Binaryx · Interview #4, Dr. James Nolt “The Pending Financial Crash And The Future Of Digital Currencies” Alex: Hi, everyone. It is the Binaryx audio podcast interview. And today, we will talk about the pending financial crisis, how the Central Bank implements Digital Currencies, and could they become a counterbalance for Cryptocurrencies. And for the first episode of our interviews, we’ve invited Dr. James Nolt. Dr. Nolt is the Adjunct Associate Professor at New York University in the International Relations department and the Political Economy blogger. Hi, Dr. Nolt! Nice to meet you! James: Hi! It’s good to be here, Alex! Alex: Thank you for accepting my invite. Let’s talk about the coronavirus and the financial crisis. On your blog, you have an article discussing the influence of the quarantine and the COVID-19 obstacles. Could you please tell our readers more about the economic problems and how they’re connected to the quarantine and coronavirus? Most troubles start with a restriction of credit and a kind of finance first collapse, you know. Asset prices collapsed, stocks, bonds, companies default, sometimes banks fail. And then gradually, the financial failure translates into a loss of the real economy. James: Yes. It’s an unusual economic crisis compared to history because a major problem usually starts with something happening in finance. Indeed, many people don’t realize that there was already the beginning of a financial crash in December of last year, just before the coronavirus hit. But that was counteracted by the Fed’s pervasive intervention in the United States and central banks worldwide trying to inject liquidity into the banking system. The coronavirus hit, which is what is so unusual compared to many past crises that it started with a significant decrease in production. Most troubles start with a restriction of credit and a kind of finance first collapse, you know. Asset prices collapsed, stocks, bonds, companies default, sometimes banks fail. And then gradually, the financial failure translates into a loss of the real economy. As more people are thrown out of work, companies close down and can’t pay their debts. So, usually, it starts in finance, and it’s transmitted to the real economy. And there were problems in finances I mentioned even before this crisis began. But, the real impact of the coronavirus was to keep people at home and not produce. Of course, there are severe hits with things like tourism, commercial real estate, all kinds of small businesses that rely on foot traffic. Large parts of the economy just shut down with no production whatsoever. And that stimulated other sections. As you know, companies like Amazon did very well because they took over the delivery of goods and the time when people might have gone out to shop for stayed in the past. There were problems in finances I mentioned even before this crisis began. But, the real impact of the coronavirus was to keep people at home and not produce. Alex: Sure. James: But, in general, there was such a big closing of the physical production of goods and services. It would have immediately precipitated a horrendous financial crisis except that all Central banks worldwide pumped in trillions of liquidity from the central banking sector and more from spending such as the relief package passed in the United States this year. It would have immediately precipitated a horrendous financial crisis except that all Central banks worldwide pumped in trillions of liquidity from the central banking sector. Alex: So, the situation in the world’s economy is very desperate right now. And there’s a tense situation with the COVID-19 and the problematic use of fiat money. Governments of many countries have begun to create their own Central Bank digital currencies. They claim to be a healthy alternative for cryptocurrencies. Have you ever been interested in cryptocurrencies or digital currencies right now? James: Yes, it’s an area that I’ve studied because I wanted to research finance banking, financial assets, and currency values. So yes, this is an area that I look into. I’m not incredibly a specialist in that area, but I need to research and understand it because it’s a part of the general picture. Alex: And right now, about the digital currencies created by the European bank and China and waiting to be prepared by the USA. Do you believe in intense competition for cryptocurrencies or just as an excellent alternative to usual fiat money nowadays in front of quarantine? Cryptocurrencies are not currencies; they are assets with an exchange value. I think they’re more like, for example, art or antiques. They are scarce assets with no tremendous intrinsic value but may be very high in exchange value based on supply and demand. James: OK, this is where we are going into the massive financial theory issues that a lot of your listeners may be unfamiliar with. But first of all, I don’t consider everything called a currency as a currency. Cryptocurrencies are not currencies; they are assets with an exchange value. I think they’re more like, for example, art or antiques. They are scarce assets with no tremendous intrinsic value but may be very high in exchange value based on supply and demand. Cryptocurrencies are not very quickly used in transactions, so they’re not currencies any more than, let’s say, art is a currency. Yes, you can sell art for actual currency and then use that for many transactions, but cryptocurrencies are very limited. So, cryptocurrencies I put more assets than as a currency. Of course, this is the matter of graduation as they become more used in transactions they do move forward. But I think the currency part of the name of cryptocurrencies is more of an aspiration than reality. The second point is that currencies themselves are not fiat money. This type of money has gotten to be very popular in some circles, but I think it’s accurate and let me explain why. The definition of fiat money is “government-determined.” The government doesn’t determine and never has determined the value of national currencies. It is determined by the efforts to expand and contract credit. The amount of currencies comes from the credit system. If the credit system, which is mainly in private hands, expands credit very rapidly, the economy’s driving force (e.g., US dollar or euro) will go down in value if there is too much purchasing power produced and available for sale. On the other hand, if the credit is withdrawn and contracted within the banking and financial system, then currencies will go up. Countries with a robust banking system have a strong currency. OK, that’s no accident. Switzerland is not a great power, but the Swiss Franc is a strong currency. It doesn’t have to do with the government; it has to do with Switzerland’s powerful central bank. It has nothing to do with the government in the first instance. Private currencies long predated the government. The first instance of private currencies was circulating with merchants in China in the 5th century. It was until the 11th century later but the Chinese government got involved in currencies. So, paper currency is not based on the government’s values; it’s based on its amount through the financial system. So why does the financial system sustain above the currencies? It’s super important to understand because loans, bonds, and bills are also denominated in that currency. Who issues loans, bonds, and bills? Largely banks. They have a compelling interest in maintaining the value of their portfolios. Therefore, bonds, bills, bank loans, and other financial instruments are denominated whose value is denominated in currencies, while private banks have an incentive to keep those high values. They do that by either expanding to lower or contracting to raise currency values to acquire credit currency values. That’s why most of the community that talks about the importance of assets and currencies misses a big part of the picture, the credit system. If you understand that, you’ll realize that countries with a robust banking system have a strong currency. OK, that’s no accident. Switzerland is not a great power, but the Swiss Franc is a strong currency. It doesn’t have to do with the government; it has to do with Switzerland’s powerful central bank. If you look at the 19th century, what were the strong currencies? The British pound, the German mark, the French Franc, the Belgian Franc. What do those countries have in common? An effective banking system. On the other hand, we have the currencies like Austro-Hungarian krone, the Italian lira, and the Russian ruble. What do those have in common? They have weak banking systems. And the only way you could hold up the value of the weak currency is by linking up to gold and having strong currency countries supporting them essentially through loans via central banks. But the natural tenancy of the currency in a country with weak banks is inflationary because they tend to be an expansion of credit faster than the robust banking system would lie. When you have a healthy banking system, they don’t want the currency to inflate prices too quickly because that would reduce the value of their entire portfolio of loans and bonds. OK, so that creates a powerful private interest in the currency that does not depreciate. So that’s why it’s not a fiat currency. The banking system determines its value, and it tries to defend the currency to control the credit, mostly issued by the banking systems. If the credit system, which is mainly in private hands, expands credit very rapidly, the economy’s driving force (e.g., US dollar or euro) will go down in value if there is too much purchasing power produced and available for sale. On the other hand, if the credit is withdrawn and contracted within the banking and financial system, then currencies will go up. Alex: Understood, thank you. When the first wave of the virus started, many cryptocurrencies agreed with their value. And in front of the second wave and the next quarantine, would you instead invest in cryptocurrencies or gold? James: Well, golden cryptocurrencies both depend on the broader circumstances in the economy. Right now, I don’t think there is going to be a strong tendency for inflation of the primary currency, such as the US dollar, Euro, Swiss Franc, or the Japanese Yen. I think they’re going to hold their value. There are maybe some weaker currencies that have significant inflation. As long as you have assets that depend on these or you own these currencies, you’re not going to lose a great deal of value. There’s an idea that the money is going to deflate to nothing. I think it’s wrongheaded because it assumes that the banking system is powerless. The only way is the major collapse of the financial system as a whole. Generally, these currencies are going to be relatively healthy. And the question comes. Some assets are going to be more valuable than national currencies. If there is going to be instability, they want to get to something that they believe will not be subject to downward pressures expected of ordinary currencies. However, that’s a kind of short-run phenomenon as people seek various liquid assets. And another problem comes: if you have a relatively deep financial crisis and recession, many institutions and individuals will have to liquidate their assets to pay their debts. In defense of the cryptocurrencies, I can say that many services can track the order of the trades by the blockchain network because of how it is built. Each block just connected to the last one and the next one. So right now, you have a very long chain of different trades and transactions. And in theory, you can even find each transaction to be made from this year to the 29th April 2010. So, as people are liquidating assets in every situation, they sell acceptable assets to pay their debt on those assets. That’s what the financial crisis is: you sell all the valuable assets. It means that it’s a kind of contagion effect where the best assets become downgraded. They will likely be sold in Great quantities to pay for debts. If all the holders of cryptocurrency had no obligation, then crypto would be a vital asset. If I don’t have to liquidate anything in a crisis, I will be in a strong position, and I won’t have to sell my asset. However, if I have a lot of debt in a crisis, I have to liquidate those assets that appreciate the best return from there to pay my debts and everything else. So yes, it depends a lot on the credit system more than anything else. Part of the difficulty with cryptocurrencies is that they are not very transparent, so you don’t necessarily know where they’re being held. Some banks or public companies have some cryptocurrency on their balance sheets, and you can see that. But if there are the holders of cryptocurrency, you don’t know who they are and their debt position. Alex: In defense of the cryptocurrencies, I can say that many services can track the order of the trades by the blockchain network because of how it is built. Each block just connected to the last one and the next one. So right now, you have a very long chain of different trades and transactions. And in theory, you can even find each transaction to be made from this year to the 29th April 2010. You can find even the person who did it first. The person was anonymous because there is only a problem that you need the KYC identification for some user’s transactions. Many exchanges provide you a demo interface like a small number of cryptocurrencies to trade or sell without verifying your personality. James: Even if you know all crypto owners and their balances, we don’t know their credit position and private companies’ data. I’m not saying that’s wrong or right. I’m just saying, as a matter of fact. That’s the information we don’t have. So if you want me to predict what’s going to happen with cryptocurrencies, I wouldn’t know that. If most people holding crypto have a little debt and secure income, then the value is likely to go up. It’s just a data point, which I don’t know. So it’s hard to predict without knowing the totality of the credit positions. I would feel more secure about it if I knew that many people who buy cryptocurrency are quite solvent. Alex: What cryptocurrencies will become more adopted and legal everywhere globally and their role in their price? Would you wonder about buying, for example, the Bitcoin before the quarantine or something like that? James: I do think that many governments who may be concerned about competition from cryptocurrencies made a try to regulate their use in transactions. So I guess that’s implied by some of your questions where you’re asking about the digital currencies. And this is awkward because people use the term currency again for things that were very different. I don’t particularly like cryptocurrency. I’d instead call them crypto assets until they become very fluid in transactions and widely used. Cryptocurrencies could be used as fine art because you could sell your art if you’re in debt. It’s probably a little harder to do like Citibank wants you to pay off your loan; you may have to use US dollars. It’s one step removed, and you have a problem then in a crisis. The value will be uncertain and may collapse, or it may become harder to transact. I’m not sure that the cryptocurrency world will be as fluid as the bank system. I do think that many governments who may be concerned about competition from cryptocurrencies made a try to regulate their use in transactions. Alex: In your opinion, which steps central banks and financial institutions should do to prevent the possible financial crash? James: It’s difficult because one of the arguments I make is that central banks are only as strong as their balance sheets. And the problem that has happened recently is that we’re running an experiment that’s never been done in world history. That’s we’re assuming that central banks will never run out of bullets. They will never run out of the capacity to inject new credit into the system. Traditionally they did it mainly by buying government bonds and bills. So, purchasing the credit instruments of the government. Since 2008, we’ve seen central banks greatly expand categories of assets that they buy. Major central banks worldwide buy commercial bonds, commercial bills, and even stocks, which in the past as always has generally been prohibited either by law or the policy. There are several dangers in this. One is that if you’re loading up on assets like these and they start crashing in value, the Central Bank could lose money. The Swiss Central Bank was losing money about a year ago. The strongest currency in the world at the Central Bank of the world’s strongest currency was losing money because they bought many American stocks when the stock prices were crashing earlier that year. Central banks have never had negative returns because they own government securities of central governments that don’t default, and they make a low interest but pay some yield on those bonds. But now we have government bonds in Europe, particularly in Japan, where it’s a negative yield, so they’re not making money on the government portfolio. And they’re buying private commercial papers and stocks that can potentially lose value or even default. The problem that has happened recently is that we’re running an experiment that’s never been done in world history. That’s we’re assuming that central banks will never run out of bullets. They will never run out of the capacity to inject new credit into the system. So, as you’re going to the severe economic crisis, central banks will start to see their portfolios go negative. It’s something that has never happened in world history. It’s a kind of a brave new experiment. I think the worst case is that to avoid having massive inexpensive taxpayer bailouts of central banks. What’s going to happen is in the midst of a crisis, the central bank will stop credit issuance and try to start selling assets instead of buying assets, which would intensify the situation. We haven’t thought about that much, and I’m working on a paper for my blog. It’s going to be precise about when the Central Bank runs out of bullets, when do they exhaust their capacity to expand the economy’s credit. And some people think that central banks have some kind of magical position in the financial system, but they don’t. They are just banks like any others, and, in some ways, they are weaker than most banks because they have been traditionally restrictive on what kind of operations they can undertake. Even though they may have some privileges granted to them by the government, they are still operating in the financial system, much like any other bank. That is the buying and selling assets. Alex: As the media says, China has already launched its digital yuan, and right now, they’re testing their technology. It could give China’s economics a head start in front of other countries in the world. How do you think can digital currencies and cryptocurrencies influence political or economic relationships between the countries? James: I would say there’s a couple of things that I knew. First of all, the general idea is that all currencies have been digital currencies for a long time. That is the vast majority of the stock of other currencies at any one time. It’s just an electronic entry in some account; that’s not new. The fact that any entries are in a ledger. What’s different about these is the central control in information on transactions. Right now, ledger books are distributed as a kind of ledger. We have a distributed ledger for national currencies in the sense that the transactions are recorded all over the place in credit card companies and commercial companies that are buying and selling merchandise and in banks that are doing the clearing. The Chinese digital currency is essentially bringing all information into a centralized government control data repository. So, the government will be able to have information to monitor all the transactions that are done. And that is a new power. That’s essentially increasing the management of the Central banks and government. I think there will be a lot of the push back against this in some countries. I don’t believe the United States, for example, will adopt it and trust it. Many democratic countries have already been skeptical about Central banks’ relative independence and the banking system in general. They’re going to be suspicious about it. It won’t be easy for some European countries; indeed, Sweden has gone down the road to developing it. But in China, it is well developed. Part of the reason was the use of electronic payments. It is entirely impossible to use cash in many places like a lot of stores and small shops. They don’t deal in cash anymore. Even if a woman is sitting on the street and selling fruits, she will give you a QR code to scan with your phone to make an electronic payment. So, already electronic price is more prevalent in China than cash. The Chinese digital currency is essentially bringing all information into a centralized government control data repository. So, the government will be able to have information to monitor all the transactions that are done. And that is a new power. However, the Chinese government is concerned with getting information about these transactions more controlled. It’s all because many private companies like Alipay and WeChat control most of the operations. Some time ago, the Chinese government established a new regulation that you couldn’t get paid on WeChat if you didn’t have a Chinese bank account. That’s why these digital payment systems controlled by private companies are increasingly useful only by the Chinese. I think what the government’s going to do with its cryptocurrency or digital currency will try to squeeze more and more of the payment system into its means. They will monitor these transactions more directly to prevent criminal activity, fraud, and mostly unauthorized currency flight out of the country. Alex: So, since we mentioned cash, how do you think about how some cash will leave the market? James: That depends a lot on the country, and in China, it’s already far advanced. I haven’t been to Sweden, so I don’t know. I think it’s a bad thing because that money is too opaque. It’s not unclear to the government or centralized authorities that are issuing it. Still, it’s opaque for the consumer. That is, they don’t know much about the creditworthiness of the institutions that are backing this. Let’s take a private payment system like Alipay. What if they have some major financial problems and they collapse? You thought you had currency in this company, and it disappears. You don’t necessarily have guarantees from the government that values they might try the backstop somehow. But right now, there’s no official way to do that. The Assumption is the company is being honestly managed, and it’s not doing dangerous things with your deposit in that company. There have been many scandals in China on a smaller scale where bike-sharing systems are in China and private companies. You put a deposit with those bike-sharing companies, and then you basically can use a bicycle for free. You get a code on your phone, and you unlock the bike as long as you’re registered with it. But they keep your deposit and then take your deposit and invest it to make money; that’s how they make money. So, all those people unable to pay means also a lot of property owners can’t pay their debts. Then you get a whole collapse of the credit bubble when a lot of loans go bad. It’s almost inevitable that it’s going to happen. They don’t charge rental for the bikes, but they get money by investing your currency. Now what happens is sometimes those companies investing in older members’ deposits go bankrupt, and these deposits disappear. There’s no physical record; it’s an electronic saying you don’t have paper currency, don’t have anything holding on to it. It’s in their ledger, and it doesn’t exist anymore else. And the money itself that you have deposited there is only as good as the company’s solvency. That’s happened a few times, but it hasn’t shaken that sector. It spins on growing very fast, so there are all kinds of things on the bike share widely used in China today. So that’s not only in terms of a payment system, it’s also in terms of your deposit and gets membership in various kinds of share systems. There are all kinds of possibilities for this kind of a shared economy. But a lot of them rely on this business model of putting a deposit, which means that you can potentially lose if a company is insolvent. Alex: Nowadays, money is actively manipulated and inclusive by economic institutions and the government. And here on this point, I want to ask you about the election in the USA. As I know, Biden became a winner and the next president of the USA. So, in your opinion, how Biden could affect the cryptocurrencies and the global economy? James: Well, I’m expecting a significant financial crisis, probably in 2021. And regardless of who the president is, there’s not much that can be done to stop it because it depends on what’s happening with the private asset and credit market more than whatever the president can do. The only thing the president will be able to do is decide how to improve the situation around people suffering from losses. I’m not very optimistic about that in part because the Senate will remain under the control of the Republican party. And so, President Biden will be in the position where he basically can’t pass any legislation, which includes appropriations spending money without the opposing party’s approval. It means there will probably be a minimal stimulus in the next downturn. I’m sure your listeners are aware that a massive stimulus package passed in the United States at the beginning of the COVID crisis to try to help people and companies severely affected by the COVID. There was an attempt to pass a second stimulus package beginning in June this year and continuing up the election, and the Senate mostly blocked it. The Senate is still under Republican control. And if the Republican Senate refused to pass a stimulus when Trump was in power, they are even less likely to make it when president Biden is in power. I expect if there will be a stimulus at all, it’ll be directed to corporations. There’ll be a lot of bankruptcy, a lot of loss of homes and apartments. It’s right for both individuals and commercial properties. I think only the very most significant cryptocurrencies created by companies and are already big like PayPal or Facebook with millions of users might want to capture some of the value of transactions that occur in cryptocurrencies. But they have no necessary reason to give that privilege to outside groups unless they have a business alliance with them. Suppose you’re the restaurant owner in New York, and you rent a space for it. Your restaurant has been closed since March, and you can’t pay your rent; you have a 10-year lease. What’s happening is those restaurant owners obviously can’t pay the lease. They go to the landlord, and they say, “I can pay maybe half.” Their landlord may say, “if you can’t pay, so get out,” or “OK, this is very common now that you can pay half but I’m not forgiving it. You have to pay it next year”. It means that many small businesses and individuals right now have their payments deferred but not forgiven, so they’re being piled up in 2021. They can’t pay their debts, so that’s for the financial crisis. The landlord has evicted a tenant and has difficulty finding a new tenant that can pay rent. That’s why there are many empty commercial and residential buildings in every city. So, all those people unable to pay means also a lot of property owners can’t pay their debts. Then you get a whole collapse of the credit bubble when a lot of loans go bad. It’s almost inevitable that it’s going to happen. Of course, we’re unlikely to get any fresh stimulus. If we get a stimulus, it will be targeted at specific companies that the Republicans support, and so forth. It won’t reach most people, so I think it’s very likely that we’ll have a severe crisis. All those people unable to pay means also a lot of property owners can’t pay their debts. Then you get a whole collapse of the credit bubble when a lot of loans go bad. It’s almost inevitable that it’s going to happen. Alex: Thank you very much. And for the last one, I wanted to ask you a question about the future. So I can say that one of the primary purposes for the blockchain and digital currencies is to maximize speed and opportunities of usage and also to minimize information and privacy losses. Based on these terms, what do you think which industries can adopt the blockchain and digital currencies next, or would they evolve in the future? James: It’s a challenging question because it will depend on some factors. For example, some large internet companies might decide to allow us to purchase products by digital currencies, but they also might choose to create their competing currency. It depends on the policy of the companies. There’s no reason why this is the difference from national currencies, so there’s no reason why it needs particular commercial insurance to necessarily want to make payment available to a specific cryptocurrency. Number one, most cryptocurrencies except for the few, but the very biggest don’t have a significant user pool. And it’s not allowing those to be used for purchases because it doesn’t affect much the company’s business. All those who own those currencies have alternative payment methods, and for the company deciding to use them as a means of payment, there is a certain complexity. They have to create accounting systems and exchange rate calculations, just like if you need to accept payment in a foreign currency. There’s no reason to add that complexity in cost unless you’re accessing a significant amount of funds spending stream that would be otherwise inaccessible too. I don’t think any customer who owns cryptocurrency has alternative means of payment, so not accepting the currency doesn’t mean that the company would lose the sale. Getting the money will mean a substantial cost. Unless it becomes a considerable means of payment, companies will not adopt crypto as a means of payment because it’s possibly costly to them and will not gain customers all that much.