In this guest post, economics professor and former Bank of England economist Tony Yates talks about the potential for “cryptocurrencies” to compete with government-backed money, and what central banks can do about it.
The total value of all cryptocurrency in circulation is now almost $100bn. This is roughly double what it was just a few months ago, but it’s still tiny compared to the face value of paper dollars issued by the Federal Reserve, which alone amount to about $1.4trn. We are therefore nowhere near the point yet where cryptocurrencies pose a credible threat of supplanting central-bank-issued money.
Nevertheless, it’s worth thinking through some of the implications if something like Bitcoin (which has about a 45 per cent market share) were to wholly or even partially supplant central bank fiat currency. Not least because central banks themselves are thinking about it out loud, and wondering what they might do to avoid being usurped in this way.
The agreed protocols that govern Bitcoin are effectively its monetary policy. In exchange for expending computing power to verify the legitimacy of transactions and record them, Bitcoin “miners” get paid in Bitcoin. (This is roughly analogous to seigniorage income.) These rewards increase the supply of Bitcoin, but the growth of the Bitcoin money supply is constrained by the increasing difficulty of verifying transactions. More and more computing power is needed to verify each transaction and create new Bitcoin, which means that the total supply gradually approaches its limit of about 21 million. (There are currently just under 16.5 million in circulation.)
Our fiat money has its own protocols that give rise to a different monetary policy: appoint a bunch of clever people and tell them to stabilise inflation using interest rates and bond-buying. The money supply that results from all this is generally ignored.
A strand of monetary nostalgia likes the fixed money supply rule of Bitcoin, which sort of resembles the classical gold standard. But most economists and central bankers long since left this view behind. As David Andolfatto crisply points out, a money supply rule that does not respond to shifts in money demand generates large fluctuations in prices. And since society tends not to tolerate outright declines in wages, these fluctuations often carry over into unemployment.
Some argue this is precisely what will prevent Bitcoin and other cryptocurrencies from taking over. Fluctuations in demand for Bitcoin and its competitors, in the face of relatively fixed supply, cause wild swings in the price. We seem to be living through one right now. This makes Bitcoin impractical as a money. Cryptocurrencies provide a belt and braces alternative to traditional reserve currencies such as the dollar in places with poor monetary policy and weak banks, but their role may develop no further than that.
The adoption of Bitcoin and similar as money would have other disadvantages.
Cryptocurrencies are borderless. That is, their usefulness derives from a set of agreements struck by participants who aren’t confined to any one state. This might be good insofar as it could facilitate greater trade and capital flows, but from a monetary policy perspective, the Bitcoin ‘area’ is not likely to be an ‘optimal’ currency area. Without a state directing fiscal transfers to make up for the inability to adjust exchange rates within the area, the result is going to be a monetary policy consistently too tight and too loose for different groups at different times, as the euro area has spent the last 16 years figuring out.
Further, a partial adjustment by one set of users in the world will have spillovers to everyone else. The more amplified boom and bust that a gold-standard like cryptomonetary policy would imply for its users would disturb the business cycles of its neighbours. Central banks and fiscal authorities controlling the non-Bitcoin areas would have to work their levers harder to stabilize their economies.
In principle, you could imagine Bitcoin or other currencies changing the protocols so that monetary policy improved, but it seems vanishingly unlikely.
You’d need an agreement somehow that the verification rewards for miners depended on the state of the economy in the same way that central bank interest rates are flexible according to conditions. And this could not be hard-coded, any more than central banks could hard-code interest rate policy. (There is a reason so many central bankers object to the #AudittheFed idea of binding interest rates to the Taylor Rule.) You’d need some kind of standing committee appointed by the diffuse network of Bitcoiners. That centralised model is the opposite of what cryptocurrencies are supposed to be about.
Central banks could simply step in and offer their own digital currency, to pre-empt a Bitcoin takeover. There is such a thing already, of course. It’s what happens whenever central banks buy assets by creating bank reserves. It’s all just digital entries on a spreadsheet. Creating central bank “digital currency” simply means offering existing digital account services to a wider group of entities. Central bank speeches thinking through this idea have been given by Ben Broadbent and Andy Haldane at the Bank of England and Jon Nicolaisen at the Norges Bank.
There are other reasons for central banks to offer these services to the broader public, especially if digital central bank money came to replace physical money. It would help combat tax evasion and illegal economic activity, which Ken Rogoff dubbed the ‘Curse of Cash’ in his book by that title. Digital money replacing cash would also make it easier for central banks to lower interest rates far below zero per cent, as Buiter, Haldane, Kimball and others have explained. Investors would have no cash to run to.
As Broadbent explains, offering these accounts might well disintermediate retail banks, as depositors pull their money out of banks and opt for central bank accounts instead. This would be an implementation of something similar to the ‘Chicago plan’ for narrow banks by accident. The central bank would become the ‘narrow bank’, backing deposits with government securities. Private-sector lenders would have to fund themselves with non-deposit debt and equity.
There might be intermediate outcomes too, where banks are not entirely eliminated, but instead grow and shrink as credit risk waxes and wanes and people move between the central and private banks. All this might increase the amplitude of the business cycle — exactly what central banks would be trying to avoid by stopping the spread of bad Bitcoin monetary policy.
If any one country went down this route — to avoid the unpleasant consequences for monetary policy of a Bitcoin takeover — it would likely have spillovers for others. For starters, a larger credit cycle in one country means larger booms and busts for its trading partners.
Beyond that, foreigners outside the digital central banking country might desert their own banks and deposit directly with the foreign central bank, or indirectly via some local intermediary. The increased ease of shifting deposits into a safe foreign asset might exacerbate the flows of capital in and out according to changing perceptions of the health of the domestic banking system, amplifying the credit cycle in their home country.
In the financial crisis, capital flight from the most afflicted countries was limited by the difficulty and inconvenience of getting hold of and managing cash and by the state of banks in alternative countries. Direct or indirect access to foreign digital money would have none of these drawbacks and potentially facilitate periodic flights to safety.
These problems would be avoided if all monetary authorities acted in concert. But global central banks presenting a common front on anything is historically very unusual.
The latest difficulties with Bitcoin make the prospect of a crypto currency takeover seem fanciful at the moment. But if solutions to these problems were found, or a new currency were devised with better protocols, central banks will have to resolve these dilemmas one way or another.
Tony Yates is Professor of Economics at the University of Birmingham. He was Reader in Economcis at Bristol for 2 years and before that worked at the Bank of England for 20 years in the directorate devoted to monetary policy.