzone.Soinorderforthecentralbankingsystemtokeepfunctioninginthemediumterm,thetrustofthegeneralpopulationiscrucial.Iquotefromthereporton“VirtualCurrencySchemes”:
“ 
Thereputationofcentralbanksisakeyelementindeterminingtheeffectivenessoftheirvariouspolicies
 ,especiallymonetarypolicy.A
image:St.LouisFed
…thecentralbanksbecamemoreandmoresubordinateofficesofthetreasuries,meretoolsfortheperformanceofcreditexpansionandinflation.Itdoesnotmakeanydifferencepracticallywhethertheyareorarenotownedbythegovernmentanddirectlymanagedbygovernmentofficials.Ineffectthebanksgrantingcirculationcreditareineverycountrytodayonlyaffiliatesofthetreasuries.”
LudwigvonMises,1949inHumanAction
“I’mstruckbyaphraseusedbymyfriendAllanMeltzerinarecentphoneconversation.Hesaid,“It’saracebetweentheinflationrate,thetaxrate,andcontrols,andallthreearegoingtowin.”
ex-secretaryofthetreasuryGeorgeP.Shultz,2009

4
“ImplicationsforCentralBanksoftheDevelopmentofElectronicMoney”,october1996,p.15.
5
Source:
“PerceptionsandMisperceptionsofFiscalInflation”,p2.(http://www.bis.org/publ/work364.htm)

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