If you spend some time in Bitcoinland, you'll notice that a vocal section of the community strongly dislikes central banking. In their view, the digital currency is the solution to central banking's many problems, including a lack of transparency, a close relationship with the global power elite, and the central banks' ability to conjure money from thin air. For these people, using bitcoin is a way to disempower central banks—and empower the individual.
So what would happen to the world's central banks if bitcoin replaced national currencies? Turns out it would look a lot like a return to the gold standard, which was abandoned a long time ago, according to a recent staff working paper from Warren Weber at the Bank of Canada, the country's central bank. And most people wouldn't necessarily be better off in a bitcoin world. In fact, they could be left more vulnerable to financial crises.
In the paper, Weber "imagines a world in which countries are on the Bitcoin standard, a monetary system in which all media of exchange are Bitcoin or are backed by it," and compares this imagined future to a real past (1880-1913) when gold performed the same function.
The predictions? Central banks would generally have a lot less room for some key stabilizing activities: setting nationally independent interest rates, creating money, and targeting inflation. Currency exchange rates would be fixed. Financial crises would still occur, and in the end might actually cause enough of an uproar to prompt a return to government-backed money.
However unlikely mass bitcoin adoption may be, according to this Bank of Canada report, it would seriously hurt central banking as we know it
Under a bitcoin standard, Weber points out that central banks' key interest-rate setting power would vanish thanks to the "virtually costless arbitrage of Bitcoin across countries." In other words, bitcoin-holders around the world could actually offset the actions of central banks, and affect the national money supply, just by chasing better returns for themselves.
David Yermack, a finance professor at New York University, compares this scenario to Europe today, where national central banks have "ceded control over monetary policy to the [European Central Bank] and the Euro," causing particular trouble for Greece, as he told me in an email. "A central bank loses a lot of its power if it cannot control the money supply."
Since bitcoins are created by the bitcoin network at a predetermined rate, a central bank under a bitcoin standard would be "limited in what it can do because it cannot act as the lender of last resort to itself" by printing unlimited amounts of its own currency, according to Weber.
That's because money backed by bitcoin would have to conform to the supply of bitcoins, which is hard coded to increase at a set rate until a 21-million cap. So under a bitcoin standard, not only would economic crises still happen, but authorities would have fewer tools at their disposal to fight them.
The news isn't all bad for bitcoin. The Bank of Canada paper predicted that economic growth likely wouldn't change much if it became the primary world currency, despite its deflationary model. Weber also found that prices would be more predictable, and that dealing with currency exchange would naturally be much less of a headache.
But not all economists agree that deflation isn't a problem. Yermack points out that the gold standard's deflation caused social upheaval "and many people felt this was a real brake on economic growth…The optimal rate of monetary growth should really equal economic growth, not some artificial limit imposed by software."
So will bitcoin take over? Not if governments or central banks have anything to do with it. Weber argues that they'll "take actions to prevent it," for two reasons. One is to protect the revenues they bring in from "the ability to almost costlessly create money," he writes.
The second, according to Weber, is to protect their ability to "implement interest policies to affect their domestic economies. Governments would lose the ability to do either or both of these under the Bitcoin standard," he writes—not an acceptable outcome.
However unlikely mass bitcoin adoption may be, according to this Bank of Canada report, it would seriously hurt central banking as we know it. But bankers might not have to worry. Eventually, a better technology will probably emerge anyway, replacing bitcoin altogether, Weber argues. Or bitcoin itself may evolve into something completely different.