In a previous piece, we examined the inner workings of a gold-based fractional-reserve free banking system–the monetary system that was roughly used in the United States for much of the 19th century and before. The system works as follows. Customers deposit gold–which is the system’s actual money, legal tender–at private banks, and receive paper banknotes in exchange for it. Customers can redeem the banknotes for the gold at any time.

In such a system, the market eventually comes to accept the banknotes of credible banks as payment in lieu of payment in gold. The banknotes become “good as gold”, operationally equivalent to the base money that “backs” them.

Importantly, banks take advantage of the fact that, on a net basis, very few banknotes actually get redeemed for gold. This convenient fact allows them to issue a quantity of banknotes that exceeds the quantity of customer gold that they have on hand to meet redemptions. They issue the excess banknotes as loans to borrowers in exchange for interest. In this way, they expand the functional money supply, and make it possible for the economy to grow in a non-deflationary manner, despite being on a hard monetary standard.

A fractional-reserve free banking system with gold as the base represents a coveted Libertarian ideal because it requires no government involvement, other than the simple enforcement of contracts. There are no complicated and cumbersome regulatory rules to follow, no externally-imposed reserve requirements or capital adequacy ratios, no interest rate manipulations on behalf of economic, corporate, and political interests, and so on. All that the system contains are individuals, banks, and naturally-occurring gold (legal tender, base money), with the individuals and banks free to use fractional-reserve lending to “multiply” the gold into whatever quantity of circulating paper money they wish. Consistent with the Libertarian ideal, if they screw up, they pay the consequences. There is no lender of last resort to come in and clean up the mess, only private entities entering into contractual agreements with each other and doing the due diligence necessary to ensure that those agreements work out.

In the modern era, it is inconceivable that any serious legislative body would choose to put an economy on a fractional-reserve free banking system. Such systems are highly unstable, prone to bank runs and severe liquidity crises, particularly during periods of heightened risk-aversion. That’s precisely why central banking was invented–because free-banking doesn’t work.

However, it is conveivable that the private sector, working on its own, could one day put the economy on a fractional-reserve free banking system. The most likely way for it to accomplish this feat would be through the use of a cryptocurrency such as Bitcoin. In what follows, I’m going to explain why fractional-reserve free Bitcoin banking is a necessary condition for Bitcoin to become a dominant form of money, and how the government will easily stop its emergence and proliferation.

Economic expansion in a capitalist system is built on the following process. Individuals borrow money and invest it. The borrowing for investment does three things. First, it adds capital to the economy and increases the economy’s real output capacity. Second, it expands the operational money supply. Third, it creates new streams of monetary income. The new streams of monetary income are used to consume the new streams of real output that the investment has made possible. The spending of the new income streams by those who receive them creates income for those that made the investments. That income is used to finance the borrowing, with some left over as profit to justify the investment. The economy is thus able to “grow”–engage in a larger total value of final transactions at constant-prices–without needing to increase its turnover of money, because it has more money in it, money that was created through the process of borrowing and investing. The relevant economic aggregates–real output capacity, money supply, income–all grow together, proportionately, in a balanced, virtuous cycle.

Crucially, for Bitcoin to evolve into a dominant form money, it needs to be the dominant form of money in each stage of this process. If workers are going to get paid in Bitcoins, the investment that creates their jobs will need to be financed in Bitcoins. If consumers are going to go shopping with Bitcoins, the associated Bitcoin revenues that their shopping creates will need to be distributed as wages and dividends in Bitcoins, or reinvested as Bitcoins. And so on and so forth. Trivially, we can’t just pick one part of this process and say “that’s going to be the part that uses Bitcoin.” If Bitcoin is going to reliably displace conventional money, the whole package will need to use it.

To be clear, it’s possible that Bitcoins could become popular for use as a form of payment intermediation–in the way, that, say, a gift card is used. You put money on a gift card, give it to someone as a gift, and they spend it. When they spend it, the merchant that receives it converts it out of literal “plastic” form and back into money, by electronically zeroing it out and taking final claim of the money that was used to buy it. In a similar way, even though the corporate recipients of spending have no reason to want Bitcoins–they don’t owe debts to bondholders in Bitcoins, salaries to workers in Bitcoins, dividends to shareholders in Bitcoins, or taxes to the government in Bitcoins–it is conceivable that they might still accept Bitcoins, given that there is a market to convert Bitcoins into what they do want: actual money.

But with a gift card, the intermediation is conducted for a clear reason–to eliminate the coldness and impersonality associated with giving cash as a gift, even though cash is always the most economically efficient gift to give. With respect to Bitcoin, what would be the purpose of the intermediation? Why, other than for techy shits and giggles (“Hey, look guys, I just bought a pizza with Bitcoins, isn’t that cool!”), or to hide illicit activity, would anyone bother to hassle with it? Just use conventional money–in this case, dollars. The fees associated with using dollars are imperceptible, hardly a reason to waste time with an intermediary, especially an intermediary that is extremely volatile and speculative in nature. And it’s not even clear that those who use Bitcoin for intermediation will manage to escape fees.

When we talk about the proliferation of Bitcoin as a replacement for conventional money, we’re talking about something much bigger than a situation where certain people switch into and out of it for purchasing convenience. In such an environment, the underlying dollars are still the ultimate monetary “end”–the cryptocurrency acts merely as a way of temporarily “packaging” that end for preferred transport. Instead, we’re talking about a situation where the Bitcoin becomes the actual money, the medium through which incomes are earned and spent.

Fundamentally, such an outcome requires a mechanism through which Bitcoins can be borrowed. If Bitcoins can be borrowed, then it will be possible for the virtuous process of borrowing and investing to grow the supply of Bitcoins at a pace commensurate with the demand to use them in commerce, and commensurate with the growth in the supply of everything else that grows in an expanding economy. But if Bitcoins cannot be borrowed, then their supply will only be able to grow at the pace of computer mining output–a pace that, by design, is very slow (and that has to be slow, in order to prevent the currency from being excessively produced and depreciating in value), and that, unlike conventional money, has no logical or causal connection to the growth that occurs in any other economic aggregate.

If, as output and incomes grow, the supply of Bitcoins is unable to efficiently increase to sustain the increased volume of commerce conducted, then the exchange value of Bitcoin will always be appreciating relative to real things. The continual appreciation will bring with it extreme bi-directional volatility as individuals come to expect continual appreciation, and attempt to speculate on it in pursuit of an investment return. Consequently, “money illusion”, the conflation of money in the mind of the user with the things that it can buy, will not be able to form. Without “money illusion”, no one is going to be inclined to measure the commercial world in Bitcoin terms, and therefore nobody is going to be comfortable storing wealth in the currency.

Granted, individuals will be comfortable speculating in Bitcoin, trying to aggresssively grow and expand wealth by investing in it, but not storing wealth in it, which is a different activity entirely. The result will be a volatile, stressful-to-hold instrument that functions more like an internet stock–say, $FB or $TWTR, except without the earnings prospects–than like cash in the bank or under a mattress, which is how money is supposed to behave. Internet stocks can certainly rise on reflexive hype, but without the prospect of eventual income (something that Bitcoins don’t offer), they don’t stay risen.

Ironically, the extreme bi-directional price volatility will give Bitcoins the opposite characteristic of gift cards and other temporary stores, which is why they won’t even be survivable as forms of payment intermediation. Who wants to buy a gift card, or receive payment with a gift card, that randomly increases or decreases in value by huge amounts every minute, every hour, every day? Again, it’s conceivable that someone might want to purchase such a thing for shits and giggles–as a fun gamble of sorts–but not for serious commercial purposes.

It’s important to recognize that the vast majority of people that are buying Bitcoins are not doing so because Bitcoins removes hardships associated with conventional money. In everyday life, the people that are buying Bitcoins still use their dollar bills, their credit cards, their online bill pay, and everything else, with no real gripe or complaint. The reason they are buying Bitcoins is to speculate. They want to get in on a futuristic technology that they think has the potential to massively “disrupt” the financial world, creating wealth for those that invest ahead of the pack. That is the only thing that’s “in” the current sky-high price–that expectation, held in the minds of a large number of people. The current price is not evidence that Bitcoin has successfully solved any economic or financial problem that actually needs to be solved–expense, intermediation, value storage, whatever. Conventional money is working just fine.

Now, to return to free banking, the natural way for Bitcoin to latch onto an expansionary mechanism that would allow it to become a dominant economic currency, and to thereby displace conventional money, would be if a free banking system based on Bitcoins, similar to what existed in the U.S. in the 19th century, were to evolve. On such a model, banks would “hold” Bitcoins for their customers, and issue electronic deposits redeemable for Bitcoins in exchange. Because depository Bitcoin inflows would roughly match or exceed depository Bitcoin outflows for the system as a whole, it would be possible for the banks to issue more Bitcoin deposits than exist in actual Bitcoins on reserve. The excess deposits would then be available for use in lending, which would increase the operational Bitcoin supply in a way that would allow for credit transactions–the lifeblood of economic growth–to shift to Bitcoin in lieu of conventional money, and for price stability and an associated money illusion in the Bitcoin space to emerge.

On such a system, investors and entrepreneurs would be able to take out Bitcoin loans to build homes, buildings, factories, technologies, and so forth. The workers that build those entities would receive the Bitcoins as new income, and spend them. The new spending would produce Bitcoin revenues, which would turn into recurring Bitcoin interest payments to the Bitcoin lenders, recurring Bitcoin wages to the workers, recurring Bitcoin dividends for the investors and entrepreneurs, and so on. At that point, Bitcoin will have “arrived.”

If people were so inclined, one can envision this setup producing a situation where conventional government currencies become obsolete–where no one wants to use them anymore, or has a need to. If that happens, the Fed’s central planning, and the central planning of other central banks, will have been fully bypassed–defeated once and for all. Central banks will no longer be able to force bailouts, excessive inflation, negative real interest rates, financial repression, and so on down the throats of unwilling market participants. The system will be a true Libertarian utopia, based on limited government, private enterprise, and personal responsibility.

Fortunately (in my view), and unfortunately (in the view of Bitcoin aficionados), legislators and policymakers can easily prevent this outcome from happening. All they have to do is put in place a regulation that imposes a 100% reserve requirement on entities that “bank” in Bitcoins, i.e., that hold Bitcoins for customers. Then, expansion of the Bitcoin supply through lending will be impossible, and the currency will forever remain a constrained, volatile, illiquid, wholely speculative venture, something inappropriate and improperly fitted for serious, non-speculative, non-shits-and-giggles, non-scandalous economic activity. Those that are seeking to borrow and invest–to take the first steps in the virtuous process of economic and monetary growth–will have no reason to want to mess around with the cryptocurrency.

Which brings us to the “death blow.” It appears that legislators and policymakers are already a few steps ahead. The New York State Department of Financial Services, for example, recently issued a set of proposed virtual currency regulations. Among them:

That line right there, if accepted into regulation, would be enough to conclusively destroy any hope of a Bitcoin monetary takeover. It effectively sets a 100% reserve requirement for Bitcoin banks, making it imposible for the supply of Bitcoin to expand in the ways that would be necessary for the cryptocurrency to displace conventional money.

The significance of this vulnerability should not be understated or underestimated. It’s very easy for the government to stop the proliferation of Bitcoin, and ultimately send the cryptocurrency to the graveyard of investment fads. The government doesn’t have to resort to draconian, unpalatable, freedom-killing measures that would try to stop consenting adults from innocently trading Bitcoins amongst each other. All the government has to do is impose a full-reserve banking requirement on any institution that purports to engage in Bitcoin banking. Far from wading into controversy, it can impose such a requirement under the seemingly noble and politically palatable auspice of “protecting” Bitcoin users from risky bank behavior, even though the requirement will have the intended side effect of eventually extincting the cryptocurrency, or at least of squashing its hopes for greatness.