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August 22, 2014

Bitcoin Currency: The New Frontier for the CFPB

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The Consumer Financial Protection Bureau (CFPB) has unparalleled powers over nearly every consumer financial product and service.  Given that virtual currencies can serve as a form of electronic money, the CFPB has, predictably, decided to weigh in on this topic.

A CFPB statement this week warned people about the dangers of private digital currencies such as Bitcoin, XRP, and Dogecoin.  It started perfectly reasonably, noting that:

In a nutshell, while virtual currencies offer the potential for innovation, a lot of big issues have yet to be resolved – some of which are critical. If you are interested in using or buying virtual currencies, you should be aware of the associated risks.

It went on to list several risks associated with digital currencies, such as hackers, limited investor protection, cost, and outright fraud.

Fair enough.  There are certainly legitimate risks associated with using digital currencies, and potential users of these services should understand those risks.

But then the CFPB statement goes on to perpetuate one of the great myths of history:

But virtual currencies aren’t regular money. To begin with, virtual currencies are not issued or backed by the United States or any other government or central bank.

Makes you wonder how the US survived until 1913 without just one government-backed currency.

Richard Cordray, the CFPB’s Director, then piled on by adding: “Virtual currencies are not backed by any government or central bank, and at this point consumers are stepping into the Wild West when they engage in the market.”

But there’s a hitch. These taught “facts” are dead wrong.

Yes, there were many problems with the pre-Fed banking industry, but most of these centered on poorly structured rules and regulations.

For instance, prohibitions on branch banking made the financial system unstable because it tied the success of each bank to its own local economy.  After the Civil War, a key shortcoming was that banks were barred from issuing currency without adequate backing of U.S. government bonds, even though the process of acquiring bonds was cumbersome and expensive.

After 1865, state-chartered banks faced a similar problem because the federal government placed a prohibitive 10 percent tax on their currency issues.

All of these problems contributed to seasonal currency shortages which were often severe. But the problem was not that banks could issue their own currencies.  The historical record shows that the fact that banks issued their own individual currencies – typically backed by either gold or silver – was a positive feature of the system, not a negative one.

In fact, the reform movement that eventually gave us the Federal Reserve largely debated whether banks should be allowed to issue their own currency against government bonds or, instead, against the general assets of each bank.  There was no massive outcry – especially in Congress – for a government monopoly on currency issue.

(The US ended up with such a system largely due to the populist politics of William Jennings Bryan who argued that government control over money was preferable to the private control of the “plutocratic” bankers).

Economic historian Elmus Wicker identified at least 10 distinct reform proposals from 1894 to 1913.  All of these plans influenced the debate to some extent, but none called for a government monopoly on money, and only a few called for a central bank.

Even the proposals that did call for a central bank, almost without fail, were based on legalizing and expanding clearinghouses – associations of private banks that issued clearinghouse notes/loans during banking panics.  The main question here, too, was whether the clearinghouses should be allowed to issue notes based on general assets or bonds.

The reform debate lasted for more than a decade, and although the 1913 Federal Reserve Act gets all the press, Congress actually passed a temporary reform measure known as the Aldrich-Vreeland Act in 1908. Surprisingly, the Aldrich-Vreeland Act successfully stemmed a banking panic after the Federal Reserve Act passed in 1913.

In 1914, before the Federal Reserve System was fully operational, the Aldrich-Vreeland Act was amended to allow banks to issue emergency currencies.  More than 2,000 banks throughout the US issued nearly $375 million in their own notes, successfully ending a panic.

The notes were issued against the general assets of the banks, and they were used both to pay depositors and to make inter-bank payments.

It is impossible to know for certain, but the Federal Reserve may not have been created in 1913 had these events unfolded closer to 1908.  The Aldrich-Vreeland Act success showed that allowing banks to issue their own currency against their assets, without restrictive bond requirements, could in fact mitigate the nation’s banking problems.

But it happened too late to alter the Federal Reserve Act.

Hopefully, the same people who “know” how beneficial a single government-backed currency is to the US will take the time to really evaluate what they know about digital currencies.

 - An expert on financial regulation, Norbert J. Michel is a research fellow in The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.

Originally appeared in Forbes

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