Hyperbitcoinization And The End Game Of Central Bank Policy
Logo

Hyperbitcoinization And The End Game Of Central Bank Policy

With El Salvador making bitcoin legal tender and the growing interest of retail investors and institutions in bitcoin, the case for hyperbitcoinization is becoming increasingly likely. In this article I will discuss what hyperbitcoinization is and why it might be closer than people realize.

Table of Contents

A Brief History Of The Gold Standard

In order to understand hyperbitcoinization we have to look at the history of money. Today, money is whatever a government deems legal tender and allows its citizens to pay taxes in. In 1971, Nixon severed all ties between the US dollar and gold. He effectively ended the gold standard that was in place until then.

During the gold standard, which all countries were on before World War I and II, all paper currency was backed by gold. This started a long time ago. Before the modern banking system existed in its current form, gold smiths were the go-to place where people deposited and stored their gold. In return for storing your gold at a gold smith, you would receive a paper receipt. This receipt was redeemable for physical gold at any time which overcame a major flaw of gold: While it preserves value and serves as a great medium of exchange in small amounts, it is impractical to transport large amounts of it across far distances.

Furthermore, carrying around large amounts of physical gold poses a security risk since it is bulky and hard to hide. This can attract criminals. Depositing gold with a gold smith and getting a paper receipt allowed people to overcome the transportability issues of gold. These paper receipts were so convenient and interchangeable that people started trading them more than actual physical gold.

Eventually, banks accepted these paper receipts and held their own gold reserves, paving the path for the gold standard. People could redeem their paper receipts at any time for physical gold.

US gold certificate

(US gold certificate from 1922)

In 1913, the Federal Reserve was founded. Other central banks, already existed in various forms in Europe before that. These central banks each held a certain amount of gold reserves in their vaults.

On the gold standard, central banks couldn’t create an excessive amount of paper money (or in other words paper receipts acting as substitutes for physical gold) because they still had to honor the redeemability of the paper money into real money. Each dollar bill was redeemable for physical gold at any time. To keep this promise, every paper dollar in circulation had to be backed by a certain amount of gold in physical vaults.

This meant that central banks couldn’t arbitrarily expand the supply of paper money unless they held more gold in their vaults. Paper money was still controlled by an external factor: The scarcity of gold. While governments could increase their spending through taxes and issuing bonds, they weren’t able to print money out of thin air. Or at least, any paper money they printed required an increase in gold reserves to keep the paper money sufficiently backed.

How Governments Abandoned The Gold Standard To Fund World War I & II

During World War I, countries like Germany and France, while technically still on the gold standard, temporarily abandoned the redeemability of paper money into gold. They did this in order to print money to fund World War I.

After the war, Germany as well as other European countries involved in the war, were left with huge debts. Germany expected to pay back its debt with the proceeds and gold reserves seized after conquering their enemies. They were overconfident and neither expected the war to last this long nor loose it. After Germany was defeated, the Versailles Treaty forced them to pay reparations to the other countries.

Weimar Germany, already greatly indebted from World War I, wasn’t able to make these reparation payments and was forced to print more money. This devalued the German mark and caused hyperinflation and an eventual currency collapse. The same happened to Austria and Hungary during that time. Other countries, such as Britain and France experienced significant currency devaluations as well. Only the United States walked away as beneficiary, since many European countries owed them money after the war and they weren’t willing to forgive this debt.

Hyperinflation in Weimar Germany

(German paper marks pulled from circulation and ready to be destroyed after World War I)

The gold standard was already in trouble during and after World War I, but it didn’t get any better from there. About a decade later, Hitler and the Nazi party seized power in economically troubled Weimar Germany. The hyperinflation ended in 1923 and Germany recovered surprisingly fast from the currency collapse. The government issued a new currency called Rentenmark and instilled trust by backing it with mortgages on agricultural and industrial land.

Despite the swift currency reset, the economy was still struggling and the country was politically divided. It wasn’t long after Hitler became chancellor and effectively initiated a dictatorship that the next war started. Once again, World War II had to be funded and it couldn’t be done with taxes alone. Germany ramped up the printing press and so did other countries to keep the war machine going.

Without severing the ties between paper money and gold, neither World War I nor World War II would have been able to turn into such brutal blood baths.

The Bretton Woods System Or How The US Dollar Became The World Reserve Currency

The gold standard was in ruins. After World War II ended, in July 1944, world leaders met in the Bretton Woods resort in Mount Washington to draft a new monetary system known as the “Bretton Woods System”.

As part of the Bretton Woods System, the US dollar was the only currency backed by physical gold reserves. All other currencies used the dollar as their reserves. This is when the US dollar gained its status as world reserve currency. It was one of many steps leading to the abandonment of the gold standard. But technically, since all currencies were pegged to the US dollar and the US dollar was backed by gold, paper money was still directly or at least indirectly backed by gold.

In 1971, president Nixon “temporarily” halted the redeemability of US dollars into gold because the gold reserves couldn’t keep up with the pace at which the United States government wanted to spend money. Again, another war was involved: The Vietnam war. In order to fund the war as well as other government expenses, the government started taking on more debt which put pressure on the US dollar.

To prevent other sovereign nations which held US dollars in their reserves from making a “gold run” and converting their US dollar reserves into physical gold, Nixon severed all ties between the US dollar and gold. This was the last nail in the coffin of the gold standard.

Since then, all currencies, including the US dollar, are fiat currencies. This means all currencies are only backed by the faith and credit of the United States government. Simply put: The US dollar “has value” because the government can print as much money as it wants to and as such it is believed the United States can’t default on its debt.

The United States Sovereign Debt Crisis

Fifty years after ending the gold standard, the United States debt has ballooned and is in a large bubble. In response to the Covid-19 pandemic, the government engaged in huge amounts of quantitative easing throughout 2020-2021. The debt to GDP ratio reached 128% in 2020. This means, the US government cannot pay back its debt through economic growth or regular taxation.

US government debt to GDP ratio

(US government debt to GDP ratio by Tradingeconomics)

As Graham Summers points out in his book “The Everything Bubble”, the endgame for central banks will consist of nuclear levels of quantitative easing, wealth taxes, cash bans, negative interest rates and bail-ins. Central bankers at the Federal Reserve and politicians fear nothing more than debt deflation. If the debt balloon starts deflating, this would result in a major economic crisis and depression. This is why central banks need to resort to ever more extreme monetary policies.

All of this can be traced back to Nixon’s decision to uncouple all currencies from gold. Ever since 1971, the fiat system has been in a state of serial bubbles. There is no escaping from the final “Everything Bubble” though, which is based on the bubble in bonds.

The Federal Reserve as well as other central banks around the world are stuck between a rock and a hard place. They have to continue their extreme monetary policy and resort to ever more extreme measures to prevent the bubble in bond markets from popping and causing debt deflation.

Once extreme measures like negative interest rates, bail-ins, wealth taxes and cash bans prove ineffective, central banks will have to fall back on the “tool” Weimar Germany used to get out of the post-war reparations debt: Insane amounts of money printing. This inevitably leads to heightened inflation and possibly hyperinflation in the future.

The Characteristics Of Money And Why Gold Used To Be The Best Money

We’ve discussed how receipts for gold deposits turned into paper money that traded as substitute of gold. But we haven’t covered why gold became money in the first place.

Most mainstream economists (with the exception of proponents of chartalism or the “state theory of money” who claim money always results from governments), agree that money emerges from barter. Bartering goods and services can work on a small scale but is ultimately inefficient because most commodities are perishable, erode or break over time, are hard to transport, indivisible or not scarce enough.

For a commodity to become widely used as money, it must fulfill a whole range of criteria:

It must be durable since otherwise it is incapable of storing value over a long period of time. While cattle has been used in certain cultures as form of money, you wouldn’t want to store your wealth in cattle for long periods due to it’s weakness as a store of value. Commodities that are extremely durable and don’t break, erode or deteriorate are better suited as money since they preserve and store value over prolonged periods of time.

The second criteria is that money must be divisible. Just because something is durable and able to preserve value over prolonged periods of time doesn’t automatically mean it’s good money. Additionally to being a store of value, money must serve as a medium of exchange. And in order for a commodity to be easily exchanged it has to be divisible.

Buying a coffee at Starbucks with a cow wouldn’t work since the cow is worth more than the coffee. The cow, since it is a living creature, can’t be divided to make smaller payments. The same is true for shoes, antique furniture and Grand pianos. You cannot break up any of these commodities into smaller units while preserving their function as a store of value.

In other words: Most commodities aren’t easily divisible and thus don’t work well as money since they are an ineffective medium of exchange.

Barter economies

(A man attempting to pay for a newspaper subscription through barter)

Money also has to be verifiable and fungible in order to work as medium of exchange. This simply means it must be verifiable that a certain unit of money carries the same value as another same-sized unit of money. If it’s easy to counterfeit a commodity and hard to identify counterfeits, the commodity wouldn’t work as medium of exchange since people would exchange things of unequal value. When equal units of a commodity don’t represent equal values, the commodity isn’t “fungible” and interchangeable.

Cattle is less fungible because one cow might be smaller or older than another cow. Does an old and bony cow have the same value as young cattle? And how can the age, health and quality of a cow be universally verified? When using cattle as money, it’s more likely people end up exchanging commodities with unequal value.

Another feature of money is that it should be scarce. Seashells worked quite well as money for some cultures until better fishing boats and nets allowed people to extract huge amounts of seashells from the ocean. Seashells went from being a scarce and hard to obtain commodity to being available in sheer unlimited quantities. When something is available in unlimited or large quantities, it doesn’t work as a store of value.

The Stock-To-Flow Ratio Of Commodities

The stock-to-flow ratio of a commodity determines how much new supply is created in comparison to its existing stock.

Commodities with a high stock to flow ratio, which means the supply is growing fast in comparison to the existing stock, aren’t well suited as stores of value. The more units of a commodity are available in comparison to the total circulating value of all goods and services of an economy, the less valuable the commodity is in comparison to all other goods and services.

The faster and easier it is to create more units of money in comparison to all goods and services in an economy, the faster it will lose its purchasing power. Prices of goods and services will surge due to inflation, leading to a flight to other commodities that are more scarce and thus a better store of value.

From all commodities known to mankind, gold meets this criteria better than any other commodity. It is durable and doesn’t easily break down which allows it to store and preserve value for years, decades and even centuries. It is divisible since a bar of gold can be broken down into smaller chunks, coins and even dust. Minting coins with equal weights and gold purity makes gold divisible and a great medium of exchange. Gold is relatively easily verifiable and there are tools to check gold’s purity level. And gold is also scarce since there is a limited amount of it under the earth’s crust. Mining gold is incredibly expensive and cumbersome which gives it a low stock-to-flow. The supply of gold cannot be easily inflated which makes it a good store of value.

This is the exact reason why gold became the universal money of choice for centuries. And it’s the economic explanation why the world adopted the gold standard until 1971.

The History Of Currency Debasement, Monetary Inflation And Seigniorage

As emperors and later nation states became greedy and wanted to spend more money than they held in gold, they used various methods to debase the circulating money. Initially this ways done by clipping gold coins. People would clip or shave small amounts of gold off the edges of coins for personal profit. Some even placed a number of gold coins in a bag and shook it to produce gold dust which they melted into chunks of gold and kept for themselves.

This had a negative impact on gold’s ability to store value. Practices like shaving and clipping the edges of coins made it harder to trust that a particular gold coin had the same value as all other same-size gold coins in circulation.

Currency clipping and debasement shows why we need hyperbitcoinization

(Various degrees of coin clipping and debasement during the Roman Empire)

Later on emperors and governments got more ruthless and debased gold coins by changing the amount of gold that was present in the minted coin. Gold coins were mixed with silver and less precious metals during the minting process. The gold content in coins continued dropping, making the coins people were storing their wealth in and exchanging goods and services for decrease in value. This was a common practice in the Roman Empire for example. One could argue that the continuous debasement of circulating coins directly lead or at least contributed to the collapse of the Roman Empire.

What we can learn from this is that anyone who controls the process of minting coins or issuing money is subject to human greed and will engage in debasement. Every group of people, every emperor and every government that ever had a monopoly on money has misused that power to enrich themselves.

By debasing the circulating money, either by reducing the content and purity of gold coins, printing fresh paper money or pressing a button on a computer, anyone in control of money creation can make a profit. As long as the process of creating money costs less than the face value of the issued money, governments can pocket the profit. This profit is called seigniorage.

Seigniorage can be used to fund government programs, wage wars and in some cases goes straight into the pockets of politicians. When money printing and seigniorage are used to bail out banks or investors that engaged in reckless speculation, such as during the financial crisis of 2008, those who receive the freshly printed money are profiting as well.

The reason for this is relatively simple: Those who are in control of the coin mint or printing press have access to newly created money before it enters circulation. They can spend the money before the increase in money supply has caused price inflation. In this sense, those closest to the coin mint and printing press are elevating their purchasing power at the cost of the general public.

This is why even John Meynard Keynes wrote:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.

John Meynard Keynes on inflation

The End Game Of Central Bank Policy

As we have seen, gold served as money for many centuries because of its excellent properties as a commodity. Despite this, Nixon severed all connections to gold in 1971 and the world embarked on a large-scale monetary experiment where money isn’t backed by anything but the credit and faith of the United States government.

There is a couple ways this could play out moving forward:

The extreme measures of central banks to avoid deflation fail, or central bankers and politicians intentionally let deflation happen. The latter scenario seems less likely since no central banker or politician wants to impose this level of economic pain on society. It would result in the loss of jobs of everyone at the Federal Reserve, end the careers of central bankers and politicians in charge and make re-election impossible.

Unwanted deflation might be more realistic which would mean the Federal Reserve is unable to reflate the “Everything Bubble” even through extreme monetary policies.

A more likely scenario is that the Federal Reserve and other central banks around the world will do everything in their power to prevent the “Everything Bubble” from popping. They might try to raise interest rates slightly, taper their quantitative easing programs or even reduce the Federal Reserve’s balance sheet. But it’s likely that at the slightest hint of doing this, financial markets start tanking which could trigger debt deflation.

Jerome Powell indirectly accelerating hyperbitcoinization

(Current chair of the Federal Reserve Jerome Powell during a press conference)

Whenever there is a sign of another big financial crisis or economic meltdown, the Federal Reserve will use this as an excuse to continue their extreme monetary policies. And depending on the severity of the crisis, they’ll even resort to more extreme measures such as negative interest rates, wealth taxation and greater levels of quantitative easing than in 2020-2021.

Depending on how extreme the measures are and how much money is printed, this will lead to persistent heightened inflation or even a period of hyperinflation. Other sovereign nations that are holding US dollars in their reserves would lose trust in the dollar.

This could lead to several things:

  1. China tries to market their CBDC as new reserve currency
  2. The United States launches their own CBDC on the back of a currency collapse
  3. The IMF steps in and attempts to fix the situation with their Special Drawing Rights (SDRs), which consist of a basked of currencies that can be used as reserve asset

The problem with these solutions is that they are all based on fiat currencies, so it will just be a matter of time until the Chinese Yuan, Fedcoin and SDRs would suffer from the same problems discussed in this article. The IMF might be able to continue the game for several more years or even decades. At this point, we can only speculate how they would react if the US dollar lost its status as world reserve currency.

A more favorable situation would be that by the time all of this happens, several sovereign nations around the world have already adopted bitcoin as legal tender. Sovereign nations that have adopted bitcoin as legal tender would be in a much better position than countries that only held US dollars in their reserves. They would emerge from a period of heightened inflation or hyperinflation stronger than other nations.

This could lead to an “imitation effect” and a flight form US dollars to bitcoin. Retail investors and institutional investors would convert their US dollars into bitcoin to preserve their purchasing power. And sovereign nations would pass laws to make bitcoin legal tender at an accelerating rate. Both things would push up the price of bitcoin and reward those individuals, institutions and sovereign nations that adopted bitcoin.

At this point, if enough sovereign nations have passed laws to make bitcoin legal tender, it would be very hard for the IMF and even individual governments to continuously ban bitcoin.

Why Bitcoin Is Perfectly Engineered Digital Money

From a free market and Austrian Economics perspective, different commodities compete with each other for the status of money in the same way that products and services compete with each other regarding features, benefits and customer service. The best products and services, and the companies behind them, out-win their competitors.

We’ve already discussed the criteria that makes a commodity well-suited as money.

Until now, gold met these criteria better than any other commodity. However, Bitcoin was engineered to be the perfect money and embodies all these characteristics better than any commodity, including gold.

Bitcoin is durable since it has never been hacked and is secured by the biggest computer network in the world. The security of bitcoin is determined by its hash rate. And the hash rate of bitcoin increases with adoption.

One bitcoin is divisible into 100,000,000 units called Satoshis. This makes bitcoin suitable for large transactions as well as small transactions. Micro-transactions are also financially feasible on layer two networks such as the Lightning Network where transaction costs are near to zero.

The bitcoin blockchain is a public ledger run by tens of thousands of computers that is constantly verifying every transaction that is happening. It isn’t build on trust but rather automatically verifies every transaction. Bitcoins are also fungible and interchangeable. If you sell a bitcoin and buy another one later it makes no difference to you. As far as you’re concerned, one bitcoin equals one bitcoin.

Some minor issues do exist with fungibility though since certain coins that have been through a conjoin or have been linked to illegal activity or mined with “dirty energy” could be rejected by some bitcoin exchanges. This reduces some of the fungibility of bitcoin but not in a major way.

There are some solutions that can improve the fungibility, such as most transactions happening on the Lightning Network instead of the base layer.

Finally, bitcoin is scarce because it was preprogrammed that only 21 million bitcoin will ever be mined. This means, the total supply of bitcoin is known in advance unlike any other commodity. Nobody knows how much gold exists under the earth crust, in the oceans and on asteroids. But the total supply of bitcoin is programmatically given.

Since bitcoin runs on a decentralized network of computers across the world, there is no way for a government or the IMF to shut it down. Especially once more sovereign nations have adopted bitcoin as legal tender, it could be seen as an act of financial war against any country that has made bitcoin legal tender. With increasing adoption by sovereign nations, attempts to shut it down or ban it will not only be technically impossible but become politically unfeasible.

In case free market principles prevail, bitcoin should become the preferred and predominant form of money because it meets the criteria for money better than any other commodity.

The Case For A Bitcoin Standard And Hyperbitcoinization

There’s a few ways we could see a bitcoin standard playing out: Either each sovereign nation issues their own currency which is backed by bitcoin reserves similar to the gold standard. In this case, sovereign nations would acquire and hold bitcoin in their treasury like El Salvador. They would maintain convertibility, which means paper money or CBDCs must be redeemable for bitcoin. And sovereign nations need to maintain a certain percentage of bitcoin.

The danger here is of course that at some point in the future, governments become greedy and unpeg their currencies from bitcoin to issue more debt. In that case, history would likely repeat itself leading to money printing and currency collapses in the future.

Another option would be that sovereign nations adopt bitcoin outright as legal tender and don’t issue their own currencies. Payments and smaller transactions would happen on layer two solutions such as the Lightning Network as is the case in El Salvador. Large payments could still happen on the base layer.

Hyperbitcoinization in El Salvador

(A newly installed Bitcoin ATM in El Salvador by Karlalhdz)

Should this be the case, bitcoin might even rise up and become the unifying, single currency of the world. This would mean that governments need to fund expenses with tax revenue rather than the indirect taxation through inflation. As Jack Dorsey said, bitcoin could unify a deeply divided world.

How The Internet, Self-Education And Younger Generations Could Accelerate Hyperbitcoinization

Fiat currencies are slowly but steadily losing their value due to excess money printing. All fiat currencies will eventually collapse and lose most of their value if we look at a long-enough time horizon. With the increasing unsustainability of government debt and more extreme monetary policies deployed by central banks, this loss of purchasing power will be accelerated and the time-frame for a currency collapse shortened.

The question is what will happen once trust in the US dollar as the world reserve currency is lost. After the German hyperinflation in 1923, the government issued the Rentenmark. They had to “rebrand” and gain the German people’s trust by backing the currency with agricultural and industrial mortgages. During the hyperinflation, people fled to foreign currencies, stocks, gold and scarce commodities to protect their wealth. A perfectly engineered, decentralized asset that meets the criteria for sound money better than any other commodity didn’t exist at the time.

There was also less awareness and education about what inflation is. Speculators, profiteers and jews were blamed for what was happening back then. Today, there is more information available about inflation and how money works. There are hundreds of thousands of YouTube videos, articles, blogs, Tweets and books available on the topic. Younger generations are converting their fiat currency to bitcoin and other cryptocurrencies at a staggering rate. They are educating themselves online.

These same people will eventually become elected politicians and leaders.

If a currency collapse takes place, or is on the horizon, and enough individuals, institutions and sovereign nations already store their wealth in bitcoin, the demand and political pressure to make bitcoin legal tender might reach a tipping point that leads to hyperbitcoinization.

December 22, 2021