Epicenter - Learn about Crypto, Blockchain, Ethereum, Bitcoin and Distributed Technologies - David Andolfatto: Fedcoin – The Implications of Cryptocurrencies Issued by Central Banks

Episode Date: June 15, 2015

Many people think of Bitcoin as the ultimate contender against the power of central banks, most importantly the Federal Reserve System. But that is certainly not the only way that cryptocurrencies and the blockchain can be used and one particularly interesting idea is that central banks could issue their own cryptocurrencies. To discuss how this could be done and what the consequences could be we were joined by David Andolfatto, a Vice President of Research at the Federal Reserve Bank of St. Louis and a professor of Economics at Simon Fraser University. The views and opinions expressed by ou guest are his own and should in no way be attributed to his employer. Topics covered in this episode: What makes good money? How does Bitcoin fare in comparison? What is Fedcoin and how could it work? Why the tension between a governments desire for control and the desires for ‘permissionless innovation’ could make this difficult to implement Whether Fedcoin would threaten fractional reserve banking Why competition between currencies, both governmental and non-governmental, could be a good thing Episode links: David Andolfatto: Why Gold and Bitcoin Make Lousy Money David Andolfatto: On the Desirability of a Government Cryptocurrency Business Insider Interview with David Andolfatto Robert Sams: Seignorage Shares This episode is hosted by Brian Fabian Crain and Sébastien Couture. Show notes and listening options: epicenter.tv/083

This episode of Epicenter Bitcoin is brought to you by Ledger, makers of the Ledger Nano hardware wallet, half piece of mind in knowing your private keys are protected by industry standard physical security. Go to ledgerWallot.com to learn more and use the offer code EB-09 at checkout to get 10% off your first order. Hello, welcome to Epicenter Bitcoin, the show which talks about the technologies projects and startups driving decentralization and the global cryptocurrency revolution. My name is Sebastian Kutjou. And my name is Brian Fabian Crane.

We're here today with David Andolfato. He's a professor of economics at Simon Fraser University in Canada. And he's also a VP of research at the St. Louis Fed. So this is the first time that we are joined by a proper real-life central banker. And as, you know, we talk so much about money and about how money work and all those things. And I think it's something that most people in the Bitcoin space don't know that much about how it like sort of works deep underneath. So I'm super excited that David's joining us today.

What's a great pleasure to be here. Thank you for inviting me. Yeah. And I guess the reason why I would sort of come to this is because you've written a blog post called Fedcoin. And then you've also given a few lectures on the topic, basically exploring a question what it would be like and how a federal government or a federal bank could issue their own cryptocurrency because it's sort of an obvious idea, but it's also really interesting to think through all the implications. Yeah, so I guess there's, you know, we have to also kind of define, I suppose, what we mean by cryptocurrency. I mean, central banks and other banks already issued.

kind of virtual currencies and and the the question really is what sort of properties do you want to you know surround that currency with in the very extreme I proposed the idea that I saw J.B. Coney present once on a blog post of Fed coin so that the idea was not mine but I took it to the natural limit like suppose you know we actually had the Federal Reserve Bank issuing a cryptocurrency that was actually where the payments were actually processed by Bitcoin miners. I entertained that possibility as kind of an extreme. Yeah, I know.

I think that's a fascinating one. But maybe before we, well, let's start with that question. Like, how long have you been interested in Bitcoin, curious about it, or do you remember how you first heard about it? Well, you know, I've always had an eye on the pay. system kind of just from a theoretical level as by way of background I'm an academic I'm a macroeconomist so I I actually don't have very much detailed knowledge of the the actual plumbing of the way the payment system works but I've

always you know I've likened the payment system to kind of like the circulatory system it's like when it's working fairly well nobody notices this you know your circulatory process in your body but when things screw up that that's when you really find out the potential problems. So I guess I got a heightened interest in the payment system during the financial crisis, and at about that time is when Bitcoin kind of came around. And I had my eye on it, but more of, I didn't understand it. I thought it was kind of like a crazy sort of idea.

You know, we see these kind of crazy ideas out there. But then Marcella Williams, who was in my department. asked me if I would like to kind of speak on the subject because there seemed to be a growing interest in it. And the Federal Reserve Bank of St. Louis has this very, very, I think, nice program. It's called Dialogue with the Fed, where we give public lectures on topics that are of public interest. And that's about a year. When was it March? March 31st of 2014 is when I gave that public lecture. So I began to research Bitcoin kind of quite intensively at the beginning of 2014, so just over a year ago. Cool. And what were your, what were your thoughts about Bitcoin,

your first thoughts from the perspective of a monetary economist? Well, I mean, it's the type of faults are very easy to come by because of just the language that people use to describe things. So for example, mining is, it's, it's, it's, it's, it's, it's, it's, it's, something that kind of confuses economists. I mean, you're immediately, you know, Paul Kruitman famously made the same mistake. And it's quite natural because people call a process mining and it's like you have this vision of actually just this digital gold and you're out there mining it. And as you know, I mean, mining is not an accurate description of what is the purpose of the miners.

And so, you know, in the classical theory, I mean, we know there's these well-known theorems of the inefficiency of commodity money, the inefficiency of mining. I mean, why do we exert effort into extracting yellow metal from the ground or silver metal and just to store it again underground, say, in Port Knox? I mean, it just doesn't make sense. And it's very, very easy to get kind of, if you don't kind of read up on it, it's very easy to be led astray and to have some misconceptions. Touching on Bitcoin, I believe that it's your opinion that Bitcoin doesn't actually make a good store of value. It does have an interesting payment system, but the store of value, in your opinion, necessarily isn't there. Can you talk about what makes good money?

Yeah, so I think it's, I wouldn't go so far as to say that Bitcoin is not a good store of value. I think that it could potentially be a good long-run store of value. So I make a distinction, and I think a lot of monetary gears do as well, on the short-run rate of return versus the long-run rate of return of an asset. And, of course, it's desirable if you could to have high long-run rate of return and a high-stable short-run rate of return, but life is full of trade-off. So my view would be more of, yeah, you know, I think as a source, store of value? I mean, if people wanted to put aside some Bitcoin in their wealth portfolios,

you know, not too much of it, that it might perform kind of in similar ways to say gold or something like that, and that would be okay. But there is a fixed supply of the stuff. And, you know, you could imagine with demand growing that over the long run, it might be a good store, a decent store of value. But to be a good money, you know, a good money needs more than just that. I mean, it's good if it has a long run, good long run store of value. But what's also important is that it has a good short run rate of return. That, in other words, that its purchasing power doesn't fluctuate too dramatically in the short run. Or even if it does remain stable for a while, that it isn't subject to wild swings in its purchasing power.

And I think it's a property of these types of monetary policies like the gold standard and also Bitcoin, that in times of heightened demand for money, like during a financial crisis, you see these very large increases in the demand for money, that if the supply of money is fixed, that what's naturally going to happen is that the purchasing power of that money is just going to skyrocket, which is to say it'll create a huge deflationary event. And we know that these unexpected deflationary events are very harmful because, because, you know, most people organize their payments in terms of like nominal debt contracts. I mean, you pay the rent in so many dollars per month.

I mean, you're paying your employees a certain amount of wage. And if firms see the product prices plummeting in a big deflation, they're going to have difficulty meeting these nominal obligations. They're going to have to lay off workers, renege on their debts. And, you know, this is why this type of Bitcoin, the monetary policy is not necessarily a good monetary policy relative to a well-designed kind of elastic monetary policy that would increase the supply of money during a crisis to alleviate the pressure that there is on the demand for the money. And in doing so, you're able to kind of smooth out the price level effect

and kind of avoid the worst consequences of these unexpected deflationary events. That's basically... No, I mean, I think that makes complete sense, right? Also, there are some of these perhaps rather unlikely scenarios, but one can imagine that, right? Let's say Bitcoin was adopted by the world, became in a new world currency or something, you know, it might happen. And of course, the consequence would be there would be an incredible increase in the value

of a Bitcoin. And there would be incredible change in wealth, like a shift in how the wealth is distributed and all those things. And it's pretty obvious that those would be incredibly disruptive events. Maybe some good consequences and some bad consequences, but in any case, like really, really disruptive. So, I mean, I think it makes sense that, you know, when you say that this inability, which I guess in Bitcoin case is also a feature, right, but to adjust the money supply is, you know, has its downsides in some scenarios. Yeah, the disruptiveness of these events, though, as, you know,

in the best case scenario for Bitcoin advocates as it becomes widely adopted, I mean, it'll be disruptive, but, you know, the key thing is, it's not necessarily going to be something that just happens overnight. I mean, that sort of disruption can be kind of more or less forecast and people can adapt to it. The type of disruption I'm talking about is, you know, suppose, like the Great Depression. Yeah, suppose Bitcoin does become the, the new, you know, the numerator, the unit of account. Suppose that it is the base money.

that that money supply, as in kind of like the goal centers, is basically fixed. And that's not best practice when it comes to the conduct of monetary policy, at least according to a wide body of theory. Now, some have proposed, I mean, it's simply been talked about that we would have some fork in Bitcoin at some point, some modification in Bitcoin, where we would integrate some monetary policy as an automated part of how Bitcoin works. Do you think that at some point it would be possible, in the current sort of given the current state of Bitcoin,

a decentralized currency with no central bank, et cetera, do you think it's possible to have monetary policies integrated without oversight by central bank, essentially an automated monetary policy? That's an excellent question, you know, and the thought had occurred to me, and I have seen people kind of think about that idea, and I haven't thought it through as much as I would have liked, unfortunately, but here's the issue. I mean, my own feeling is, yeah, I think that that's possible, and it'd be interesting, right, if such a fork were to occur.

And then, of course, these two types of currencies could coexist. And we could kind of see, you know, there'd be a competition, just as there would be a competition between the U.S. dollar and Bitcoin. There's a competition about which type of monetary policy is kind of a dominant. There is the question of, you know, how we could automate it. I mean, it'd have to be like a, you'd have to, you know, write something into the program. I think the challenge, I mean, it would be very easy. to write into the program a rule that, for example, during a crisis, you know, that could be measured by some publicly observable event,

say the price level or something like that, I mean, you typically see the price level begins to plummet in a crisis deflation. You can program, you know, a state contingent policy in the Bitcoin protocol to actually inject new Bitcoins into the system conditional on that event. That would be very easy. I mean, it would just say, you know, if the price level falls below this level, I mean, we're going to inject, you know, everybody's Bitcoin balances are going to increase by 1%. Something like that. I mean, you could build that into the protocol very easily. Injecting the cash would be easy. I think that the problem, the more challenging issue would be how do you withdraw that money after the crisis has passed?

Yeah. Well, yeah. I mean, it's interesting to bring that up because we actually did a podcast episode on, on, on his paper senior chairs. And he developed exactly a model to do that. Oh, okay. So, I mean, we'll have to link the show notes, but I can very, very briefly sort of reset the idea. Like, he had, there would be, I mean, the idea was that you have a stable, a stable currency, right? so that in case people, more people want the currency, more coins get issued.

And if fewer people want the currency, then the coins get destroyed. So the question is, how do coins get destroyed in particular? And he would have, there would be coinholders and sort of shareholders. So shareholders, you could think of like the owners of the system. And in the case of where you need to destroy coins, essentially, the shareholders can buy those. And, or no, the coin holders can destroy the coins, and in a turn, they get the shares, right?

So in a way, you have this sort of equilibrium that's between the two coins that. I see. So like I said, I mean, so I didn't think through that part of it very carefully, and it wouldn't surprise me that smart people like Robert, example, and other people might come up with solutions, the problem. The interesting part is, suppose we do come up with a solution like that, and there's a fork. It'd be a very interesting experiment to see, just to see how it performs.

I mean, I don't think there's much chance that's going to happen with Bitcoin, but maybe someone else is going to do another currency. And it's not without its complexity. Let's take a short break to talk about sponsor, Ledger, Ledger, Archer. are the makers of the ledger nano hardware wallet, a small, beautiful, simple device that lets you keep your Bitcoin safe without buying a Swiss bunker, without digging a hole in the basement, without buying a data center defended by autonomous robots. None of these you need.

All you need is a small device, lets you plug it into any computer, whether it's safe or not, and your private keys remain safe. So the nice thing about the ledger is the wallet, which is really great to use. And by the way, there's a companion app also for iOS and Android, which allows you to do the second factor authentication required anytime you do a transaction. But you can also use ledger with Coin Kite. So if you have a Kite setup, you can use ledger as one of the private keys in that setup. So for instance, if you're just an individual and you want to secure your Bitcoin, so you could have a multi-signature setup where Koykite would have one key. and you would have another key and perhaps, I don't know, maybe like your girlfriend has another key.

Or if you're a company, you know, you can also have it set up so that, you know, all the founders have keys and there's like a three out of five keys required to sign. So there's something, you know, the possibilities are endless and that's made possible by the partnership between Coinkight and Ledger. So if you're interested in trying Ledger out, you can go to ledger wallet.com and use the offer code EB-09 at checkout. and that'll give you 10% off your first order, so don't delay in getting a secure set up today. And we'd like to thank Ledger for their support of Epicenter Bitcoin. Can you give a brief introduction about what the big idea is? Well, I mean, none of these ideas are kind of original to me.

I mean, I was just remarking on, you know, I gave a talk actually in Frankfurt earlier this year, and actually prefaced my Fed. It was called Fedcoin, but I prefaced the discussion on FedCoyne with what I call Fedwire for all, which is kind of an old idea. And the idea is basically why can't everybody, you, me and firms, have direct accounts at the central bank at the Fed? Now, there's a number of reasons why we can't,

but I mean, that's all kind of stuff that could, in principle, could be changed. And if not direct accounts, why not segregated accounts at private banks that are basically, you know, segregated and constitute 100% backed cash reserves with these accounts? So basically some form of narrow banking proposal, which is kind of an old idea. And I was just going, you know, I mean, the present system that we have in place now is a system that's evolved over centuries based on pre-internet technology. You know, maybe there was even a reason or a rationale for why you didn't necessarily want every Tom Dick and Harry to have a personal service account at the Fed and why you might want to delegate this responsibility to private banks. But, you know, since the Internet, which is still very, very new, I mean, there's really no reason why people couldn't have a direct online account with the Fed. And I was surprised to learn that, in fact, in the United States, people are permitted to have direct online accounts with the U.S. Treasury. So I can go and open up an account directly online with the U.S. Treasury.

And what am I buying there? I'm buying, you know, electronic digits, interest-bearing electronic digits. And now the Treasury hasn't set up so that I can easily make. make payments across people within the system, but that's just a detail. That could be very easily accomplished. And if the Treasury can do it, why can't the Fed do it and just let, you know, just let, you know, businesses directly deposit in an account with the Fed or through some sort of private bank that has a segregated account.

And there's some technical legal issues to overcome there, but they could be a overcome and they could earn interest on on directly they could in earn interest on on this this money as well i mean they could be just like treasury bills interest bearing the government money they would be a 100 percent insured there'd be no no need for fdic or any sort of insurance like that because the fed prints the money i mean there's there's no issue of losing it a lot of businesses today that you know who are managing their cash You know, they don't feel like they can deposit 50 or $100 million in banks because the deposit insurance doesn't cover that much.

So that's why they're motivated to go into the shadow banking sector and into the repo markets. And as we know, that was the shadow banking sector was the source of the financial crisis in 2007, 2008. So I said, why, you know, in principle, kind of ignoring a bunch of details, why couldn't everybody just have a direct account with a Fed. You could trust the Fed to do the bookkeeping. You know, the Fed is, people say, how can you trust, you know, the Fed to do the bookkeeping? I mean, like, I say, my response is, you don't expect the Fed to kind of steal your money.

I mean, if the Fed can print all the money at once, it's not going to, like, mess around with your bookkeeping. So, you know, we have this big spreadsheet, you know, the blockchain, if you want, but it's just managed by the Fed. And it's very cheap, much cheaper than Bitcoin, if you're willing to delegate the responsibility to a third party. And but then the downsides to all of that, of course, is, you know, some, you know, you'd actually, suppose you didn't want the Fed to be responsible for processing their payments. I mean, suppose, you know, the Fed will likely impose some KYC restrictions on some purchases. they might not process some purchases that you might want to undertake.

And so it was at that point that I said, well, you know, we could if we wanted to extend the concept one step further. I'm not saying that this is ever going to happen, but just conceptually, you could imagine not Fed wire for all, but kind of like a Fed coin, where what the Fed would do is actually just issue these, you know, Bitcoin-like objects, but, and they would enforce a par exchange rate with the US dollar. That would eliminate the exchange rate volatility. But they could delegate the clearing of these payments to some third party, you know, some sort of ripple-like protocol or possibly even Bitcoin. I mean, we could delegate the responsibility of processing these electronic, you know,

Fed coin payments to the miners. And the idea there. would be, you know, because we can't really expect the Fed to turn a blind eye to kind of certain types of transactions. In fact, the Fed does turn a blind eye to a lot of type of transactions already. Those would be the type of transactions that are facilitated by the cash that the Fed prints, right? So the Fed doesn't impose any KYC restrictions on cash payments. you know, we somehow, society somehow seem to manage, you know, over the centuries to not implode because of the availability of cash and kind of these anonymous kind of payments that leave

no trail. So to the extent that the Fed would be, is already kind of comfortable or, for lack of a better word, kind of willing to live with the fact that we already live in a world where these Fed live are circulating to facilitate, you know, anonymous or underground exchanges, we are already living with this reality. Why don't we just issue a Fed coin and permit it to be cleared through these miners? And it's just kind of like the equivalent of what's happening with the cash we already, we print out. Yeah, I mean, this is such a novel idea. And there's so many, there's so many topics that, that we can cover on this. But so the KYC, um, I'd The idea that, okay, so currently in the cash system, there's no KYC, you can make these cash transactions without any, the government knowing where the money is going and what you're doing with the money.

But, you know, the cash has certain limitations. So cash is hard to transport in large quantities over borders, for instance. You can't pay digitally with cash. And it seems to me that if the Fed or if there was some like government issued coin, that, that, It's just so unlikely. It would be preposterous to think that the government would not want to impose some sort of KYC on there. Because the implications of not having KYC are, I mean, think about capital controls, for instance, or being able to send, like, large amounts of money to countries where there are economic sanctions. Like, just that.

Do you really think that governments would not impose KYC on, like, a proposed Fed coin? No, I think that you're quite likely right. I mean, you know, but for that matter, you know, government is kind of strange sometimes. I mean, for example, look at all the $100 bills of the Fedprints. I never see a $100 bill. Where are they? Where did they all go? Yeah, similarly in Europe, we have these 200 and 500 euro bills and I don't know where they go either.

Yeah, well, as far as I can tell from what I'm reading, I mean, all these $100 bills are like circulating over in Russia or around the world. And it's quite clear, you know, I mean, there's some legitimate uses as well for $100 bills. I'm not saying that people who hold $100 bills are necessarily criminals, but I'm just saying. It's quite clear that, you know, the Fed and the authority seem to be turning a blind eye to this fact and in principle. You know, the other thing, though, is that you have to keep in mind that you know, even on the blockchain, I mean, it's possible to, you know, the IRS or the FBI, I mean, it's possible to do the forensics and kind of trace where these payments are going, ultimately.

I mean, I know there's all these games being played to kind of anonymize payments and all that. But that's just the property of the blockchain. It's going to be there if it's with Fed coin or with just Bitcoin. This blockchain is public information. It's living out there. you're going to be able to trace payments one way or the other. I mean, people are going to, the authorities are going to design techniques to trace payments somehow. The people in the Bitcoin space will develop ways to get around it.

There will be kind of this continual arms race. So, yeah. So just to come back to what you say, yeah, I think you're right from a practical point of view. I think it's unlikely that the authorities would kind of really turn a blind eye to AML. or KYC sort of concerns. But I was just kind of throwing it out there as kind of in principle, what's kind of possible.

And that it wouldn't really be that much different than kind of what's happening today with cash. I mean, if we sort of take the other perspective, so I mean, I agree, I think this is probably going to be a hard sell, right? But, I mean, you could say one of the big political advantages and the reasons why the U.S. is such a strong country is because the U.S. dollar is like that, the world's strongest currency, right?

That in many countries that have very weak currencies, like a lot of Latin American countries and other countries, you know, the dollar is like de facto has a very important role that a lot of economic transactions are done with the dollar. And that's despite the dollar being quite a pain to use there, because, well, you only have the cash, and, you know, if you want to get at a gross border, you may get caught, and then there's all these things.

But, well, if we imagine now a Fed coin, well, that's an entirely different thing, right? So then you could, I think that would be extremely threatening to countries that have, you know, terrible monetary policies. But on the flip side, it might also be really attractive for the U.S. in that it would solidify potentially its sort of position as this dominant world currency. No, I think that's absolutely correct. I mean, you know, it would give the U.S. a great advantage in that sense. There are some pitfalls associated with having your currency circulate globally, but on net it's probably positive.

And this type of idea, this Fed coin idea, is something that would just enhance the attractiveness of the U.S. currency abroad and solidify its purchasing power, I think. But of course, the downside of the program is, of course, that the people who use Fedcoin or FedWire for all, whatever the case may be, are subjecting themselves to U.S. monetary policy. And, you know, for the past 30 years, one could make the case that the U.S. monetary policy has been run responsibly in the sense. that inflation is being low and stable. I know there's all sorts of critics out there about Fed policy, but we could spend all day debating that.

By and large, for the past 30 years, inflation has been low and stable. But, of course, just because that's the case in recent history doesn't mean it always has to be the case. So people who would be using Fedcoin, of course, are subjecting themselves to whatever political uncertainties might afflict. the central banks, the U.S. Fed or institutions.

I mean, I think that's certainly one thing that, for example, you know, it might even be the case, right, that the Fed coin would have a better monetary policy than Bitcoin, right? But that's perhaps an aspect where Bitcoin would have an advantage because it's neutral in a way. But even there, I think, you know, I mean, people use the U.S. dollars today, right? and they are subject to US monetary policy. I think you could probably still succeed there,

but where I think if you do have to start imposing KYC, that's not going to work, right? Like having KYC on people in other countries and those kind of things, that, you know, it will break down, I think at that point, you know, unless the Fed or a hypothetical central bank would really be willing to give up that control. Yeah, and I think that for myself, I think that, I mean, if I was in charge, I would give up that control, especially over small transactions, right?

I mean, you could actually condition the KYC specification. You could say transactions below $100 or whatever, $1,000, whatever the parameter is, whatever, do what you want. But, yeah, I mean, I agree with you. I mean, for people who are concerned who are just not going to trust the government currency, whatever, there's Bitcoin or there's other cryptocurrencies. I think that's great. I think it's fantastic that these alternatives coexist and meet the demands of these people who want to make. They're willing to live with the day-to-day volatility in the currency.

They're comfortable with the idea of the long run. The currency is going to maintain its value. they're not subject to these KYC restrictions. I mean, go for it. That's fine. I think there's room for these currencies to coexist. So one important Robert Sam's writer post will link to it in the show notes as well, which I thought was very interesting in response to your post.

And he sort of said, well, you and also JP Cunning kind of maybe underestimated how just how revolutionary this concept is. Because in his view, it would really undermine the very idea of fractional reserve banking, in that it would make deposits, holding deposit of banks really, really unattractive, because everybody would want to hold Fed coins. So it would be a huge issue for the existing financial systems.

What is your view on that? Well, this is a, this is, a, interesting and fascinating subject for study. And so my views on this matter are not set in stone. They're continually evolving. So I noticed you mentioned Fedcoin and not Bitcoin. Is that what you meant Fed coin? Yeah, yeah, yeah.

I mean, I guess Bitcoin could have a similar effect, but that's a much harder shot because it can't compete. Well, this is quite interesting, you know, it would definitely impact to some extent on the incumbents in the banking sector, that's for sure. But it wouldn't take away their business in the sense of their lending arms, what they do. I mean, banks, you know, in narrow banking systems, you're separating out the payments from the credit side of the economy. Banks could still go out and lend money. They could still make mortgages, they could still finance, you know, finance, you know, firms, small firms, inventory

investment or whatever. So, so, so, you know, I think that that part is, is going to be very disruptive for the incumbent banking sector, but, you know, arguably for the benefit of society. Yeah. But just let me jump in there. But wouldn't, would that be the sort of banking system where, because I can, I don't think, in my view, it's possible to have a fractional reserve Bitcoin system. I mean, you can have, people can run a closed, sort of a closed fractional reserve,

like Mount Gox is doing apparently, right? But then you can't use, like, Mount Gox Bitcoins to pay anywhere else. It's a closed system. and then as soon as people realize it and withdrawing off, like it breaks apart. So wouldn't this work out in a similar way that, you know, okay, maybe there would be banks that do lending, but then, you know, if they had one billion in deposits from depositors, well, they could only actually lend out one billion in loans and not 50 billion with a fractional reserve system.

And do you don't think that would be the case? So, no. And that's a kind of a provisional no, because I've actually been corresponding with Robert Sams by email, and we've been discussing debating the issue. And so I'm familiar with Robert's assertion that fractional reserve banking is impossible, essentially under a Bitcoin system. And I'm not so sure about that. And my feelings on this follow both from what I think I've seen in history and also from what I know in type of the theoretical models I write down.

But the basic argument would be something like this. I mean, you know, I think one of our Roberts arguments is like, look, in the old days, maybe fractional reserve banking made sense because what would happen is you'd have these banks issuing paper banks. notes redeemable in gold and the reason why it was useful to have bank notes is because gold has some undesirable properties I mean to to move gold from New York to San Francisco you'd have to hire Wells Fargo and a stagecoach and all the security I mean it's really really difficult to transport gold to assay gold you know does keep gold secure and for that reason there may have been a role for these intermediaries called banks to

kind of monetize that goal in the form of paper notes redeemable in the gold. But, and Robert might argue one argument, yes, is, you know, today Bitcoin is not like, it's kind of like gold, but it's like digital gold. It's like if I want to send digital gold from New York to San Francisco, there's none of these issues. And so why do we need a bank to kind of intermediate this Bitcoin stuff when it's already such a great kind of payment object?

My argument on that is, well, one property of Bitcoin is that it doesn't earn any interest, right? You don't earn interest on your Bitcoin. You might earn some capital gains if the purchasing power goes up. And you might earn some capital losses as this purchasing power goes down, but you don't earn any interest on it. So it's a zero interest bearing asset, which is okay, but that's just the fact. It's a zero interest bearing asset. Now, banks are still going to be motivated, I think, to go out and say, you know, the way the banking system works is they could imagine a world where Bitcoin is kind of the unit of account and the base money. Banks could still, you know, I'll go up to the bank and say, can you lend me a million bitcoins?

I've got a business, a restaurant business I want to finance. And what the bank does is even if it has just a hundred thousand Bitcoins in its possession, it could just issue me those Bitcoins on account. I mean, that's how demand deposit. That's how the banking system work. It just in the act of making the loan, it actually creates Bitcoin denominated liabilities that are redeemable on demand for the limited amount of Bitcoin reserves it has, but are otherwise constitute legal claims against the bank.

But who would accept those? I mean, if I was like now maybe a supplier, I mean, I wouldn't give, I certainly wouldn't treat those at parity. Well, suppose I offered you 5% return on your deposits held with me. Suppose that. Suppose that you felt, you know, we're in a period of economic tranquility, the economy's kind of moving along, humming along, you know, banks are doing well. But that's a bit like a pyramid scheme, you know?

I mean, then... No, not and not at all, because what the bank is doing is investing in my business. I'm generating 10% profit for the bank. The bank takes 5% and pays the depositors. In the meantime, people are using the bank liabilities as payments. You say, who would do it? My friend, we're doing it today. We use this bank money today all the time.

And moreover, even before FDIC, I mean, people would just use private bank money of exactly this. But so you would, so the bank would, so you would, the bank would have 100,000 in Bitcoins, 100,000 Bitcoins. And they would give you a million, a credit of a million, uh, correct, a Bitcoin, worth Bitcoin. And now you have, obviously, they're not Bitcoin, right? Like, because they don't have those. So you have this. I don't know maybe another cryptocurrency another ledger maybe it's tracked on another ledger right yeah on the bank's ledger just like it is on the bank's ledger and then you would want to pay someone else and they would say okay but I mean for

me for example now you have a million bitcoins if I wanted to I mean I would never be willing for example to accept more than 10% right what if you gave me a 10,000. I mean, if I went to the bank, they wouldn't be able to give it to me. That's correct, but they could just sell off the loan to acquire it. You know, they have assets on their balance sheet that constitutes a loan against my business. They could sell off that security to some other bank to acquire the Bitcoin they need to meet the redemption request. The other thing we have to be careful is when you say, I wouldn't do this. I'm sure that you would.

But the question is, here's the question. If banks were to offer such a product, would there be people out there, agents or agencies that would be willing to accept these bank liabilities and treat them at close to par with the actual base money, the Bitcoin or the gold or the U.S. dollar? And the overwhelming evidence shows us that not only people are more than willing,

even for small, you know, this is the reach-for-yield phenomenon, Even for small gains in yield, they're willing to substitute into these types of liabilities. And we saw this in the shadow banking sector. We saw this, you know, people had the option of when they wanted to deposit, say, $500 million overnight, that they could take a U.S. Treasury as collateral for this loan. But instead, you know, they're going, you know what, why should I take this U.S. Treasury? I mean, maybe this AAA-rated tranche of mortgage-backed security, which earns a slightly higher yield, is kind of like a better product or something. You know, you kind of saw this kind of reach-for-yield phenomenon in the shadow banking sector.

And it's just kind of a phenomenon that seems unavoidable, especially during periods of tranquility, you know, they see that they go, oh, you know, I've used the bank. I've used my bank account for the past five years. Everything seems to be working well. Now I have the option of holding my money in the form of zero interest-bearing Bitcoin or 3% interest-bearing account at a well-established and reputable chartered bank. Which am I going to pick? I'm telling you, people are going to be willing to hold these bank liabilities, and it's going to generate a system of fractional reserve banking, I think.

So the question is, is this desirable? I mean, you mentioned a few minutes ago that if we were to get rid of fractional reserve banking, that would be for the benefit of humanity, would it be desirable to fall back into this system of, that can essentially implode at some point? Well, I have to be careful. I actually, in the theoretical models I work with, there's actually benefits to fractional reserve banking. There's kind of costs and benefits. So I wouldn't go so far to say that I'd be in favor of banning it. The real issue with fractional reserve banking or what we see these behavior in the shadow banking sector is this, you know, to what extent are the people who partake in these activities?

To what extent do they have, are they going to be bailed out by the public? That's the issue. Okay. And so, you know, one school of thought says, well, let fractional reserve banking have its way, let it go, just as long as people are. understand that if and when such a system kind of, you know, subject to a run or if there's some sort of losses to be incurred, that the depositors will take responsibility on their own for these losses. They have to understand the risks and not be expecting some sort of government bailout. My view on this is if the government could commit not to bail out people or certain groups of people in these types of traumatic events, then, yeah, fractional reserve banking or any other type of financial structure, I mean, let it fly.

I mean, I think that, you know, these institutions, these structures exist, presumably for a reason. people should be free to trade. They should be free to contract with each other. And if these are the designs that they find useful for their own purpose, let them go ahead and do it. But my more cynical side says, the government does not have that ability to commit not to bail out in these events. And it's that government inability to prevent itself from bailing out is kind of what leads to the troubles. It certainly can make a very credible claim that it's never going to be able to bank out in the financial crisis. I just wanted to come back to what we were mentioning a while ago about the sort of the strength of the U.S. dollar

and the advantage that the U.S. would have if they were to, if this Fed coin were ever to become a reality. Because, by the way, this is all theoretical. This is just thought experiments. So, you know, let's say this, you know, there's a Fed coin and it's, it's, you know, it's, starts being used, presumably, by, you know, for international trade as well as, uh, as the currency to trade like oil and commodities. And also starts being used in countries where, you know, the currency is not as strong. Um, could, could we done this like, and then, okay, so for example, the, you know, the European Commission or the, uh, the European Union rather, also does their

coin. And then you have, start having these competitions between coins. And then, can we assume that in sort of a macroeconomic scenario, one coin will, maybe like one or two coins will become the de facto coins that everybody is using? Because if Zimbabwe starts doing their coin, who's going to use that if they could use use the US dollar and it's as easy to use as cash? Well, that's right. So that's a very good question. You know, who knows how this such a system might evolve.

I mean, my best guess, you'd see, I mean, I think history provides us some guide as to what's likely to happen, because, you know, what you're describing is not new, this phenomenon of currency competition of multiple currencies. Take a look at the system as it exists today. We do have a few dominant currencies around the world, right? The U.S. dollar, the yen, the euro. I mean, these are dominant. A lot of international pricing and international trade is done in U.S. dollars. But at the same time, even within the United States, we see, you know, what people aren't aware of is we see thousands of local currencies coexisting.

You know, the Ithaca hour in Ithaca, New York is kind of a prominent example. So it is conceivable that you'll have this system of where you have a system where you have a few dominant currencies coexisting with a plethora of local currencies. I mean, that's what history suggests is likely to happen. I mean, I think also one important thing to consider sort of when thinking about this, and I think that's something that is really radically changing with cryptocurrencies, is that there is no reason anymore that national boundaries are respected, right? Because, I mean, in the past, and, you know, still for the most part today,

but a currency is very much like embedded in their financial system and the banks and that's regulated and controllable by the government. But when that starts breaking apart, well, then I think it's extremely hard to tell how it's going to turn out. I think it will be very interesting. And, yeah, I guess that idea that competition between currencies is a very old idea. I guess it's never sort of fully come diffusion, right? But it might now.

Yeah. And in terms of like the, you know, people living in some jurisdictions like, actually I just heard that Ecuador was pegging its cryptocurrency to the U.S. dollar. You know, you look at what's happening in Venezuela today as well. I think that the availability of a Bitcoin-like object, or if it was Fedcoin or Bitcoin or whatever, is potentially a great boon to the people who are living in these jurisdictions because it can free themselves from, I mean,

this like Venezuela is what I would call, kind of an example of not a well-managed monetary system, and it inflicts a great deal of pain on the local population. And the ability to free themselves, of this mismanaged fiscal and monetary authority, I think would be a great benefit to the people who live in these types of places. Today's magic word is money, M-O-N-E-Y. Go to let's-talk-Bitcoin.com to sign in, enter the magic word, and claim your part of the listener

award. Can we talk about perhaps some of the more technical aspects of what this would look like. So we were discussing this earlier and curious in your idea of how Fedcoin would work, like would there be mining, for instance? Would it be a fully decentralized system or would we be relying on centralized nodes? I'm sure our listeners would be familiar with technologies like Hyperledger and other more, or Ripple, for instance. How would that play out? Yeah. So I'm not an expert in the technical aspects here. But like I suggested at the very beginning, you know, those are details that could kind of be worked out. And it'd be kind of important

because, you know, at one extreme, you could just dispense with these miners altogether and just, you know, I mean, why not just trust the Fed to kind of do the... Yeah, a central database. Hmm? I didn't hear it. Yeah, just a central database, right? It's just a, it could even be a public ledger. I mean, I mean, there's nothing that prevents it from being a public ledger. you know, and the identities of people's, of them and their accounts may or may not be made public. You know, I mean, there's so many parameters.

But at the end of the day, at one extreme, you could just imagine the Fed managing the bookkeeping. And that system would be extremely cheap, really cheap relative to, say, a Bitcoin protocol, which consumes vast quantities of electricity, for example, we know. No, I agree now. But if we presume that it's a centralized system with just a central database, so there's some issues with that. And so we can look at it from the perspective that we want to have an open system or a more closed system. And if you have a central database, then you run into some issues like censorship.

So some countries may, like, all out, block DNS requests, like requests to the central database at the Fed, and making it impossible to use that currency in those countries. But then there is also sort of in between where you could have a semi-decentralized system with semi-trusted nodes all around the world that are operated by the Fed and run peer to peer where you trust those nodes because they are run by the Fed,

but you don't have this sort of like one central server that can be censored by certain countries. Correct. Right. And you could have the Bitcoin, the Fed Coin component in my blog post, I liken Fedcoin as the issuance of just a different denomination of currency. I think it would be conceivable to have that part of the money supply exist on a distributed ledger, right? So just the way Bitcoin is today. The only difference is that the Fed would stand ready to enforce a par exchange rate, against Fed coin and regular US dollars. And that would have the benefit of eliminating

the exchange rate volatility. And then at the other extreme, you're asking at the other extreme, you could imagine the Fed just delegating the responsibility of clearing the Fed coin request using some third party like the Bitcoin miners at one extreme, or you can imagine some intermediate system, kind of like a ripple protocol.

I mean, the possibilities are endless. I mean, I don't know which would be the best way to do it. And one other possibility that would be the Fed could just buy PayPal and start using that with their central payment system. They've got a good system in place that's used by a lot of people, so why don't just do that now? Well, indeed, I mean, PayPal could actually, if the federal government would have to be careful, right? We don't want to confuse the Fed with the federal government. A lot of people make that mistake. Maybe we should be clear up front.

The Federal Reserve Bank of the United States is not the federal government. It's the central bank that was created out of an act of Congress in 1913. So what was the question? So the, I lost it there, sorry guys. I lost it in my... We were talking about PayPal. Oh yeah, I was saying PayPal. PayPal at present is, you know, they're prohibited from doing a lot of stuff, right?

I mean, if PayPal could, I suppose that they would be willing to offer kind of like a pseudonymous Swiss bank, you know, Swiss-style bank accounts, for example. Why couldn't you do something like that? I mean, they're prohibited from doing that. But I mean, you know, if, so a lot of this technology exists out there already, like PayPal could do all of this stuff. And it's just what's what's preventing them from doing it. it is the existing body of legislation, obviously.

Yeah, no, absolutely. I think this is very fascinating to think where this all can go. I think especially, and that's a direction that seems inevitable to me that there will be a lot of currencies competing with each other, with different features, different protocols. And that's going to be a very novel world, you know. I mean, well, like the Bitcoin, not Bitcoin, the ripple protocol is actually, they sell it as kind of more of a currency agnostic system. So one does have to make a distinction, I think, between the currency and actually the payment system, you know, how you actually affect payment.

So Bitcoin is both, of course. Bitcoin is both a money and a payment system. It has the currency unit. It manages a supply of the currency unit. And it is a protocol that affects transfers of value across accounts. Ripple is, Ripple can, you know, in principle, operate without its native currency, I think. I mean, it's more of a protocol designed to affect transfers of value that don't depend on the actual management of the supply of a native currency. I just think it's important to make a distinction between the creation and management of a money supply and the protocol in place for affecting transfers of the value across accounts.

Yeah, absolutely. No, no. We may have just a few or one, maybe even a way of transferring value, but then there might be all kinds of currencies on top of it. So this is probably going to be a difficult question for you, but I'm curious anyway. So we've been talking a lot about these sort of interesting scenarios for the future. And what do you think the probability is or the time frame that maybe the Federal Reserve

or some other central bank or government in the world will do something like that? Oh, so I think that, you know, the big players like the Federal Reserve, you know, the EMU, they're probably going to be relatively slow. I think where you're going to see the innovative attempts occur as kind of like smaller, smaller countries, smaller jurisdictions. And in fact, I think you're already kind of seeing that in some countries. I think I just mentioned Ecuador, for example. If I didn't read the article in depth,

but it sounded like in Ecuador, for example, what they're doing is issuing their own cryptocurrency with the property that it's going to be, evidently backed by the U.S. dollar. So you can kind of expect, I think, these types of innovations occur kind of at the fringes, these small countries. And these experiments will take place.

Economists and other people will observe the outcomes. And, you know, if something good comes out of it, if it becomes an obviously dominant sort of institutional arrangement, then at that point, of expect, you know, larger players to kind of develop kind of the best policies that have worked out well in these experiments. And at the same time, you can expect, though, it's not like the Fed or the big banks or the big money services businesses, you know, MasterCard, PayPal, you know, Western Union.

These agents, they're not standing still in time. They're continually innovating as well. And so it's not going to be clear how it's going to all happen. I think the only thing I'm really confident of is that the trend that we've seen so far in terms of the advancements in the payment system are going to continue in the future. And, you know, one thing that is, I think, instructive along this dimension for your listeners is to just think about, for those of you who are old enough, just think about how difficult it was to affect payments

even just in the 1970s. So I tell a story that when my mother took me to Italy in 1971, I was just a 10-year-old kid at the time, but I remember distinctly she had to go and get travelers' checks, right? We had to go to the local office. We had to find it through the yellow pages, not on the Internet. You had to go and drive and then you had to pay a fee to get these travelers checks. You had to take these travelers checks to Italy.

And then, you know, my uncle would, we'd have to find a local office for American Express. I mean, we'd have to drive 100 kilometers to get to that office. Maybe that office was open. Maybe it wasn't open. Then you'd pay another fee to kind of convert it into the Illera. And then, you know, you'd want to do a big chunk because you didn't want to be carrying a, do it all the time. And when I went to Frankfurt just earlier this year, I didn't take any cash. I flew there with my credit card. That was it. You know, so for people who are complaining about

how the payment system is working today, I got you. You know, I understand we all wish it kind of would work better. There's obviously, there's room for improvement. But we're, you know, don't just take a static view of it. I mean, we've come a long way. There's been a lot of innovation, lot of progression. And I think what we have to expect is that these innovations are going to continue into the future. Absolutely. I agree. And I mean, sorry, Brian, I agree. And I think that in the next 10, 20 years, we'll see the same sort of innovation in the payment system that we've seen in other sectors like biotech, like, you know, the content business. And that the financial sector is now going to see some radical changes and will be disrupted by these technologies.

Yeah, for sure. Yeah. And just to, you know, we were not talking about timeline here, but I just want to point out, David Johnston, a well-known Bitcoin angel investor, once came on this show and said that if a government isn't integrating blockchain technology within five to 10 years, not only will they be obsolete, but their currencies will be gone. So that's just something to perhaps end on and that say to say that we need to get a move on because we only have five to ten years to get this right I have to I have to caution everybody to I mean in the following sense I mean even in that sort of scenario which I don't think it's going to happen but I mean you know a lot a lot of this movement a significant component of this movement is kind of motivated by you know the libertarians

the ones who free themselves from the shackles of government, money manipulation. The one thing I want to caution people is that this is not going to, even if you eliminated government currencies, this is not going to be a solution to that problem of bad governments. I mean, governments can still tax. They could say, go ahead, go run your blockchain technology. Awesome. We're still going to tax you. In fact, we might even have to tax you more.

and that's just the way it's going to be. So I'd be, you know, careful in saying, for those people out there who think that somehow this movement to, you know, an apolitical currency unit is going to be the end of oppression, you know, it's not. Okay. Well, David, thanks so much for joining us today. It was really interesting talking to you,

and I think it's a super interesting topic. And yeah, I guess we'll have a few. years, maybe we can do another episode or maybe before that and see how things have progressed because I'm sure we'll see a lot of events in this area. It's going to be fun, yeah. It's going to be fun, yes. So is there some place you want to point, some place you want to point our listeners to, we'll link to your blog. Definitely in the show notes.

Is there some other resources or? Well, let's see. So I think Tim Swanson has an excellent blog. So, yeah, you know, so. We know him, yeah. I'm not an expert in cryptocurrencies or anything like that. I do blog about it once in a while. So I would say if your listeners are kind of interested to see a central banker's perspective

and how his views are evolving over time on the subject, I do intend to post something on this notion that we talked about about the possibility of fractional reserve banking in a Bitcoin-like world. And I'd be interested, if your listeners would like to go to my blog, I'd say just monitor my blog and I could potentially point them to feel free to email me as well, by the way. Okay, perfect. We'll do that.

We'll have links to all and also your talks we find in the show notes. So David, thanks so much for coming on. It was a big pleasure. Thank you very much. It was fun, yeah. Yeah. And thanks to a listener for listening. We release episodes of Bethlehend of Bitcoin every Monday.

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