Table of Contents
The bitcoin monetary system has a neat and simple mechanism for managing user balances. Individual users can opt to run a full bitcoin node, which constantly keeps track of all bitcoins and their ownership among bitcoin public addresses. The network measures the exact number of coins at any point in time with impeccable precision, down to the last satoshi (100,000,000 satoshis = 1 bitcoin). Every ten minutes, all network nodes reach consensus on the distribution of coins among all addresses. An individual’s ownership of the coin is entirely contingent on their command of the private keys of the address containing the coins, and cannot be revoked by any authority. In the fiat standard, balances are a far more complicated affair, with significant implications for the way users save and borrow.
Four unique characteristics of fiat balances, outlined in this chapter, set it apart from all other monetary technologies. The fourth one will help us understand how this monetary system leads to a preponderance of debt and the destruction of savings.
Nobody knows exactly how much fiat exists, and there is significant disagreement over the correct method for calculating the fiat supply. Central bank issues several statistics to measure their money supply according to different definitions, which vary over time, and across countries. M0 is usually the number given to the total amount of fiat tokens that have been printed into physical paper notes and metal coins and are in circulation. M1 is a measure of M0 and bank checking accounts, allowing for the calculation of all forms of money that are available to their owner on demand. M2 adds to M1 all savings deposits and certificates of deposits. This money is held by individuals but has not reached maturity, meaning it is not liquid enough for individuals to spend it in its current form, but can be liquidated quickly. M3 adds to M2 money market mutual funds and other large forms of liquid assets.
There is no clear-cut answer on which measure actually constitutes money, as the nature of fiat is to conflate future fiat with present fiat. As government-guaranteed entities can transform claims on future money into present money for the settlement of current trades, they blur the line between the two. So it is unclear where one should draw the line between the maturity of monetary instruments when counting them as part of the money supply.
To aid the comparison between metals and bitcoin, this book and The Bitcoin Standard utilize M2 as a measure of the money supply. M2 is the broadest consistent measure of money supply growth collected by the World Bank and OECD, meaning that it allows us to make international comparisons that are somewhat consistent. The exact quantities of different fiat currencies are not as important for us as their growth rates over the years, and the consistency of the M2 measurement across countries and time allows for better and more consistent comparisons.
Unlike with bitcoin, fiat assets cannot be reconciled with full network issuance. Running the numbers is impossible with fiat. There is no precise way of keeping track of all liabilities, assets, and issuance, which makes financial reconciliation for the system overall impossible. Mining by issuing new debt is done by fiat and can rehypothecate the same collateral several times. Consequently, there is no hard limit on how much lending takes place and no easy way of keeping track of all issuance taking place across all financial institutions in real time.
Tentative and Revocable
Most fiat balances exist on the balance sheets of government-licensed financial institutions, making them at all times revocable by the local fiat node, or the global full node, the U.S. Federal Reserve. If ownership is understood as the ability to command and control something, then one never quite owns fiat in the sense of full sovereign control; one merely holds it tentatively, at the beneficence of the government, which effectively owns all the liquid wealth in its jurisdiction.
There is effectively no final clearance in the fiat monetary system. As monetary inflation has devalued fiat currencies, physical cash notes have declined in real value to the point where they have become extremely inconvenient to use for large value transactions, and holding significant wealth in paper fiat is impractical. Central and commercial banks continue to make it harder for individuals to cash large sums out of their accounts. But even when individuals can withdraw physical notes, they do not confer safe wealth to their holders, as governments can revoke these notes at any time.
Peculiarly among all monetary systems known to this author, fiat is the only monetary system where the sum of all balances at any point in time is negative. Because of the enormous incentive to accumulate debt, and the fact that the native token is not physical or scarce in any real sense, financial institutions constantly generate negative balances for their clients. The total sum of all debts far exceeds the quantity of money available. All other media of exchange are present goods, and any debt must be lent by someone who owns it first, so the balances always add up to a positive number.
As explained in the previous chapters, the underlying technology behind the fiat standard lies in its ability to create monetary units through the process of lending. This monetization of debt has the same effect as the monetization of any market good: it highly incentivizes the creation of more monetary tokens. In the case of fiat, this means that the economic system is highly geared toward the creation of more debt, and individual fiat users have the incentive to get into debt as much as possible.
Fiat is a tiered system. The low level of users are the ones only able to access physical paper money. The higher level of users are able to have an account at a bank and secure debt, and the financially responsible ones will get into large amounts of it. For the bottom tier, which constitutes the majority of fiat users worldwide, balances are positive. But the balances of the top tier of users, who constitute the vast majority of global monetary wealth, are usually negative. Under the fiat standard, being rich does not usually mean having many fiat tokens. It rather signifies owing a lot of fiat-denominated debt, which dwarfs the amount of physical fiat and fiat in savings and checking accounts.
Holders of present fiat tokens, in cash or bank accounts, are constantly getting diluted by lenders who get to create new present tokens by issuing credit based on future receipts of fiat tokens. It therefore makes the most sense for individuals, corporations, and governments not to hold positive balances, as they will be devalued through inflation, but to borrow. Users with negative balances, i.e., those in debt, lack security and risk catastrophic loss. Financial security, in the sense of having a stable amount of liquid wealth saved for the future, is no longer available in the current system. You will either witness the dissipation of your wealth through inflation, or you will borrow and live in the insecurity of losing your collateral if you miss a few payments. Fiat has effectively destroyed savings as a financial instrument, with enormously negative consequences.
Saving is the deferral of consumption from the present to the future. It is the abstention from the enjoyment of economic resources to meet the needs of the present, in order to preserve them for the future. An individual forgoes the consumption of a good in the present time in order to have it, or its monetary equivalent available for the future. Holding durable goods is the first form of saving known to humans. With time and the development of money, humanity could develop the ability to save in money itself, which is the most efficient medium of saving, since its liquidity means it can be very easily transformed into any other type of good. The suitability of money for saving increases with its hardness. Our civilization has progressed through holding ever-harder money, which has provided increasingly reliable mechanisms for transferring value to the future. The harder the money, the more difficult it is to produce new quantities of it in response to increases in demand, and the better the money will be at retaining its value. This has allowed individuals to lower their time preferences and generate more future wealth. The more abundant the savings, the more individuals are likely to invest in capitalist ventures which carry the risk of loss but result in increases in productivity. In short, hard money reduces uncertainty over the future and allows individuals to orient their actions toward the long term.
Saving in physical money has existed for thousands of years. Its pinnacle was the gold coin, which had superior salability across time and space, was recognized the world over, and held its value across millennia. With the gold coin, anyone could save and expect their savings to hold their value relatively well over the long term. Children would start saving the day they were born, as friends and family traditionally gifted them money via their parents. Children were then taught to save from an early age. They learned to work and save money, and as they grew, they were incentivized to be more productive, to earn more and save more. At a certain level of savings, it became possible for individuals to invest in capital goods, increasing the productivity of their own labor, or to invest in someone else’s business, which provided income. Once an individual had reached a level of savings that afforded them independence, they married, bought a house, and started a family. Saving continued throughout life and savings were passed on to the next generation.
Human progress consists of providing the next generation with a better life, and savings have played an important role in that process. Only by saving were humans able to lower their time preference and provide for their future. Only by saving first could humans invest and accumulate capital. The more a society saves, the better the lives of its future generations. The development of the concept of saving is a crucial part of the development of human civilization. As money progressively got harder, people started saving more and more, and this became part of culture, religion, and tradition.
We have naturally evolved to use the hardest money so that it can hold its value best. Saving did not require much expertise or effort. Anyone earning a gold coin could hold on to it and see it appreciate by around 1–2% in value per year. Things claiming to be backed by gold would periodically fail, but the physical gold coin never failed. It very rarely depreciated, and when it did, it did not depreciate much or for long.
This outlook that hard money encouraged existed in most of the world until the 1980s and 1990s, by which point fiat money, and the central bank-led glut of fiat mining, had made debt inevitable and saving pointless for most people. Rather than save for major expenses, people now get into debt to purchase them, accruing a larger negative balance of fiat. People are born to families in debt and spend their entire lives in debt. Success consists in being able to secure ever-growing quantities of debt as you pass through the stages of life: a big college loan that allows you to get into the best paying job, whose salary will allow you a much larger loan for a large house and another loan for a car. With more hard work at the company and dedication to its cause, you may succeed in getting an even larger negative balance of fiat for an even bigger home and fancier car. With more hard work at the company and dedication to its cause, you may succeed in getting an even larger negative balance of fiat for a bigger home and fancier car. Should you succeed even more and start your own business, you do not do it with your own accumulated capital, but rather with a bigger loan. The larger and the more successful the business, the more you are able to borrow. In sum, success in fiat means accumulating larger negative cash balances, and people live their entire lives stacking debt obligations upon themselves.
Once central governments suspended the ability for savers to redeem paper money for physical gold and removed physical gold from circulation, the fiat bank account replaced the gold coin’s savings technology. Few held on to paper money for long-term savings; the paper itself could ruin or burn, and the central bank issuing it would usually be expected to engage in inflationary monetary policy, thus reducing its value. The bank account was supposed to offer a rate of interest that would overcome inflation and offer the saver a positive return.
However, as discussed in Chapter 2, removing currencies’ gold backing meant more monetary growth and currency devaluation. The ensuing search for yield and monetary inflation create economic bubbles, which are very tempting for the banks to engage in, as happened in the 1920s, resulting in the 1929 stock market crash and ensuing financial crisis, destroying many people’s savings.
In 1934, the U.S. Congress passed the Glass-Steagall Act. That act mandated the separation of commercial banking from investment banking, with commercial banking deposits protected by the Federal Reserve. This provided individuals with something close to the old physical gold coin: a guaranteed savings account that offered interest rates intended to beat price inflation. Those who wanted to take on risk in search of profit could then invest in investment banking without government protection.
This arrangement was never workable in the long run because it is not possible for banks to offer real, positive, riskless returns that can keep up with the government’s devaluation of its currency. It did work in the immediate aftermath of World War II; however, that was a period in which the U.S. accrued a large influx of gold from all over the world, and in which the majority of the world’s countries adopted the dollar standard, buying large quantities of the currency. Add to that the expiration of most of the New Deal’s statutes and a large reduction in government spending, and it is understandable how this arrangement seemed to work for most Americans from the 1940s to the 1960s. However, with increasing government spending in the 1960s to finance the Vietnam War and the Great Society welfare programs, and the monetization of government debt, price inflation began to rise noticeably, and savings accounts failed to keep up. When inflation made maintaining the U.S. dollar’s gold peg untenable in 1971, fiat savings became unworkable. Those who wanted to save wealth into the future would have to speculate through the shadow banking system and set up an investment portfolio. The stock and bond markets emerged as the pseudo-savings technologies of choice to beat inflation. Retail banking increasingly centered around checking accounts and payment processing, with savings accounts becoming increasingly irrelevant.
From the 1970s until the 1990s, government bonds functioned as the world’s savings account, offering inflation-beating returns. However, government bonds are not a useful monetary asset and cannot work as a long-term store of value because there is no effective mechanism restricting their supply from growing. As demand for bonds as a store of value increases, their prices rise and their yields drop, which means their returns eventually stop beating inflation. Bond issuers can borrow on increasingly favorable terms, which encourages them to become less fiscally responsible. By banning the use of gold as money, governments created and amplified demand for their own debt far beyond what their creditworthiness would merit.24 Increasing demand for government bonds has driven the ever-growing government debt bubbles of the past few decades. By the late 2000s, bond yields in Western economies could clearly no longer beat inflation, and their role as a savings mechanism became less appealing. The stock index emerged as the new savings account in the post-2009 world.
While investment is an essential part of a market economy, it is distinct from and is not a substitute for saving. The two terms have become almost interchangeable in the modern lexicon, and the relationship between them is confused beyond any semblance of reason in modern macroeconomics. The differences between saving and investing are extremely significant. Saving refers to accumulating money in cash balances to hedge against future uncertainty. From a basic accounting perspective, investing is a cash outflow, while savings are held on a balance sheet. Cash is acquired for its salability (the ease with which a money can be sold across time and space). However, the most important distinction between the two is that investment inherently involves more risk. There is no risk-free investment, and any investment can suffer a complete and catastrophic loss of capital. Savings, on the other hand, are kept in the most liquid and least risky assets. The decision to go from saving to investing is the decision to sacrifice liquidity and increase risk in exchange for a positive return.
One should not need to choose between saving and investment, and the two have their place in a portfolio. People would keep a cash balance they would like to have with certainty, and would risk their investment funds in search of returns. Under a hard money standard, such as gold, the hard money itself would be held as saving, given its slight but steady appreciation. In a modern, easy-money economy, cash is trash, as every money manager knows. Instead of holding cash, people hold the equivalent of their savings in government bonds or low-risk investment stocks. Savers need to study financial assets in order to maintain the value they earned and protect it from inflation. This makes it harder to have a stable cash balance and limits the ability of savers to plan for their future.
One of the Keynesian rationalizations given for governments forcing the use of easy money is that devaluing currency encourages people to invest more than they otherwise would, which causes increases in employment and spending. However, this inflationist logic confuses capital for credit. For investments to occur, consumers must defer consumption to direct their resources to production. The devaluation of money does not magically increase the amount of capital and resources available for production. However, it does lead to the perverse scenario in which projects earning even a negative return in real terms are profitable in nominal terms, making them better than holding cash. The devaluation of a fiat currency is usually also accompanied by credit expansion, which causes a boom-and-bust cycle.
A reliably liquid and low-risk financial asset as a form of saving would be highly valuable for people, as it would allow them to reduce future uncertainty. Being able to secure a specific amount of purchasing power with a relatively high degree of certainty would be financially liberating, and it would allow people to make risky investments proportionately.
Ironically, it might actually be the case that there would be a far smaller demand for savings under a monetary system in which money was hard and held its value. If you knew with good certainty that you had 10 years’ expenditures saved, and could reliably expect them to be there for you at any time, you probably don’t need to add more savings, and can then take a lot of risks with the rest of your capital. However, when money is a bad store of value, and stocks and bonds involve risk, you are less certain about 10 years’ expenditure stored in investable assets. This might well lead to risk aversion, insecurity, and requiring larger quantities of savings.
The problem with fiat is that simply maintaining the wealth you already own requires significant active management and expert decision making. You need to develop expertise in portfolio allocation, risk management, stock and bond valuation, real estate markets, credit markets, global macro trends, national and international monetary policy, commodity markets, geopolitics, and many other arcane and highly specialized fields in order to make informed investment decisions that would allow you to maintain your wealth. The simple gold coin saved you from all of this before fiat. Why should a doctor, athlete, engineer, entrepreneur, or accountant who is successful in their field have to develop expertise in these many fields just in order to maintain the wealth they already produced and earned freely on the market?
This arrangement has been a big boon for the investment management industry. Arguably, the majority of money in investment accounts is held by people who would rather not be investing it and taking risks with it, but would prefer to have a store of value for the future. But with this not available, individuals need to hire professionals to help them meet their financial goals. Given the rate of monetary inflation, and the fees charged by the investment management industry, it is arguably only a small minority of investors that can beat inflation reliably. For the vast majority, they must continue to work harder and earn more to continue to have wealth.
While many had long believed that index investing or real estate provide reliable ways of beating inflation, this is becoming harder to maintain, particularly in the last year. As interest rates drop to negative territory, it is very difficult to find investments that can beat inflation. Even lending to highly incompetent governments now comes with a negative nominal return, effectively expropriating investors while also subjecting them to serious risks.
The correct and successful financial strategy under the fiat standard is to constantly take on as much debt as is possible, be meticulous about making all payments on time, and to use the debt to buy hard assets that generate future returns. Being able to do this continues to improve your credit score and allows you to borrow at lower rates, while placing your wealth into goods that cannot be inflated as easily as fiat. The fiat system thus acts as a tax on savers and subsidy to responsible borrowers. The Fiat Standard encourages everyone to live fragile, at serious risk, because the alternative is a slow continuous bleeding of wealth.
The more irresponsible you are in taking on risk, the more likely you are to succeed and fail. The path to success ends up necessitating irresponsible decisions along the way. Businesses that are more reckless in taking on debt are more likely to fail than those who do not, but they are also far more likely to grow their business and drive competitors out. A business whose cash flows grow slower than the growth in the money supply is effectively witnessing its value decline in real terms, because its cash holdings and assets and future earnings are all getting devalued by the monetary issuance. An individual whose income is not increasing by a rate faster than the rate of monetary issuance is witnessing their standard of living decline. Such a company and individual need to constantly be growing their earnings in order to maintain their economic status.
In the fiat standard, those who choose to hold positive balances are robbed as the purchasing power of their fiat is eroded by all the debt others are creating. Those who are in debt, on the other hand, get to benefit from some of the seigniorage. Not taking on debt is reckless financial irresponsibility. Irish economist Richard Cantillon described the redistributive impact of inflation as benefiting the people who receive the newly created money first at the expense of those who receive it later. In the modern fiat standard, the beneficiaries of the Cantillon effect are the borrowers, and savers are the victims. Spending less than you earn and keeping savings on hand are simply no longer optimal financial strategies; they are expensive luxuries most cannot afford.
Under a fiat standard, users are incentivized to accumulate hard and cash-generating assets instead of accumulating more fiat, which continuously loses value. Whatever wealth one saves in a liquid and internationally redeemable financial asset is continuously and systematically debased. Even saving in gold, the legacy hard money, carries significant transaction costs and spatial salability constraints.
The path to financial success under the fiat standard lies in acquiring hard assets. Financing these acquisitions with debt is even more profitable. Not only is inflation likely to devalue the loan for the asset more than it devalues the asset, but as the lender and borrower are partaking in fiat mining, there is enough benefit in the mining seigniorage to make the purchase cheaper for the borrower. The most profitable route, however, comes from being able to issue fiat and get others into debt. Among the most effective ways to issue debt is to build a business that pivots to providing banking services to its customers, which explains why so many businesses in so many fields offer credit products to their customers.
Under the fiat standard, every business model degenerates into interest rate arbitrage. The purpose behind setting up business is increasingly less about making money from serving customers but establishing a creditor relationship with them. Managing to secure debt at a lower interest rate becomes the most significant market advantage. Businesses live and die by their ability to turn over debt at a healthy arbitrage.
This phenomenon is apparent in many modern companies. Most businesses that provide credit will give their customers very good deals on their products if they use the company’s credit card. The incentive for doing so is clear: large corporations can borrow at very low rates, but they can charge their customers interest rates in excess of 20% on their credit cards. Before it went bankrupt, the U.S. department store Macy’s was generating about as much revenue from the credit cards it issued its customers as the clothes it sold them.
The consequence of fiat balances being negative is that everyone is constantly in debt. Your homeownership is contingent on you fulfilling your financial obligations for decades. Your future depends on you and many others fulfilling financial obligations in a timely manner. Your future uncertainty is higher than what it would be if you could place your wealth in a hard money, and that causes a rise in time preference. Everyone is less peaceful and more insecure.
In the fiat standard, money becomes a liability rather than future security. Rather than owning dollars that you can use to pay for your future needs, you owe large amounts of dollars, and you need to work for the rest of your life to pay them back. The age-old wisdom of every grandmother has been turned on its head. Instead of saving for the possibility of a rainy day, fiat makes you borrow against all of your future sunny days.
In this absurd mountain of ever-growing debt, one must wonder what would happen if people had the option of placing their wealth in a low-risk store of value with limited upside, similar to a hard money cash balance. Such a hypothetical thought experiment recently became a reality with the failed attempt to build the Narrow Bank.
The Narrow Bank
In 2018, the Narrow Bank applied for a banking license from the U.S. Federal Reserve. It had a unique and very simple business model: it would take money from depositors and deposit it at the Fed, the least risky balance sheet in the world, where it would collect interest. It would simply pass on the interest rate it received from the Fed to its customers, minus a small fee.
The business model seemed like a great deal for all involved: depositors would get a small return without taking on significant risk, a trade that arguably many would have taken, given the current uncertainty surrounding global capital markets. The bank would make a profit, and the Federal Reserve would have little cause for concern regarding the bank’s solvency and liquidity. Tellingly, the bank’s license application was rejected.
The fundamental reason the bank was rejected was that its safety and reliability would have endangered the other banks in the financial system. If the safety of the Federal Reserve’s balance sheet were easily available to investors, many would have chosen it over traditional financial assets as the bedrock of their portfolios. This is not to say everyone would have put all their wealth in it, but a lot of money, particularly institutional money, would have seen the value in a low-risk, liquid allocation in savings. In all likelihood, there is a large demand for about a 2% interest rate with very low counterparty risk. While the rate is not high, it is highly attractive as a savings instrument because of its low risk.
Such a bank would be even more appealing during times of crisis, when everyone searches for wealth protection. The more people seeking out the safety of the Narrow Bank, the fewer there would be investing in traditional financial institutions, and the more precarious the liquidity position of traditional financial institutions would become. The Fed’s refusal to grant the Narrow Bank a banking license shows that it recognized that in a free market, many investors would prefer the safety of guaranteed returns over the risky search for a few extra points of yield.
Fiat central banking is built on the fictional idea that devaluing currency will cause people to invest more, thus inducing more economic production. But like all coercive government interventions into markets, there is no free lunch, and the costs are paid in ways that may not appear very clear initially. The Fed’s policy to encourage more investment leads to people engaging in riskier investment than their risk profiles would otherwise indicate, leading to financial bubbles and crises.
What would happen if a large percentage of people placed significant portions of their wealth in a financial instrument that offered liquidity and safety but low, or no, returns? Would this reduce the amount of economic production that takes place? Would this reduce the amount of actual capital for investors and entrepreneurs? Arguably, the opposite would be true.
Savings and investment are not competing for a set, fixed pool of money. They are together competing against present consumption. Saving must precede investment, and an increase in savings leads to an increase in investment. Both are driven by, and must be preceded by, lowered time preference and delayed gratification. When money is expected to appreciate, people are more likely to defer consumption and save. If savers can hold cash balances with a high degree of confidence in their value over time, they would have the freedom to take on more risks with their investments. When these savings increase in value, the opportunity for the savers to invest increases. In a world of hard money, the only investments that would make sense would be those that offer positive real rates of return. In a world of easy money, on the other hand, investments are made that accrue positive nominal returns but negative real returns, leading to capital destruction in real terms. The misallocation of capital under an easy monetary system also causes a lot of capital destruction.
The Fed did not stop the Narrow Bank from operating because it was dangerous, but because it would expose just how dangerous the rest of the banking system is and how much demand exists for safe savings. In the third part of this book, the rise of bitcoin is understood in this context. It is a new savings technology that allows anyone in the world to store their wealth, and unlike the Narrow Bank, it does not need a license from the Federal Reserve to operate.