How the government engineered the rise and fall of crypto

She further added: “Cryptocurrencies are by definition borderless and require international cooperation to prevent regulatory arbitrage. Therefore, any legislation for regulation or for prohibition can be effective only after significant international cooperation.”

The RBI is not the first central bank to have doubts about crypto, and the Indian government is not the first government. Both Chinese and Russian authorities have also cracked down on crypto. So, what makes many central banks and governments dislike crypto? In this piece we will try to understand this.

But first we need to understand how governments and central banks had a very important role to play in making crypto popular.

Before September 2008

Central banks drive the monetary policy of a country with the aim of maintaining low inflation and a stable growth environment where unemployment is low. Usually, until 2008, they used to do this by trying to set the short-term interest rates.

In mid-September 2008, Lehman Brothers, the fourth largest investment bank on Wall Street at the time, declared bankruptcy. AIG, the largest insurance company in the world, was also on the verge of bankruptcy. Many other financial institutions were in trouble. If these financial institutions failed, the global economy would be thrown into turmoil.

To stabilize the financial system and prevent an economic depression, the Federal Reserve — the US central bank — printed money and bought $600 billion worth of bonds from many financial institutions.

This was referred to as quantitative easing and was seen as an act to stabilize the financial system, after the housing bubble, which has been going on since the turn of the century, burst. Many financial institutions had taken on heavy leverage to bet on this bubble in various ways, thus getting themselves into trouble.

In November 2010, the Federal Reserve decided to start a second round of quantitative easing. By this time, financial institutions had more or less stabilized. So why did the Fed decide to print money and buy bonds? Until then, the Fed had operated by trying to control short-term interest rates. Now it wanted to drive down long-term interest rates by printing money.

With excess money in the financial system, long-term interest rates would fall and this would encourage people to borrow and spend more. Businesses would borrow and expand, and in turn help economic activity. At the end of the day, one man’s expense is another man’s income.

As Christopher Leonard writes in The Lords of Easy Money: “[The Fed] tried to stimulate the entire American economy.” Other rich central banks—the European Central Bank, the Bank of England, and the Bank of Japan—followed the Fed.

Apart from driving down interest rates, there was another thing that this move hoped to achieve. Investors typically viewed long-term government bonds, referred to as Treasuries, as a safe haven. It’s the kind of investment you make and forget. But when the Federal Reserve bought up government bonds for months, very regularly, there was a shortage of those bonds. Leonard writes: “The Fed bought the long-term [bonds] because to do so was like closing the one safe deposit box in which Wall Street investors could stash money.”

The Fed wanted investors to take more risks with their money, which they eventually did.

The Fed continued quantitative easing well into 2014. In the process, they made what was supposed to be an emergency measure, a regular one. At the same time, other problems grew. “The real problem lay outside the banking system, in the real economy where the deep problems were festering, problems that the Fed had no power to fix,” Leonard writes.

What happened next?

In 2010, the decision to go for a second round of quantitative easing was made by Ben Bernanke, then chairman of the US Federal Reserve. At the time, Thomas Hoenig was president of the Federal Reserve Bank of Kansas City and also a member of the Federal Open Market Committee, which set the US monetary policy.

Indeed, Hoenig explained the risks of open-ended quantitative easing to Bernanke. As Leonard writes: “Hoenig said the program could ‘remove’ inflationary expectations. This was different from saying it would cause inflation. He warned that companies and financial speculators would begin to anticipate higher inflation in the future thanks to the supply of new money, and they would start investing accordingly.”

What Hoenig said is that with so much money being printed and pumped into the financial system, investors would begin to believe that sooner or later high inflation would set in. To protect against high inflation, investors would want to generate increasingly high returns and make riskier investments in the process.

This is exactly what happened. The search for higher returns led investors to invest in all kinds of asset classes – from commercial property to oil to shares and riskier bonds from less developed countries (read Sri Lanka). They also ended up investing in bitcoin and other cryptos.

The first block of bitcoin, referred to as the genesis block, was mined in January 2009. Nevertheless, it was only after 2012, when the Federal Reserve had been running its quantitative easing program for a while, that buying bitcoin first became popular . among the geeks and then among the average retail investors. The idea was that unlike government backed fiat money that a central bank could keep printing and keep creating out of thin air, only a limited number of bitcoin could be created. This logic caught people’s fascination and they started buying bitcoin. In that sense, bitcoin became digital gold for many young people.

Therefore, the behavior of the government-backed central banking system led to the popularity of cryptos in general and bitcoin in particular. This popularity peaked in November last year and has been going downhill ever since with a price crash, which has also led to several other problems.

Government dislike of crypto

There are two important things that make a government a government: The right to tax and the right to create money out of thin air.

Governments did not always have the full right to create money out of thin air. Until 1913, before World War I started, many countries were on the classical gold standard. Each currency unit was worth a certain amount of gold and could be exchanged for gold.

In this scenario, the government could not create money out of thin air by printing it because people could exchange that money for gold. And the governments risked running out of gold. Many countries suspended the classical gold standard in order to be able to print money to finance the expenses required to fight the First World War.

After the end of the war, countries went back to the gold standard, and being on the gold standard meant that governments had to maintain a tight economic ship. They could not manipulate the monetary system to make things easier for the common man. The gold standard did not allow them to do so. They simply couldn’t print money to drive down interest rates.

As Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: “World War I and the Great Depression created great displacement and unemployment… Workers, many of whom had become politically conscious in the trenches of World War I, organized to demand some form of protection against financial hardship. But the reaction really set in during the Great Depression, when they were joined in country after country by other losers—farmers, investors, war veterans, the elderly.”

The Great Depression started after the American stock market crash of 1929. This forced the hands of many governments around the world and they gradually got rid of the classical gold standard.

The US dollar was the core of the financial system that emerged after World War II. In this system, only the United States could convert dollars into gold. This allowed the dollar to be at the heart of the global financial and trading system. Every other currency was a fiat currency and the government could create this money out of thin air.

Rajan and Zingales further write: “The gold standard … imposed strict budgetary discipline on governments, making it difficult for them to intervene much in economic affairs … Politicians had to respond, but such a large demand for protection could not be satisfied within the tight conditions. limitations imposed by the gold standard. Therefore, the world abandoned the straitjacket of the gold standard … With their ability to turn finance on or off, governments gained extraordinary power.”

Governments and central banks have used this extraordinary power over the years to pursue easy monetary policy when the economy is in trouble. This is something that happened after 2008 and early 2020, when the covid pandemic broke out and central banks printed money to push down interest rates.

Legitimation of crypto would mean sharing the power to create money out of thin air with private enterprises and private individuals, which many governments do not like. People in the business of selling cryptos obviously understand this, which is why many are happy for cryptos to be categorized as an investment asset. But even that does not solve the problems central banks have.

What about RBI?

The RBI has made its displeasure with crypto more than clear, time and time again. In fact, in the latest edition of the Financial Stability Report (FSR), published at the end of June, it gave several reasons for the same.

First, “anything that derives value based on belief, without any underlying basis, is mere speculation under a sophisticated name.” Second, “cryptocurrencies, usually created on decentralized systems, are designed to bypass the financial system and all of its controls, including Anti Money Laundering (AML)/Counter Financial Terrorism (CFT) and Know Your Customer (KYC) regulations .”

It is worth mentioning here that India does not have full capital account convertibility and only a limited amount can be moved out of the country in a given year. As the RBI put it in the FSR: “For developing economies, cryptocurrencies could erode capital account regulation, which could weaken exchange rate management.”

Cryptos allow people with enough technical finesse or the ability to pay for such expertise to get around limited capital account convertibility. Of course, crypto can and is used for money laundering and other illegal things.

Third, “historically, private currencies have resulted in instability over time … as they create parallel currency systems, which can undermine sovereign control over money supply, interest rates, and macroeconomic stability.” This is the RBI’s and many other central banks’ great fear.

Fourth, cryptos are “characterized by highly volatile prices,” and this can create its own set of problems along with “increased use of leverage in investment strategies; concentration risk for trading platforms; and opacity and lack of regulatory oversight of the sector.”

Given these reasons, it is hardly surprising that the central bank has been very vocal in opposing crypto.

To conclude, the legitimacy that cryptos ended up with was perhaps an unintended consequence of the quantitative easing program run by the Federal Reserve in particular and other rich central banks of the world in general. And it has ended up causing problems for governments and central banks around the world. Of course, if crypto prices fall further from current levels, this is a problem that will resolve itself. Perhaps, the central government and the RBI are hoping for just that.

Vivek Kaul is the author of Bad Money.

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