The fable of the indispensible central bank

TL:DR: Central banks were created to solve a lack of trust in commercial banks, but just force us to trust central banks. Crypto flips this upside down, removing the need for trust and offering hard security.

Central banks have been a fixture of the modern financial system for centuries. Established to manage a country's monetary policy and provide financial stability, central banks have played a crucial role in ensuring the stability of the banking system and the economy as a whole. However, there was a time before central banks, and it’s worth looking at the reasons why we ever created central banks to see why they're becoming unnecessary now.

In the time before central banks, commercial banks generally issued their own paper money, which was backed by their own assets or by a limited amount of gold and silver. There were different monies going around, say an HSBC Dollar, JPMorgan Dollar etc, which were often used in a certain region and had differing qualities of assets backing them. The reputation of the bank was vital – if people lost trust in HSBC, they’d redeem their HSBC Dollars. However, what happened time and time again is that excessive money was issued, which led to an eventual bankrun, bankrupting the bank, starting the cycle all over again. As gold was hard to transact in directly people nonetheless sort of had to trust a commercial bank to hold it and issue receipts.

To address the issues of i) currency instability and ii) instability of the financial system, central banks were established. Central banks were given the (often exclusive) power to regulate the money supply, control interest rates, and provide emergency loans to banks in times of crisis. The theory behind this was that this helps to ensure the stability of the banking system and prevent economic disruptions caused by bank runs. Given that central banks were given the exclusive charter to provide currency and had implicit or explicit backing by the government, bank runs were less likely to happen and currencies were more stable.

The flipside of this is that power, and forcing of trust in that power, was transferred to a bigger entity – from individual banks to a central bank. Whereas before commercial banks could do fractional banking, e.g. having $100 of gold in reserve and issuing $500 of money with the idea that not everyone would want to withdraw at the same time, this power now rested exclusively with central banks. Central banks often used this power to “redenominate” their currencies, stating that whereas previously 1 gram of gold would give you $5, they’d now give you just $4 for your gram of gold. “Hey, what you gonna do? We’re the central bank.”

The key word in all this is trust. Previously you had to trust commercial banks, and they often broke that trust. Because of this, a bigger, hopefully less unstable institution was created, a central bank. You’d still need to trust them. Central banks however also often broke and break this trust. See for example Zimbabwe, Venezuela, or the hundreds of (hyper)inflation episodes in history.

All currencies devalue or die. That is because printing a lot of currency and devaluing debt is the most expedient way of reducing or wiping out debt burdens. – Ray Dalio

Central banks were created to solve a trust problem. Untrustworthy commercial banks exist? Well, here’s a more trustworthy central bank. They’re still in the same paradigm, though. Trust still can be broken, and repeatedly is. There are also other costs associated with a central bank paradigm:

1. Printing and distribution costs: The cost of printing and distributing physical currency.
2. Monetary policy implementation costs: Central banks incur costs in implementing monetary policy, such as setting interest rates, buying and selling government bonds, and managing the money supply.
3. Speculation costs: Tons of trading happens around central bank policy announcements, trading and speculating purely on what central banks might do.
4. Economic inefficiency costs: Rather than the economy developing through a natural flow, boom/bust cycles are engineered leading to inefficiencies.
5. Swapping costs: So many countries, so many currencies. Travel, and you have to exchange. Trade, you have to exchange.
6. Redistribution costs. Increasing the supply is a tax on everyone holding the currency, but this tax also gets redistributed to a different group.

Crypto forces us to reconsider the very basis of this system. If, before commercial banks and central banks ever showed up, we were able to transform our gold, things might have been different. If our gold had been easily divisible, if it would have been more transportable, if it had been, in short, usable as money in and of itself we would never have had to resort to placing our gold with commercial banks. If we had never placed our money with commercial banks, there would have been no breaking of trust, no fractional reserve banking, no bankruns, and no need for central banks.

This is what crypto is moving us into. Money where commercial banks aren’t necessary to use it, where central banks aren’t necessary to keep commercial banks in line. Money that doesn't come with all these hidden costs and trade-offs. Money that can’t be corrupted by any individual, whose supply can’t just be expanded, money that is not vulnerable to a bank run.

We're living in a time where central banks have to spin stories about why they are important, why we can't do without them. It makes sense. Would you want to give up the power to literally create money? It's an increasingly weak story, and people will increasingly wonder why they should hold money that someone else can print when there's a hard form of money available.

If you want to read more of these sorts of articles, I got some here including one on why crypto will win the battle for money from the bottum up.