How the Government Planned the Rise and Fall of Crypto

He added: “Cryptocurrencies are by definition borderless and require international cooperation to prevent regulatory arbitrage. Therefore, any law to regulate or ban can take effect only after significant international cooperation.”

The RBI is not the first central bank to be skeptical about crypto and the Indian government is not the first. Both the Chinese and Russian governments have cracked down on crypto as well. So, what is it that makes many central banks and governments dislike crypto? In this article we will try to understand it.

But first, we need to understand how important a role governments and central banks play in popularizing crypto.

before September 2008

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

In mid-September 2008, Lehman Brothers, the fourth largest investment bank on Wall Street, declared bankruptcy. AIG, the world’s largest insurance company, was also on the verge of collapse. Several other financial institutions were in trouble. If these financial institutions were allowed to fail, the global economy would be in turmoil.

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

This was referred to as quantitative easing and was seen as an act of stabilizing the financial system, after the real estate bubble, which had been running since the turn of the century, burst. Many financial institutions had taken huge leverage to bet on this bubble in different ways and thus got into trouble.

In November 2010, the Federal Reserve decided to launch 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? Up until that point, the Fed had acted by trying to control short-term interest rates. Now, it wanted to reduce long-term interest rates by printing money.

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

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

Apart from lowering interest rates, there was one more thing that was expected to be achieved by this move. Investors generally look to long-term government bonds, called treasuries, as a safe haven. It’s the kind of investment that you make and forget. But with purchases of the Treasury at the end of the months by the Federal Reserve, these bonds were running short, very regularly. Leonard writes: “The Fed was buying long-term” [bonds] Because doing so was like closing a safe deposit box where Wall Street investors could deposit money.”

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

The Fed continued well into 2014 with quantitative easing. In the process, he took an emergency measure, a routine measure. At the same time other problems also increased. Leonard writes, “The real problem was outside the banking system, in the real economy where deeper problems were brewing, problems that the Fed had no power to fix.”

what happened next?

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

In fact, Hoenig told Bernanke about the risks of open-ended quantitative easing. As Leonard writes: “Hoenig stated that the program could “unlink” inflationary expectations. This differed from saying that it would cause inflation. He was warning that companies and financial speculators could expect higher inflation in the future. Will start expecting, thanks to the influx of new money, and they will start investing accordingly.”

What Hoenig was saying is that with so much money printed and pumped into the financial system, investors will start to believe that sooner or later, high inflation will set in. To protect themselves from high inflation, investors want to generate fast. Make high returns and risky investments in the process.

That’s exactly what happened. The pursuit of higher returns has prompted investors to invest in all types of asset classes- from commercial real estate to oil to stocks and riskier bonds of less developed countries (read Sri Lanka). He also ended up investing in bitcoin and other cryptos.

The first block of bitcoin, called the genesis block, was mined in January 2009. Nevertheless, it was only after 2012, when the Federal Reserve briefly ran a quantitative easing program, that buying bitcoin began to become popular, first among idiots and then among average retail investors. The idea was that unlike government-backed fiat money, which a central bank could print and create out of thin air, only a limited number of bitcoins could be created. This logic caught people’s attention and they started buying bitcoins. In this sense, bitcoin became digital gold for many young people.

Therefore, the behavior of the government-backed central banking system led to the popularity of crypto in general and bitcoin in particular. This popularity peaked in November last year and since then things have gone downhill with prices falling, causing many other problems as well.

Government dislike for crypto

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

Governments haven’t always had every right to make money out of thin air. By 1913, before the start of World War I, 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, governments could not make money out of thin air by printing it because people could convert that money to gold. And governments risk running out of gold. Many countries suspended the classical gold standard in order to be able to print money to fund the expenditure needed to fight World War I.

After the war ended, countries went back to the gold standard, and being on the gold standard meant that governments needed to maintain a tight economic ship. They could not manipulate the currency system to make things easier for the common man. The gold standard did not allow them to do so. They could not print money to lower interest rates.

As Raghuram Rajan and Luigi Zingless write in Saving Capitalism from the Capitalists: “World War I and the Great Depression created great disorder and unemployment … workers, many of whom had become politically aware in the trenches of World War I. , organized to demand some kind of protection against economic adversity. But the reaction actually occurred during the Great Depression, when they joined country after country who had lost – farmers, investors, war veterans, Elderly.”

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

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

Rajan and Zingless further write: “The gold standard … imposed strict budgetary discipline on governments, making it difficult for them to intervene much in economic matters … politicians had to respond, but to such a high demand for security. could not be satisfied within tight. The restrictions imposed by the gold standard. Therefore, the world abandoned the straitjacket of the gold standard … With their ability to turn finances on or off, governments gained extraordinary power “

Whenever the economy is in crisis, governments and central banks have used this extraordinary power to drive easy money policies. This is something that happened after 2008 and early 2020, when the Covid pandemic broke out and central banks printed money to lower interest rates.

Legalizing crypto would mean sharing the power to make money out of thin air with private enterprises and private individuals, something that many governments do not like. People in the business of selling crypto clearly understand this and therefore, many are happy to classify crypto as an investment asset. But even this does not solve the problems of central banks.

What about RBI?

The RBI has made its displeasure towards crypto more clear than ever again and again. In fact, in the latest edition of the Financial Stability Report (FSR) published in late June, it cited several reasons for this.

The first, “anything that acquires value without any underlying belief is mere speculation under a sophisticated name.” Second, “Cryptocurrencies, typically built on decentralized systems, are designed to bypass the financial system and all of its controls, including anti-money laundering (AML)/financial terrorism (CFT) and Know Your Customer (KYC) rules.”

It is worth mentioning here that there is no full capital account convertibility in India and only a limited amount can be taken out of the country in any given year. As the RBI put it in the FSR: “For developing economies, cryptocurrencies could destroy capital account regulation, which could undermine exchange rate management.”

Cryptos allows individuals with sufficient technical proficiency or ability to pay for such expertise to have limited capital account convertibility. Of course, crypto can and is used for money laundering and other illegal things.

Third, “Historically, private currencies have created volatility over time … as they form parallel currency systems, which can undermine sovereign control over the money supply, interest rates, and macroeconomic stability.” This is the RBI and many other central banks. major fear.

Fourth, crypto is “characterized by highly volatile prices” and it can create its own set of problems with “increased use of leverage in investment strategies; concentration risk of trading platforms; and ambiguity and lack of regulatory oversight of the sector”.

Given these reasons, it is not surprising that the central bank has been highly vocal in opposing crypto.

To conclude, the legitimacy that ended with cryptos was an unintended consequence of the quantitative easing program run by the Federal Reserve in particular, and other prosperous world central banks in general. And it has created problems for governments and central banks all over the world. Of course, if crypto prices fall further from current levels, this is a problem that will resolve on its own. Perhaps, that is what the central government and RBI are hoping for.

Vivek Kaul is the author of Bad Money.

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