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What Crypto Should Learn From Monetary History

Mr. Market

November 14, 2022

The crypto movement aspires to decouple money from state power. If money enables transactions between private actors, where the state is involved only insofar as it guarantees money, then why can’t we simply replace the state with a decentralized system supported by cryptography and raw compute power? Yet this idea is hardly original to the crypto movement. In the 18th century, advocates of what would later be described as the “real bills” doctrine envisioned a self-sustaining, self-correcting system in which banks would provide all the money society needed through short term loans collateralized by “real” economic activity. The crypto movement, in its current hour of distress, could benefit from a brief history in the transformation of this most elegant world of “real bills” to the very monstrosity of state-backed modern banking that it confronts and aspires to overthrow today.

The Elegant World of Real Bills

To illustrate, let’s say Merchant A sells grapes to Merchant B for 10 dollars, where Merchant B intends to turn those grapes into wine which B will later sell for 12 dollars. However, it takes time for Merchant B to turn grapes into wine and wine into money. So rather than give Merchant A money for his grapes, Merchant B hands him an IOU, known as a “bill,” that promises payment in 90 days. But Merchant A needs money now to pay workers and invest in his vineyard. How can the system give Merchant B time to turn grapes into wine without sacrificing Merchant A’s ability to expand grape production? How can the system, in a word, provide enough money to fund more economic activity today, which will only be realized as money in the future?

The “real bills” advocates envisioned that this would be done through a private banking system. In such a system, Merchant A brings his bill (Merchant B’s IOU) to a bank, which buys the bill for a small discount and provides Merchant A with a bank deposit that’s the equivalent of, let’s say, 9 dollars. In 90 days, Merchant B pays Merchant A 10 dollars which Merchant A then uses toward repaying the bank. The bank receives the 10 dollars and has now made a modest profit (of 1 dollar). Because the bank is lending on a relatively short time horizon (90 days) against “real” economic activity (the processing of grapes into wine), the bank takes limited risk. Thus, the economy benefits from an “extra” 10 dollars, which gives Merchant B time to turn grapes into wine while simultaneously enabling Merchant A to produce more grapes—all without the state having to determine how much money to print. In this system, money supply would naturally expand or contract in line with the needs of “real” economic activity, that is, activity tied to the production of real goods and services. The bankers’ jobs were to ensure that they were lending against “real” economic activity i.e. real bills. Money and the economic activity enabled by money would thus be decoupled from the state.

But this system had one very important quirk. Instead of giving 10 dollars of cash (or gold) to Merchant A, the bank would have credited Merchant A with a deposit at the bank with this deposit serving as money. For the most part, Merchant A would have been able to transact with his suppliers by exchanging deposits, and thus would not have needed to draw down actual cash or gold from the bank account. Hence, the bank would have needed to hold only only a fraction—let’s say 20%—of its deposits in cash (or gold). Thus, a bank theoretically on the hook for 100 dollars of deposits could have only held 20 dollars of cash (or gold). The “missing” 80 dollars would have been held in IOUs collected from parties like Merchant A. And as long as those IOUs paid off in a reasonable time, the bank would always have had enough cash on hand to redeem its depositors over time. This marked the rise of the “fractional reserve” system of banking, in which banks served not just as vaults to hold money, but actually created money through purchasing IOUs.

Limitations of Real Bills and the Shift to Monstrous Modern Banking

Within a century of its introduction, the “real bills” doctrine for determining money supply without state interference broke down due to the expanded scale and investment time horizon of production that emerged through the Industrial Revolution. “Real bills” sufficed for a commercial society that needed short term loans (e.g. 30 to 90 days) to fund working capital (e.g. inputs) in relatively small scale production. But with the Industrial Revolution came the need to fund enormous fixed capital outlays (e.g. big, complex machines and factory buildings), where it could take 10, 15, or even 30 years to earn back invested capital rather than 30 or 90 days. Not only did the amount of capital needed increase significantly, but the time it would take to earn it back did so as well. This made the banking system inherently more unstable: if banks were “wrong” about whether or not a large factory was needed for “real” economic activity, they could have created too much money against it in the present, risking large losses for themselves while plaguing the wider economy with inflation.

Indeed, the fractional reserve system came into significant crisis in the Industrial Revolution. In a business cycle, business earnings could decline and businesses could prove unable to repay loans they had taken out from banks. This could trigger fears that banks would prove unable to redeem their depositors in full when asked to do so. These situations became referred to as “financial panics” and “bank runs” and in the first couple decades after the Industrial Revolution occurred nearly as frequently as business cycles.

In cases where assets held by banks were enough to cover their liabilities, but could not be converted quickly enough to money to make their depositors whole, were they to redeem their deposits at once, banks were said to be solvent, but not liquid. In cases where assets held by banks no longer had value sufficient to cover their liabilities, regardless of how much time banks had to convert them to money, banks were said to be insolvent. To rescue solvent but illiquid banks, early financial centers like Amsterdam and London founded large banks that could provide liquidity to the banking system when there were bank runs. These became the first “central banks” and were initially formed in the period of “real bills.” However, rather than being government-run institutions, the first central banks were private firms (with some minority government ownership or sponsorship) owned by the largest merchants that generated the most value from them (by receiving easy access to credit). The state, up to a point, could still have been seen as uninvolved in money.

But these private institutions ultimately proved unable to save the banking system during financial crises occurring on an ever larger scale throughout the late 19th century and early 20th century. After the Panic of 1907 where JP Morgan himself had to organize a bail out of the system, a new central bank was formed in the US, the Federal Reserve. Amidst the “progressive era” politics of its time, in which the outsourcing of economic and political crises to the state was not only accepted but viewed as desirable, the Fed institutionalized state interference in money by becoming the ultimate backstop to the entire banking system. Bureaucrats, rather than private merchants and their banks, would act as the lender of last resort to determine if an institution was illiquid or insolvent and whether or not it was systemically important and thereby worthy of rescue.

Being systematically important means being responsible for providing time to the economic actors in society, where the withdrawal of that time instantly freezes all economic activity. Thus, state involvement in the modern banking system, which may or may not “work” in returning economic actors back to their activity, is not a fluke of bad design, but endemic to the world economy created by the Industrial Revolution.

In the 1970s, the state formally expanded its role in money by tasking itself with the management of prices and unemployment below a fixed “natural” rate through the Federal Reserve’s Dual Mandate. But to predetermine what’s a good or bad outcome and then take unilateral action to solve for it means the state is repressing society’s capacity to determine outcomes through its own free activity. Thus, even as Fed bureaucrats saw themselves as champions of the “free market” movement starting in the 1970s, they embodied the victory of 19th century progressives who viewed state interference with the markets as not only necessary, but desirable. Even as Fed Chairman Paul Volcker conceived of himself as acting on behalf of society in resisting political pressure to lower rates during the recessions of the early 1980s, because he did so as the state he was actually repressing society through his deus ex machina struggle against inflation. Volcker is not intrinsically different from Greenspan or Yellen, who have gone down in history as his opposite for “caving” to political pressure to lower rates and keep them low. Thus is the monstrosity of modern banking.

Limitations of the Crypto Movement

Given the devastation that central bank policy over time has visited upon society, it is no wonder that people have cried out for an alternative solution. Indeed, the famous Bitcoin white paper was released in October of 2008, just one month after the collapse of Lehman Brothers in the last systematic banking crisis. The crypto movement that was started around that time has aspired to decouple transactions between private actors from the state and form a new currency that was programmatic and self regulating through computer code and consensus achieved through computing power.

But to do so, the crypto ecosystem would have to become fractionally reserved to support the vast scope and always anticipatory nature of economic activity today. Money would need to expand to meet production versus the limitations of the initial code. One group that could take on this role are crypto exchanges who could lend out their customer deposits to other crypto users.

But a fractional reserve system only potentially “works” if (i) its loans are self liquidating and (ii) in a bank run, an outside party can discriminate between insolvent and merely illiquid institutions (whose loans are secured against “real” assets with value sufficient to cover their liabilities) and bail out the system in a crisis. Indeed, (i) and (ii) are hardly sufficient but merely necessary conditions, as they have not guaranteed the survival of even modern banking institutions. In crypto, (i) and (ii) are essentially the same as there is no “real” economic activity that crypto is meaningfully enabling. Even in 2008, illiquid banks held loans against securities backed by houses, which were a “real” good worth something. Thus in 2008, some banks were solvent but merely illiquid while others were both illiquid and insolvent. In the case of crypto, tokens are largely being traded between groups of financial speculators without recourse to economic activity and the “real” assets it generates.

Thus, the implosion of crypto prices over the last 12 months has seen the collapse of a number of crypto firms. They became illiquid and because their assets were not paired off against “real” economic activity, they were also effectively insolvent.

FTX, founded by a former trader named Sam Bankman-Fried (SBF), was an exchange for trading crypto assets. What makes FTX and what happened to it last week special is that FTX was viewed as one of the most legitimate institutions in crypto, while SBF was viewed as a generous philanthropist through his sponsorship of Effective Altruism carrying the legitimating credentials of being the second largest donor to the Democrats in the 2020 elections. SBF was even said to be the second coming of JP Morgan, looking to bail out the crypto ecosystem after the volatility it saw this year.

Yet what appears to have been the case was that SBF was trying to bail himself out and was likely insolvent long before the events of last week. When the value of their assets came under question, there was a run on FTX (i.e. customers tried to withdraw their deposits all at once) and within a matter of days, FTX declared bankruptcy. It’s unclear if customers will get their deposits back in whole. The do-gooder billionaire is now under investigation for potentially having illegally lent out customer deposits on FTX to his crypto trading firm (Alameda Research).

While many are now calling SBF, the “Bernie Madoff” of crypto (although one is inclined to think all those political donations bought something—like a get out of jail card for SBF), alleging that he is one bad actor, the point is that for crypto to have truly enabled commercial activities at scale--fund industrial investment, for example--it would eventually have had to become fractionally reserved anyways. Just to fund more demand for crypto and speculation in crypto—long before enabling real economic activity—the crypto ecosystem had already become fractionally reserved. Being fractionally reserved invites the possibility of bank runs. And if those runs are on systemically important institutions (which FTX may have been in the crypto ecosystem but probably not in the wider financial one) they do not merely welcome but necessitate arbitrary state domination. Crypto, in other words, under the current system, would not be decoupled from state power.


A new way is required if, on the one hand, society is to continue operating at industrial scale, and if, on the other, society does not want to be subject to state domination. Society cannot return to the real bills doctrine, nor ought it make its peace with state domination. Crypto may not survive this hour of distress, but its impetus does not have to be buried with it.

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