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Blockchain and finance in 2019
Are Cryptocurrencies a Solution to Combating Recession in the Conventional Financial System?
Recessions are a natural part of the economic cycle, characterized by a contraction in the economic output of a country. In other words, recessions happen when there is a decline in the production of goods and services within the country. Every country has experienced some form of recession in their economy with varying degrees of impact, from minor slow-downs to deeply-feared depressions – the most severe form of recession. A country is likely to experience economic downturns every nine years. Some are not that lucky; for example Greece has been in technical recession for a quarter of their history since the 1960s. Despite the differences, it is a given fact that recessions have a devastating effect on the greater society, contributing to unemployment, reduction in income, increased inequality, and a generic rise in poverty.
Governments are constantly in the lookout for signs of recession and will use all the tools at their disposal to prevent recessions from forming, or limit its devastating effects if it should occur. However, there have been critical debates on the effectiveness of government intervention. Cases have occurred where government efforts to contain recessionary effects have backfired and even worsened the situation. This article will explore the viability and effectiveness of blockchain-powered cryptocurrencies as a possible alternative to the global financial system.
History of Recessions
Recessions have always been an inherent part of the economic system, characterized by a slowdown in economic expansion, or a decline in performance over a period of time. Although the period of a recession can and does often vary, nevertheless a recession can have lasting and structural effects on the economy. Fundamental changes effected by a recession can include the eradication of legacy industries and technologies, ad hoc economic and monetary policy changes that impact businesses, or political and social brouhaha resulting from economic suffering and rising unemployment. To get perspective on past recessions, let us examine key global recessions over the past 100 years.
The Great Depression (1929–1939)
Unanimously considered to be the worst financial crisis in the past century, the Great Depression was triggered by the crash of the United States stock market, and further exacerbated by the ineffective monetary policies of the US government. The depression lasted close to a decade, resulting in a colossal loss in real income, a high unemployment rate of up to 25%, and a reduction in economic output.
The OPEC Oil Crisis (1973)
This crisis was triggered by Arab nations in OPEC (Organization of the Petroleum Exporting Countries) beginning an oil embargo to the US and its allies, as a result of their role in supplying arms to Israel during the Yom Kippur War. This resulted in a sudden spike in oil prices, and caused shortages in the oil supply. This in turn led to an economic crisis in the US and other developed countries, due to the huge dependence of oil on the developed economy at that time. Making matters worse, that period was already rife with high inflation, leading to a long-term economic stagnation that lasted years.
The Asian Crisis (1997)
Originating in Thailand, the Asian crisis was as a result of over-leveraging and an exponential rise in debt to fuel a period of economic expansion and optimism. When Thailand had to abandon its fixed-exchange rate pegged to the US currency, it kicked off a frenzy of panic that spread to the Asian financial markets, affecting the economies of East Asian countries. The IMF had to step in to offer bailout packages to Asian governments, and the knock-on effects of this chaos lasted for several years.
The Global Financial Crisis (2007-2008)
The increasing interconnected nature of financial markets and globalization amplified the subprime mortgage crisis originating in the US, which culminated in a global financial crisis second only to that of the Great Depression. The US government’s lax economic policies in terms of low interest rates and the absence of regulation for complex derivatives, led to a frenzy of subprime mortgage securitization and over-leveraging, which in turn led to unsustainable levels of debt. When the bubble finally popped, many financial institutions were on the brink of collapse and found themselves at the mercy of the government for a bailout. The Global Financial Crisis of 2007-8 wiped out millions of jobs in the economy, and billions of dollars in the system.
Tools Used to Combat Recession
Little can be done to prevent recessions since they are a natural part of the economic cycle. However, governments and central banks also assume the responsibility of lessening the impact of a recession, using the following methods:
Expansionary Fiscal Policy
To stimulate the economy in a recession, the government will try to increase government spending or reduce the tax rates – or both. The purpose of both mechanisms is to facilitate aggregate demand in the economy by increasing the disposable income of citizens, and also to foster economic activity.
Expansionary Monetary Policy
In a recession, the central bank will seek to increase the money supply using such mechanisms interest rate reduction, and printing more money (formally called ‘Quantitative Easing’) to jump-start the economy. The goal is to ‘flood’ the economy with more money so that citizens can spend it on goods and services, which will then foster economic growth. There are limitations to this approach, since a country with already-low interest rates has precious little maneuvering capability using monetary policies, especially if printing more money will devalue the domestic currency and hurt international trade. Central banks are also warming to the idea of a negative interest rate policy, which essentially charges depositors for storing money in the bank, instead of compensating them with interest growth.
This entails the use of public funds to prevent an institution from failing or shutting down, due to the destructive consequences that may follow in the event that it does. This is best exemplified by the Federal Reserve bailing out major financial institutions in the subprime mortgage crisis in 2007.
Perhaps the last resort in the event that a government is unable to expand its resources to solve its country’s misery, is to depend on the global governing body – the International Monetary Fund (IMF) – to provide the affected countries with funding.
Effects of Monetary Policies
The most common tool employed by central banks and governments is monetary policy, since it is the quickest to execute. Central banks slash interest rates, to boost lending and spur spending in a bid to stimulate the economy. This happened in the years leading up to the subprime mortgage crisis, when the Federal Reserve slashed interest rates, creating a low-interest environment that fueled massive borrowing and over-leveraging, which then became major factors in causing the crisis. When the Global Financial Crisis occurred, the Federal Reserve had to further cut the interest rates down to almost 0%, leaving very little room for maneuver around its monetary policy.
The aftermath of the crisis led countries to consider leveraging negative interest rates to bolster economic activity, with Denmark, Japan, Hungary, Sweden, and Switzerland leading the way in implementing a nominal negative interest rate policy after 2014. This ‘punishment’ on consumer savings is intended to stimulate growth and raise inflation. In a technical sense, the objective is to prevent the domestic currency from rising too much to increase its competitiveness in relation to other currencies. However, the fact that normal citizens bear the brunt of the reduction of their savings in the bank is unfortunate, to put it mildly.
Characteristics of Cryptocurrencies
Bitcoin’s introduction at the aftermath of the global financial crisis has propelled its standing as a viable alternative to the traditional monetary system, filled as it is with inherent weaknesses and inefficiencies. The characteristics of Bitcoin and cryptocurrencies in general seem to be far superior to that of fiat money.
Society’s worse enemy in the financial system is inflation, which refers to the general rise in prices of goods and services. More importantly, inflation reduces the value of the money that we hold over the long term. A $100 worth of fiat currency a 100 years ago can buy much more things than $100 of today’s money. The unlimited supply of fiat currency, and the ability of central banks to print more money at will, inevitably erodes the value of fiat money in the long-term. With cryptocurrencies however, the supply is often fixed. Bitcoin for example, has a fixed supply of 21 million Bitcoins (BTC). Fixed-supply money is protected from inflation since its value will increase with greater demand and velocity, given its rarity.
The inherent decentralization of cryptocurrencies allows for the empowerment of the masses, since anyone can be a part of the financial system. The rules for joining and participating in the global financial system are clear and transparent, with every expansion in the monetary supply recorded on the public ledger. This is the opposite to the fiat system, where the mechanics of the expansion or contraction of the money supply is opaque and only known to the higher echelons of the government and financial institutions.
Cryptocurrencies are built on blockchain technology, which are public ledgers that record every single transaction, complete with all the relevant data, and are free and transparent for anyone to access globally. This prevents any form of tampering or opacity from occurring in the financial system.
Cryptocurrencies, led by Bitcoin, have proven themselves to be a viable alternative to the fiat system. With features of transparency, empowerment and protection against inflation, cryptocurrencies were created to address the inherent weaknesses of fiat money, as well as the inadequacy of governments in effectively managing their own economic and monetary policies.