What are the lessons from history for digital currency?

Experiences from the past suggest that digital currencies – such as Bitcoin, Tether and Dogecoin – will eventually be regulated or monopolised by central banks.

A short time after the tumultuous events of the global financial crisis of 2007-09, Satoshi Nakamoto, a pseudonymous individual or group, published a white paper introducing Bitcoin to the world.

In a 2009 blog post, Satoshi Nakamoto used history to justify the creation of Bitcoin: ‘The root problem with conventional currency is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.’

In this article, we use the lens of history to understand how digital currencies such as Bitcoin might evolve in the future and whether central banks can be trusted.

Have there been innovations in money before?

The history of money is one of innovation (Bordo, 2021). Within the past 400 years in the UK, we have seen a transition from using gold and silver coins, to using bank notes and deposits redeemable for silver and gold, to having central bank currency redeemable for gold and silver, and finally to having fiat money – government-issued currency that isn’t backed by a commodity like gold.

This process had happened by 1931. Subsequently, the automated teller machine (ATM) was introduced into the UK in 1967 when comedy actor Reg Varney became the first person to withdraw cash from one (Barclays, 2017).

Then, there was the advent of credit and debit cards in 1966 and 1987 respectively. Internet banking was introduced into the UK in 1997, chip-and-pin cards in 2003, and contactless cards in 2007. PayPal launched in the UK in 2003. These innovations resulted in less cash being used and in 2017, debit cards overtook cash as the most common means of payment in the UK.

As Figure 1 shows, cash was only used in 17% of the 35.5 billion payments made in the UK in 2020. Thus, in many senses, we already have digital money. So, the question is how big a deal is the innovation of digital currencies like Bitcoin? Is it just hype? Or is digital currency going to give us faster, safer and more efficient means of payment, which can be accessed by those who are excluded from traditional banking systems?

Figure 1: Share of total payment volumes in the UK (excluding CHAPS), 2020

Source: UK Finance, 2021

What gives money value?

History sheds light on the importance of what economists call the last period problem with money (Thompson and Hickson, 2000). In other words: in the final transaction, what gives money value? Gold and silver had value as money because they have value as jewellery and ornamentation and have useful industrial properties. Gold and silver were also scarce commodities.

Paper money issued by banks or central banks in the past had value because it was convertible into gold or silver. Fiat money has value because governments require future taxes to be paid with it. Bank deposits have value because they are convertible into fiat money. So, what gives digital money value?

Cryptocurrencies such as Bitcoin are not convertible into anything. Bitcoin advocates suggest that the upper limit of 21 million Bitcoins makes it the digital equivalent of gold. But unlike Bitcoin, gold has use value outside its role as money (Prasad, 2021).

The history of money raises an existential question about the value of cryptocurrencies. They may have value as a means of engaging in nefarious activities and criminals evading authorities and anti-money laundering and know-your-customer regulations (Gerard, 2017; Silverman, 2021). Alternatively, cryptocurrencies have been viewed as decentralised Ponzi schemes or chain letters being driven by cult-like enthusiasts and opportunists (Koning, 2021; Kelly, 2021).

Stablecoins, such as Tether or USD Coin, on the other hand, have value because they are convertible one for one into US dollars or a basket of currencies. This makes most stablecoins akin to bank money.

But there are questions about the reserves of stablecoins. Tether, in particular, has come under scrutiny because it has been obfuscating about the types and amount of reserves that it holds (McKenzie, 2019). Instead of holding cash and near-cash instruments, Tether has been holding receivables and commercial paper. Consequently, in the event of difficulties in the money market and a run on its coins, Tether may not have enough reserves to redeem all its coins.

Why do governments control money?

History also reveals that governments control money. For example, they have typically had a monopoly over the minting of coinage – although there have been some exceptions such as private mints during gold rushes in the United States in the years 1830-63 (White, 2021).

Private banks in most economies up until the early 20^th century issued their own notes. In other words, there have been numerous historical episodes where banks issued private currency. But central banks, beginning with the Bank of England, were given monopoly privileges from their founding and eventually evolved to have a complete monopoly of the currency issue.

There are various explanations why governments have controlled the currency and established central banks across time and space. The first explanation is a fiscal reason – governments control money because they earn seigniorage revenue on a continuing basis from issuing currency (Selgin and White, 1999). This is the profit made from generating currency – that is, the difference between the value of the money and the costs of producing it.

The second explanation, which is related to the first, is that governments control money so that they have access to emergency war finance. For example, the Bank of England was established in the late 17^th century to help to finance wars against France, and it played a major role in financing the Napoleonic wars and those of the 20^th century.

This original military emergency rationale for government control of money has weakened over time because of the nuclear umbrella and military technology, as well as the fiscal capacity of the modern state (Glasner, 1989; Eichengreen, 2019). But governments still need access to emergency funds to cope with natural disasters and global pandemics.

The third explanation, and the one most commonly accepted among economists, is that the banking system is inherently unstable, and this instability has such severe consequences for the economy that currency production cannot be left to competing private institutions (Goodhart, 1988; Eichengreen, 2019; Gorton and Zhang, 2021).

No matter which of these explanations is the correct one, they all still apply today. This has major implications for the future of cryptocurrencies. Governments have two choices. The first is that they regulate cryptocurrencies by imposing capital and liquidity requirements on them (President’s Working Group on Financial Markets, 2021). In particular, the chief lesson from private money issuance in the 19^th century is that stablecoins need to be regulated as banks (Gorton and Zhang, 2021).

The second choice and the one that is gathering a lot of momentum is that central banks produce their own digital currency (a ‘central bank digital currency’ or CBDC), and thus develop a monopoly of digital currency just as they did with coins and then notes. Indeed, for some, the chief lesson of history is that currency issuance tends eventually to be concentrated in the hands of governments or their central banks (Eichengreen, 2019).

Figure 2: UK consumer price index UK, 1209-2016

Source: Bank of England

Can we trust central banks?

One of the reasons why Satoshi Nakamoto created Bitcoin was the belief that governments and central banks cannot be trusted to refrain from debasing the currency. The etymology of the word debase refers to base metals being added to gold and silver coins to lower their intrinsic value but not their face value. Famously, Henry VIII debased the currency to help raise finance (Deng, 2011). Under a fiat money regime, it is relatively easy for a central bank to issue more currency than is demanded, with the result that money loses it purchasing power.

Figure 2 illustrates that inflation only took off in the UK after the introduction of a fiat currency in 1931, and really accelerated after the 1971 termination of the Bretton Woods system, which effectively tied sterling to the dollar and the dollar to gold. To purchase the same quantity of goods that £1 would have bought in 1971 would take about £14.50 today. But this masks the fact that most of the debasement of the past 50 years happened in the 1970s and 1980s.

Since then, central banks around the world have gained greater independence from governments and have been given inflation targets. These policy changes have helped to tame runaway inflation in most industrialised economies.

So, can central banks be trusted with CBDCs not to debase the currency? The lesson of history is that governments can commit to not debasing, but the credibility of such commitments depends on the stability of the democratic political constitutions that underpin them.

Where can I find out more?

A brief history of the ATM: Bernardo Bátiz-Lazo gives a brief history of the ATM.
Crypto glossary: An A-to-Z glossary on all things crypto from the Financial Times.
What are cryptoassets (cryptocurrencies)?: The Bank of England’s guide to cryptocurrency.
What is money?: A brief history of money by the Bank of England.
Central bank digital currency in an historical perspective: Michael Bordo examines central bank digital currencies in the light of monetary history.
Central bank digital currency – consideration, projects, outlook: A VoxEU overview of the issues surrounding CBDCs.
Digital and crypto currencies: A virtual panel discussion at the Griswold Center for Economic Policy Studies.