The Currency Hierarchy: Thoughts on Crypto, the Dollar, and Inflation

Original author: Mirza Suleymanov

Original compilation: 0xCC

The concept of layered currencies is not new, and Nik Bhatia summarizes his thoughts on the topic in his book "Layered currencies". Essentially, our monetary system is built on top of multiple layers of money, with margins held by our central bank that guarantee the government's liabilities to the public. In other words, central banks issue money on the premise that we can redeem our deposits when we need to, trust the central bank to store the value of our currency, keep it fungible and usable around the world, and use reserves to cover back it up (which is likely not the case in practice, since money is basically created out of thin air).

The ability of governments to create money often gets us into trouble: the so-called debasement of money. Every time an additional currency is issued, its value becomes lower. The more money is printed, the less money is worth, the price rises, and more money gets printed, creating a vicious cycle.

Excerpted from "Layered Currency" by Nik Bhatia

The US dollar and the Bretton Woods system

As the world's reserve currency, it also has its fair share of the burden. This is probably the main reason why the US runs a deficit, our currency will always be needed and its long-term stability makes it central to any transaction, transaction and reserve currency status. How did this become like this, and why hasn't it changed?

1944 Bretton Woods Agreement, for a history of monetary policy see Lords of Finance

The short answer is the monetary system that came after World War II. A longer explanation comes from the study of human trading history. In order to save a long description of past trades using coins, gems, and shells (which, while very interesting, could take up a lot of space), we move on from the abolition of the gold standard.

After World War II, the currencies of various countries were linked to the standardized weight of gold. There are many reasons, but all of them have variables. The U.S. dollar maintains a value of $35 per ounce of gold, and all other international currencies are pegged to the U.S. dollar. After the United States abandoned the gold standard like other countries, it was too late. Too much time has passed and the world needs dollars. But the Fed only prints enough dollars for domestic use, leading to what Bhatia calls “offshore” dollars — the creation of dollars outside the Fed’s jurisdiction. This could take the form of private lines of credit issued in U.S. dollars, or in the case of emergency repo facilities and other similar facilities. In short, the dollar's status as a reserve currency is not going away for a long time. The global financial system will always need dollars.

Repurchase Agreement (Repo) and Loan Facility

When other countries need dollars, they can meet the demand through repurchase agreements (Repo) or other lending instruments. A repurchase agreement is when one bank holding U.S. Treasuries gives them as collateral to another bank, which in turn provides liquidity (cash) to the aforementioned bank. The banks then return those funds with a nominal rate attached (this is where the fed funds rate and LIBOR relate), and repossess their collateral. Other forms of lending instruments can be unsecured (i.e. do not require collateral). Finally, a money market fund (MMF) is a group of highly liquid securities with a net asset value (NAV, or face value) of $1 each. These exist because the dollar has done something incredible over time, it has maintained its reserve status. By acting as the king of liquidity, the dollar continues this status.

As a result of the pandemic-related shocks, the Federal Reserve has implemented so-called QE. In this case, the Fed buys Treasuries to provide liquidity to banks that need it - which increases the money supply. We are currently entering a "tightening" phase where the Fed destroys cash once it is returned to the Fed, rather than using it to buy more Treasuries.

Inflation, shocks and counterparty risk

More and more people Be aware of widespread and persistent inflation. How did we get here? The ability of modern monetary policy to control inflation appears to be very limited: in order to really control inflation, the Fed would need to raise interest rates and implement austerity measures that would hurt everyone. And for our policymakers, who are more worried about the election than what happens 10 years from now, it is easier to expand the money supply than shrink it. Is the dollar a store of value when US Treasury yields are significantly below inflation? If U.S. Treasuries sit at the top of the monetary pyramid alongside gold, guaranteeing the value of the dollar, then the combination of a weaker dollar, higher inflation, and low yields relative to inflation will almost certainly lead to a deterioration in value, at least in theory .

In times of turmoil, the Federal Reserve relies on quantitative easing (QE) to keep the economy running smoothly. In quantitative easing, the Fed buys Treasuries from banks, leaving cash on hand. This cash is used to cover any urgent expenses. That's why people say that quantitative easing is like printing money. The Fed is simply pumping cash into the system, continuing to expand the supply at already very low interest rates.

Finally, some thoughts on counterparty risk. Our financial system is deeply intertwined, from CLOs, CDOs, CBOs, to basic forms of loans and swaps — the system is entangled. This is why our system is so fragile, it only takes one big risk to sink the whole system.

Worse, we don't seem to allow things to end naturally: too big to fail will only show the private sector that in the worst case Taxpayers will help!

Bhatia's predictions for bitcoin

Bhatia's excellent book very elegantly outlines the currency's Hierarchy: At the top of the pyramid are gold and US Treasuries. He further stated that bitcoin (intentionally designed to be gold) could take the place of gold, or, if the US Treasury were at the top of this pyramid, banks would be able to issue new forms of money backed by bitcoin itself.

bitcoin and gold share some common features, which Bhatia and other authors have aptly pointed out. The current amount of bitcoin in circulation exceeds the potential future minable or minable amount - meaning that inflation and devaluation are impossible. Similar to the situation where the vast majority of the world's gold supply is higher than future supply. Scholars refer to this type of currency that is difficult to issue or create as "hard currency." Finally, and at the heart of the crypto world: gold does not have a central issuer. Bitcoin also does not have a central issuer, it is decentralized and can be mined by anyone. This means that bitcoin is resistant to inflation and puts aside any concerns about devaluation.

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