Oct 25, 2019
Cryptocurrency Exposes the Fictions of the Nation-State
Fiat currencies rely on trust in the nation-state for legitimacy. Bitcoin undermines these myths and forms a more stable basis for our financial future.
The Role of Legal-Institutional-Political Substructure in Promoting Trust in Currency
Urs Birchler, a famous Swiss emeritus professor of banking at the University of Zurich, recently diagnosed Bitcoin as having what he calls “the birth defect of crypto money.” Birchler considers the design of Bitcoin, which replaces trust in a central monetary policy authority with an algorithm, to be brilliant in terms of programming but rather silly from an economic point of view.
For Birchler, cryptocurrencies like Bitcoin are “entries in a ledger of nothing.” His statement echoes how many other people still feel about Bitcoin, that it is a virtual, digital thing that is neither tangible nor graspable, which is why–unlike physical, analog things–they lack a real basis of value.
Anticipating criticism of his take, Urs Birchler nods toward an oft heard objection: isn’t a paper currency like the Swiss franc just as fictitious as a digital currency like Bitcoin? He does not immediately discard the proposition that the Swiss franc is a pure collective illusion; however, Birchler points out that the Swiss currency is based on a legal, institutional, and political foundation which provides the Swiss National Bank with the public trust it needs to issue a fiat currency. In his view, paper currencies owe their value only superficially to the individual laws that make them legal tender and a medium of exchange. What is more decisive is the fact that the franc functions as a lubricant for a functioning economy, imparting a sense of public confidence which is fortified by healthy public finances and a stable political framework. While the Swiss Franc is ultimately backed by “Switzerland,” there is nothing similar backing Bitcoin and therefore it has no value, or so Birchler’s argument goes.
The Nation-State as a Fictious Mega Tribe
What undergirds Birchler’s concept of a legal-institutional-political substructure are the modern achievements of participatory democracy, the rule of law, and the market economy. These have evolved over the past two centuries, merging into a single entity: the territorial nation-state. In the early 1970s, in the wake of the devastating world wars and reconstruction, the Great Moderation ushered in a period of low volatility and reasonably stable economic cycles. The world economy seemed to be in order. And with the collapse of the Eastern bloc in 1989, it seemed to be the end of history, as the political scientist Francis Fukuyama wrote in his book of the same name from 1992.
But then came the terrorist attacks of September 11, 2001, and the financial crisis of 2008/09. The latter in particular shattered confidence in the nation-state’s core institutions. As numerous surveys show, institutional confidence has reached a low point among the general public. Nation-states are often perceived as powerless, which nurtures that sense of mistrust. In the face of this crisis of public confidence, modern nation-states have to use a series of ornate fictions to maintain the semblance of legitimacy: democracy, the rule of law, and paper currency. The largest of these illusions is the nation state itself. It functions as a symbolic but fictitious mega tribe, appealing to the intuitions and feelings that the human animal has inherited from a time when people still lived in small tribal communities, as F. A. Hayek so brilliantly showed in his works.
It is also an echo of 19th century French economist Frédéric Bastiat who stated, “The state is that great fiction by which everyone tries to live at the expense of everyone else.” Today, Bastiat’s critical view has new validation from how national currencies contribute to that myth-making habit. In addition to direct redistribution of wealth, the costs of maintaining our fictitious national mega tribes is being redistributed into the future via the public-private monetary system: a triad of government, central banks, and commercial banks. On the basis of tax debts, i.e. government bonds, capital markets are cleverly leveraged in order to push unsustainable present obligations onto unwilling future backs.
Dependence on money creation
One essential fiction that nourishes dependency on the nation-state is to regard government securities as risk-free, which they cannot be. These sovereign bonds serve as the foundation for a financial pyramid of debt securities that encompasses everything from electronic cash holdings to marketable securities to volatile financial derivatives. Another fiction is built on top of this, that our current financial system, which has been decoupled from gold for quite a while now, can indefinitely operate in a permanent deficit. Although every financial liability is backed by a corresponding asset, neither the quality nor the liquidity of the latter is assured. If a critical mass of debt-holders ever tried to liquidate their assets and assert their claims to repayment, this fiction would suddenly be exposed as an empty promise. Dire financial and economic collapse could result.
Modern society, with its economic and political structure, is more dependent on money creation by central banks than it should be. Pumping liquidity into the system is supposed to be the last resort by which the central banks try to keep the economy growing, but it has become a first rather than last resort. In the US, the interest rate hikes announced for 2019 were not implemented; on the contrary, rates were cut once again. In addition, the Federal Reserve announced that it would stop its balance sheet contraction by September 2019 in order to pump new liquidity into the market. In Europe, the zero-interest rate trap runs even deeper. With Christine Lagarde as the head of the European Central Bank (ECB), it is the first time the position was occupied not by an economist but by a thoroughbred politician. Those responsible for her appointment may have supported her because she seems to be a suitably compliant companion on the path to more money creation.
The Swiss National Bank (SNB) has also ventured into this uncertain territory by massively expanding its balance sheet, especially in equities. Its US equity portfolio reached a new record high of CHF 91.2 billion at the end of March 2019. The reason for its numerous foreign currency purchases, of which equities account for 20 percent, is the strong Swiss franc. Doing so allows the SNB to justify the negative interest rates it has been charging on deposits of commercial banks since the end of 2014. Of course, this policy is not to the advantage of savers, but what else should the SNB do? It continues to enjoy a good reputation and behaves in an exemplary manner relative to other countries’ central banks. Nevertheless, it is being dragged along by global pressure to expand the money supply ever further. As Erasmus of Rotterdam once said: “In the land of the blind, the one-eyed man is king.” Switzerland is a one-eyed king who thinks that makes him Thor.
Who’s the Experimenter and Who’s the Experiment?
Bitcoin is often described as a grand experiment. That’s not wrong, as those who have been developing the core code for years would affirm. To be fair, however, the monetary policy interventions of the last decade should also be dubbed a profound experiment. Their medium to long-term effectiveness is disputed by mainstream economists. And new, more unusual experiments have been proposed, from proponents of “helicopter money,” the outright abolition of cash, new sovereign money, or Modern Monetary Theory (MMT). The stability of our financial system may be overrated.
As a reminder: Bitcoin was born in 2008 at the height of the financial crisis, in the midst of a vacuum of fiscal uncertainty. Cryptocurrency can be seen as the antithesis to the existing financial order and was deliberately not embedded in the existing structures nor based on their parameters and premises. It is therefore logical that it is precisely the “nothing” nature that Birchler spoke of which gives Bitcoin its value. This “nothing” means that the cryptocurrency is “not issued by central banks.” There is no central bank behind Bitcoin, and that is the very purpose of the project. Bitcoin thus creates a conscious alternative to a monetary system via central banks. It is a deliberate counterpart whose symbolic as well as real-life power should not be underestimated.
To put an even finer point on it, Bitcoin represents an attempt to take money out of the hands of the self-described central guardians planning our economy, politics, and social order. With Bitcoin, money is supposed to be like gold once again: scarce and decentralized. As such, it is meant to curb the endless appetite of politicians, functionaries, and empty business suits for power and control. The fact that these sorts of people are either mocking Bitcoin or are afraid of it is understandable, but at the same time it is quite pitiful.
Parallels to the 19th Century
One of the last periods of major social disruption - the liftoff into modernity in the 19th century - unfolded in a similar manner. In Switzerland, for example, the Gründerzeit (industrialization) , which finally ended in the Gründerkrach, was by no means received without skepticism. Swiss farmers, in particular, were unwilling to accede to this dynamic development. The Swiss agricultural landscape had long been capitalized as the country was embedded in the continental monetary economy thanks to the Gotthard Pass and the Bündner Passes. Interestingly, the Swiss Confederation had long been regarded as protoindustrialized. Why would Switzerland then need new investment banks with their odd financing practices? Which is why the Swiss farmers of the 19th century reacted with great skepticism to the newly emerging system of bank “notes.”
There are clear parallels between the creation of bank notes in the 19th century and the founding of cryptocurrency today. The 19th century was also characterized by euphoria and excess. Just like today, it was a time when speculators and entrepreneurs could seemingly get rich overnight. Critical reactions now and then are very alike as big landowners protested against the fact that they had to pay property taxes, while factory owners had to pay relatively low corporate taxes. The same accusation is heard today, with critics saying that crypto projects operate in a legal vacuum, while traditional companies have to obey a vast array of laws and regulations.
At that time, the old feudal system, marked by large landowners controlling many small tenant farmers, was being broken up. It was replaced by the modern age of urban employer-employee relationships, but the 19th century was also the moment when many of our most important institutions—such as companies, banks and nation-states—coalesced. Today, it is becoming obvious that we are on the threshold of another new era, a digital age in which non-central networks such as Bitcoin are likely to play a major role.
Bitcoin’s strength as an antidote to the existing financial and social system is also due to the fact that the cryptocurrency does not promote the current system’s fictions. Due to the transparent nature of a public blockchain and its game theoretically-sophisticated incentive structure, unbacked value claims are not possible. Bitcoin is based on the principle of “do not trust but verify.”
People like Professor Birchler cannot see through the nation-state’s fantasies. In their eyes Bitcoin suffers from an inherent birth defect. But to extend the metaphor, what he and others consider to be birth defects are more like ordinary childhood illnesses, things which were once possibly fatal but which have become curable in the modern world. That marks a complete contrast to our current financial order, which seems to be afflicted by a late-stage cancerous tumor.
Is the Development of Bitcoin and the Lightning Network Sustainable?
Professor Birchler also criticized how much power Bitcoin consumes as it runs the mathematical calculations necessary to validate additions to its blockchain. He is correct that Bitcoin imports scarcity from the real world by relying on energy, a finite resource. However, that power consumption is not wasteful. It makes Bitcoin secure, allowing the spread of this global, permissionless, and censorship-resistant network. The more energy consumed by the network, the higher its security and reliability. Just because the energy consumption in Bitcoin mining is currently increasing, there is no reason to believe that this will continue forever. The more Bitcoin matures, both in terms of price and user base, the more value that a single Bitcoin transaction will have. In relative terms, fewer transactions will take place but each will transfer more value, making the network more energy efficient.
People who believe that Bitcoin has reached some kind of development plateau because of excessive power consumption fail to appreciate that power generation technology is also likely to change for the better, which should make Bitcoin mining more energy efficient in the future. In this context, Bitcoin enthusiast Andreas Antonopoulos makes the pointed analogy of a doctor telling a pregnant patient, “Madam, I’m concerned about the progress of your pregnancy. At the current rate of growth, your belly will be the size of this building in just five years.”
It is also not a birth defect that Bitcoin is not yet really suitable as a means of payment for everyday business. With the basic blockchain, which prioritizes decentralization and security and is conducive to the monetary function of storing value, Bitcoin has committed itself to being modular (i.e. having a layered scaling roadmap) just as the Internet today consists of several layers. But we may not have to wait much longer for that new layer; an additional protocol called Lightning is currently being implemented based on the mainchain, i.e. the base layer within a blockchain. It enables so-called off-chain payment channels through which Bitcoin—in the form of cryptographically-secured full reserve “promissory notes”—can be exchanged as often as required and do so immediately and at lower transaction fees. The Lightning network thus creates the basis for using Bitcoin as an efficient medium of exchange.
Admittedly, since it is still a developmental network, Bitcoin is similar to a chaotic construction site; accidents are the order of the day and optimal workplace solutions have not yet been found. Nevertheless, more and more people are spending their time building out the network. Our established structures, on the other hand, look like an outdated palace. The shine of the façade has not yet fully faded and speaks of a grand past, but yawning cracks are appearing in the foundation. Likewise, in the financial realm, mistrust and suspicion are on the rise, fueling support for an alternative that makes money no longer dependent on trust in a central bank or a legal-institutional-political framework, but instead builds trust through mathematics and cryptography.
This article was first published in German with the Swiss magazine Schweizer Monat.