The ongoing technological revolution means that “digital money” – a manifestation of which is cryptocurrency – is upon us. Microeconomic tradeoffs are well known and have been debated. Digital currencies have the potential to drive financial innovation, increase efficiency through faster and cheaper payments, and increase financial inclusion. Conversely, concerns about security (cyber attacks and fraud), financial integrity (money laundering and evasion of capital controls) and energy consumption (inordinate energy requirements to mine cryptos) are also well documented. In addition, as privately issued cryptos currently serve largely as speculative assets, the need to update regulatory and consumer protection frameworks is also clear.
But even as the micro debate rages on, there is much less appreciation of the macro consequences of privately issued cryptocurrencies. What if, over time, cryptos evolve from speculative assets to viable mediums of exchange? What would this imply for the conduct of monetary, fiscal and exchange rate policies? This piece attempts to bring the macro pieces together.
For starters, how would monetary policy be affected if a private digital currency were to compete with fiat currencies? Think of it as “dollarization” by another name, but with one crucial difference as listed below. Latin America is full of increasingly “dollarized” economies. As nationals lost faith in their own currency as a store of value, they turned to and began to transact in US dollars for the security and stability it afforded. This has made national monetary policy ineffective because national central banks cannot set interest rates and inject liquidity in a foreign currency. The greater the substitution in US dollars, the weaker the power of monetary policy. Indeed, these savings imported the monetary policy of the US Fed.
The widespread adoption of privately issued digital currencies as a medium of exchange will have roughly the same impact. The larger the monetary base they cannibalize, the less effective national monetary policy will be in responding to the needs of the business cycle and to external shocks.
But what are the prospects for widespread adoption of cryptocurrencies as a medium of exchange? The intellectual arguments in favor of Bitcoin stem from fears of a degradation of fiat currencies through an unprecedented expansion of the balance sheets of G3 central banks after the global financial crisis. Its founders therefore anticipated fears of debasement by fixing the overall supply of Bitcoin, in the hope that it would become a viable alternative medium of exchange. But precisely because aggregate supply is inelastic, demand shocks lead to disproportionate price volatility. This, in turn, makes Bitcoin an inappropriate medium of exchange. Instead, it turned into a speculative asset.
To get around this problem, “Stablecoins” were introduced, the value of which is indexed to a fiat currency while maintaining equivalent reserves (think of a “currency board” exchange rate regime). By offering much greater price stability, these Stablecoins hope to serve as viable mediums of exchange and have proliferated rapidly in recent years. Does this represent a serious risk for monetary policy? Much will depend on the degree of currency substitution.
As the IMF points out, if cryptos are only used for ‘niche purposes’ – transfers and remittances between restricted countries – which are then quickly converted back to local fiat currencies, the implications for monetary policy will be. contained.
Instead, central bankers and policymakers fear a more existential challenge for the global monetary system. In a 2019 article, Brunnermeir, James and Landau discuss the possibility that tech mega-companies running global e-commerce or social media platforms may issue their own digital currencies to their global customers, which serve as both a unit of account and medium of exchange on their platforms. Considering the self-reinforcing network externalities involved, adoption would be rapid as digital currencies are bundled with other data and services. We would then have the prospect of digital currencies being traded on a large scale in active competition with fiat currencies.
Brunnermeir et al. postulate that global economic activity could eventually be reorganized into ‘digital currency areas’ (DCAs) that cross national borders, characterized by their own digital currency and unit of account issued by the network owner, the size of these DCAs eclipsing the national economies.
How would this threaten monetary policy? If these privately issued “Global Stablecoins” are tied to fiat currency, the owners of these networks would still not necessarily conduct independent monetary policy (again think of “currency board”). But if these currencies gain credibility and acceptance over time, network owners will do well to break free from fiat currency anchors to generate monetary discretion.
Once that happens, all bets are off with the private network owners who effectively conduct independent monetary policy. From a local economy perspective, think of this as “dollarization” except that monetary policy is not ceded to the Fed, but – as the IMF warns – to a grid owner who is maximizing his money. profits, which may not have the incentive to use monetary policy to smooth shocks or issue emergency liquidity when needed. The fate of economies to respond to shocks, at least in part, would be in the hands of private companies. This would pose an existential threat to monetary policy as we know it.
What about tax policy? The implications are simpler. The greater the substitution in digital currencies, the greater the loss of seigniorage income for governments through the monopoly issuance of fiat money. Separately, tax revenues can also be affected by the increased tax evasion opportunities that cryptocurrencies can facilitate.
To the extent that increased substitution for cryptos reduces the effectiveness of monetary policy, the burden of fiscal policy to respond to economic shocks will increase accordingly. This could create challenges in a post-Covid world. The pandemic has left a legacy of high public debt around the world. Fiscal policy, especially in emerging markets, will have the least room to act when it is most needed.
Finally, what are the implications for the rupee? To the extent that cryptos are mined abroad, the demand for them – whether for trading or speculative purposes – is akin to an outflow of capital. In turn, if the cryptos start to be mined on land, they will cause capital inflows. These dynamics will increase the volatility of the capital account and, to the extent that these cross-border flows bypass capital flow measures, they de facto increase the convertibility of the capital account, accentuating the political trilemma that emerging markets face.
It will also have a direct impact on the currency market. As the 2021 Global Financial Stability Report points out, there has to be a triangular trade-off between, say, the local Rupee-Bitcoin market, Dollar-Bitcoin markets, and the Rupee-Dollar market. Therefore, changes in the Rupee-Bitcoin markets will inevitably spill over into the Rupee-Dollar markets for the markets to clear.
All in all, the macro implications of the widespread adoption of crypto are complex and interrelated. For now, there is justifiable anxiety about the growing household appeal of cryptos as speculative assets, with the regulatory implications that flow from it. But the real macro challenge will emerge and worsen if and when unsupported private digital currencies are seen as viable mediums of exchange. This is what politics must anticipate and prepare for.
The author is Chief Economist for India at JP Morgan. Views are personal