Congressional Research Service Misinterprets Monetary History

Last month, the Congressional Research Service released a report on Bitcoin analyzing the structure of the network and its implications, if any, on monetary policy. The report was impressive in its accuracy describing Bitcoin’s technical aspects. The report correctly states how the network’s transactions are “pseudononymous” rather than anonymous due to Bitcoin’s use of a “public ledger,” known as the “blockchain,” which publishes all transactions using bitcoins. The report also describes how bitcoins are creating through what is known as “mining.” While the report accurately describes the infrastructure of the Bitcoin network, its criticisms were somewhat lacking.

One key criticism against the network was its deflationary nature. Bitcoin is design to have a fixed supply of total bitcoins (21 million BTC), and as demand for bitcoins increases so will their individual values. This increase in the value of the currency will result in falling prices, relative to the Bitcoin currency in question. The argument is that this will result in hoarding, as people wait for lower prices instead of spending bitcoins now.

It should be noted that deflation is not necessarily a bad aspect of bitcoin’s structure, especially since the report itself notes that a key benefit of Bitcoin is its ability to circumvent dollar inflation. The Friedman Rule was a rule designed by economist Milton Friedman which utilized a built-in deflationary slant to guide Federal Reserve monetary policy.

Within the section on Bitcoin’s deflationary nature was the following passage:

The perils of an inelastic currency were evident, for a period from about 1880 to 1914, when the United States monetary system operated under a gold standard. At this time the deflationary bias of an inelastic supply of gold led to elevated real interest rates, caused periodic banking panics, and produced increased instability of output. The Federal Reserve was created in 1913 to provide an elastic currency.

This time frame, known collectively as the Gilded and Progressive Eras, had two key “panics” (now known as recessions), the Panic of 1893 and the Panic of 1907. In A Monetary History of the United States, 1867-1960, authors Milton Friedman and Anna Jacobson Schwartz discussed these two panics in greater detail.

They explain how the Panic of 1893 had less to do with an inelastic currency, and more with a movement leading up to the crash that wanted Congress to change the currency from a gold-based valuation to a dual currency system based on both gold and silver. Rumors were only substantiated by a bill passed in the Senate in 1892 which proposed such a change in the currency. As Friedman and Schwartz explain, “the commercial failure of a stock market favorite in May 1893, after months of depressed stock market prices, touched off the panic for which the stage had been set by the general uneasiness about the currency” (page 107).

Bitcoin could itself come to ruin if there was a crises in confidence with the currency. However, this is no different from any other currency. Rather, because Bitcoin encourages a competition in money, as evidenced by its open source coding, it should be less vulnerable to such confidence shocks.

The Panic of 1907 had different factors, but essentially also tied into federal interference with the monetary system. Leslie M. Shaw, Treasury Secretary at the time, “manifest[ed] his central-banking proclivities,” according to Friedman and Schwartz (page 154). He would attempt to ease or tighten markets at times that were against the traditional behavior of the Treasury.

Shaw’s activities coincided with a public that was shifting from deposits to cash. This resulted in a rising ratio of deposits. According to Friedman and Schwartz, the public shift to cash “may well have been partly the result of the increased adoption by the Treasury of responsibility for money market conditions, which reduced the incentives of banks to keep reserves for themselves” (page 165). Since banks used a fractional reserve system, they ended up owing more money to depositors than they could afford to pay out. Thus, it was the combination of a gold standard with a fractional reserve banking system that caused the Panic.

Bitcoin, however, is not current part of a fractional reserve system, its consumers and producers interact directly, or “peer-to-peer” according to the CRS report. The criticism of Bitcoin as a deflationary currency overlooks that the network does not rely on a centralized third-party such as a bank or treasury department. The causes of past disruptions in the monetary sector are not present in the Bitcoin system. Until authorities understand the structures of decentralized networks their critiques will continue to fall short.

To reiterate, the Congressional Research Service does a great job overall in analyzing the Bitcoin network. They have an excellent understanding of its infrastructure, and they highlight the key interactions between Bitcoin at the current regulatory structure. The section on deflation is merely flawed in its historical analysis, and an underlying disagreement over how monetary policy should be structured. Despite this one section, the rest of the report remains a useful guide to understanding  how Bitcoin works and the policy implications of its existence.