[Cryptography] Fun and games with international transaction settlement (was Re: IBM looking at adopting bitcoin technology for major currencies)

[Jerry Leichter]

On Mar 14, 2015, at 4:18 PM, Robert Hettinga <hettinga at gmail.com> wrote:
[Fascinating history/discussion of how international settlements work elided.]

One thing that gets left out of all these discussions:  Calling something a "fiat currency" is a great political ploy, but misses a fundamental point.  Unlike banks, which simply hold financial assets that others have lent them (they own some of them, to some degree or another - that's their capitalization - but that's a tiny part of their total assets even if they are very well capitalized) nation-states actually govern (as in control) large numbers of people, who in turn have large capital assets.  Combining those two gives them productive capacity - the ability to create things with actual, not just notional, value - food, energy, homes, car; all that boring stuff that keeps us alive.  The people and the capital have a limited ability to leave the nation-state (unlike the runnable assets that can so quickly disappear from a bank's books), and the acceptance by the population of its legitimacy - even mor thab nation-state's monopoly on force - means that it has the ability to take portions of that productive capacity (i.e., it can raise taxes).

A bank's ability to meet its obligations is based entirely on its ability to attract deposits (and to a certain degree, capital).  A nation-state - and hence a central bank's - ability to meet its obligations is a much more complicated thing.  Most nation-states, most of the time, can pay back what they owe (though it may be painful).  The nature of the exponential growth in interest payments means that even a nation-state can get to a point where its productive capacity simply can never pay back what it owes.  This has happened many times in history, and is arguably happening today in, say, Greece.  But ... it's not the normal situation.

The reason the world treats the dollar as having real value is that the US has an almost-250-year-long history of paying back all its debts, going all the way back to Hamilton and his insistence that the newly-created nation pay back all its war debts, difficult as that was at the time.  So not only is the underlying productive capacity there, but so is the commitment to apply it.  (That's why the Republican game-playing with the debt ceiling was so incredibly dangerous, and incredibly stupid.  Throwing away a 250-year history of good behavior that produced the world's highest credit rating for some nice quotes and newspaper headlines?  Really?)

A bank's "currency" - its ability to keep attracting deposits for lending - is much more fragile, and ultimately banks that don't have strong governments to back them up are very vulnerable.  They trust each other as long as they are confident that their counter-parties are either stable in and of themselves, or have a stable nation-state to back them up.  In the 2008 financial crisis, that confidence was lost, and the very largest banks refused to lend to each other as no one could be sure who could repay.  The world economic system came close to total collapse - rescued only by the willingness of the US and a few of the strong European governments to back up the biggest banks.

It's not clear how Bitcoin would necessarily change any of this.  If Bitcoin somehow becomes completely independent of the existing banking system - and its hierarchy of backing mechanisms that go up to the largest nation-states and their productive capacity - it's not clear how it can ever be stable.  (Granted, the existing monetary systems have problems with stability, too - but we've more or less managed to keep them under control.  In fact, we kept them very stable - no major panics; they were once an every-decade-or-two-occurence - from the 1940's until 2008.)  It's a nice theory that, with a strictly limited quantity in circulation, and a strictly controlled growth rate, Bitcoins should act kind of like gold, and not be susceptible to inflation (or deflation).  The wild gyrations in the value of Bitcoins - and in the price of gold, for that matter - indicates just how little that theory tells us about the real world.

                                                        -- Jerry