(Crypto Capitalization courtesy of Coin Gecko, https://www.coingecko.com/en/global-charts)

Happy Cinco de Mayo!

Some recent legislative proposals are destined to have profound consequences on our economy. They are argued by proponents to be innovative. They are anything but. 

These proposals, the Financial Innovation and Technology for the 21st Century Act (FIT Act), the Lummis-Gillibrand Responsible Financial Innovation Act, and the Lummis-Gillibrand Payment Stablecoin Act.all attempt to legitimize the use of cryptocurrencies as a pseudo-legal tender. 

The problem is that much of these provisions have been advocated by the crypto industry itself, and may have even been authored with their help. Overall, the crypto industry is embracing these legitimizations as the least of three evils. Many crypto bros have gone to jail because of Securities and Exchange enforcements and state Attorney General (especially the New York State chief prosecutor) actions. Anything to keep these bros out of jail and their fortunes intact is welcomed by the industry. 

We have discussed in many past blogs and I have done so in my book, the Bitcoin Dilemma, that cryptocurrency is a solution looking for a problem. A bit of history will help describe why. 

Bitcoin, the first successful cryptocurrency, was forged out of suspicion of economic authorities. In the wake of the Global Financial Meltdown of 2008, a mysterious cypherpunk named Satoshi Nakamoto developed an alternative to banks and currency. (S)he wrote:

“I created Bitcoin to eliminate the need for central banks and to have more financial freedom. The fate of Bitcoin has been tied up by digital currency activists and this goes against my ideals. I invented a peer-to-peer currency, not a commodity to be traded on the stock exchange. Therefore, I urge you to reject Bitcoin ETFs in order to help promote the freedom of Bitcoin. Bitcoin is not controlled by any government and is not subject to the decisions of any politician. Thank you.”

Let us first of all debunk the business case often advanced for cryptocurrencies. It is argued that the blockchain technology underlying crypto is a huge innovation that will streamline transactions. In fact, it is a minor but perhaps useful innovation. A blockchain is simply an accounting system that cannot (easily) be changed once an entry is recorded. This way, any transactions, as a payment, as recording of stock ownership, or as a memorialization of a vote, a travel itinerary, or any other data that occurs over time, can be easily accessed and tracked. 

In the case of Bitcoin, which represents more than half the value of all currencies today, this recording of transactions is easy to observe, but almost impossible to modify once recorded. We can all see each transaction dating back to Satoshi’s first transactions less than a decade and a half ago. What we can’t see directly is the identity of those who own the accounts on each side of all transactions. It is not because their identities are encrypted. Hence, “crypto” is a bit deceptive. The brokers who allow people to open accounts protect the identities of their clients. They are the Swiss bankers of the crypto world. 

Instead, encryption is employed to prevent tampering of the record so these virtual banks cannot be robbed. Encryption always does the same thing. They fiercely protect the code by either protecting the keys or by making it extremely costly to break the code. The first technique of protecting the keys is the basis of a technique called Proof of Stake. The second category imposed almost unmeasurable costs on those who wish to manipulate accounts through a technique Bitcoin employs called Proof of Work. The cost is in computing power and electricity. That is why Bitcoin demands almost 1% of global electricity consumption, and more than 2% of U.S. electricity consumption. It would be near impossible for one bad actor to command so much energy to thwart the Bitcoin ledger, even though only a couple of very large Bitcoin pools of miners do indeed command the majority of Bitcoin encrypting. 

Any financial instrument that commands such costs and energy intensity commands our attention. Recall Satoshi’s goal was to create an anonymous alternative to the monetary and banking system. Satoshi and many others view central banks such as the Fed, and the commercial banks they oversee as the problem, with crypto the solution. They fear that federal institutions cannot be trusted, and there is no institution more fundamental than the currencies upon which we all rely. 

If streamlining commerce has not been and will not be the primary function of cryptocurrencies, what are the industry lobbyists working so fiercely and expensively to protect? It is an ability to move large sums of money in ways that frustrate oversight, and it is the avenue for unsophisticated investors to speculate on the latest financial fad. The trio of bills sponsored in the House and Senate attempt to legitimize crypto and perpetuate the false narrative that the world will be a better place if only we can all include crypto assets in our wealth portfolio. Yet, unlike every other asset in our portfolio that represents something of value and utility (earnings in a stock, interest payments on a bond, even the intrinsic value of gold for industrial and aesthetic purposes), there is no underlying value to a crypto coin except in its desirability as a gambling instrument. Even betting on a sporting event still has our underlying value of rooting for the home team. With crypto, you are only rooting for a Ponzi scheme, and avoiding the spectre of Fear of Missing Out (FOMO in cryptobros-speak). Nothing is being produced but tens of billions in wealth for originators of he new coins that constantly pollute the money supply.

Readers of this blog know that we will eventually move to some sort of digital currency. Already, since most of our purchases are through credit cards or electronic funds transfers, we already transact digitally. And while EFTs are cheap, they are not quick, while fees to merchants mean credit cards are quick, but not cheap. Central banks around the world, including our Federal Reserve, have created Central Bank Digital Currencies (CBDC) that are both cheap and fast, and many nations, especially China, have rolled them out. 

The U.S. has been relatively slow in bringing its version to market as it works out fears that direct digital transactions may bypass the traditional banking system. Hence, these bills in Congress are designed to immediately create and lightly regulate Stablecoins that can privatize what other central banks worldwide are folding into their democratic or autocratic institutions. These bills do so by offering a modicum of oversight, often through the Commodity Futures Trading Commission (the CFTC) that is notorious for its laissez-faire (French for ‘let it be’) regulatory philosophy. 

Now, I have been critical of the Fed in 2008 and more lately. Responsible monetary policy should try to anticipate economic challenges on the horizon and neutralize them before such problems as inflation and unemployment set in. Sometimes the Fed receives mixed signals or suffers from policy paralysis, and hence closes the barn door only once the horse got out. These missteps have not made matters worse, but certainly have missed an opportunity to avoid some pain. 

A frustration by Satoshi in 2008 and by legislators now with such economic institutions do not justify tying central banks’ hands from here on in. And that is what all these legislations do, in addition to giving the green light to speculating on perhaps the most speculative asset since the sale of the Brooklyn Bridge or Ponzi’s efforts to market swampland in Florida. 

By arguing that our economy needs an alternative to the dollar, and then loosely regulating an industry notorious for its efforts to obfuscate regulators, we are opening a Pandora’s Box. Central banks have the responsibility to both limit the size of the money supply and constrain banks from creating additional monetary deposits. They also enforce and oversee strict requirements on the size and quality of bank capital and reserves, and work with the Federal Deposit Insurance Corporation to subsume failed banks and protect deposits. 

One act, the recent Stablecoin legislation, argues that it gives at least some teeth to central bankers and regulators, but, in fact, place Stablecoin issuers into a dramatically more lenient regulatory regime than banks. Should this colossal experiment fail, deposit insurance, which will surely be inadequate, will step in to protect consumers but possibly at taxpayer expense. Even if all goes swimmingly well as overly optimistic legislators may hope, the only people who will make money from such legislative proposals are the issuers of Stablecoin that profit on the Fear, Uncertainty, and Doubt (FUD) of monetary conspiracy theorists and hold their cash while the companies invest in US Treasuries and other securities that "back" their coin. In the best of worlds, they make money. In the worst of worlds, we end up bailing out more colossal failures brought about by lax oversight. Faith is fine in church on a Sunday morning. In finance, I'd rather have "trust, but verify" (from the Russian proverb "Doveryay, no proveryay"), not "trust and hope for the best (I don't think there is a Russian proverb for that).

My second concern is that the Fed will lose its most important arrows in its economic quiver. The Fed relies on a relatively stable relationship between the money supply and the size of the economy. Stablecoin destabilizes this relationship by offering a new and grossly less regulated currency that can substitute for money and distort the velocity of money in the Quantity Theory of Money equation. Stablecoin also creates a new shadow banking facility that loosens the link between deposits created (which are part of the money supply) and assets that secure these deposits. Should Stablecoins linked to the value of the U.S. dollar succeed spectacularly, as backers of these proposed legislative initiatives hope, bank deposits, and hence the lending in our communities our local businesses depend, will dry up as more banking moves to the shadows of our economy. 

Our turtle-paced efforts to digitize the dollar have been problematic. Indeed, when we think of innovation, we rarely think of government. Just as the Fed moved too slowly in response to the 2008 financial meltdown, and responded too slowly to rampant spending by government and by households laden with cash government sent them following COVID, the Fed has also moved too slowly on facilitating rapid digital transfers within or in addition to traditional banks. In fact, two months ago, Jerome Powell, the chairman of the Federal Reserve, stated that the Fed is nowhere near creating a central bank digital currency. That problem created the crack in the door that crypto bros are now trying to blow through. 

The lack of a Fed and Congressional consensus will only complicate our ability to safeguard the dollar and protect our banking system. Efforts to legitimize crypto based on a lot of trust and very little verification is unnecessarily risky. Already, with an M0 measure of cash in circulation of $5.8 trillion and crypto approaching $3T, we have a major shadow rival to the US dollar. Congressional proposals will only create more monetary and economic risk.