Recently, a friend of mine asked me if mass adoption of Bitcoin wouldn’t introduce problems similar to those of Eurozone because countries would loose ability to control their own economies and it would bind them in single currency. This is a very intelligent person I’m talking about, which made me realize how many misconceptions are out there, so I asked for his permission to publish my answer.

The difference between Euro and Bitcoin is in the control and ability to centrally plan price of money in time (interest rate) and liquidity of institutions lending that money.

The problem with Eurozone is not that different countries use the same currency. There are several problems in fact, some of them catallactic, some political. One problem is, that the supply of that currency is centrally planned via interbank interest rate targeting regardless of conditions (capital accumulation) in different regions. Greece hasn’t accumulated as much capital as Germany, so the real interest rate over there should be higher because there is less capital available to fulfill the (virtually unlimited) demand. But since the interest rate was set effectively to German level, it looked like there is as much capital available in Greece, Spain, Ireland, Portugal and other less developed countries as in Germany or Holland. Investment strategies were adjusted to the newly perceived level of capital abundance and the investment cycle was prolonged to unrealistic periods. When the real state of capital was unfolded, i.e. it turned out the capital (material, technologies, skilled labor) to finish all those projects is missing or those who were expected to pay for it eventually turned out to be not productive enough (for the same reason – not enough capital to create sufficient productivity), those projects turned out to be unrealistic. That created boom/bust cycle.

Another result of common interest rate is wealth transfer. Since both consumers and government in e.g. Greece were able to borrow for almost as low interest rate as Germany (there was premium, but it was much lower than it should have been because of implicit bailout guarantee), but were not by far as productive as German companies and employees to have the same standard of living, it was much easier to simply borrow to achieve similar standard of living. Government borrowed to finance welfare state and people borrowed to finance consumer spending. As a result, they were able to buy much more stuff than they would otherwise have on a free market where they would have to actually produce something in exchange. Because lot of the stuff they bought with these cheaply borrowed money was actually produced in much more productive Germany, that money went back to German hands and remained in German economy (because Germany was not importing enough in exchange from Greece. The result was increased price inflation in Germany because more units of currency were chasing same amount of consumer goods in German economy.

Other problems are purely political. The interest rate is targeted at a discretion of a few unelected bureaucrats with questionable motives and murky decision process. Same goes for decisions on collateral requirements, bailouts, etc. It would be a different story if we were told, that monetary base of Euro would rise 2% a year constantly and that would be never changed. That would automatically eliminate the possibility of interest rate targeting, bailouts and discretionary monetary policy. Problem is, it would again be dependent on a bureaucrats who have no goodwill, no accountability and no skin in the game in keeping their word.

That brings us to Bitcoin because Bitcoin solves exactly that – the monetary base increase is defined and impossible to change thanks to decentralization. In an imaginary scenario of both Germany and Greece using Bitcoin en masse, the interest rates in both those countries would be decided by the free market based on real capital accumulation because that capital would be represented by its price in Bitcoin. In fact it would be even at the level Greece vs. Germany, but Berlin vs. Koln vs. Munchen vs. Athens vs. whatever-Greek-town and one company vs. another within that etc. Capital would have its price in Bitcoin and would be lent based on its supply in variously defined markets and credibility of the borrowers. Bailouts would not be possible because no one would have access to Bitcoin printing press to finance them.

So in fact what Bitcoin would achieve is a perfect decentralization of the essential part of the economy – money and their price in time, which would lead to better planning of real capital investments. That is in strong opposition to currency centrally planned price of capital which as anything centrally planned causes imbalances – shortages of its supply where the price is too low and insufficient demand where its price is too high (the latter would lead to lack of capital investments, which is not happening because central banks never raise interest rates too high)

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