Varoufakis and bitcoin maximalism

"Don't repay loans with more loans."

The very outspoken, Internetty, telegenic Yanis Varoufakis, who kind of ran the Greek financial system for awhile, not with any great success or even a good theory, but at least pissing off most of the right people, is not a fan of this “crypto” stuff. Apparently it is not fashionable enough for him, or something. Varoufakis is very fashionable.

But what caught my eye was a remarkable description of the Austrian credit cycle from a non-Austrian neoliberal economist. There is a kind of Archeopteryx quality here—our charismatic professor is not an Austrian; he is a believer in conventional 20th century banking and finance; he is at least hoffähig in the highest institutional circle… but from where he is, he can see it. So maybe we can get him all the way.

Here is Varoufakis’ interesting quote—which comes very close to understanding the basic realization of the Austrian school, that any supply of money is adequate.

The Gold Standard is, indeed, a great source of insight into how dangerously primitive Bitcoin maximalist thinking is.

Suppose Bitcoin were to take over from fiat currencies. What would banks do? They would lend in Bitcoin, of course.

This means that overdraft facilities would emerge allowing lenders to buy goods and services with Bitcoins that do not yet exist.

What would governments do? At moments of stress, they would have to issue units of account linked to Bitcoin (as they did under the Gold Exchange Standard during the interwar period).

All this private and public liquidity would cause a boom period before, inevitably, the crash comes. And then, with millions of people wrecked, governments and banks would have to abandon Bitcoin.

There is a sense in which this logic is correct. To understand why it is correct, though, we first need to understand why it is absurd.

This cycle—the Austrian business cycle or credit cycle—is obviously real. Austrians and neoliberals only differ on one thing: whether the problem with the gold standard was that the gold standard was used, or that the gold standard was abused. Varoufakis’ scenario, above, involves Bitcoin being abused. This is just bad accounting.

Varoufakis, on behalf of the Western world in the early 20th century, is returning the gold standard at the customer-service desk. He claims that the product is defective. I claim that it was abused—or at least misused—with predictable results. We do both agree that the product exploded.

My solution is to give him a new one for free, but be like: but this time, don’t do that. Don’t attempt to operate the unit underwater. Don’t play videogames while driving the vehicle. And don’t repay loans with more loans.

Don’t repay loans with more loans

Don’t repay loans with more loans. Like: don’t pay off your credit cards with other credit cards. All payments on a loan should come directly from return on capital.

Intuitively, when you have a financial system in which borrowers systematically borrow to pay back their loans, you have an unstable financial system which will explode in just the way Varoufakis (or Mises) describes.

Some people call this unstable regulatory configuration “fractional-reserve banking,” a term I feel is too specific and too confusing. The accounting principle is much more intuitive. Don’t pay off credit cards with credit cards. This is an unsafe thing to do for an individual, but a much more unsafe thing for an entire financial system.

Intuitively, the reason for the collapse is that all the lenders in this system realize they are playing a game of musical chairs. If the music stops and everyone decides to stop lending, those who stop lending first will get their money back—using up the system’s real capacity to pay back its current loans. But it has made far more loans than it can pay back without borrowing more; and there are no more lenders. So the rest of these loans must default—devil take the hindmost.

Intuitively, the solution to the “fractional-reserve banking” problem is: don’t do it. Mises understands this and Varoufakis does not.

But this solution is irrelevant to a system which is already deep into committing this sin. Arguably, not even Mises really has a good answer here. His answer is: stop doing it. This will lead to an explosion whose tonnage is proportional to the extent of the sin. While this worked in the 1920s and arguably, in a way, in the 1970s, there is no point in saving America from any kind of sin by blasting it off the face of the earth. Because this is the extent to which America today is just a financial bubble economy.

Varoufakis avoids this neutral death grapple by—criticizing Bitcoin, in which there is no extant banking at all. His argument is that once Bitcoin is systemic to the economy (which it certainly isn’t yet), fractional-reserve banking will be invented, then explode.

(In a sense Varoufakis may even be right—but not in the sense he means. We’ll discuss this sense in a paywalled appendix.)

Varoufakis does not believe that the financial system he believes in and has served, to which fractional-reserve banking is essential, will explode. He is right—because he is looking at insured fractional-reserve banking, which has no reason to explode ever. This cannot be true of gold or Bitcoin, neither of which can be insured by state fiat.

Insured fractional-reserve banking in fiat currency cannot explode. However, as we’ll see, this “insurance” is essentially a para-economic system of state lending. Like most ways of manipulating markets, state lending can create arbitrary irrational effects.

Also, since the converse of debt is power—the creditor has power over the debtor, or the concept of debt has no meaning—state lending implies state power. And the huge amounts of debt it creates in society imply huge amounts of power, private or public. Varoufakis is supposed to dislike power—but I am not so sure about this.

And all of this can be avoided by not paying off loans with more loans. Let’s see how this works at a slightly less impressionistic level of detail.

The rollover

There is a great ‘70s financial disaster film called Rollover, with Kris Kristofferson. Everyone who gets aroused by financial disasters should watch Rollover.

A loan is a promise to pay in future. When you pay off a loan with another loan, you are rolling it over. You could be borrowing again from the same lender, or from a different lender. Perhaps you could pay off the loan with money you actually have, and you just don’t want to. Or perhaps you are actually dependent on a new loan.

Another name for rolling over loans is maturity transformation. Because long-term interest rates are naturally higher than short-term interest rates, it is naturally profitable to borrow with short-term loans (payable in a month or even less) and lend in long-term loans (like a 30-year mortgage).

When you do this, you are fooling the market. You are convincing it that there are a lot of ways to make money on a one-month loan—a lot of enterprises that, given 100 dollars in April, can turn it into even 101 dollars in May.

Loans are for capital—like a factory that costs money to build but pays itself off. No one can borrow money in April to build a factory that pays itself off in May. There is one use for short-term lending—financing short-term inventory (“real bills”).

But if a borrower can finance a 10-year project, like a factory, with one-month bills, at a lower rate—he will. He will send a false signal to the market that there is huge and inexhaustible marginal demand for profitably borrowing money for a month.

This will create an amount of lending that is essentially unbounded—and since maturity transformation turns debt (future money) into cash (present money), an amount of money that is essentially unbounded. We might even see some inflation.

Whatever this is—it isn’t market economics. In market economics, prices are set by supply and demand—endogenous market forces. Sending, or even tolerating, false market signals creates false prices, false markets, and irrational economic activity.

For instance, it creates insane bubbles and crashes. These false signals, not stable moneys like Bitcoin and gold, are the problem.

Banks, bubbles and crashes

Varoufakis believes that his crypto disaster will begin with the birth of “wildcat”—uninsured—Bitcoin banks.

A bank is not a vault, like Coinbase. Coinbase is a coin warehouse—for every coin in your Coinbase account, Coinbase has a coin to back it. If everyone wants to take their coins out of Coinbase tomorrow, Coinbase can do that without borrowing one satoshi. This is sometimes called a “100% reserve bank”—a bank that does not pay back loans with other loans. (In olden days the Bank of Amsterdam was such a bank.)

Any regular bank is paying back a loan with another loan. This loan is a loan from you. Your “deposit” is a promise from the bank to pay you back—immediately. This is the ultimate in maturity transformation: a zero-term loan. Say it renews every second.

Usually this second you do not need the money. So you leave the money “in the bank.” What this means is that you are lending it back to the bank. This is a rollover and you are the lender.

The bank can pay you if you don’t roll over the loan, because it has a bit of cash on hand and a statistical model of expected withdrawals. If this model fails—as in a bank run—the bank is still solvent. It holds a bunch of long-term loans that are worth more than its short-term liabilities. It can sell these assets and pay everyone back.

But selling a loan is exactly the same thing as borrowing. It is trading future money for present money. In a bank run, everyone wants to trade future money for present money. No one wants to trade present money for future money.

So the price of future money must drop until this market clears. When future money is worth less, interest rates are higher; bond prices are lower. Since the price of the bank’s bonds (long-term loans) has fallen, it actually cannot afford to pay back all the depositors, even after it sells all its bonds. And the ruin is complete.

And all of this could have been avoided by not paying off loans with other loans—making the amount of debt grow without limit. Indeed, when World War I created unlimited debt, in gold, with a physically limited gold supply, of course something was going to explode. The classical gold standard didn’t die. It was murdered (by the Bank of England, which pioneered modern fractional-reserve banking in gold).

And of course it’s impossible to turn off fractional-reserve banking in fiat currency, because the explosion will be far worse. The ratio of virtual gold to actual gold, a hundred years ago, was bad. Today we have paper money, not gold money—and the ration of virtual paper to actual paper is even worse.

Any policy that is the functional equivalent of just cancelling all virtual paper—such as shutting off the rollovers and/or turning off the insurance—will result in the nuclear death of capitalism. Hundreds of trillions of dollars of global financial assets will be trying to get their hands on three trillion actual dollars. You don’t want to be in the same galaxy as this kind of financial supernova.

In a world containing three trillion grams of gold, how could there be hundreds of trillions of dollars in promises of gold? How could the apparent supply of promises of current Bitcoin, in a world containing 21 million Bitcoins, soar into the billions?

With maturity transformation, the supply of money can be arbitrarily manipulated. In a hard currency (like bitcoin or gold), such a bubble must inevitably collapse. In a soft or fiat currency, debt bubbles expand indefinitely—via covert government lending. Net government lending is inherently inflationary.

As a matter of regulation, an ideal financial market does not transform assets—by term or by quality. In order for the interest rate of a 10-year loan in dollars to be set by the market, this rate must be set by the intersection of the supply-and-demand curves of those who want to lend dollars for 10 years, and those who want to borrow dollars for 10 years. Any interest rate which is not set in this way is a false economic signal.

It matters little whether the form of regulation is coercive or voluntary. Ideally, there is a respectable financial market that can police itself, and a sketchy financial market that everyone who isn’t sketchy or gullible avoids. Most people with money aren’t sketchy or gullible, so the sketchy market stays much smaller than the respectable market—meaning explosions in the sketchy, unregulated market barely make waves in the respectable market.

Or the government could just shoot the sketchy market in the head. We don’t have to be super-libertarian about this. In any case, a financial market with an independent money supply, like Bitcoin or gold, needs to regulate itself or be regulated to avoid systemic maturity and/or asset transformation—which acts as a giant financial bomb. One way or another, savers in this currency will have to figure out this issue.

Deposit insurance is hidden government lending

As we have seen, a deposit is a loan. When you carry a bank deposit, you are lending money to the bank. The bank does not keep this money but lends it, mostly, to others.

Typically the loans the bank makes—or the bonds it buys—are long-term loans which are (ideally) materially profitable. The loan you make to the bank is a zero-term loan which is rolled over every second.

You value the “dollars” in your account—actually IOUs from the bank—at par, because you know that the bank has a formal loan guarantee from FDIC. Even though FDIC has nowhere near enough money to cover a bank run, you know FDIC has an informal loan guarantee from the Fed.

So when you have a checking account, you actually own three promises. You have a formal promise by the bank to pay you, a formal promise by FDIC to pay you if the bank doesn’t, and an informal promise by the Fed that FDIC will always pay up.

Since the Fed’s promise is not constrained by any other power—since it can print money—and since its incentive never changes, this promise is always good.

Given the Fed’s informal guarantee of FDIC’s commitments, it is proper to regard the Fed-FDIC system as a single financial unit. Call this A. You are C, the customer. You have made a rolling zero-term loan to B, the bank. A has guaranteed this loan, so that even if B, the bank, fails, you, C, get your money anyway.

Notice that when A guarantees C’s loan to B, there is another way to describe the same financial relationship using loans alone. What is really happening is that C has loaned the money to A, who has loaned it to B.

You lent the government money, and it lent that money to the bank. The risk structure is the same—A loses money if and only if B fails. A cannot fail, because A can print its own obligations. So C cannot lose.

Observe that the loan from C to A, from you to the government, need not be a loan at all. Why would the government, which can print money, borrow it? It may just be a ledger in A—a “central bank digital currency” that stores a balance for every SSN.

But the loan from A to B is classic government lending. In our actual banking system, bank lending—which is government lending, since the government insures the banks—has long since been disconnected from the volume of deposits.

Real-life lending is constrained only by the risk-discounted value of the the bond that the loan creates. There is certainly no sense in which the market sets interest rates at every term by matching lenders and borrowers at that term.

The power of state lending to create money is therefore infinite. But since money is a zero-sum game, when unmatched lending dilutes the money supply, someone is being subtly taxed. State lending is no Faustian cornucopia of printed riches. It takes from the savers and gives to the borrowers.

Ultimate trickle-down economics

The process of distorting financial markets by deploying the government’s fiat power to create money—especially by writing options which depend on that power, without using it explicitly—is both pernicious, and essential, to the Western financial system.

It is pernicious because it rotates the economy by inflating the prices of rich peoples’ assets, giving them money to spend on poor peoples’ labor. Once, not without reason, this was called “trickle-down economics.”

The effect of this river of informal options and disguised loans is to inflate the price, and therefore the volume outstanding, of securities—promises of future money. The government is using its power to print money to make the stock and bond markets go up. This gives Americans more money (the “wealth effect”), which they then spend.

It is often forgotten that equity is a liability. When a company’s stock goes up from 6B to 10B, it has (or should have) the expectation of some future stream of profit that will pay off these extra billions of liability. When a whole stock market goes up from 30T to 40T, it has issued ten trillion dollars in red ink—just as if it had been borrowing. What should shock us is the percentage of national income that comes from capital gains, realized and unrealized, on securities. This is all Fed-powered UBI for the rich.

Running an economy by giving free money to rich people is a terrible way to run a railroad. Nonetheless, the railroad runs. Junk is a terrible thing. The junkie needs it. The Western economy is so completely dependent on soft-money junk finance that turning it off cold-turkey would be impossible—a savage and pointless punishment. All recessions these days are finance-driven—once the stock market starts heading south, the rich stops spending, their UBI cut off—and then the real economy tanks.

A person who purports to have the same values as Yanis Varoufakis could not possibly support this system, or any equivalent to it. But probably he likes Cannes too much.

Self-regulation and maturity transformation

To recapitulate: the Austrian business cycle that Varoufakis describes should not happen in a fixed-supply currency like Bitcoin, because—people shouldn’t be stupid.

Unfortunately, human beings often are stupid—and do stupid things, like paying back loans with more loans. And engage in other individually sensible but collectively hazardous financial practices, which is why we have, like, a government.

It is possible for a government to hold itself accountable by doing its accounts in an outside currency; and it is also possible for a government to prosecute unhygienic financial behavior, like Ponzi schemes, in that currency. Maturity transformation is not the same thing as a Ponzi scheme—not quite—but it is certainly a scheme.

At the very least, the crypto world should have some kind of intellectual authority whose prestige can serve as a kind of legitimate self-regulation body. This authority, as a mere public service, would point out unstable and dangerous financial schemes—keeping them from becoming big enough to threaten the healthy system.

Varoufakis might well point out that no such authority exists. Indeed. But it could exist—and people like Varoufakis are the kinds of people who could make it exist.

Collateral and correlation

The crypto world is not exactly full of fractional-reserve banking per se. But are all its practices perfectly hygienic? Lol.

Let’s look at one financial practice which I keep thinking will cause a sudden implosion in the crypto world. This crash hasn’t happened yet—but no one would necessarily know it was about to happen. This seems like a good place for a paywall: