The Short View

August 15, 2014 7:16 pm

Bitcoin is small change in financial innovation

Monetary manias fuelled the tulip craze and the South Sea bubble


When it comes to losing money on a grand scale, George Osborne’s Bitcoin withdrawal last week does not meet the standards of his predecessor. True, the UK chancellor’s bitcoins dropped 13 per cent in 10 days, an annualised loss of 99.8 per cent, but Royal Bank of Scotland shares scored an annualised loss of 99.99 per cent after the bank was rescued by the Treasury. Better still for taxpayers, Mr Osborne’s PR stunt was paid for by the ATM maker.

The purchase of emoney by a finance minister was symbolic of something bigger, though: Britain wants to encourage financial innovation. It is not alone, with Mario Draghi, European Central Bank president, aiming to redesign the market for securitised loans.

It may seem surprising for policy makers and politicians to encourage financial innovation just seven years after novel structured products blew up the economy.

In fact, it fits both the history of money and the economic imperatives facing politicians.

The past four centuries saw a series of skirmishes between regulators and politicians on one hand seeking to control money and impose taxes, and businessmen and bankers on the other finding ways round the rules. Many once-controversial tricks are now regarded as entirely normal: it is hard even to explain to a non-economist the distinction between money and bank deposits. Bills of exchange in the 19th century, eurobonds from the 1960s onwards or offshore certificates of deposit all started as ways to avoid taxes or financial controls.

As in 2007, such innovations often financed booms. Economist Charles Kindleberger documented the monetary manias behind everything from the credit-fuelled tulip craze of 1637 to John Law’s 1720 Mississippi bubble, the South Sea bubble, Britain’s canal and railway manias and perhaps the most extreme example, the 1982 destruction of Kuwait’s stock market.


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In Kuwait, wrote former fund manager Edward Chancellor, shares were doubling by the hour as speculators “paid” with postdated cheques on empty bank accounts. In effect, $91bn of cheques became money – until a speculator asked for her cheque to be cashed, popping the illusion.

The 2007 bubble was inflated by somewhat better quality “money”. As Richard Robb, an academic and co-founder of hedge fund Christofferson Robb, points out, financial innovation in the 2000s was often about maturity transformation: turning long-lived assets such as housing into something close to cash. Mortgages, packaged into asset-backed securities, were sold to off-balance sheet bank SIVs financed by short-term loans from money market funds. A 30-year mortgage became an overnight money fund holding, the equivalent of cash.

In itself maturity transformation is no bad thing; but in the 2000s it was too much, too quickly, as with previous finance novelties behind bubbles.

In depth



As interest in Bitcoin increases, US officials are looking into how to regulate, rather than shut down, the virtual currency

Further reading

Financial innovation is coming back as an alternative to banks.

Europe is suffering as overextended banks cut back credit, discouraged by new regulations designed to prevent a repeat of the last round of excess. Even as regulators get what they want – less geared banks – they fear they are starving small businesses of loans.

The ECB hopes to funnel money to small businesses via securitised bonds without adding risk to bank balance sheets. The UK wants to help by forcing banks to refer rejected borrowers to alternatives, such as peer-to-peer lenders.

Avoiding banks may look popular now, but bypassing the regulated sector has always ended badly in the past. Some of the toxic acronyms of the past are starting to recover, too. Collateralised debt obligations, or CDOs, saw more issuance in the first half of this year than all of 2012 – although the $65bn of new paper is a fraction of the $521bn in 2006.

chart on bitcoin price

For now, neither CDOs nor other areas of worry such as subprime car loans look big enough to blow up the financial system (although the liquidity offered by some exchange-traded funds is akin to maturity transformation, and could worsen any price fall in hard-to-trade assets such as junk bonds). The most obvious peer-to-peer risk is that those putting in money underestimate the risks. A debt-driven peer-to-peer boom remains far away – although it is notable that hedge funds are piling in.

Meanwhile, the potential of Bitcoin is unclear, except as a way to dodge tax or buy anonymously online. This may be useful for illegal or distasteful purchases, but is anathema to government.

Still, efforts are already under way to reuse the basic Bitcoin technology for other applications, and it is part of a broader burst of truly worthwhile financial innovation: using technology to lower transaction costs.

If governments can encourage improved financial efficiency without resulting in yet another round of credit creation, Mr Osborne’s bitcoins will have been well spent. Unfortunately, history is not on his side.

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