Central banks were largely responsible for the 2008 financial crisis through their policymaking. In response, Bitcoin (BTCUSD) was created as a decentralized system with peer-to-peer technology to potentially prevent future crises by removing the central authority in charge of decisions. However, there are several drawbacks to using cryptocurrency that make a case for decentralization difficult.
It is crucial to understand the purpose of central banks before investigating how Bitcoin might change them. Central bank policymaking supports the global financial system. Each country’s central bank has different responsibilities; for example, while the Federal Reserve in America focuses on controlling inflation and maintaining full employment, the Bank of England creates stability and solvency within United Kingdom’s financial system.
The mandates of central banks are achieved using a variety of strategies known as monetary policy. However, the most significant aspect is that they influence money creation and interest rates. For example, a central bank may boost or reduce the amount of money in circulation in an economy. More money in an economy equates to more consumer spending, which leads to economic expansion. The scenario where there is less money in an economy translates to one in which consumers spend less, resulting in a recession.
The actions of a central bank have an impact on imports, exports, and foreign investment. High interest rates might dissuade foreign investors from investing in real estate because they are more expensive. Low interest rates, on the other hand, can be beneficial to real estate development by encouraging investment.
Central banks act as the foundation of an financial infrastructure that comprises of banks and other institutions. In other words, they play a pivotal role in distributing money throughout an economic system. Consequently, central bank policymaking can lead to either positive or negative outcomes for an economy as a whole.
Advantages and drawbacks of having a central agency handle an economy’s operation are both numerous. The most significant advantage is that it boosts confidence in the system. A trusted authority backs a central bank-issued currency, which may be traded at a global price. If each participant in a monetary transaction created its own coins, there would be rivalry among the currencies, and things would go horribly wrong.
Prior to the creation of the Federal Reserve, a similar problem already existed. Non-bank issuers such as merchants and municipal governments flooded the monetary system with money. Exchange rates for many of these currencies differed, and many were frauds that didn’t have enough gold reserves to back them up. Bank runs and panics shook the US economy on a regular basis.
The National Currency Act of 1863 and the National Bank Act of 1864 were passed shortly after the Civil War, and helped establish a centralized system of money controlled by the government.
In the mid-nineteenth century, just before the Civil War began in 1861, a single nationwide banknote that was acceptable at face value in commercial areas throughout the nation was created. In addition to this, the formation of the Federal Reserve in 1913 brought monetary and financial stability to the economy.
The central agency described above puts too much trust in its decisions and responsibility. Its improper monetary policy measures have caused debilitating recessions.
According to former Fed Chairman Ben Bernanke, the Great Depression, which was the most severe economic downturn in the history of the United States, was caused by mismanaged economic policy and a string of poor decisions made by local Federal Reserve banks.
The Federal Reserve’s slackening of the economy and policy of loose interest rates led to both the Financial Crisis and Great Recession of 2008.
Central banks’ responsibilities in an economy have also become more complex as a result of the financial architecture’s complexity. The velocity of money circulation throughout the global economy has increased as currency becomes digital. Financial transactions and products have grown increasingly abstract and difficult to grasp.
The 2008 Great Recession is a perfect example of this complexity. If you were to research the root cause of the recession, you would find that it was due to exotic derivative trading. To put it simply, banks sold products (housing loans) to buyers who thought they were insolvent borrowers. These trades seemed profitable at first glance, so other buyers bought them as well. Unknowingly, these tranches continued being sold around the world until everything came crashing down.
The whole financial system was profitable. You’ve got to get up and dance as long as the music is playing. We are now still dancing; Citigroup CEO Chuck Prince notoriously stated to journalists, We’re still dancing.
All of these transactions were covered by the Federal Reserve’s reserves.
Because of globalization, policymaking choices (and blunders) by one central bank may be transmitted to numerous nations. The worldwide stock market swoon that followed the Great Recession’s spread from the United States to other economies in a matter of weeks, eventually triggering a global downturn.
The need for a decentralized, global currency that was immune to the machinations of governments and banks provided the inspiration for Bitcoin’s creation.
On the basis of both economics and technology, the case for Bitcoin as a rival to central banks is strong. Satoshi Nakamoto, Bitcoin’s creator, defined it as “a peer-to-peer variant of electronic cash that enables direct payments from one party to another without the need for a financial institution.”
Bitcoin solves three problems that are found in most central financial systems:
Using Bitcoin gets rid of the typical spending dilemma. Each individual bitcoin is one-of-a-kind and kept safe using cryptography, which means it can’t be hacked or reproduced. So you’ll never have to worry about somebody else already spending your bitcoins or making fake ones.
Although Bitcoin’s network is decentralized, it is still a trustworthy system. In this instance, trust is an algorithmic construct. before Transactions on Bitcoin’s network can be approved and included in its ledger, they have to be vetted by nodes located around the world. Even if only one node disagrees with a transaction, that will make it ineligible for inclusion in the ledger.
Third, because Bitcoin’s network automates the production and distribution of money, it eliminates the need for a centralized infrastructure. Anyone with a full node can produce bitcoin at home. Intermediaries are not required for peer-to-peer transactions on the Bitcoin blockchain. As a result, a network of banks regulated by a central authority is not needed to transfer bitcoin across borders.
However, Bitcoin’s economic freedom is accompanied with several drawbacks:
One common objection to Bitcoin is that it’s not used for many legitimate transactions.
The cryptocurrency has gained notoriety for being a favorite among criminals and as an instrument for speculation.
Second, because Bitcoin is a legal means of transmission, it remains unclear whether or not it is legal. El Salvador has recognized bitcoin as money, but that’s the only nation to allow it for transactions. Other countries around the world, including the United States and China, have banned Bitcoin’s infrastructure and users.
Last but not least, Bitcoin is unpredictable and restricted in terms of supply. There will only be 21 million bitcoin generated at any one point in time. The number of bitcoin that may be created is limited. Its scarcity has also made it a desirable investment. Because its price fluctuates between extremes, making it hard to use in day-to-day transactions, cryptocurrencies are considered an attractive store of value.
Despite Bitcoin’s setbacks, many central banks are adopting characteristics of the cryptocurrency to design their own digital currencies. These Central bank digital currencies (CBDCs) have the potential to remove retail banks as intermediaries and will use cryptography for security purposes. Additionally, CBDCs may be less expensive than metal coins.
In today’s financial system, central banks are in command. The majority of nations across the globe rely on central banks to regulate their economies. While it has several benefits, this centralized form of organization grants too much power to a single entity, resulting in severe economic downturns.
Bitcoin’s technology is based on algorithmic trust, and its decentralized structure offers an alternative to the current system. However, despite its small use rates, the currency has a lot of uncertainty surrounding it. Central banks have incorporated elements of Bitcoin’s architecture and technology into their research into a digital currency created by central banks.
Many experts believe that it’s quite likely central banks will soon begin to create and circulate their own digital currencies (CBDCs). As of 2021, various countries are exploring CBDC possibilities, planning pilot programs, and some are preparing to launch their official CBDC. The Central Bank of Venezuela plans to release its SMS-based CBDC in October 2021.