A reminder why they always will be sound money and why bitcoin cannot fill that role
With bitcoin’s price still rising and expected to rise even more, there has been a growing belief in cryptocurrency circles that it will replace unbacked government currencies when they eventually fail.
The assumptions behind this conclusion are naïve, exposing hardly any knowledge in what qualities are needed for sound money. This article agrees that current events are accelerating the path towards fiat destruction, and that historical precedents point to their eventual replacement with a sounder form of money. But what that money will be is decided when governments lose control over their fiat; and the public, its users, through free markets will set the monetary agenda.
Only then will the general public determine the qualities required, and in the past, it has always opted for metallic money. And because government treasury departments and their central banks coincidently possess only gold in their non-fiat reserves, its monetisation is the only option for governments to survive the collapse of their fiat currencies. That is what will eventually happen, with silver perhaps fulfilling a subsidiary monetary role to gold.
While increasing numbers of the fiat investment community understand that the quantities of government money are being expanded without any sign of limitation, they have also concluded that bitcoin, not gold, is the pure investment play because over the next few years bitcoin will approach its final quantity.
It is almost certain that like the majority of gold and silver bulls hodlers expect to sell bitcoin for profit measured in their governments’ currencies, creating for themselves relative wealth in dollars, euros, yen — whatever their governments impose on their citizens as money. But it is an investor’s, or speculator’s approach, which is accompanied by feverish examination of charts, confirmation bias from “experts” and only a half-understood concept of what is driving the price. So sudden and wonderful has been the unbanked wealth creation in leading cryptocurrencies, that investors commonly proclaim that gold and silver are yesterday’s story and that we oldies should move with the times.
These investors claim that five thousand years of empirical evidence is about to be overturned. But they are investors. All bulls and no bears. Other than banking fabulous profits in fiat at a future date, this has nothing to do with money per se. The point about sound money is you acquire it by spending fiat, so that when fiat goes you will have it to spend. It is not an investment decision, but more like an insurance policy taken out for which a risk assessment has to be made. If it is decided the risk is that fiat currencies will not fail in one’s lifetime, then the insurance premium, which is an individual’s decision, need only be small or not even taken out. But if it is decided that the risk is there and growing, then the allocation into physical sound money should be increased accordingly. Lack of physical ownership, be it bitcoin gold or silver is not an option.
There is no doubt that economic and monetary instability are increasing. After all, this is fuelling the investment rationale for bitcoin, understood by those whose reasons for buying it are to benefit from its slow rate of quantity expansion compared with that of fiat. But the investment rationale is that all the subjective price performance is in bitcoin, and the national currency is the unchanging objective value. Otherwise, why value bitcoin in your fiat currency, and why would you ever sell it? And do you ever adjust your other investment returns for the debasement of the currency? No one does this.
The objective view of currency is so powerful that very few people can get away from it. But the decision to insure against the death of fiat currencies is about advance possession of their likely successor, not measuring gains. It requires an understanding of what money represents, its function, and the what and the why that is happening to fiat currencies. It involves an understanding that fiat money is being debased, and what that really means for the sound money of tomorrow. And it requires individuals to comprehend what is happening to fiat money’s objective value, evidenced by rising commodity prices, stock markets, house prices, bitcoin as well as gold and silver — all measured in fiat.
Today, very few owners of precious metals or of bitcoin understand that investment is fine and dandy, but the ultimate reason for possessing them is against the possibility that fiat money will fail. They are yet to make an informed choice about what that replacement will be. And talk of bitcoin going to a million dollars or gold going to five thousand misses the point entirely.
Characteristics of sound money
Figure 1 gives us a basis for assessing the credentials of the principal contenders to replace fiat money when it dies. It should be noted that throughout the history of money, money mandated by governments with nothing to back it other than its legal status has always failed and been replaced with money which is essentially chosen by individuals through their personal exchanges with each other. With the invention of cryptocurrencies, there is offered a new technological form of money which claims to be sound, competing with the established metallic monies of the past for attention. We can ignore centralised central bank cryptocurrencies on the basis that is just rearranging the deck chairs on the fiat Titanic.
In estimating the suitability of each form of money, they have to survive the tests in Figured 1. Clearly, gold satisfies all categories, but some explanation is needed why this is so, and why bitcoin and silver do not.
Both gold and silver have acted as money for millennia and are widely distributed. They are generally associated with a monetary value, that is to say suitable to be a medium of exchange. Indeed, silver was the basis of the pound sterling from as early as 775 AD and was the monetary standard until the adoption of the gold standard in 1816, though Sir Isaac Newton introduced a secondary standard for gold in 1717. That’s over a thousand years of monetary silver. Silver was still the currency standard in many jurisdictions on the European continent until the Franco-Prussian War, when Germany exacted tribute from France in gold, allowing it to change its monetary standard from silver to gold.
Both metals have a long history of being used as money throughout Europe and Asia. And when Columbus discovered the Americas, it was found that these metals were also valued by their civilisations — principally the Aztecs and Incas — which had had no prior trading connection with Europeans and Asians. Deep in the human psyche there has always been an appreciation of their constancy and their suitability as mediums of exchange.
The same cannot be said of bitcoin, which is held out as the leading and most sound cryptocurrency. But its distributed ledger cannot be corrupted by anyone, including governments. So long as electricity flows through our economic veins and our computers and mobile phones remain interconnected there will be bitcoin and its blockchain. But as a replacement for fiat, it suffers many disadvantages, some of which will doubtless be overcome. But the one thing it cannot do is act as the medium of exchange for those unwilling or unable to use it. The hodlers’ enthusiasm for bitcoin as money does not stretch much beyond educated millennials — less than a hundred million perhaps out of a transacting population of seven billion. It falls at this fence because it is not hodlers who ultimately decide what to use as money, but the wider public.
But bitcoins are already accepted in some outlets, and even Elon Musk is said to accept them in exchange for his Teslas. Maybe; but if someone thinks bitcoin is going to rise in price, then they would likely accept it as payment. It would be a way of acquiring bitcoin, so that they can be sold for a greater profit at a later date. This is not bitcoin being used as money.
For a medium of exchange to be effective, it must be accepted by everyone in a community of people who divide their labour, and if one community is to benefit from trading with other communities, it must be accepted more widely for the exchange for goods. But we know that confining transactions to coins or metallic money by weight is an inefficient form of money. This is why fiat currencies started out as gold or silver substitutes in the forms of both cash and bank deposits, exchangeable into physical metal on demand at a fixed rate.
The convenience of being able to pay in sound money substitutes cannot be underestimated. A national currency fully fungible with gold or silver was central to the economics of the industrial revolution and is the basis of the currencies of the great nations of today. Markets in them developed, such as discounted bills, loans, bonds, stocks, and trade finance. Gold and silver substitutes were trusted. Businesses developed internationally, exchanging their money substitutes for commodities, importation of consumer goods and goods of a higher order. While Country A’s money did not circulate in Country B it was accepted and could be redeemed for its money at a cross rate fixed by their gold standards, or alternatively exchanged for physical gold. This was the basis of global trade before the First World War.
The monetary system based on the free exchange of gold and silver substitutes was so successful that it brought the nations that benefited from the arrangement out of feudal subsistence living into the greatest economic advancement for mankind since the ending of barter. It set the basis for modern economies and their technological advancement. Money could be trusted. You could save it, making it accessible for entrepreneurs to finance their production, knowing that gold or silver backed money would retain their purchasing power over time. It was fundamental to the evolution from medieval societies into free markets.
Through their money substitutes it was governments and their central banks which cheated on metallic money. Starting with the suspension of gold standards to finance the First World War, European nations failed to return to them and some currencies collapsed. Britain eventually introduced a gold bullion standard in 1925, replacing its gold specie standard at the pre-war rate. By only permitting the exchange of pounds for 400-ounce bars and removing the pre-war commitment to swap paper pounds for sovereigns, the general public effectively lost the gold substitute facility. The UK’s bullion standard only lasted until September 1931, when it was “temporarily” abandoned, never to be reintroduced.
The flaw in the system was not the fault of gold, or in earlier times, silver. The fundamental problem was that banks were free to expand the quantity of money in the form of credit, which when drawn down and spent was indistinguishable from gold substitutes. Following the Bank Charter Act of 1844 which permitted the existence of unbacked bank credit, the cycle of bank credit expansion was broadly self-liquidating through periodic bank crises. That changed when the Bank of England adopted the role of lender of last resort, subsequently copied by the Fed.
The credit tail had begun to wag the monetary dog, and led to the situation today, where money originating from bank credit makes up the bulk of money in circulation. Without a reform of the banking system to restrict the role of bank credit, the reintroduction of gold and silver substitutes is corrupted and cannot work for long. This must be addressed when fiat dies, otherwise the cycle of bank credit will destabilise the new monetary system.
If bitcoin is to be the money of the future, it will need enormous degrees of persuasion for the public to accept it as sound money compared with gold or silver. That persuasion is unlikely to come from markets, which are the sum total of people’s transactions, so it can only come from the state. An establishment agency of some kind, a revolutionary government in agreement with other revolutionary governments would have to successfully impose a cryptocurrency, over which no state has distributive control, on the general public whose traditional concept of money is very different. Not only is this proposition illogical, but it is logically the consequence of assuming the state decides what is money and not the people.
Official sanction of the new money
The last thing any government or central bank would wish is to lose control over money. These agencies will continue with fiat until the last possible moment and will then want to determine its replacement. Intellectually, they are not suited to the task, believing that the state must retain control of its national money at all times in order to manage economic outcomes. It sees free markets as the enemy of state-imposed order.
The collapse of fiat currencies will demolish the state theory of money, and not for the first time. Irrespective of how long it takes, the rapid loss of fiat currencies’ purchasing power means that governments will no longer be able to finance their obligations. There will, therefore, come a point where fiat money must be abandoned in the search for monetary stability. The demise of fiat is the demise of state money and the function of its replacement will be to restore public trust.
It is theoretically possible for trust to be restored without abandoning fiat, but that would be to act in anticipation of a monetary crisis. Cutting government spending to an economically sustainable level, balancing budgets, reforming the banking system and abandoning regulatory and other interventions in favour of free markets would have to be a deliberate policy. But it is unlikely that the necessary reforms would be possible politically ahead of a major economic and monetary crisis. Therefore, the crisis comes first, and then the state responds with an electorate fully aware of the consequences of failure.
At some stage in the collapse of a fiat money’s purchasing power it will have to be halted. In November 1923, Germany’s paper mark was finally exchanged for a new mark notionally tied to the gold mark at the rate of one trillion to one. The reasoning behind the conversion rate was it enabled the new Reichsmark to enter circulation. Today, the replacement of fiat currencies with the new money will almost certainly follow a similar procedure.
The replacement money can only be based on something in governments’ possession. And either in their treasury departments or central banks, other than each other’s fiat they only possess gold in their monetary reserves. It may take a few debilitating attempts by states to avoid it, but we can be certain that the only replacement for fiat money will be to back them with gold. It is necessary to stabilise everyone’s money. The other actions, reducing the scope of government and freeing markets from intervention will also have to be addressed. But following the increasingly obvious prospect of a total monetary collapse, stabilising the currency by turning it into gold substitutes exchangeable for gold coin should then become a politically viable solution.
It is not the intention to make light of the difficulties involved, nor to dismiss the political consequences. Based on the German experience following the collapse of its paper mark, Hayek’s The Road to Serfdom is instructive reading. The demise of the dollar raises geopolitical questions, because China has effectively cornered physical gold markets and there is evidence that she has accumulated very large quantities of non-monetary gold. Gold as circulating money would enhance her power relative to that of the United States. Russia’s central bank has also built her gold reserves at the expense of the dollar and can be assumed to have accumulated significant amounts of physical gold not otherwise declared.
The time taken for a fiat monetary collapse is another important factor not addressed in this article but will have significant consequences. If it is as much as a year from now, governments might introduce price controls and attempt to confiscate gold — these are traditionally resorted to in the past, going back as far as Roman times. The introduction of central bank digital currencies might just be advanced, hurried along by a falling purchasing power for traditional fiat. And the impoverishment of the middle classes through monetary inflation must not be ignored.
But eventually, a movement towards gold substitutes is bound to occur, and silver can then become supporting coinage. But one thing is clear, and that is a publicly distributed ledger cryptocurrency not in possession of the state cannot be adopted as a substitute for its fiat currency, because states do not have the means to introduce it.
It is a mistake to think that a sound money is one that doesn’t vary in its quantity. The point behind sound money is that it is the users, the general public and businesses, who decide the quantity required and not the state. It was Georg Knapp’s State Theory of Money, published in 1905 that led to Germany’s inflationary financing that ended with the paper mark collapsing in 1923. It was Knapp’s theory and his Chartalist fellow travellers that permitted Germany to arm itself ahead of the First World war and then to prosecute it at no visible cost to the taxpayer. It is not a strict limitation on the quantity of money that is the problem, it is who determines its quantity.
We are told that above ground stocks of gold total some 200,000 tonnes, and that its extra supply is about 3,300 tonnes of annual extraction. Growing at about 1.5% annually, that is wrongly taken to be gold’s money supply. Monetary gold is just one function of the metal, and only 35,220 tonnes are officially monetary gold. In addition to official holdings, there are vaulted bars on behalf of governments and their agencies not officially designated as money, as well as hoarded bars owned by the general public. And with an estimated 60% in the form of jewellery and other uses, that leaves a global gold money supply of about 80,000 tonnes.
This gives gold enormous scope for increasing its monetary use. If gold is used as backing to turn fiat currencies into credible gold substitutes, its purchasing power becomes the determinant of the quantities of scrap acting as an arbitrage between uses. Free markets will decide how much gold is needed, and the supply is available if required.
With its predominantly industrial uses, silver acting as money is a more complex issue. Increasing values relative to gold will diminish industrial demand until the time monetary stability eventually returns, leaving the majority of an estimated 840 million ounces annual mine supply then feeding into the quantity of monetary silver. But unlike gold, above ground silver stocks are minimal, and furthermore, ownership of monetary silver by government agencies is virtually non-existent. And having been generally abandoned as monetary backing for note issues in European states as long ago as the early 1870s, silver is likely to have a future monetary role only secondary to gold. But its reintroduction as coinage would serve as a public affirmation, along with higher value gold coins, that currency reform is soundly based.
Unlike metallic-backed money, for its hodlers the virtue of bitcoin is the strict limit on its quantity, meaning that so long as governments expand their fiat money quantity, its price is bound to rise. But if the general public is to determine the future of money through free markets, they will need a form of money whose quantity is not dictated by government and the banks. Under a bitcoin standard one country can only expand the quantity of its bitcoin in circulation by obtaining them from another country. The economic mechanism is for the country to have lower prices of goods and services than the others, so that it obtains bitcoin in payment for net exports. Assuming no change in the proportion of savings relative to immediate consumption, this would require the government to increase its surplus of revenues relative to spending in an attempt to supress demand in its own economy and thereby lower prices.
Consequently, a bitcoin standard requires government intervention to operate, with governments setting marginal demand. But they cannot act in concert. And if one country contrives to increase its quantity of circulating bitcoin, it causes more accute deflation in the others. The lack of any monetary flexibility is bitcoin’s Achille’s heel.
Following the ending of the post-war Bretton Woods agreement, over the last fifty years financial markets have developed on the back of an unprecedented expansion of the quantity of money. In the US alone, since August 1971 broad M3 money supply has increased from $685bn to $19.4 trillion, a multiple of twenty-eight times. And the major US banks have increasingly diverted credit expansion from financing production to financial activities. These include purchases of government and other debt, rising from $160bn to $4.92 trillion over the same timescale. The expansion of regulated futures markets and the far larger over-the-counter markets have been explosive, with the Bank for International Settlements estimating the notional amounts outstanding of OTC contracts at $609 trillion in June 2020.
While much of these increases are the consequences of monetary inflation, there can be little doubt that having the ability to hedge risk, which is what derivatives are all about, is demanded by economic actors in any monetary system. In fact, futures, forwards and options existed long before the current fiat regime. We must therefore assume that financial markets will continue to find these services demanded, but perhaps in lower quantities.
A replacement monetary regime must therefore allow for derivatives and other financial activities, such as trade finance and the provision of credit to the non-financial sector to continue. The fact that derivatives have a longer history than fiat money is proof that metallic monies are no obstacle to them. Similarly, bond markets existed alongside bank credit, which are necessary to facilitate production and therefore consumption.
With prices generally stable, the purchasing power of metallic money increases over time as a result of competition driving manufacturing innovation along with the development and application of new technologies. Consumers can save in the knowledge that they are safeguarded from monetary debasement by the state, and that their standards of living will improve over time along with the purchasing power of their savings.
None of this would be possible with a form of inflexible money strictly limited in its quantity. Instead of the current situation of wealth being transferred from depositors to borrowers through currency debasement, wealth would tend to flow strongly the other way, only offset by contracting economic activity to act as a counter-pressure on a tendency for a rise in the purchasing power of a fixed-quantity form of money. The world as a whole would find itself in a permanent depression led by a decline in production.
Banks would be unable to fund themselves beyond sight deposits, with negative interest rates likely to offset the fixed money supply leading to its increasing purchasing power. Bond markets would be driven by negative yields increasing along the yield curve. In this upside-down world no entrepreneur would consider financing production from initial investment to final product sales, because prices for final products in that fixed currency would almost certainly fall substantially over time. And the wisest choice a consumer might make would be to spend nothing except on the barest essentials in order to hoard as much of this fixed quantity money as possible. These would be the basic conditions under a bitcoin currency regime.
This article has made the simple assumption that the demise of fiat currencies will be succeeded by sound money. It has glossed over the likely political and economic turbulence such a change would cause, which is assumed herein to be a temporary phase. Nonetheless, there are other institutional changes that need to be made for the introduction of a sound money regime to stick. These include governments reducing both their financial commitments and economic involvement to a bare minimum, maintaining balanced budgets, not discouraging savings by taxing them and ensuring they never take actions which discourage free markets. It must be admitted that the prospect of a smooth transition to sound money is close to zero, but transition there will eventually be.
This article has also played down the role of banks, whose credit creation is by far the greatest factor in the expansion of money. The misunderstanding of the importance of the factors behind the cycle of bank credit expansion and its sudden episodes of contraction led to interventionist policies with fatal long-run consequences. It is not generally understood that banks create money, with the financial establishment believing they simply have an intermediary role: it is not for the first time we see the high priests of central banking being utterly deluded about the business of commercial banking.
In a monetary revolution there can be no place for this type of loose thinking, so with it will have to be a process of rapid re-education for politicians and planners alike — probably in the real world of experience. Bank reform will have to be aimed at dampening the bank credit cycle. Purists of the Austrian School have suggested that banking must be realigned into deposit takers, who operate as off-balance sheet custodians, and financial arrangers for savers investing in productive enterprises. Then there should be no doubt in anyone’s mind about the status of their money, and unbacked bank credit would be eliminated.
While this approach is an ideal, it might be more practical to simply remove limited liability from banks. This would allow them to continue with existing banking practices and accounting. But the risks arising from balance sheet leverage would be significantly reduced because the homes and other assets of shareholders and directors would be on the line. This simple measure would likely be enough to drive banks towards the Austrian solution.
Aside from the institutional changes, the eventual replacements for fiat currencies that will initially be required will be driven by the establishment attempting to save itself from only having a worthless currency as its means of finance. Inevitably, it will require governments to use the only means at their disposal, and that is to monetise gold reserves because they are the only money they possess in non-fiat form. On this basis alone, cryptocurrencies, including planned central bank cryptocurrencies which are merely another unbacked form of fiat, don’t even get to the starting gate.
If that were not enough, we have established that a future sound money must be flexible enough to not only finance production, but to act as the mainspring for markets. Bitcoin enthusiasts have failed to grasp the importance of a degree of flexibility in the quantity of money, driven by free markets and not imposed by the state, for it to act as a medium of exchange. For now, bitcoin as money is merely poorly informed speculation. And when the world has returned to metallic money for all the reasons outlined in this article, bitcoin’s legacy will be the invention of a blockchain and all that follows it, and not its price in fiat currencies, which will be of no consequence.
The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated.
Reprinted with permission from Goldmoney.