By Michael Kendall Man on the Margin January 12, 2018
In Part I, I examined Wright’s monetary views expressed in The illusion of scale in segregated witness. It is a rehash of Friedman’s failed monetarism experiment of the 70s, with fixed money supply instead of constant supply. Monetarism without an increase in supply distorts the entire basis for the theory, but Wright gets around it by theorizing that money velocity will increase linearly along with the value of the cryptocurrency.
Monetary theory, traditionally, distills down to how a currency issuer adjusts the supply of currency to meet demand without inflation or deflation. Currency issuers use a target that determines when to increase or decrease supply. In the global economy from 1694 to 1971, the target under a gold standard was a parity price with gold. Supply was adjusted to maintain currency at a defined weight of gold.
After the breakdown of Bretton Woods, the Fed discarded gold as a target. In a continuous series of failures, the Fed transitioned its target to Friedman’s monetary aggregates, the funds rate, QE, and the current defined increase in inflation. (The Fed defines inflation by tortured, hedonic adjusted, hindsight data that excludes a monetary standard as a base reference. The definition of inflation, which is the same as deflation, is a decline in the monetary standard.) As I write, Fed officials are teeing up a rule-based NGDP target as the next experiment in monetary failure. The result of post Bretton Woods monetary error is that the dollar has lost 97 percent of its value. Wage earners, savers, and pensioners bear the brunt of this chaos.
Along comes cryptocurrency. Despite its blockchain, Merkle trees, nonces, nodes, hard and soft forks, and cryptography, it is still a currency. The historical, trial-and-error process that advanced mankind’s knowledge of stable money is not suddenly negated. There is no currency in the world whose supply is fixed nor any discussion of fixed supply currency in the history of economics. It is axiomatic that currency must expand along with the expansion of the economy it supports. If it doesn’t it will become increasingly deflationary, with each unit continuously gaining in value. A deflationary currency is as unreliable a unit of account as an inflationary fiat currency. Wright recognizes that bitcoin is deflationary, but he believes that every other money, including gold, is inflationary.
Wright’s view of money appears to derive from his misunderstanding of gold and gold standards. At the 2017 Future of Bitcoin Conference, Wright describes how he views the monetary role of bitcoin as it relates to gold. Wright states:
What we have now is a system that changes everything. Our new genesis is the creation of the first ever hard money. The first money that allows for freedom. Gold was never hard, because we never had it. When Nixon took America off the gold exchange standard, which wasn’t a gold standard, do you know how much of that gold was actually there? Around 5% so they didn’t actually have the gold that they were backing their currency with.
Wright further theorizes that “gold has been flooded” causing it to be inflationary. He references the influx of gold and silver from the Spanish conquest of the Americas in the 1500s as the cause of an inflationary collapse of the Spanish empire.
Wright’s view is that 100% gold must back a gold standard. This is the most prevalent gold standard fallacy that I debunk in Gold Standard Fallacies. Japan linked the yen to gold, via the dollar during Bretton Woods, while holding virtually no gold reserves. But according to Wright even if 100% gold backed a gold standard, it wouldn’t matter because a brief influx of gold in Spain over several decades in the 1500s permanently altered gold’s stability as a monetary standard.
This is complete nonsense. The Americas gold production was a mere blip in the thousands year history of gold’s stability of value. (Silver production increased 10 fold over this period while gold production only increased 50%.) The decline of the Spanish empire followed the template for the decline of all empires throughout history; ever-increasing taxes, regular currency devaluations, and increasing payoffs to political cronies and welfare handouts to maintain support for unpopular government. Sound familiar? It had nothing to do with a brief, irrelevant transfer of gold from one continent to another. Spain remains a laggard today for the same reasons.
To achieve his monetary view, Wright has to ignore the 300 year history of the gold standard era. Roy Jastram, for his book The Golden Constant, spent a decade in England reconstructing price indices going back to the 16th century in England and to the 18th century in the U.S. His data showed that though prices of a basket of goods will diverge over periods of time, they always come back into relationship with gold. Jastram termed this “the retrieval phenomenon”. It demonstrated that on a gold standard, prices remain stable, even over centuries, without inflation or deflation.
There is a reason there has never been a 100% gold standard. It will not work. If it would work, the world would have evolved to a 100% gold standard. Instead, it evolved to the gold standard successfully implemented by Great Britain that is not based on the quantity of gold but rather on its stability of value. It is not possible to maintain a 100% gold reserve system beyond a small, irrelevant sovereign state. The Bank of Amsterdam, founded in 1609, is the only recorded attempt at a 100% reserve system. It was initially conceived as a “100% reserve” deposit bank, but this experiment was relatively short. By the end of the second decade, the Bank of Amsterdam had outstanding loans of 2.1 million guilders and bullion reserves of 1.6 million guilders. What the Bank of Amsterdam’s brief experiment proved was that interest rates could be lowered under the stability of gold. The Bank of England developed its successful gold standard based on this knowledge and exported its template to the rest of the world for a 300 year run.
Wright’s monetary view in its practical application to cryptocurrency is seriously flawed and unworkable. The current experiment in cryptocurrency is great for short-term speculation but completely unpractical as a functional currency. When stripped of its obtuse technological patina, cryptocurrency gets laid bare as an experiment in fixed supply currency. A fixed supply currency does not suddenly become viable because decentralization and technology define it. The world moves forward not backward. For obvious reasons no fixed supply currency has ever existed. It is easy to see that Wright’s initial cryptocurrency experiment will have a short life. Warren Buffett may not know anything about cryptocurrency, or pretends that he knows nothing, but his instinct is correct when he states,
In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending.
Regardless of its current flawed design, the blockchain still provides the promise for a future disruptive, decentralized, viable cryptocurrency.