Cryptocurrencies & An Inflationary Tale

Hans Wagner shuddered whenever he was tasked by his mother to buy a loaf of bread at the local bakery in the tiny hamlet of Quedlinburg, Germany. Ever since the end of the Great War, inflation had run out of control across the Weimar Republic rendering the Reichsmark virtually worthless, meaning that something as simple as buying a loaf of bread could be a logistically challenging task.

On Monday, a fistful of Reichsmarks could get a substantial loaf of Landbrot, but by Friday, you’d need a barrel full of Reichmarks just to buy a handful of pretzels.

So Wagner was understandably reluctant to visit the local bakery, who knows what sort of bread he could buy on this day?

And yet, over a century later, it would seem as if the developed world has finally routed the evil that is hyperinflation.

 

To be sure, bouts of inflation still regularly occur in basket case economies, including Venezuela, Zimbabwe and Argentina, but these cases are viewed more with intellectual curiosity than with any genuine concern that the contagion of inflation could spread to the developed world.

Yet such complacency among developed world economists is precisely why there is reason to be concerned.

Inflation & Independence Go Hand-In-Hand

One of the key reasons for muted inflation and stable economies in the developed world has been the strength and independence of institutions, chief among which has been central banks.

But the global rise of central bank independence is a relatively nascent development, having established itself firmly only in the last 25 years or so.

As recently as the 1970s, it was normal (perhaps even considered respectable) for politicians to manipulate interest rates to goose their own approval ratings.

 

This habit of juicing the economy with low interest rates led to a scourge of inflation and so many rich countries (and to a lesser extent some poorer ones) shifted to a system in which politicians set broad goals — stable prices, economic growth, financial stability — and left independent central bankers to realize these goals by whatever means at their disposal and primarily through interest rate manipulation.

In a single generation, billions of people around the world have grown accustomed to low and stable inflation as well as the belief that interest rates on their bank deposits and mortgages are under control. Yes, interest rates on deposits are not great, but as a trade off, mortgages are not terribly expensive either.

But today, these assumptions are being threatened by a confluence of populism, nationalism and economic forces that are making monetary policy political again.

Make Monetary Policy Political Again

U.S. President Donald Trump has demanded publicly (something not witnessed since the Reagan administration) that interest rates should be slashed, speculated about firing the boss of the Federal Reserve (his very own appointee) and declared that he will nominate Stephen Moore and Herman Cain, two unqualified cronies, to the board of the Fed.

Across the pond, delusional Brexiteers question the competence and motives of the Bank of England, while in Turkey, President Recep Tayyip Erdogan has been in a tussle with Turkey’s central bank in a vain effort to boost an ailing Turkish economy.

 

India’s government has replaced a capable (and independent) central bank chief with a pliant insider who slashed rates ahead of an election.

The last time central banks were this politicized was almost five decades ago.

After the post-war Bretton Woods currency system that was tied to the value of gold collapsed under its own weight, central banks failed to tame raging inflation because politicians, who pulled their strings, were unwilling to bear the short term political costs of higher unemployment.

But two decades of rampant inflation and numerous crises led to a period of introspection and a new orthodoxy which saw the need to provide central banks with sufficient autonomy to pursue inflation targets, free of meddling by their political masters.

In Europe, Japan and the United Kingdom, central banks became legally independent in the 1990s and in the United States, the White House refrained from even publicly mentioning Fed policy.

But as the Trump administration has demonstrated, conventions do not guarantee compliance.

And while central bank independence may have survived the financial crisis, with global inflation only 4% a year on average over the past two decades, there’s no guarantee that the politicization of central banks will not challenge the current consensus.

To be sure, the undermining of central bank independence has several causes. While populist leaders like President Donald Trump combine the urge to undermine institutions with the desire for low interest rates to claim credit for a growing economy, central banks themselves have also broadly increased their scope of activities beyond their original ambit since the financial crisis.

Many central banks today hold large portfolios of government bonds, while policing the financial industry at the same time and the setting of interest rates has a direct bearing on the value of the bonds held.

 

And to make matters worse, hawkish central bank policy has contributed to an unequal and slow recovery from the financial crisis, undermining the faith of voters in technocrats whose loyalty is allegedly to the public interest.

While populist leaders can deliver catchy soundbites, central bankers are not known for their oratory skills, which makes it all the more easy to view central banks as political tools.

In the meantime, the raison d'être for central bank independence has faded from memory at a time when the pressure on that very independence is coming from a variety of sources.

President Trump has launched repeated and highly publicized attacks on the Fed and although his legal authority to fire Federal Reserve Chairman Jerome Powell is suspect at best, if he wins re-election in 2020 (not unimaginable) he will be able to nominate a new Fed chairman and two more governors.

In Europe, many top jobs at the European Central Bank (ECB)are coming up for grabs. By the end of the year, three members of the six-strong executive board and 8 of the 19 national governors who also vote on rates will have left, meaning that the ECB could swing in ways not hitherto imagined.

And behind the revolving doors of the ECB, an ongoing political battle is being waged to control European monetary policy, with Northern Europe viewing the ECB’s bond-buying as a means of subsidizing Southern Europe.

Rather than duke it out in political debate, many European Union countries are looking to install their own people into top jobs at the ECB to directly control outcomes.

Against this backdrop, there is a clear and present danger that global inflation (once laid to rest) will rise again from the grave and weakened central banks will lack the strength to kill it off.

More likely however is that the world will go through a period of economic downturn and central banks will find themselves needing to slash rates to pep up their moribund economies.

Enter Cryptocurrencies

But the developed world has hardly any room left to cut interest rates before hitting zero, which means that central banks will need to turn (yet again) to unconventional stimulus, including bond-buying — the very yeast which led to the baking of the Bitcoin whitepaper and the creation of cryptocurrencies.

To be sure, cryptocurrencies have been criticized for a variety of reasons and on a variety of levels, but given that the macroeconomic conditions which led to its creation are likely to persist and prevail for some time coming, it’s worth examining the value proposition that cryptocurrencies, in particular Bitcoin provide during a time of economic uncertainty as well as inflation.

Whether its inflation or an economic downturn, cryptocurrencies in general and Bitcoin specifically, have shown a lack of correlation to the broader markets generally and to the dollar specifically.

From a portfolio perspective, many investors have recognized the versatility of the nascent digital asset and accumulated positions in Bitcoin, in anticipation (or perhaps, expectation) of a continued decline in the real value of fiat currency. 

Others have simply stocked up on Bitcoin as a tool for speculation on its perceived future value.

Regardless of whether one views Bitcoin as a hedge for inflation, a store of value, or a means of exchange, there are greater economic forces at play, particularly the politicization of central banks which provide a reasonable argument for at least a holding of some Bitcoin.

Central bank independence has not been challenged on this level in almost five decades. In today’s political environment, the more that central banks are in the limelight, the more pressure they will face during their month-to-month decision making, whether from external forces or from boards packed with politically-appointed cronies.

It is specifically this sort of politicization that theorists behind independent central banks wanted to avoid and a brief study of financial and monetary history will provide a flavor of what could go wrong and the value of a deflationary currency such as Bitcoin under such circumstances.