A Crypto-Monetary System

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A Crypto-Monetary System

If there is a cryptocurrency that can actually serve as a currency, it’s not bitcoin. Bitcoin is inherently deflationary and possesses significant scalability issues. But let’s assume another cryptocurrency exists that solves these problems.

Part of cryptocurrencies’ appeal is their decentralized nature. Unable to be commandeered, inflated, or otherwise manipulated by governments and central banks, they seem to offer an opportunity for a more democratic and inclusive monetary system. However, because of this decentralized nature, there are significant doubts as to whether such a crypto-monetary system is viable.

Without some centralized body possessing the power to regulate currency flows, there would be no obvious way to institute capital controls. Such a complete opening up of national capital accounts could exacerbate and even give rise to financial crises, especially in developing and emerging markets (the 1995 Mexican crisis and the 1997 Asian crisis are only two of many instances that validate the dangers of open capital accounts). Emerging markets would be subject to excessively volatile financial flows, pouring in during times of optimism, then draining out when pessimism emerges and subjecting economies to sharp contractions. Capital controls are an effective way to moderate these damaging “hot money” flows, and instead promote more stable foreign direct investment (FDI). In a monetary system with no central authority, implementing these controls could prove impossible.

Most importantly, central banks would largely be sacrificing the ability to conduct monetary policy (assuming governments are able to tax cryptocurrency incomes just as effectively as fiat incomes, fiscal policy would be feasible if not effective). Some like this idea; they think that central banks have debased the value of money, pursued reckless policies of quantitative easing, and promoted a monetary system that lacks a certain “purity.” However, these views are based less on an objective analysis of monetary policy as they are on analyzing money with moral and sentimental criteria.

There is definitely an aesthetic attractiveness to a “pure” monetary system; a self-regulating, libertarian institution with a currency backed by something real, something tangible and natural, unable to be debased by reckless, greedy actors (like central banks). Like the gold standard. But we want a monetary system based off of realistic theory and empirical evidence, not nostalgic attachments. And as we’ve learned through experience and the refinement of theory, central bank monetary management is desirable.

To understand why, look to the Great Depression and the 2008 crisis, and the different policy responses that they incited. It is widely acknowledged that the Great Depression was so severe partly because central banks didn’t step in and provide liquidity to the banking system. Without a lender of last resort to guarantee bank deposits, depositors panicked and led runs on banks (sometimes even healthy banks), further draining liquidity from the banking system, leading to even more panic in a self-reinforcing feedback loop. The Federal Reserve in particular failed to mitigate these bank runs when it had the ability, and the economic contraction was more severe as a result. And this view, which emphasizes the lack of central bank action as the problem, was popularized by Milton Friedman, notable anti-government crusader.

In the most recent financial crisis, policy makers learned from the mistakes made in the Great Depression; in fact, the Fed Chairman at the time, Ben Bernake, studied the Great Depression in his days as an academic. The Fed, working with the Treasury, effectively provided guarantees of liquidity to the financial system, cut interest rates to zero, and embarked on three rounds of quantitative easing to hold down long-term bond yields. The crisis was severe, no doubt. But if policy makers approached the 2008 meltdown with a 1929 mentality, it could have been just as bad as — and maybe worse than — the Great Depression. For reference, unemployment following the recent crisis peaked at 10.8%; in 1933, it reached more than double that, at 25%.

Those who advocate a monetary system without central banks implicitly rest on the assumption that credit markets are self-regulating. In other words, left untouched (and with the minimal proper institutions in place), credit markets will match the supply and demand for credit and settle on an efficient, equilibrium interest rate; active central bank policy only disturbs this equilibrium and distorts credit markets. If credit markets were not self-regulating, then that would inherently call for a body to regulate credit markets, like a central bank.

This notion of self-regulating financial markets has been challenged countless times, both empirically and theoretically. Credit markets have shown that they operate more like Hyman Minsky’s pro-cyclical credit model. Basically, this model explains that during economic booms, optimism reigns supreme, and credit becomes more easily available, further driving the boom. Optimism turns to euphoria. Eventually, sentiment turns negative, leading to economic contraction. During the contraction, pessimism reigns supreme, and credit dries up, just at the time that it is most dearly needed. So, the Minsky model portrays credit markets as volatile, unstable systems when left to their own devices.

In a crypto-monetary system, absent central bank control over credit and the crypto-money supply (control that would defeat the decentralization utopia anyway), this is likely how the financial system would operate — both domestically and, because of the absence of capital controls, internationally. Within booming countries, the supply of credit denominated in the cryptocurrency would increase, and there would be no central bank to raise rates and contain the unsustainable boom. The contraction stage of the cycle would be more severe (the more unsustainable the boom, the harder the fall), and there would be no central bank to cut interest rates and maintain liquidity in the financial system. The absence of capital controls that we mentioned earlier could exacerbate this process even further, as capital would be extremely mobile across borders, ready to fly into booming countries and flee contracting countries at a moments notice. Unemployment could again reach Great Depression levels.

In theory, there are ways that a crypto-monetary system could possibly work. Such a system would probably need to have many different cryptocurrencies circulating around the world, each one associated with a certain country or regional bloc (see more on optimum currency areas). Additionally, these cryptocurrencies would probably need to have floating, rather than fixed, exchange rates to serve as an adjustment mechanism in the absence of capital controls.

Nonetheless, any decentralized currency system will have disastrous effects on employment and output in times of economic distress. Fiscal policy can only do so much, and fiscal deficits are already fairly large in countries like the United States. Such a decentralized system would resemble the classical gold standard, an era in which employment and output held comparatively little weight as indicators of economic health. Such neglect of employment was manageable in the gold standard’s glory days before World War 1, when governments were not held democratically accountable. In today’s era, which heralds the morality of democracy and provides platforms (like social media) for distressed communities to communicate and organize, it is virtually impossible that the citizenry of the United States would tolerate 20% + unemployment rates in times of crisis. And for this reason, any system that eliminates the capacity for active monetary policy is an inherently untenable system. The only crypto-monetary system which stands a chance to survive is one that gives control of currency and credit to the government and central banks — the antithesis of the decentralization ideal.