A Guide to Consensus Algorithms on Blockchain Networks Part 4

Problems with fiat currencies and governments being financial third parties.

 

There can be many issues with a currency controlled by a government and this article will give a few examples of how things can go wrong. Ultimately, all these examples boil down to one big problem: there is a central authority that can change the rules of the game at any time it wants and do whatever it wants.

This is the biggest issue that the blockchain technology and the consensus algorithms on blockchain networks solve: each network has rules of the game and because of the decentralized nature of blockchain networks no central authority can change the rules of the game. While many of the blockchain networks do have non-profit foundations in charge of software development, miners and users can leave whenever they want. If the majority of miners on a network do not agree with what a foundation is doing, the miners can join the forces and keep creating blocks of an alternative blockchain on which rules have not changed. This is the main difference between a blockchain network and a government with a fiat currency.

One of the most outrageous examples of things going wrong with a fiat currency is the country of Zimbabwe. The economy of the country and the standard of living of its citizens have been deteriorating in the 1990s. The government of the country has then decided to run land reforms during which the farms in the country would change ownership. However, the reforms were not successful because new owners did not have sufficient agriculture experience and couldn’t run the farms effectively and efficiently. Because of this, economic conditions in the country kept worsening. In an attempt to make the situation better, the central bank of the country started printing more money.

Inflation can be a huge problem with a fiat currency because for a central bank to start printing more money it doesn’t need anything else other than a decision. With a commodity-based currency, the country would need to increase the supply of commodities before it could print any new money but with a fiat currency a decision is enough.

In Zimbabwe, this decision has led to skyrocketing inflation rates. In 2008, the inflation in the country was between 230,000,000,000% and 500,000,000,000%. These numbers are not typos. They are two hundred thirty billion, billion with a b, and five hundred billion percent. The situation got to a point where the central bank of the country was printing bank notes that were equal to trillions of Zimbabwe dollars. At a certain point, 1 trillion of Zimbabwe dollars was worth about USD$0.4 (forty cents). The banknote that had the highest nominal value was one hundred trillion Zimbabwe dollars. Eventually, the country decided to stop using Zimbabwe dollars altogether and has switched completely to using United States Dollar in 2009.

 

World Financial Crisis of 2007/2008

Fundamentally, the World Financial Crisis has occurred for the same reasons as the hyperinflation in Zimbabwe, even though the crisis did not hit the residents of the countries where it occurred in the same way. These reasons were mistakes made by central authorities and large corporations and the ability of the governments to enact measures that have essentially changed the rules of the game and shifted the responsibility for the crisis.

One of the main reasons for the world financial crisis of 2007 and 2008 was subprime mortgage crisis in the United States. The crisis has occurred because large organizations in the financial industry, including banks and insurance companies, started operating based on the assumption that property values in the United States would always be going up. The erroneous conclusion that follows from this assumption is that banks can and should let anyone apply and get a mortgage or a home refinancing credit.

Here’s how this works: Let’s say a home costs $50,000 and the bank gives someone a mortgage for $50,000. Even if the person can’t pay the mortgage tomorrow, the value of the property tomorrow will be higher than it is today. Therefore, the person would be able to sell the home for more than $50,000, get profit and pay back the mortgage. Once banks give such mortgages, securities companies such as Bear Stearns and Lehman Brothers would package these mortgages into what they called investment vehicles and re-sell these investment vehicles. Obviously, the scheme could not last forever and the housing market in the United States collapsed in 2007 and 2008.

When the market started going down and the government officials figured out what was going on, they have decided to bail out some of the banks, insurance companies and other businesses. Their logic was very simple: they believed that letting big banks fail would do more harm to the economy than giving them money they didn’t deserve.

To bail out all the companies the government wanted to bail out, in started the process of “quantitative easing.” Here’s what this means in simple terms: the government would sell debt, acquire funds and distribute the funds among the corporations it was bailing out. The issue with this is that the debt became a part of the country debt, meaning that in the future it would be paid by the money that would be coming from the taxes. Therefore, what happened was the following: certain big players made mistakes, yet the government decided to pay for those mistakes with the money of regular tax payers who did nothing wrong. According to an article in the New York Times Magazine from April 30, 2014, out of all executive officers to run financial companies during the 2007/2008, only one person went to jail. He was an executive at Credit Suisse and the name of this person was Kareem Serageldin.