Currency Stratification: Thoughts on Crypto, the U.S. Dollar, and Inflation

The concept of layered currencies is nothing new, and Nik Bhatia summarizes his thoughts on the topic in his book Layered Money. Essentially, our monetary system is built on multiple layers of money, and our central bank has a margin that guarantees government liabilities to the public. In other words, central banks issue money on the premise that we can redeem our deposits when we need them, and trust in the central bank’s ability to store the value of our currency, keep it fungible and use it around the world, and use reserves to Support it (most likely not in practice, since money is basically created out of thin air).

The ability of governments to create money often gets us into trouble: the so-called currency devaluation. Every time a currency is issued, its value becomes lower. The more money is printed, the less the currency is worth, the price goes up, and more money is printed, creating a vicious circle.

Currency Stratification: Thoughts on Crypto, the U.S. Dollar, and Inflation

From “Layered Money” by Nik Bhatia

The dollar and the Bretton Woods system

It also has a fair share of the burden as the world’s reserve currency. This is probably the main reason why the U.S. runs a deficit, our currency is always in demand, and its long-term stability makes it central to any trade, transaction, and reserve currency status. How did this come to be, and why hasn’t it changed?

Currency Stratification: Thoughts on Crypto, the U.S. Dollar, and Inflation

The Bretton Woods Agreement of 1944, for the history of monetary policy, see Lords of Finance

The short answer is the monetary system that emerged after World War II. A longer explanation comes from the study of human trading history. In order to save the long descriptions of the past dealings with coins, gems, and shells (which, while very interesting, can take up a lot of space), let’s move on from the abolition of the gold standard.

After World War II, national currencies were tied to the standardized weight of gold for a number of reasons, but there were variables. The U.S. dollar remains at $35 per ounce of gold, and all other international currencies are pegged to the U.S. dollar. After America abandoned the gold standard like other countries, it was too late. Too long has passed and the world needs dollars. But the Fed prints only enough dollars for domestic use, which has led to what Bhatia calls “offshore” dollars—creating dollars outside the Fed’s jurisdiction. This could take the form of a private line of credit issued in U.S. dollars, or in the case of emergency repo facilities and other similar instruments. In short, the dollar’s status as a reserve currency isn’t going away for a long time. The global financial system will always need dollars.

Repurchase Agreement (Repo) and Loan Facility

When other countries need dollars, they can meet that demand through repurchase agreements (Repo) or other lending facilities. A repurchase agreement is when a bank that holds U.S. Treasuries gives them as collateral to another bank, which in turn provides liquidity (cash) to that bank. The banks then return those funds with a nominal interest rate attached (this is where the federal funds rate and the London Interbank Offered Rate (LIBOR) relate), and get their collateral back. Other forms of loan instruments can be unsecured (ie, require no collateral). Finally, money market funds (MMFs) are a group of highly liquid securities with a net asset value (NAV, or par value) of $1 per share. These exist because the dollar has done some incredible things over time and it has maintained its reserve status. The U.S. dollar continues this status by serving as the liquidity king.

Because of the pandemic-related shocks, the Federal Reserve implemented so-called QE. In this case, the Fed buys Treasuries to provide liquidity to banks that need it – which increases the money supply. Right now, we’re entering a “tightening” phase where once the cash is returned to the Fed, the Fed will burn the cash instead of using it to buy more Treasuries.

Inflation, shocks and counterparty risk

More and more people are aware of widespread and persistent inflation. How did we get here? The ability of modern monetary policy to control inflation seems very limited: to really control inflation, the Fed needs to raise interest rates and implement austerity measures that will hurt everyone. And for our policymakers, who are more worried about elections than what will happen 10 years from now, it’s easier to expand the money supply than to shrink it. Is the dollar a store of value when Treasury yields are significantly below inflation? If U.S. Treasuries sit alongside gold at the top of the monetary pyramid, securing the value of the dollar, the combination of a weaker dollar, rising inflation, and low yields relative to inflation will almost certainly lead to a deterioration in value, at least in theory .

During turbulent times, the Fed relies on quantitative easing (QE) to keep the economy running smoothly. In quantitative easing, the Fed buys Treasuries from banks, leaving cash on hand. The cash was used to pay for any urgent expenses. That’s why people say that quantitative easing is like printing money. The Fed is simply pumping cash into the system and, at already very low interest rates, continues to expand the supply.

Finally, a few thoughts on counterparty risk. Our financial system is deeply intertwined, from CLOs, CDOs, CBOs, to the basic forms of loans and swaps — the system is entwined. That’s why our system is so fragile that it only takes one big risk to sink the entire system.

Worse yet, we don’t seem to allow things to just fall by the wayside: “too big to fail” only shows the private sector that at worst the taxpayer will help!

Bhatia’s prediction for bitcoin

Bhatia’s wonderful book very elegantly outlines the hierarchy of money: at the top of the pyramid are gold and U.S. Treasuries. He further noted that bitcoin (which was intentionally designed to be gold) could take the place of gold, or, if the U.S. Treasury was at the top of this pyramid, banks would be able to issue new forms of money backed by bitcoin itself.

Bitcoin and gold share some characteristics, which Bhatia and other authors have aptly pointed out. There are currently more bitcoins in circulation than the potential future mint or mine – meaning inflation and devaluation are impossible. Similar to the situation where the vast majority of the world’s gold supply is higher than its future supply. Scholars refer to this difficult-to-issue or create currency as “hard money.” Finally, and at the heart of the crypto world: gold does not have a central issuer. Bitcoin also does not have a central issuer, it is decentralized and can be mined by anyone. This means that bitcoin is resistant to inflation and puts aside any concerns about devaluation.

Posted by:CoinYuppie,Reprinted with attribution to:
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