How the US Fed thinks a Bitcoin ban could preserve deficit spending

Bitcoin has been called many things, but a “balanced budget trap” is probably not one of them. Or at least not noticeably — until now.

A recent paper published on the Federal Reserve Bank of Minneapolis website suggests that Bitcoin (BTC), or something like it, could one day force the United States federal government to balance its budget.

That would arguably vex policymakers and legislators because they want to keep all their spending options open in case of serious emergencies, like a COVID-19 pandemic or a recession. A burst of spending can stimulate an economy, after all.

 So, how can the US escape this “balanced budget trap”?

“A legal prohibition against bitcoin can restore unique implementation of permanent primary deficits, and so can a tax on bitcoin,” the paper’s authors write.

A primary deficit is the difference between government spending and revenues, excluding interest payments.

A red flag for the crypto industry?

Even the suggestion of a Bitcoin ban is bound to chafe the crypto community. 

The reaction of those who managed to plow through this dense 37-page paper issued on Oct. 17 was often a mix of befuddlement, outrage and derision. 

It also raised some questions over whether such a ban is even feasible, and how a digital currency with a $1.4 trillion market cap could wield such power over a government holding a debt 25 times that capitalization.

US public debt now surpasses $35 trillion. Source: US Federal Reserve

“Bitcoin is not a way to force the US government to balance its budget,” Matthew Le Merle, CEO of Blockchain Coinvestors, told Cointelegraph. “At $35 trillion-plus of debt, something is wrong with the spending patterns of US politicians, and something needs to change.”

“I find this paper quite hilarious in an ironic way,” Daniel Lacalle, chief economist at Tressis — a Spanish investment firm — told Cointelegraph. “It is basically admitting that Bitcoin is a protection against currency debasement and could limit the government’s constant debt accumulation. The funny thing is that if the government was responsible and wanted to defend the purchasing power of the currency, there would be no threat.”

The possibility of banning Bitcoin

But what about the notion that the US government could preserve its spending options by prohibiting Bitcoin? Is a ban even doable? 

“Although it would be incredibly difficult for a government to eliminate the use of Bitcoin completely, a large government opposed to Bitcoin could significantly reduce its use,” William Luther, associate professor of economics at Florida Atlantic University, told Cointelegraph. 

The usefulness of a medium of exchange depends on the size and composition of its user network. “So, if a government can limit the size of the Bitcoin network, it might reduce Bitcoin’s usefulness to those beyond its jurisdiction as well.”

The paper drew attention in part because it appeared on the website of the Federal Reserve Bank of Minneapolis, which is part of the Federal Reserve, the most powerful economic institution in the United States.

But one should not assume that the views of the authors, Amol Amol and Erzo Luttmer, are necessarily those of the Minneapolis Fed.

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“This is independent research that was done by those who work in their research department,” Joshua Hendrickson, associate professor and chair of the department of economics at the University of Mississippi, told Cointelegraph, adding:

“These research departments are much more like university departments. Everyone is free to write research papers about the topics that they want.”

Besides, the sustainability of government debt — and perpetual primary deficits — is a popular topic right now among academics, he added. 

A thought experiment

The paper essentially asks under what circumstances the government could run a permanent primary deficit, explained Hendrickson. The answer depends on whether Bitcoin, or something like it, exists. 

“When there is no such thing as Bitcoin, the answer is that yes, it would be possible to run a perpetual primary deficit.”

But something like Bitcoin does exist, and that makes things more complicated. “An asset like Bitcoin can be a release valve,” the professor continued. If people expect their dollar-denominated assets to depreciate in real terms, people can switch to assets like Bitcoin.

“But this very substitution creates a scenario in which the perpetual primary deficit is no longer feasible,” suggested the researchers, according to Hendrickson.

Can governments “hold back the incoming tide”?

But is a prohibition feasible given that BTC is a cryptocurrency with users in nearly all the countries in the world? 

In its “2024 Global Adoption Index,” Chainalysis ranked 151 countries on their level of crypto adoption. The US ranked fourth, behind India, Nigeria and Indonesia.

2024 Global Adoption Index rankings. Source: Chainalysis

“You might as well try and ban the internet as ban digital monies, commodities and assets,” said Le Merle, who recalled the “Stop the Internet Now” movement of the 2000s, “which similarly looked like King Canute trying to hold back the incoming tide.”

Still, a US ban could certainly put a damper on things, even in countries outside its jurisdiction. Luther said.

“If my foreign trading partners don’t want to use Bitcoin out of fear that they will be punished by their government, I am less likely to use it as well — even if I am beyond the reach of their government and my own government is relatively permissive.”

Hendrickson has co-authored papers on the topic of whether governments can ban Bitcoin. “A simple response is that passing a law would be insufficient.”

For a ban to work, a government would have to take actions that would destroy Bitcoin’s “network effect” — where its value rises when more people use it. This could come in the form of passing laws that prohibit people from accepting it and punishing people for being caught using it, Hendrickson explained. “What we have shown is that it is possible for policies like this to result in scenarios in which Bitcoin is no longer used or held.”

But that’s not the end of it. What Hendrickson and his co-authors also found was:

“If the network effects are sufficiently strong, or if there is a large enough group of Bitcoiners who will accept Bitcoin no matter what, then these policies will not work.”

Moreover, Bitcoin isn’t the only possible constraint on permanent primary deficits. There are other “alternatives” that can effectively limit the US government, including currencies issued by foreign governments like the euro or yen.

“Banning Bitcoin isn’t enough,” said Luther. “To eliminate the constraint imposed by alternatives, the government would need to ban all the alternatives.”

That would be a draconian policy, he continued. Indeed, relatively few governments prevent their citizens from holding foreign currencies or cryptocurrencies, “and those that do tend not to be the sort of places Americans would like to emulate,” Luther added.

Government deficit spending has generated debate among economists for a long time, almost as long as the profession has existed.

Along the way, groups like the Republican Party and the Peterson Foundation proposed amendments to the US Constitution mandating a balanced budget, arguing “that future generations have a right to be protected from debts accumulated by earlier generations.”

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Opponents of such a drastic remedy say it would limit the ability of future policymakers to use fiscal policy to counteract recessions or respond to national emergencies.

“Bitcoin constrains governments”

But a paper like the one on the Minneapolis Fed’s website can raise indignation within the crypto community. “This is a classic situation where we need to fix our own behaviors but prefer to pretend the problem with our behaviors is being caused by someone else. Bitcoin is not what is threatening the US’ health and prospects — that much is clear,” said Le Merle.

“What this paper shows is that there is an economic and fiscal limit to the dollar, and even a small threat like Bitcoin could endanger it,” said economist Lacalle, further adding:

“It is profoundly immoral because it is basically advocating for the suppression of BTC because they know that the government will continue to destroy the currency.”

Still, the paper can serve as an indication to the crypto industry where future resistance to its flagship currency could arise. “Bitcoin constrains governments by giving people an outside option,” Luther noted. A day may come when the US and other governments may try to shake off that constraint.