The government’s hand in the rise and fall of crypto

She further added: “Cryptocurrencies are by definition borderless and require international collaboration to prevent regulatory arbitrage. Therefore, any legislation for regulation or for banning can be effective only after significant international collaboration."

The RBI is not the first central bank to have had doubts about cryptos and the Indian government isn’t the first government. Both the Chinese and the Russian governments have also cracked down on crypto. So, what’s it that makes many central banks and governments dislike crypto? In this piece, we will try and understand this.

But first, we need to understand how governments and central banks had a very important role to play in making crypto popular.

Before September 2008

Central banks run the monetary policy of a country with an aim to maintain low inflation and a stable growth environment where low unemployment prevails. Typically, up until 2008, they used to do this by trying to set the short-term interest rates.

In mid-September 2008, Lehman Brothers, the fourth largest investment bank on Wall Street at that point, declared bankruptcy. AIG, the largest insurance company in the world, was also on the verge of going bust. Many other financial institutions were in trouble. If these financial institutions were allowed to fail, the global economy would have ended up in turmoil.

In order to stabilize the financial system and to prevent an economic depression, the Federal Reserve —the American central bank—printed money and bought bonds worth $600 billion from many financial institutions.

This came to be referred to as quantitative easing and was seen as an act of stabilizing the financial system, after the real estate bubble, running since the turn of the century, burst. Many financial institutions had taken on heavy leverage to bet on this bubble in different ways and thus, they ended up in trouble.

In November 2010, the Federal Reserve decided to start a second round of quantitative easing. By this time, the financial institutions had more or less stabilized. So why did the Fed decide to print money and buy bonds? Up until then, the Fed had operated by trying to control the short-term interest rates. Now, it wanted to drive down long-term interest rates by printing money.

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

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

Other than driving down interest rates, there was another thing that this move hoped to achieve. Investors typically looked at long-term government bonds, referred to as treasuries, as a safe haven. It’s the kind of investment you make and forget about. But with the Federal Reserve buying up treasuries for months at end, very regularly, there was a shortage of these bonds going around. Leonard writes: “The Fed was buying the long-term [bonds] because doing so was like closing the one safe deposit box where Wall Street investors could stash money."

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

The Fed continued with quantitative easing well into 2014. In the process, they made what was supposed to be an emergency measure, a regular one. At the same time, other problems grew. “The real problem lay outside the banking system, in the real economy where the deep problems were festering, problems that the Fed had no power to fix," Leonard writes.

What happened next?

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

In fact, Hoenig explained the risks of open-ended quantitative easing to Bernanke. As Leonard writes: “Hoenig said the program could “unanchor" inflation expectations. This was different than saying it would cause inflation. He was warning that companies and financial speculators would start anticipating higher inflation in the future thanks to the inflow of new money, and they would start to invest accordingly."

What Hoenig was saying is that with so much money being printed and pumped into the financial system, investors would start to believe that sooner or later, high inflation would set in. In order to protect themselves from high inflation, investors would want to generate increasingly high returns and make riskier investments in the process.

This is precisely what happened. The search for higher returns drove investors to invest into all kinds of asset classes— from commercial real estate to oil to stocks and riskier bonds of less developed countries (read Sri Lanka). They also ended up investing in bitcoin and other cryptos.

The first block of bitcoin, referred to as the genesis block, was mined in January 2009. Nonetheless, it was only post 2012, when the Federal Reserve had run the quantitative easing programme for a while, that buying bitcoin started to become popular, first among the nerds and then among the average retail investors. The idea was that unlike the government backed fiat money which a central bank could keep printing and keep creating out of thin air, only a limited number of bitcoin could be created. This logic caught the fascination of people and they started buying bitcoin. In that sense, bitcoin became digital gold for many youngsters.

Hence, the behaviour of the government backed central banking system led to the popularity of cryptos in general and bitcoin in particular. This popularity peaked in November last year and things have gone downhill since then with prices crashing, which has led to several other problems as well.

Govt’s dislike for cryptos

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

The governments did not always have the full-right to create money out of thin air. Up until 1913, before the start of the First World War, many countries were on the classical gold standard. Every currency unit was worth a certain amount of gold and it could be exchanged for gold.

In this scenario, the governments couldn’t create money out of thin air by printing it because people could exchange that money for gold. And the governments ran the risk of running out of gold. Many countries suspended the classical gold standard to be able to print money to fund the expenditure required in order to fight the First World War.

After the War ended, countries went back to the gold standard, and being on the gold standard meant that governments needed to maintain a tight economic ship. They could not manipulate the money system to make things easier for the common man. The gold standard did not allow them to do that. They simply couldn’t print money to drive down interest rates.

As Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: “The First World War and the Great Depression created great dislocation and unemployment … Workers, many of whom had become politically aware in the trenches of World War I, organized to demand for some form of protection against economic adversity. But the reaction really set in during the Great Depression, when they were joined in country after country by others who had lost out– farmers, investors, war veterans, the elderly."

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

The US dollar was at the heart of the financial system that emerged post the Second World War. In this system, only the US could convert dollars into gold. This allowed the dollar to be at the heart of the global financial and trading system. Every other currency was a fiat currency and the government could create this money out of thin air.

Rajan and Zingales further write: “The gold standard … imposed tight budgetary discipline on governments, which made it difficult for them to intervene much in economic affairs … Politicians had to respond, but such a large demand for protection could not be satisfied within the tight constraints imposed by the gold standard. Hence, the world abandoned the straitjacket of the gold standard … With their ability to turn on or turn off finance, governments obtained extraordinary power."

The governments and central banks have used this extraordinary power over the years to run easy money policies whenever the economy is in trouble. This is something that happened post 2008 and in early 2020, when the covid pandemic broke out and central banks printed money to drive down interest rates.

Legitimizing cryptos would mean sharing the power to create money out of thin air with private enterprises and private individuals, something that many governments don’t like. People in the business of selling cryptos obviously understand this and hence, many are happy for crypto to be categorized as an investment asset. But even that does not solve the problems that central banks have.

What about the RBI?

The RBI has made its displeasure towards cryptos more than clear, over and over again. In fact, in the latest edition of the Financial Stability Report (FSR), published June-end, it offered several reasons for the same.

First, “anything that derives value based on make believe, without any underlying, is just speculation under a sophisticated name." Second, “cryptocurrencies, typically created on decentralised systems, are designed to bypass the financial system and all its controls, including Anti Money Laundering (AML)/Combatting the Financial Terrorism (CFT) and Know Your Customer (KYC) regulations."

It is worth mentioning here that India does not have full capital account convertibility and only a limited amount of money can be moved out of the country in any given year. As the RBI put it in the FSR: “For developing economies, cryptocurrencies can erode capital account regulation, which can weaken exchange rate management."

Cryptos allow individuals with enough technical finesse or the ability to pay for such expertise, to get around limited capital account convertibility. Of course, cryptos can and are used for money laundering and other illegal things.

Third, “historically, private currencies have resulted in instability over time… as they create parallel currency system(s), which can undermine sovereign control over money supply, interest rates and macroeconomic stability." This is the RBI’s and many other central banks’ major fear.

Fourth, cryptos “are characterised by highly volatile prices" and this can create its own set of problems along with the “increased use of leverage in investment strategies; concentration risk of trading platforms; and opacity and lack of regulatory oversight of the sector."

Given these reasons, it is hardly surprising that the central bank has been highly vociferous in opposing cryptos.

To conclude, the legitimacy that cryptos ended up with, was perhaps an unintended consequence of the quantitative easing programme run by the Federal Reserve in particular and other rich world central banks in general. And that has ended up creating problems for governments and central banks all over the world. Of course, if crypto prices fall further from current levels, this is a problem that will solve itself. Perhaps, the central government and the RBI are hoping for just that.

Vivek Kaul is the author of Bad Money.