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Association for Information Systems
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MCIS 2016 Proceedings Mediterranean Conference on Information Systems
(MCIS)
2016
Decentralized Banking: Monetary Technocracy in
the Digital Age
Adam Hayes
University of Wisconsin-Madison, USA, ahayes8@wisc.edu
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Recommended Citation
Hayes, Adam, "Decentralized Banking: Monetary Technocracy in the Digital Age" (2016). MCIS 2016 Proceedings. 3.
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Tenth Mediterranean Conference on Information Systems (MCIS), Paphos, Cyprus, September 2016 1
DECENTRALIZED BANKING: MONETARY TECHNOCRACY IN THE
DIGITAL AGE
Completed Research
Hayes, Adam, University of Wisconsin-Madison, USA, ahayes8@wisc.edu
Abstract
Bitcoin has ushered in the age of blockchain-based digital currency systems. Secured by cryptography and computing
power, and distributed across a decentralized network of anonymous nodes, these novel systems could potentially
disrupt the way that monetary policy is administered – moving away from today’s human-fallible central bankers and
towards a technocratic, rules-based algorithmic approach. It can be argued that modern central banks have failed to
stem macro-economic crises, and may have, in fact, exacerbated negative outcomes by incentivizing excessive risk-
taking and moral hazard via unconventional monetary tools such as quantitative easing and negative interest rates. A
central bank typically serves three primary functions: to issue and regulate the supply of money; to serve as
clearinghouse for settlement of payments transactions; and to serve as lender of last resort. Could a digital currency
system serve as a rational substitute for a central bank? This perspective paper examines that question, and then
suggests that indeed it could be plausible. While Bitcoin in its current form will prove to be inadequate to function as
monetary authority, I put forward what an operative case could resemble.
Keywords: Bitcoin, Digital currency, Blockchain, Monetary policy, Central banking
1 Introduction
1.1 Preamble
Fluid began to flow through plastic tubing, from one small tank to the next, as the hum of hydraulic pumps
whirred in the background; the economists who had gathered at the London School of Economics quieted
down. Graduate student Bill Phillips, who would later gain notoriety for describing the antithetical
relationship between inflation and unemployment, stood at the controls of the six-and-a-half foot by five-foot
analogue machine he had himself built. Phillips had arrived at the LSE from his home in New Zealand by
way of Asia, where he was held prisoner in Java by the invading Japanese forces for three-and-a-half years.
Now, in 1949, he adjusts the slider labeled ‘tax rate,’ sets various dials, and fiddles with the valve that will
balance the budget; moments later The Phillips Machine gurgles and produces an estimate for the
unemployment and interest rates, supposedly within a +/- 2% margin of error (Phillips & Leeson, 2000).
Later dubbed MONIAC, it was an achievement in technology over fallible human minds in formulating
monetary policy and informing central bankers to precisely what action to take upon observing the economy.
Since the Phillips Machine was first turned on, there has been a marked decline in the use of simple
technocratic decision-making for monetary policy. Central banking has become much more nuanced, opaque,
and complex as economies have grown larger and more intertwined. The nuance and complexity has also
brought with it uncertainty regarding policy decisions, which manifests itself in financial markets in the form
of volatility: Will the bank raise interest rates? By how much? When will they do it? Why was a specific
word used in a statement by the Bank? Every last shade is scrutinized. Central bankers have shifted the
conceptual basis of monetary affairs away from rules and standards such as gold or fixed exchange rates, and
toward an evolving relationship with the public, rooted in sentiments and expectations (Holmes, 2009).
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1.2 The Case for Following Rules: A Literature Review
The argument that central banks ought to be governed by rules, rather than by achieving a set of goals
whatever way possible, has a great deal of support. If market participants incorrectly judge how interest rates
will change, or if the central bank surprises the market by changing rates contrary to expectations, market
fluctuations could increase. This applies to both how often rates are changed and by how much. In fact,
empirical research has shown that too much tinkering with interest rates can produce negative economic
outcomes (Kydland & Prescott, 1977).
In the United States, House Republicans have introduced a number bills that would require the
Federal Reserve to follow a ‘rule.’ Recently, Congressman Jeb Hensarling (2014), who heads up the
committee on finance which oversees the Federal Reserve, voiced concerns over the amount of leeway that
exists in setting rates and the unanticipated consequences it can cause; he has urged central bankers to instead
follow a simple set of explicit rules. On the campaign trail, Republican presidential candidate Ted Cruz has
expressed his desire to implement an explicit monetary policy rule in a number of presidential debates in
2015 and 2016.
Political think-tanks have also voiced favor for a rules-based monetary policy. In February 2015, the
Heritage Foundation commented that an explicit monetary policy rule will “greatly improve transparency and
predictability,” a belief echoed vociferously at the November 2015 monetary policy conference hosted by the
Cato Institute.1 From a policy perspective, a rules-based approach allows policymakers to evaluate the
Bank’s consistency with overt monetary policy or to other relevant legislation (Walsh, 2015). According to
Walsh, this style may be contrasted with a looser “goals-based” approach, such as modern-day inflation
targeting, whereby central bankers are evaluated on how well policy objectives are met, leaving much room
for flexibility and creativity in achieving those goals.
Academics (e.g. Taylor & Williams, 2010) agree that simple rules-based decision-making is a robust
method of implementing monetary policy, and point out evidence that historical experience has shown a set
of simple rules works well in the real world. Taylor & Williams’ studies show that relative macroeconomic
performance has been better when central bank decisions were described by rules, and assert that such rules
are not undermined by financial crises. Central bankers presently have quite a bit of discretion over how to
set and implement policy. Problems tend to arise when the uncertainty surrounding these decisions (e.g. on
setting interest rates) causes instability in financial markets (Deshmukh et al., 1983). If market participants
incorrectly judge how and when interest rates will change, or if the central bank surprises the market by
changing rates contrary to prevailing expectations, the potential for adverse volatility could increase.
Kydland & Prescott (1977) suggest that a mandate to follow a strict set of rules could serve to reduce
economic uncertainty.
An argument can be made that modern economies are too large and too complex for central banks to
deviate from a basic set of rules (Walsh, 2015). How can central banks be expected to successfully manage
economic stability via manipulations which can generate unpredictable results with unintended
consequences? Prominent Austrian School economist Ludwig Von Mises (1953) argued that central banks
actually cause economic instability by inducing an unsustainable expansion of bank credit. F.A. Hayek, a
student of Mises, understood the need for central banks to regulate monetary policy as sort of a necessary
evil lest a completely laissez-faire monetary system fall apart (White, 1999). More recently, former Federal
Reserve Chairman Ben Bernanke (2000) has written extensively on how central bank policy exacerbated the
1 http://www.heritage.org/research/reports/2015/02/why-congress-should-institute-rules-based-monetary-policy,
http://www.cato.org/research/banking/rl-monetary-policy.html
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Great Depression of 1929 by incorrectly raising interest rates instead of following the established rules,
which would have caused them to act in the opposite manner.
Rule following also confers, inherently, independence to a monetary authority, which is a virtue that
almost all can agree on. Political influence or other external pressures cannot in any way sway the
absoluteness of an emotionless algorithm. Elected officials often face incentives to favor policies that
promote short-run gains in output and employment, and voters are likely to remember a recent period of
economic growth rather than consider the damaging long-run inflation or instability that policies could bring
in the future. A central bank needs to be willing and able to make unpopular decisions and take actions that a
politician could not. For instance, a government may seek a policy of high inflation in order to achieve
monetary financing of deficits. Such a policy has often been the harbinger of collapse for national economies,
from Argentina and Zimbabwe to Weimar Germany and Hungary (Minsky, 2015). The incentives for paying
off debt with inflation are enticing. If a government owes e.g. a million dollars a day in fixed interest
payments to creditors, it would be much easier if that nominal one million dollars were made to represent
significantly less purchasing power. Inflation causes the value of a currency to drop, and that would be an
attractive fix for out-of-control government obligations. An independent central bank would not be swayed
by the size of a national debt and may not agree with the attractiveness of devaluing the currency through
inflation. An autonomous monetary authority with a mandate for a stable inflation target serves as a safety
mechanism.
To be sure, the argument for independence is not a new one: one of the founding fathers of modern
economics, David Ricardo (1849), accused the Bank of England, which was already well over a hundred
years old at the time, of bending to the whims of the throne. Ricardo proposed that a central bank be
independent from political pressure in three important ways: with the power to create money separated from
the power to decide how to spend it; with preventing a central bank from financing the State’s budget; and
with external accountability for its decision-making. Drawing on Ricardo, article 130 of the Maastricht
Treaty of 1992 established the current basis for central bank independence for Europe, and has since been
copied in practice by much of the developed world (Lastra, 2012).
While pneumatic tubes and mechanical dials are relics, sophisticated algorithms built into silicon and
traversing optical fibre have replaced them. In this digital age, can cutting edge technology allow monetary
policy decisions to function in a rationally consistent manner – and bring with it the potential for macro-
stability that some level of certainty brings to markets? Digital currency systems today are obvious examples
of technology that could potentially function as technocratic monetary authority. These are known
generically as a 'cryptocurrencies', owing the name to the process of encryption that facilitates them, with the
most well-established and widely used being Bitcoin. 2,3
For simplicity, I take the position that the technology of today – and specifically blockchain
technology – can, indeed, produce such a result. At the same time, I am not advocating that a digital currency
is the ideal protocol for implementing a rules-based central bank policy. Rather, I take the broader position
that a technology-driven rules-based system can exist within the framework of a decentralized, blockchain-
based digital currency system, even if such a framework proves to be inferior to traditional centralized fiat
banking in terms of effectiveness in the real world. It should be made clear that technology, in and of itself, is
most likely insufficient to promote stability given a set of explicit rules. Algorithmic (a.k.a. high-frequency)
trading firms are largely thought to have contributed to recent spurts of market volatility including “flash
2 For convention, ‘B’itcoin with a capital ‘B’ refers to the protocol, network, and system. ‘b’itcoin with a small ‘b’ refers to the currency and units
of that currency.
3 Cryptocurrencies today are based on a blockchain data structure, which is essentially a distributed ledger system. The technical details of
Bitcoin, cryptocurrencies and blockchain technology are beyond the scope of this paper.
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crashes” (Kirilenko, et al. 2015), and have caused the public to distrust some market participants (see
Michael Lewis’ Flash Boys). Alternatively, proponents of algorithmic trading cite evidence that technology
actually increases market efficiency and liquidity (Boehmer, et al. 2014); more empirical work is needed to
resolve this emerging discussion. Regardless, there are bound to be both positives and negatives for any
technological intervention – including the use of cryptocurrencies – and reducing the potential negatives
should be paramount. Of course, many of the algorithms employed in high-frequency trading are kept secret
and proprietary, so it is unclear whether failures caused by such systems are the result of the technology itself
or manmade flaws in the code. Any algorithmic approach to central banking must be both robust and
transparent so that any technical errors can be easily identified and corrected. Most blockchain
implementations are fortunate to rely on open-source software code and feature a fully visible and auditable
ledger of transactions.
This paper is intended to provide perspective on how a blockchain-based digital currency system
could function as an independent, rule-following monetary authority, taking up some of the roles now played
by central banks. Bitcoin was designed to be a global currency system, and yet there is scant little literature
on its use as such (Selgin, 2015). In fact, examination of a digital currency system as de facto central bank
has been quite overlooked by the Academy, and the purpose of this paper is to provide some initial insights
and perspectives on the issue. In this paper, I have already made the case that a rules-following monetary
policy is desirable. I next summarize what traditionally central banks undertake, and then develop a practical
as well as a theoretical framework for a viable “decentralized” central bank based on a digital currency
system. The hope is that it will be able to spark further research, both qualitative and quantitative, in to the
subject and inform both academia as well as practitioners of macroeconomics and monetary policy.
2 Contemporary Central Banking
Before examining digital currency systems such as Bitcoin, it is important to understand three core functions
of modern central banks: to issue and regulate the supply of money; to serve as clearinghouse for settlement
of payments transactions; and to serve as lender of last resort.4 Only then can we examine if and how a
digital currency system could potentially take over some or all of these tasks.
2.1 Central Bank as Monetary Authority
The most visible function of a modern central bank is that of monetary authority – creating and managing the
supply of currency that exists in an economy. An effective monetary authority regulates the creation and
destruction of money in such a way as to promote overall macroeconomic stability (i.e. low inflation and/or
full employment). Controlling the money supply is achieved using a set of policy tools that either directly or
indirectly influence the supply or demand for currency.
Direct measures include open market operations (OMO), where the bank creates money by
purchasing assets (typically high-quality domestic sovereign debt) in the open market using newly minted
currency.5 Unconventional monetary tools can also directly inject liquidity into markets. Quantitative easing
(QE), credit easing, and asset stabilization are all examples of measures that have been tried for the first time
since the Great Recession of 2008-2009. In QE, the central bank purchases riskier assets in the open market
4 There are other functional roles of many central banks, such as custodian of cash or foreign currency reserves, and banker to the government
that play a much smaller role from the perspective of a technocratic implementation using digital currency systems.
5 Currency here refers to both physical or electronic funds.
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such as mortgage-backed securities or corporate debt in exchange for new money. In November of 2008, the
Federal Reserve initiated its first round of quantitative easing (QE1). The aim was to prop up the asset values
of ‘toxic’ instruments in order to prevent a collapse of the financial system, which had massive exposure to
what it mistakenly thought were high quality securities. Rated ‘A’ or similar by debt ratings agencies,
investment banks and buy-side institutions alike found their balance sheets laden with mortgage backed
securities, which became virtually worthless paper after the housing market collapsed and the financial
markets crashed. The U.S. Federal Reserve Bank also did not stop at one round of quantitative easing. When
$2.1 trillion worth of MBS purchases failed to keep asset prices aloft, QE2 was rolled out in November of
2010. And in December 2012, the Fed debuted QE3. To put all of this into perspective, in 2007, prior to the
crisis, the Federal Reserve System held approximately $750 billion worth of Treasury securities on its
balance sheet and virtually no privately issued assets (Joyce & Scott, 2012). By August, 2015, that number
had swelled to nearly $2.5 trillion. Today, the Fed still maintains more than $1.7 trillion of mortgage
securities on its books.6
Indirect measures for controlling the money supply involve mechanisms for fixing interest rates, and
central bankers have great influence in using interest rates as a tool to accomplish their goals. Modern
economies are intrinsically linked to interest rate levels, which affect everything from consumer spending
and corporate investment to government debt levels and net exports. The ‘risk-free’ interest rate set by a
central bank serves as the foundation upon which all other lending rates are built, and therefore it effectively
dictates the cost of borrowing for all. In other words, interest rates help determine the ‘price’ of money
(Woodford & Walsh, 2005).
High interest rate levels tend to discourage economic growth: when interest rates are high, loans
become more costly and consumers will, in turn, buy less on credit. Some individual borrowers will be
unable to service the higher cash flows needed to obtain a mortgage on a property that they could otherwise
afford in a lower interest rate environment. Corporations may not issue bonds if they are uncertain that
revenues generated from projects undertaken can sufficiently cover interest obligations, and thus risk default.
Interest rates affect all financial markets in some way; equity, fixed income, derivatives, forex, and
commodity markets are all highly dependent on this key figure.
Interest rate setting lends itself to a systematic approach (Clarida, Gali, & Gerler, 1998). The Taylor
Rule, for example, informs central bankers how they should change nominal short-term interest rates in
response to changes in inflation and GDP output. One version of the Rule is:
it = πt + rt* + απ (πt - πt *) + αy(yt – yt*) (1)
In this equation, it is the target short-term rate (e.g. the federal funds rate in the U.S.), πt is the rate of
inflation as measured by the GDP deflator, πt * is the target rate of inflation, rt* is the assumed equilibrium
real interest rate (or neutral rate), yt is the change in real GDP, and yt* is the change in potential GDP output,
as determined by a linear trend. Taylor proposed that the sensitivities of each term (α) should be 0.50
(Orphanides & Wieland, 2008). Thus, given some macroeconomic data and observations, a certain lever of
economic policy will be pulled to the specified setting.
Orphanides & Wieland (2008) find that, indeed, the Taylor Rule predominantly explains how the
Federal Reserve Open Market Committee's (FOMC) decision-making has been characterized over the past
few decades. Even if the individual decision makers or committees formulating monetary policy responses
overtly deny that they are following such a hard and fast heuristic, the outcomes (incidentally or not) show
6 http://www.federalreserve.gov/monetarypolicy/files/quarterly_balance_sheet_developments_report_201508.pdf
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otherwise. As such, a viable digital currency system must be able to effectively create and regulate the supply
of the monetary base in order to fulfill this purpose of a central bank.
2.2 Central Bank as Clearinghouse for Settlements
An often overlooked role of central banks, but one that is crucial for economic stability, is oversight of the
payment system. Payment systems provide a vital piece of infrastructure in modern economies, allowing
for the seamless buying and selling of both consumer and commercial goods and services. Faith that
everyday transactions will settle and clear in a timely fashion underpins the value that people place on the
usefulness of money. In other words, money is only useful in practice when there is a reliable and robust
payments infrastructure with which to use it.
By virtue of its ability to regulate the money supply, the central bank stands at the center of this
payment system infrastructure. That central place today often involves electronic interchange between
various private payment systems and the central bank’s own internal settlement account system. In the course
of their own operations, central banks are usually users of payment systems and are accordingly exposed –
both financially and practically – to glitches in their functioning.
Central banks have historically often been owners and operators of payment systems. In the United
States, the Federal Reserve’s automated clearinghouse (FedACH) is an electronic alternative to retail
payments through cheques, and Fedwire is its wholesale securities and large value fund transfer service. In
Europe, examples include the TARGET and TARGET2 systems (Trans-European Automated Real-time
Gross Settlement Express Transfer System), which provide for the real-time payment and settlement of large
value euro-denominated transactions, as well as debt settlement at central banks which is immediate and
irreversible. In order for a digital currency platform to fulfill this function, it would need to integrate a
mechanism to confirm and validate transactions and accommodate the volume of transactions generated in an
economy.
2.3 Central Bank as Lender of Last Resort
When banks or other eligible institutions are experiencing financial difficulty, or are considered
systematically risky or near collapse, the central bank can step in as lender of last resort to offer them loans
when there is no other means of borrowing and whose failure to obtain credit would dramatically and
negatively affect the economy. The lender of last resort functions not only to protect banking institutions, but
also individuals who have funds deposited at those firms, preventing bank runs and stemming contagion if
such a run were to take place.
In practice, when a financial company is forced to borrow from the central bank in such a manner, it
signals to the market that an economic crisis may already be underway. As such, this facility, while crucial, is
rarely invoked in everyday business.
Central banks, however, need not be the lender of last resort, and historically, private banks or
syndicates have satisfied this duty. Before the Federal Reserve System was founded in the United States in
1913, private banks did indeed act as lender of last resort. For instance, The Suffolk Bank of Boston became
lender of last resort during the financial panic of 1837-1839 (Rolnick, Smith and Weber 2000), staving off a
more widespread depression. Later, during the panic of 1857 a policy committee of the New York Clearing
House Association (NYCHA) allowed the issuance of clearing-house loan certificates, alleviating the crisis
(Timberlake, 1984). Governments have also directly stepped in as “lender of last resort” on occasion by
offering bailouts to the financial sector (among others), a recent example being the U.S. Treasury bailing out
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the banking (and automotive) sectors following the collapse of Lehman Brothers.
Critics have opposed the use of a lender of last resort altogether, claiming that it incentivizes
excessive risk taking and moral hazard, since a bank knows it will be rescued in the event they collapse -
they are more likely to perceive the potential consequences of risky actions to be less severe (Goodfriend &
King 1988, Meltzer 2000, De Grauwe 2011).
Since it would be difficult for a digital currency system, as they exist today, to facilitate this particular
role, I propose that if a blockchain-based monetary authority were to function, the job of lender of last resort
would have to be either privatized or relegated to the state, or else eliminated entirely if the risk of moral
hazard exceeds the risk of financial collapse.
3 Technocracy via “Decentralized Banking”
As described above, a central bank must effectively implement monetary policy, oversee settlement of
transactions, and function as lender of last resort. I put forward that a digital currency system can, indeed,
fulfill the first two roles, while allowing the third to be outsourced. A central bank may be able to leave the
“every day” monetary policy in the hands of an automated set of rules governed by a digital currency regime
and intervene hypothetically only if and when a crisis were to arise.
In the run-up to the latest episode of the Greek banking crisis, former finance minister Yanis
Varoufakis surmised that his country could adopt Bitcoin (or some similar system) to function as a bridge
currency to a new drachma if Greece did indeed leave the common euro currency (Mason, 2015). Quite
correctly, Varoufakis has pointed out many shortcomings of Bitcoin itself as a practical long-run substitute
for a nation's monetary system – such as its potential to be deflationary and its inability to react to external
forces (Varoufakis, 2014). He has, however, gone on the record stating, “[a]lmost paradoxically, the
technology of Bitcoin, if suitably adapted, can be employed profitably in the Eurozone as a weapon against
deflation and a means of providing much needed leeway to fiscally stressed Eurozone member-states.” The
Phillips Machine is now consigned to a museum, but cutting edge information and communication
technology (ICT) ought to allow an adherence to technocracy, free from human fallibility and corruptibility.
Such a technology can be built upon a distributed network, such that no one individual or organization has
sole control over the system, and yet it can still remain remarkably stable and robust without a single point of
failure. While it will be made apparent that Bitcoin in its current form is likely a poor candidate to operate as
an important global reserve currency, a system that builds off of its core technology – the blockchain – may
in fact be a viable use case.
The Bank of England, Britain’s central bank, has conducted research that finds clear macroeconomic
benefits to implementing a central bank-backed digital currency (what they call a ‘CBDC’) based on
blockchain technology (Barrdear & Kumhof, 2016). They find that such a currency based on distributed
ledgers and that competes with bank deposits as a medium of exchange could permanently raise the GDP of a
country by as much as 3% due to reductions in real interest rates, distortionary taxes, and transaction costs.
They also suggest that a cryptocurrency monetary system crucially would contribute to the stabilization of
the business cycle.
3.1 Bitcoin and its Inadequacies
The importance of Bitcoin as a proof-of-concept for blockchain technology and decentralized cryptocurrency
systems cannot be understated. The advent of Bitcoin has shown that such a system can operate on a global
scale, and has grown to command an aggregate value of more than $10.5 billion, with more than $150
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million of notional value changing hands each day on its network.7 Still, Bitcoin in its present form cannot
function as a standalone monetary authority.
First, there is an ultimate limit of 21,000,000 bitcoins ever to be produced; once this amount has been
mined, no new bitcoins will ever be created. Such an upper bound will likely create an artificial constraint
that ultimately serves to make it an increasingly deflationary currency – each ‘coin’ will become
progressively more valuable as demand for money increases and the supply cannot accommodate. To serve
as an effective monetary authority, there cannot be an arbitrary limitation in place given the probability of
increasing demand for money as an economy grows in population and in GDP. Of course, this technical
limitation could be circumvented by using fractional amounts as the functional unit (say a nano-bitcoin) in
everyday commerce, but having an unlimited potential supply is a more elegant solution. Empirical research
has shown that granting no limit on ultimate supply seems to have no influence on a cryptocurrency’s relative
value (Hayes, 2015). Furthermore, cryptocurrencies do currently exist with no cap on the money supply, for
example Peercoin, which has exhibited a fair amount of price stability despite its unlimited potential supply.
Second, Bitcoin’s network cannot process more than approximately seven transactions per second
(tps). While this may be sufficient to handle the amount of traffic that occurs on the Bitcoin economy
internally, it pales in comparison to a nationwide economy. To put this in to perspective, VISA can handle
upwards of fifty-six thousand transactions per second (although it averages only 2,000-4,000 tps on a typical
day). PayPal, which is a much smaller network, could handle around 115 tps in 2014.8 In order to handle the
number of transactions actually occurring in an economy the system would need to handle many tens of
thousands of tps on a consistent basis.
Third, and related to the problem with transactions per second, is the block size limitation. Currently,
Bitcoin only allows for one megabyte of data to be stored in each block. The block size is already a matter of
heated debate in the Bitcoin community, with little agreement between opposing sides. With an increase in
transaction throughput, it would follow necessarily that the amount of data in each block would have to
increase substantially (since each individual transaction carries with it some amount of data).
Fourth, and also similar to those above, Bitcoin transactions do not validate in real-time; rather they
are confirmed only when a new block is mined, and that takes place by design once every ten minutes.
Therefore, transactions will only be confirmed after a minimum of ten minutes, and likely more as many
vendors prefer to have between three and six confirmations before accepting settlement. Having to wait for
up to an hour is unacceptable for a large portion of daily financial transactions which must be confirmed and
processed as immediately as possible. Distributed denial of service (DDoS) attacks on the network can also
cause transaction speeds to drop below expectation, a problem not unique, however, to digital currency
systems.
Fifth, Bitcoin addresses are pseudonymous rather than anonymous, meaning that the actual identities
of those transacting on the network could be made known. This can be achieved by scraping data from the
internet, or by analyzing transaction patterns of various address clusters on the blockchain (see, for example
Tasca, Liu, & Hayes forthcoming). While certain regulations such as anti-money laundering (AML) laws and
know-your-customer (KYC) are required of financial institutions, cash money is anonymous and should be
so in order to protect the privacy of individuals.
Sixth, Bitcoin has a fixed rate of unit formation (one block every ten minutes), and a rule for
arbitrarily reducing the amount of bitcoins found in each block approximately every four years.9
Interestingly, a constant predetermined growth of the money supply does happen to have some theoretical
7blockchain.info/stats
8 https://web.archive.org/web/20141226073503/https://www.paypal-media.com/about
9 The current block reward is 12.5 BTC as over July 9, 2016
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support. The so-called Friedman Rule (Friedman, 1948) proposes that the central bank should establish a
fixed constant rate of growth for the money stock, and maintain that growth rate no matter what emerged
from the state of the economy. Such a rule has some advantages: it is easy for the public to understand; the
rate of inflation cannot take off toward plus (or minus) infinity; and, market-determined interest rates are free
to fluctuate in response to changing economic conditions (Taylor, 1999). A fixed rule, however, critically
ignores feedback from the economy and does not have the ability to adjust and smooth out the effects of
macroeconomic changes.
There are other, less important factors that make Bitcoin inadequate to serve as “central bank,” such
as the possibility of reversing transactions through a certain type of attack on the network (although the
chances of this happening in reality are very remote).
3.2 Bitcoin and its Virtues
Despite its shortcomings Bitcoin has proven itself useful with respect to aspects of the concept of
decentralized blockchain-based money. It has established that a conceptually digital money-form can be an
acceptable store of value and a means of payment, both crucial features of any currency (Ingham, 1996)
(Bamert, et al., 2013).
A currency needs to have societal trust in its security and fidelity. Bitcoin and related cryptocurrencies
have exhibited recognition of so-called trustless trust. As a distributed network, Bitcoin transactions have
never been compromised or hacked, and a bitcoin has never been forged or counterfeited.10 A well-
understood consensus mechanism amongst a network of anonymous and far-flung nodes has shown that a
central authority or overseer is not a necessary requirement.
For a digital currency to operate as monetary authority, it must at the very least satisfy the
requirements of being money. Aristotle, in ancient times, proposed four characteristics needed for something
to be a “good form” of money (Smithin, 2002):11
1. It must be durable. Money must stand the test of time and the elements. It must not fade, corrode,
or change through time.
2. It must be portable. Money must hold a high amount of 'worth' relative to its weight and size.
3. It must be divisible. Money should be relatively easy to separate and re-combine without affecting
its fundamental characteristics, i.e. it should be 'fungible'.
4. It must have intrinsic value. This value of money should be independent of any other object and
contained in the money itself.
Does Bitcoin fulfill these criteria? Taking Bitcoin as the general example, it is durable – its security is iron-
clad and the existence of transactions is made permanent in the blockchain data structure without any
degradation. It is portable – it can be accessed from any internet connected computer or mobile device. It is
divisible – one bitcoin can be broken down to eight decimal places (the smallest such unit known as a
satoshi), and it is fungible.
It has intrinsic value. This final point warrants some elaboration. Some have asserted that Bitcoin has
no intrinsic value at all; that it has any market price is solely due to fleeting social popularity and the hope of
speculators (Yermack 2013, Hanley 2013, Woo, et al. 2013, Polasik, et al. 2014). Hayes (2015a), however,
has demonstrated that Bitcoin does in fact have some sort of intrinsic value, directly related to its cost of
10 Certain hacking events or theft have compromised services that use Bitcoin, such as the Mt. Gox exchange, but never Bitcoin itself.
11 There are many alternative criteria with which to evaluate the ‘moneyness’ of something, but those arguments are beyond the scope of this
essay and are unlikely to change the outcome of this analysis. To Aristotle, at least, a digital currency could reasonably satisfy all the
requirements to be a “good” money.
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production. In other words, its value behaves much like a commodity produced in a competitive market:
electricity goes in and bitcoin comes out. If the average cost of production decreases, producers will offer
their product in the market at lower and lower prices, in competition with each other, until marginal cost
approaches marginal product (Hayes, 2015b). Therefore, it is appropriate to consider bitcoin more akin to a
commodity form of money such as gold or silver than to fiat money. In fact, implementing Bitcoin as a
national monetary system would be like a hard return to the gold standard in many ways.
In sum, Bitcoin has proven that it can function as a trusted form of money, and that its protocol can
control its rate own rate of money supply – even if that controlled rate of supply is flawed from a practical
perspective. And, it has shown that it can act as overseer and clearinghouse for its own transactions, even
though its capacity is far too limited for everyday use. Those two features - to issue and regulate the supply
of money and to serve as clearinghouse for payments – are two of the primary functions of an effective
monetary authority that must be present for any viable alternative. That Bitcoin can serve these two roles,
albeit inadequately, gives us a strong platform from which to build a more useful system.
3.3 A Workable “Decentralized Bank”
We have seen both the negatives and positives of Bitcoin, a truly decentralized, distributed system of digital
currency. How can its protocol be improved upon to function as a true monetary authority for an economy; as
a technocratic, rules-following “decentralized” central bank. First, I will address some fundamental
macroeconomic issue such as using interest rates in a digital currency economy, then I will propose workable
remedies to the limitations of Bitcoin.
One hurdle to overcome is that it would be technically quite difficult for a cryptocurrency system to
directly set a target interest rate per se. Interest rate setting has become a hallmark of modern monetary
policy, but there are other ways to influence the “price of money” with similar effect: a digital currency
could still achieve monetary policy goals by manipulating the rate of change to new money formation to
similar effect. There is a theoretical basis that changing the rate of money supply formation is a logical
equivalent to changing the interest rate (Tobin, 1969). Interest rates and the quantity of money are
intrinsically linked, in that increasing interest rates makes money more “expensive”; decreasing the supply of
new money would have similar effect.
As we have seen above, the Friedman rule provided a theoretical foundation for a fixed, constant rate
of new money supply. I have reasoned that this falls short in terms of Bitcoin’s controlled supply of money.
Fortunately, McCallum (1988) and Meltzer (1969) have augmented the constant growth rate formula with
quantity-based rules that yield a dynamically changing growth rate of the monetary base contingent on
widely available economic indicators. Notably, the McCallum Rule has been proposed as an alternative to the
Taylor Rule, and moreover it has been empirically shown to perform better during crises (Benchimol &
Fourçans, 2012).
The McCallum Rule can be expressed as follows to give a target for the monetary base in the next
quarter:
mt+1 = mr – Δv*t-16 + 1.5(ΔpD + Δq*) – 0.5Δxt-1 (2)
Where: mr is the natural logarithm of the M0 monetary base at time t (in quarters); Δv*t-16 is the
average quarterly change in the velocity of M0 over a four-year period; ΔpD is the targeted rate of inflation
expressed as the natural logarithm of the quarterly change in the price level; Δq* is the long-run average
quarterly increase in the natural logarithm of the real GDP; and Δxt-1 is the quarterly change in the natural
logarithm of the nominal GDP from time t-1 to t. The lagged change in the velocity of money (Δv*t-16) is
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included to reflect long-lasting, permanent changes in the demand for the monetary base that occur because
of technological developments or regulatory changes, and is not intended to reflect cyclical conditions
(McCallum, 2000).
Such a rule would be much easier to implement within a digital currency system as regulator of
monetary supply, since there would be no target interest rate in the traditional sense. The McCallum rule
determines the optimal change in the monetary base given changes in GDP, inflation and the velocity of
money. It is also intended to reflect long-lasting, permanent changes in the demand for the monetary base
that occur because of technological developments or regulatory changes, and not intended to reflect cyclical
conditions (McCallum, 2000).
If we take a monetary policy with an explicit inflation target (say 2.5% annually), one could easily
construct a McCallum-like rule for a digital currency to follow that will change the rate of monetary
formation from one-time period to the next. This can be achieved by adjusting how many monetary units are
produced when each block of digital currency is created, or by changing the interval in which blocks of
currency are produced. For example, if the economy is growing too rapidly, the rate of money formation
should be reduced over the next time period. This would have a similar effect to raising interest rates in that it
would make money scarcer on the margin. In practice, to promote stricter monetary policy the number of
currency units in each block would be reduced over some interval (for example from 25 to 10 ‘coins’ per
block), and/or the time between block formation can be made longer (for example from 10 to 15 minutes),
while to promote expansionary monetary policy the reverse would take place.
A potential consequence is given that a digital currency system like the one described herein relies on
publicly available, anybody can deduce its next move(s). Market participants, rationally motivated by profit
maximization, will be incentivized to act on any perceived mispricings observed in the market which differ
from how the digital currency mechanism is expected to behave as it reigns in or bolsters the rate of money
formation. Under a fairly reasonable no-arbitrage assumption, this will serve to increase market efficiency as
it will greatly reduce the asymmetry of information that people can trade on.
Another structural-economic issue is that in a fractional reserve banking system, like the one we have
today in much of the developed world, the central bank regulates so-called “high powered” money, also
known as the monetary base, or M0. This base supply is then amplified through the financial system via
lending and credit mechanisms, through a money multiplier. A digital currency system cannot amplify itself
via fractional reserve banking, but it can still work nevertheless. “Full-reserve banking” (Fisher, 1935) is a
proposed alternative whereby banks are required to keep the full amount of each depositor's funds in cash –
or in our case in digital currency. This 100% reserve system was offered as a theoretical solution for the
causes of the Great Depression, although no country has yet implemented this policy. Since World War II,
there has been an increasing focus on fractional banking, however a number of economists have advocated
for it in the past few decades across various schools of thoughts ranging from the Monetarists to the
Austrians (Kotlikoff, 2009). Proponents of full-reserve banking argue that not only could such a monetary
system function, but that it would also eliminate the risk of bank-runs, bailouts of the financial sector, and
increase macroeconomic stability (Rothbard, 1974). In the wake of the 2008 financial crisis the idea was
again revived, finding favor with Martin Wolf, chief economics commentator of the Financial Times, who
has called for stripping banks of their right to create credit money. His argument that allowing banks to
create money by lending out deposited funds is what is responsible for creating destabilizing credit bubbles
and busts has also been echoed by a number of well-respected economists (Cochrane 2014, Krugman 2014,
Polleit 2010). A digital currency-based technocratic monetary authority would likely have to operate in a
100% reserve environment.
Accounting for interest rate setting and fractional reserve banking, a new digital currency system can
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be put in place that also obviates many of Bitcoin’s weaknesses. The number of transactions per second
needs to be ramped up to accommodate an economy’s worth of transactions. The block size, in turn, must be
increased to allow for that throughput. The money supply potential will be unlimited, with no cap.
Transactions will be confirmed as close to real-time as possible, and users will remain wholly anonymous.
These suggestions are not all pie-in-the-sky. Without a doubt, there are a number of alternative
cryptocurrencies (known as “altcoins”) which individually attempt to solve one or more of these issues. For
example, Dash (formerly Darkcoin) enables entirely anonymous transactions on its blockchain, with almost
instant confirmations, and has plans to increase its block size limit.12
Such a rule-following digital currency could operate completely independent from outside influence.
It would only need to incorporate publicly available macroeconomic data into its function as feedback in
order to adjust the rate of new money formation in the succeeding periods. Not only would such a currency
system be independent, but it could be made completely decentralized with no single authority or regulator in
place. Like Bitcoin and other cryptocurrencies today, it could even exist across a decentralized network,
democratizing the money-creation and transaction validation process.
A completely decentralized monetary system on a macro scale may seem wildly idealistic, but a
digital currency can also exist across a distributed “permissioned” blockchain, where each node in the
network is a known and trusted entity. Commercial banks and financial institutions could be obvious
candidates to operate these nodes, and yet still operate with transparency with a well-understood consensus
mechanism from the point of view of the population. Within a nation’s borders, a permissioned blockchain is
probably most appropriate as it can keep out foreign actors, can greatly reduce the need for expensive and
resource consuming “mining” operations, and greatly increase the speed and capacity of transactions. An
open blockchain, like Bitcoin, where all nodes are (for all intents and purposes) anonymous requires an
energy-intensive consensus mechanism (mining, or proof-of-work) in order to prevent bad actors from
undermining the system. Under a permissioned blockchain all nodes are vetted and known, making such an
expensive and potentially limiting mechanism unnecessary. The system will need to have the capacity to
handle the extremely large amount of transactions that are likely to occur each and every second across a
nation’s economy.
To sum up the above analysis, to provide the greatest chances for creating a viable digital currency
system that could function as “central bank” it should: 1) have a potentially unlimited money supply; 2) be
anonymous; 3) settle transactions in close to real-time; 4) follow rules based on dynamically adjusting the
rate of new money formation; 5) have a mechanism to obtain feedback from the economy; 6) operate in a
100% reserve banking environment; and 7) operate as a permissioned blockchain with appropriate speed and
capacity for all transactions in an economy.
4 Conclusion
Prof. Bennet T. McCallum has recently written a piece on Bitcoin which appeared in the journal for
the Cato Institute (McCallum, 2015). In it, he acknowledges that Bitcoin in its present form could not satisfy
the role of the monetary authority. For example, he reiterates that with a limit of 21 million bitcoins and an
economy that grows each year, deflation will become a rampant problem. He does, however, generally
propose the viability some alternative digital currency system, such as the one described in this paper, but he
(perhaps ironically) fails to incorporate his own namesake Rule into his analysis.
With advances in blockchain technology now removed from the constraints of Bitcoin, it is possible
12 https://www.dash.org/what-is-dash/
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to encode smart contracts, algorithms that will act as a trusted enforcer of agreements. With deployable smart
contracts, a blockchain-based monetary authority, which follows a McCallum-like rule for new money
creation, might also engage freely in emergency measures such as open market operations to drastically
increase or decrease the money supply when warranted. Such a crisis situation might be runaway inflation or
deflation, a collapse in employment, or a period of recession. In these cases, the digital currency itself will
act as a decentralized autonomous organization (DOA), making “decisions” on its own and interacting with
real financial markets directly. Such a DOA Bank could feasibly buy up existing digital currency, and even
destroy some of that money by sending it to unusable wallet addresses in order to quickly reduce the money
supply outstanding. The DOA Bank could engage in purchases of foreign currencies in FOREX markets, as
well as stabilize prices by purchasing bonds and equity in exchange for some of its stock of digital currency.
Coupled with improvements in artificial intelligence and machine learning, an AI-enabled DOA Bank acting
as monetary authority can truly be removed from government, central authorities, or the influence from
policymakers and corporate lobbies.
Bitcoin has proven itself to be a fairly robust proof of concept use-case of blockchain technology in
creating a global, decentralized digital currency and payments system. Bitcoin, however, is flawed in many
ways if it is to be adopted as a true economic currency. Many of these issues can be rectified to make a more
useful and dynamic digital currency, able to meet changes in supply and demand for money. If programmed
as a decentralized autonomous organization, a blockchain-based monetary authority can even engage in its
own emergency measures with effects similar to quantitative easing in order to stimulate a flagging economy
or else halt rampant inflation. Doing so will enable a truly independent monetary authority to operate and
perhaps even improve the prospects for economic stability and efficiency.
The conceptual framework outline above, I hope, will serve as a springboard for future analysis and
research involving interdisciplinary collaboration in order to further the study of digital currency systems,
blockchain technology, and its role as a viable, functional piece of the global macro-economy.
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