Digging into fiat vs. crypto mining...
By COMPARING the money we already use with Bitcoin, we will be better able to decide if it can substitute our long-standing currencies, which certainly have their problems,
writes Paul Tustain, founder and chairman of BullionVault.
A strictly limited issue
By design, the total number of Bitcoins in existence will never exceed 21 million. It is a fundamental top limit on their possible issue. About 18.5 million of them have now been digitally mined.
This strict upper limit is a design reaction to an ongoing problem we have with our existing western money systems. These have all fallen under the control of governments, which are abusing their position to create money out of thin air by so called 'fiat', to spend as they choose. Many people, and the large majority of Bitcoin users, believe the uncontrolled issue of fiat currency will in the long run render them worthless.
So Bitcoin and Pounds (or Dollars) differ in that one absolutely cannot be further issued by fiat decree, and the other routinely is.
Yet the outright control and steady fiat corruption of monetary systems by western governments is a relatively modern phenomenon. If you go back to the 1900s and before, you will find government's role in the money system was much smaller.
The traditional creation of money
Back then, the creation of money was done by private institutions – ordinary banks – and the money they created had a value basis resting in real capital.
As the Victorians were building Britain's capital stock the wealth bound up in it could be mobilised – through a private bank – by creating money. It was perfectly sound money, not like the fiat currency we see our governments granting themselves today.
The way it worked was that someone who had property rights over something of value, for example a factory, would persuade a bank that against a promise of this property as collateral he could safely be extended a credit balance in a bank account, alongside a matching debit balance for his loan, secured on his property.
The debit side, together with its parallel collateral agreement, connected newly created money to tangible assets, whose genuine value could be recognised and realised in trade and exchange. Collateral factories can be sold.
That was how money was privately created in those far off days, and how it was directly connected to the real capital wealth from which it derived its fundamental worth.
In just the same way a modern mortgage on a new house creates new money out of a capital asset which has been built, and which has a real value in exchange. A house can be sold to pay down the debit balance on its mortgage account, long after the credit half of the transaction – the money which was created by the mortgage – has been paid to the builder and distributed via the builder's employees and suppliers throughout the economy.
The only difficult bit of managing this connection between money and capital was establishing a meaningful and stable 'unit' of money. That was the government's role. It defined what £1 or $1 meant. It was not directly involved in the creation of money via ordinary commerce.
It's unusual for citizens today to understand how natural and well controlled all this 'free market' private money creation was. Shareholders in banks contributed the original capital buffer, and the bank then created money by collateralising the capital assets belonging to its predominantly local customers.
Private monetary issue could be extended where there was a demand for it, i.e. where owners of capital assets chose to monetise their property, and they paid the bank a fee – interest.
If a borrower went bust then the collateral property was sold. If the bank went bust the shareholders and then the creditors lost their money too.
This organisation of risks left banks standing on their own two feet; there was no such thing as 'too big to fail'. It also persuaded most banks to act with far more monetary caution than you would find in one of our modern western governments.
The destruction of money
Just as money can be created safely, so it can be destroyed safely.
When depositors transfer some of their current account's credit to pay down the outstanding balance on their mortgage the credit money cancels out some of the debt. The money disappears.
Where did it go?
It disappeared in the process of releasing the mortgaged house from its collateral function, and it took the house a few pounds nearer to being the owner's outright property.
This again shows how Victorian money was connected to wealth. Money was much more than the dimly understood 'medium of exchange' which people used; it was a call on real property.
Bitcoin does not have that link to real property. At least, not yet…
Volatility
So back in Victorian times money was routinely created and destroyed, in the normal course of commerce.
This ability to expand when money was short, and to contract when in surplus, created another feature of Victorian money. Because its issued quantity was self-adjusting, a shortage did not drive up its value. Neither did a surplus drive it down. It was the quantity, not the price, which absorbed fluctuations in supply and demand for money.
Bitcoin's limited stock does not have the expansion and contraction mechanism.
As a result its price is extremely volatile.
Usually a volatile monetary value is not what users of money want. It's exceptionally agreeable while it's going up, but the reverse more than outweighs that advantage. A money system cannot afford to keep on injuring its users, because they will soon abandon it.
When does sound money become fiat money?
It's all very well appreciating the elegance of the Victorian's monetary system, but without there ever being a definite boundary, that sound money system has decayed into today's 'fiat' style money. Something went badly wrong.
'Fiat' money is credit in a monetary system,
where the debit side has no collateral support. The debit side of fiat money is, in the language of bankers, a "bad debt".
Anyone who gets the power to impose collateral-free-lending on a bank has gained the power to issue fiat currency through it.
There was little that was fiat about Victorian money. Bank directors didn't wave money into creation in the absence of collateral, or if they did, it was at their own risk and ultimate expense. The stockholders of banks took great pains to employ risk-averse directors, and the directors would usually have had a substantial stake in the bank themselves. These were powerful motivations to manage collateral prudently, keeping the creation of dangerous fiat money to a minimum.
Any fiat currency emerging in the Victorian banking system tended to be expelled naturally. For example where, through the passage of time, falling collateral values challenged the support of a bank's monetary issue, then if the bank failed to re-capitalise, it would itself fail, taking with it all the low-collateral loans and the accidental fiat currency created on its books. Bank failure actually cleansed the monetary system.
Now that is reversed. Banks are considered too big to fail, and a splurge of government issued fiat money resuscitates the corpse of a busted modern bank.
Our governments have grasped the power to issue fiat currency, which they exercise through their monopoly control of central banks. The "collateral" offered is their sovereign right to tax the people, or – more accurately – the children of the people, as the fiat device is used to defer liabilities for as long as possible, away from the immediate attention of electorates.
Governments would probably not have been able to get away with this for so long if the result had been the significant inflation which usually follows uncontrolled fiat issue. But, at least since the early 1980s (and ignoring financial assets) retail price inflation has not really been a problem.
This is because for 40 years we have been going through a naturally disinflationary period, as the microchip reduced production and distribution costs by approximately 3% per year – across the whole of industry.
Increasingly analysts think this disinflationary period will soon peter out, and that the next phase of global economic focus will be 'sustainability', which seeks to replace cheap but harmful economic solutions with more expensive but sustainable alternatives.
This new and naturally inflationary tendency is unlikely to sit easily alongside ongoing fiat money creation. Traditional economists fear the change could trigger very serious inflation indeed. There is a real risk that the result will be the hyperinflationary implosion of our monetary systems, because of their very large fiat element.
The national debt problem
The ongoing creation of fiat money expresses itself statistically through the growth of the national debt – the uncollateralised debt of government. It equates to the total of government bonds issued and still outstanding.
In Britain this was over £2 trillion in August 2020 and continues growing monthly. Even if it were – arguably – under control in 2008, the 2009 financial crisis and the 2020 pandemic have caused it to have two sudden lurches upwards, of £200 billion and £400 billion each.
These – on their own – might have been manageable, but the government's fiat habit has made it extremely difficult, more likely impossible, to bring this back under control.
The problem is that in the non-crisis years from 2010 to 2019, the average budget deficit (which means net fiat money creation) was £82.6 billion a year. This is £2,994 for every one of 27.6 million households in the UK.
So to simply stop the growth of the national debt, and rein in the never-ending issue of fiat currency, government would have to charge an additional average of £3,000 of tax to every UK household, not just next year, but every year.
It is not difficult for each of us to estimate how much less we could afford to do in such a scenario, and a reasonable prediction is that if it happened lots of restaurants, holiday companies, fashion retailers, hairdressers, bars, football clubs, leisure parks, and many, many other businesses would cease to exist, and then our economy would generate a lot less tax and we'd be right back where we started.
So we cannot now be taxed at the level necessary to make the 'sovereign right to tax' a credible security on £2 trillion of outstanding government bonds. If it were tried, our economy would turn to mush.
Government fiat money creation has generated intractable problems arising from what fiat is all about, which is creating the false money which allows a nation to live beyond its means. When Sterling's long history comes to an end, and it joins the many world currencies already in the graveyard, its death will likely take the form of a sudden hyperinflationary puff.
The end game for fiat money
As we have seen, the debits in a money system are what tie it to real property and give the money its fundamental worth. As the fiat element of a currency begins to dominate numerically it eventually sets off a chain reaction, culminating in very rapid inflation.
The aggregate purchasing power of a money system is set at any instant by human emotions, being what they feel about using it in payment. But in the end the value shadows the value of the real collateral wealth supporting it. As money succumbs to fiat, the people who own that collateral find:
- that it's becoming progressively easier to get hold of money,
- that the value of their collateralised asset is rising high above the loan it supports, and
- that each time the bank wants to renegotiate the loan, the interest rate rises, and the length of the available term for a given rate reduces.
Having to pay rising and increasingly unpredictable interest rates borrowers start to demonetise, paying down their loans with relative ease and reclaiming their collateral as their outright private property.
As they do this, the higher quality debits in the system – the ones supported by real collateral – diminish as a proportion of the total debits, and uncollateralised fiat currency becomes a larger and larger proportion of the total. This further incentivises de-monetisation, speeds it up, and spirals to a still higher proportion of fiat money in the system.
The end point is a currency system with almost no collateral support at all. What will remain for Sterling's creditors is £2 trillion of credit balances in their private hands, and £2 trillion of uncollateralised debits in the government's accounts. Then the credits will be unsupported by any real capital assets; there will be no collateral property to call.
It's the gathering realisation of this worthless endpoint that manifests itself as hyperinflation, as in an increasing panic people switch their money into property, shares, commodities – anything in fact.
A modification to Bitcoin?
Trade will not come to an end because Sterling does. Already, by the time of its hyperinflationary puff, people will be using other forms of money to trade, just like Zimbabweans and Venezuelans took to using US dollars. In a Sterling hyperinflation it is likely that one of the currencies people would turn to is Bitcoin.
But what is currently very odd about the Bitcoin system is that while it undeniably cannot be subjected to further issue it is, nonetheless,
already 100% fiat! There is currently no link to real capital assets.
It is no more valid for a Bitcoin enthusiast to say 'it has value because it does' than it is for the very many people who have said exactly the same thing with their government-corrupted fiat currency - just before its hyperinflationary collapse.
If, in the long term, money tends to the worth of the real wealth supporting it, then Bitcoin's value will tend to zero sooner than people anticipate
unless in the meantime it uses the strength of its brand, and its popularity, to bring in some real world collateral.
Perhaps we could have
a Bitcoin standard?
A Bitcoin standard
One monetary system which used to appeal to hard money enthusiasts was to define money according to a standard weight of gold. Gold has been widely used as money throughout history, and perhaps most famously under the
gold standard in the prosperous West during the 100 years to 1933.
The gold standard is now widely misunderstood. Many people think that to issue a pound, or a dollar, under its rules, an honest bank was required to place the standard amount of gold into some sort of specific reserve.
But that is not how it worked. It wasn't a gold
backed currency but a gold
standard currency. It was up to bankers to decide what collateral capital they would accept; they just had to reckon on how much a collateral house or factory would sell for in gold, and since gold was fixed to pounds they only had to concern themselves with how much a collateral house would sell for in pounds.
They were then free to create money, at their own risk, secured on any marketable collateral property of sufficient value.
The complete absence of gold in a small town, with plenty of good factories and houses owned by its wealthy inhabitants, was not a barrier to creating lots of perfectly sound gold standard pounds in their various bank accounts. Bricks and mortar collateral was sufficient.
This flexibility as to collateral is – surely – a vital component of a monetary system. Surely no system would be widely accepted if it restricted the usefulness of money to places which had lots of gold.
Unfortunately, as it stands, Bitcoin is not this flexible. A Bitcoin exists exclusively on the blockchain. It is one of the 21 million, and it is owned outright. Once you start collateralising property, and creating Bitcoin denominated debits secured on them, the spendable credits created alongside the real Bitcoins are not themselves real Bitcoins, just as gold standard pounds were not gold. They become Bitcoin denominated assets, and they would change hands in bank ledgers, not on the blockchain.
The absolute ownership of all Bitcoin money, via the blockchain, collapses as soon as you use collateralised property, debits and credits, to link Bitcoin to real-world capital. You would introduce the prospect of losing a Bitcoin credit to the default of a banker. The elimination of that risk is partly what gets Bitcoin its fans.
But that is not the reason Bitcoin collateralisation will not happen.
For as long as the Elon Musks of this world are squeezing spare billions into Bitcoin the last thing any Bitcoin owner wants is a collateralised expansion of their system. They are making extraordinary paper profits, and while that goes on everyone will suspend a realistic assessment of traditional value based on underlying assets. Human emotion is in the driving seat, and it alone is establishing the value of Bitcoin.
Most Bitcoin owners already believe the cushion of today's price, probably well above what they paid, will keep their heads above water. Few would now see themselves as the 'greater fool' who buys and gets stuck with his holding as a bubble bursts (which they mostly don't think will happen anyway).
On the other hand it is more than likely that Elon Musk and/or his imitators will sell early. One thing no-one should do is assume is that they would not do this! At some point a few big sales will trigger more. Once it starts falling
the last thing anyone will want is dilution – with or without collateral.
A Bitcoin standard is extremely unlikely to happen, and without it, Bitcoins have a future which might look a little like their past. They will remain volatile, and be useful on the fringes of society where their volatility largely offsets the tax liability which can often be avoided by their use.
There is not so very much which is totally new in the world, and Bitcoins look remarkably similar to a monetary device from history – the Trade Coin.
What was a Trade Coin?
Trade coins were mostly made of silver. Like Bitcoin, there was no debit or collateral relationship, nor a link to any other asset. The monetary value was bound up in the coin itself, via its bullion content.
They were a commodity money used as an alternative to legal tender coins, commonly at the fringes of legality. Smugglers – for example – made regular use of trade coins. Their accepted silver content made their value easily measurable to both sides of a smuggling trade.
They became particularly widespread in use in the 19th century. At its end British silver trade dollars were minted in both Bombay and Hong Kong, making use of a local supply of bullion and – not being legal tender – did not not need special licence for their production; neither did they find their way back into the banking system as a liability of the Bank of England.
They were produced mostly in the aftermath of the Opium Wars in which Britain (shamefully) went to war with China, won, and forced open her ports for the use of opium traders who were supplying a growing Chinese opioid addiction problem. Silver trade coins became the standard currency for trade in silks, spices, and of course opium.
Trade coins could not be deposited in a bank. Using them depended only on having them in your possession, and finding someone who would accept them.
In some respects, because it represents nothing but itself, Bitcoin seems to resemble a modern electronic version of a bullion trade coin.
Where does this leave gold?
It is hard not to be struck by the similarity between Bitcoin and gold. Both being of no great direct industrial use their usefulness only becomes apparent when you consider their utility as money.
Neither is easily found. Neither is used up. In both cases they deliver a treasured and tightly guarded above ground stockpile which will not shrink and will only grow slowly – thanks to the considerable efforts of miners.
In the final puff of a government corrupted fiat money – when the possibility of hyperinflation makes depositors search for a greater fool – savers are automatically drawn to whatever offers them reliable scarcity. Both Bitcoin and gold appear to offer this.
But there is a big difference in the science of their scarcity. While there certainly could be an emergence of structurally identical 'betcoin' and possibly 'buttcoin' (both of which should find their trade coin niche easily enough) the elemental nature of gold eliminates such potential duplication.
No, as a gold owner I expect that I will be grinding my teeth as I watch Bitcoin soar away for a little while yet. But I doubt mine, or for that matter Elon Musk's, will be the last teeth to grind.
