Central banks played an important role in the 2008 financial crisis through their policymaking. Bitcoin (BTCUSD) was one of the solutions to this crisis. Bitcoin (BTCUSD) is a peer-to-peer and decentralized technology that has the potential of dismantling a banking system where a central authority makes decisions that impact the economic fortunes across entire countries. The downsides of cryptocurrency make it difficult for anyone to argue for a decentralized system that is made up of cryptocurrency.
- Bitcoin’s peer-to-peer technology and the decentralized system have the potential of upending the central bank’s role in modern financial infrastructure.
- Central banks are a vital part of the economy, according to proponents. They help stabilize prices and maintain employment. Critics claim central banks can have a negative effect on consumers and the economy, and they are responsible for debilitating recessions.
- Although it is a potential replacement for central banks, Bitcoin has many drawbacks. For example, there is a limited supply of Bitcoin and a lack of legal status in most countries.
- The central banks have borrowed elements from Bitcoin’s design and technology in order to explore the possibility of using CBDCs (central bank digital currencies) in their economies.
Role of the Central Banks in Economy
Before we can examine the impact of Bitcoin on central bank policymaking, we must understand the role central banks play within an economy. The global financial system is supported by central bank policymaking. The mandates of central banks vary from one country to the next. The Federal Reserve in the United States, for example, is responsible for controlling inflation as well as maintaining full employment. The Bank of England is responsible for the stability and solvency of the UK’s financial system.
To achieve their mandates, central banks employ a range of tactics known as monetary policies. They manipulate interest rates and money supply in the majority of cases. A central bank may increase or decrease the amount of money in an economy. A greater amount of money in an economy means more consumers spending and consequently, more economic growth. Conversely, if there is less money in the economy, consumers will spend less, and then there will be a recession.
The actions of a central bank can also impact overseas investment, imports, and exports. High-interest rates, for example, can discourage foreign investment in real estate. However, low-interest rates may encourage investment.
To distribute the money within an economy, central banks use a network bank to do so. They are, in this sense, the center of an economy’s financial system that includes banks and financial institutions. Central bank policymaking can lead to economic booms or busts.
There are advantages and disadvantages to entrusting an agency central with the operation of an economy. The greatest advantage of a central agency managing an economy’s functioning is its ability to build trust.
This was a situation that existed before the Federal Reserve was established. The U.S. monetary system was populated with money issued by non-bank entities such as merchants and municipal corporations. Each currency had its exchange rate. Many were frauds and not backed up by sufficient gold reserves. Occasionally, panics and bank run erupted throughout the United States economy.
The National Currency Act of1863 and the National Bank Act of1864 were passed immediately after the Civil War. This set the foundation for a federal and centralized system of money.2 In addition, a uniform national banknote was created that could be used in all commercial centers throughout the country at face value. The Federal Reserve was also established in 1913 to bring monetary stability and financial stability to our economy.
Recessions: A Central Decision-Making Authority
The problem with the above-described structure is that it places too much trust in central agencies and takes too much responsibility for their decisions. Incorrect monetary policy decisions by central banks have led to debilitating recessions.
According to Ben Bernanke, former Fed Chairman, the Great Depression was caused by mismanaged economic policies and a series of bad decisions made by local Federal Reserve banks.3 Another example of the economy crashing due to the Federal Reserve’s easing of its grip on the economy and adopting a policy of low-interest rates is the 2008 Great Recession.
The complexity of modern financial infrastructure has made it more difficult for central banks to play a role in an economy’s functioning. The speed of money’s movement through the global economy is increasing as it takes on digital forms.
This complexity is again illustrated by the 2008 Great Recession. Many academic articles and papers have linked the recession to exotic derivatives trading, in which insolvent borrowers’ housing loans were repackaged into complicated products to make them attractive. Banks were attracted to the profits of these trades and sold the products to unsuspecting customers who then resold the tranches to other buyers around the globe. The whole financial system made huge profits. The Federal Reserve provided the money to backstop all these trades.
Because of the interconnected nature and scale of the global economy, policymaking decisions (and mistakes) made by one central bank can be transmitted to many other countries. The Great Recession contagion spread quickly from the United States to other countries, leading to a worldwide slump in stock markets.
Bitcoin’s inception was fueled by the potential responsibility of a central banking institution for manufacturing and precipitating crises.
Can Bitcoin kill Central Banks?
Both technology and economics are the basis for Bitcoin’s potential as an alternative to central bankers. Bitcoin’s creator, Satoshi Nakamoto described the cryptocurrency as an “e-money version of electronic money” that allows payments to be made directly to any party without having to go through a financial institution.
Bitcoin solves three problems in a financial infrastructure system that is dominated by central bankers. It solves three problems in a financial infrastructure system dominated by central banks.
Second, Bitcoin’s network, although it is distributed, is still trustworthy. Second, Bitcoin’s network is still trustworthy even though it is decentralized.
The third benefit of Bitcoin’s network is that it eliminates the need to have a central infrastructure. It streamlines the process of producing and disseminating the currency. Anybody with a full node can generate Bitcoin at their home. This allows them to transfer the currency between two addresses in Bitcoin’s blockchain.
Bitcoin promises economic independence, but there are many catches. First, Bitcoin’s status as a medium for the transaction. Bitcoin’s status as a medium of the transaction has been largely unknown since its release to the public.5 Bitcoin is a popular tool for criminal transactions as well as speculation.
Second, Bitcoin’s legal status as a means of legal transfers is not known. Although the cryptocurrency is now legal tender in El Salvador it remains illegal to use for payments. Other countries around the globe, including the United States of America, China, and India, have taken steps to curb Bitcoin’s users and infrastructure.
Bitcoin supply is also limited and volatile. There will be 21 million Bitcoin mined. The number of Bitcoin available is limited severely by a cap. The cryptocurrency has been attractive as a speculation asset due to its scarcity. Its price fluctuates between extremes making it difficult to use for daily transactions.
The difficulties with Bitcoin’s usage have not stopped central banks from using elements of the cryptocurrency to create their digital currencies. Several central banks are exploring the use of digital currencies called Central Bank Digital Currencies, or CBDCs as they are commonly known. Central banks could issue a digital currency that eliminates intermediaries such as retail banks. They will also use cryptography to make sure it isn’t duplicated or stolen. It could also be less expensive to produce than metal coins.
The bottom line
The current global financial system is run by central banks. The vast majority of countries use central banks to manage their economy. However, this centralized structure has led to severe economic recessions and too many people being unable or unwilling to exercise control.
Bitcoin’s technology is based on algorithmic trust. The decentralized system offers an alternative system to the existing system. However, the cryptocurrency’s adoption rate is very low and its legal status remains under the cloud. Central banks have also co-opted parts of Bitcoin’s design and technology to investigate the possibility of central banks issuing a digital currency.