Cryptocurrency and the Future of Central Banking

It seems impossible in 2018 to avoid the topic of cryptocurrency. Often, the discussion in the media focuses on the wildly fluctuating price of Bitcoin. However, in more niche cryptocurrency communities, talk is commonly about the ability of blockchain technology to ‘disrupt’ the financial services industry. But if we were to abandon our conventional currencies in favour of these new decentralised alternatives, what would the economic implications be? To start with, we should briefly explore the operation of our existing monetary systems.

The operation of central banks

Central banks, such as the Reserve Bank of Australia, employ ‘monetary policy’ – essentially some economic strategy – to manage the trade-off between stabilising the inflation rate while maximising the total production level in the country’s economy and minimising unemployment levels. The ability to implement this strategy relies on the central bank’s ability to manipulate the total supply of cash in the economy, mostly through the buying or selling of government bonds. By selling bonds, the central bank takes money from the buyer, pulling it out of circulation and reducing the total supply of money in the economy. The opposite effect occurs when the government buys bonds back from private entities. This allows governments to influence interest rates, and therefore to promote or discourage private investment in the economy. While manipulation of the money supply is a useful tool for the maintenance of economic stability and predictability, it relies on the fact that the central bank is the only authority capable of issuing a legal tender in a given economy.

The value of a decentralised currency

The decentralisation of cryptocurrency is one of its greatest strengths. Conventional ‘fiat’ currencies only have value on the basis that their status as legal tender is guaranteed by the government. Demand for these currencies only exists as long as people believe that the government is able to uphold this guarantee. Failure of a government to do so can have catastrophic economic effects, such as in the Indian cash crisis of late 2016, where the vast majority of India’s circulating cash was declared worthless by the country’s government.[1] Decentralised currency, on the other hand, is valuable because, like gold, it is a scarce and finite resource which people agree to attribute value to.

The problem with decentralisation

In cryptocurrencies like Bitcoin, coins are generated by individuals known as ‘miners’ on the network. Production becomes exponentially more difficult as more coins are mined, meaning that it will eventually reach a point where the supply becomes fixed. However, decentralisation of a currency means that no one authority has the ability to manipulate the money supply. This ensures scarcity and security but means that the value of tokens can change only at the whim of market demand. Further, it means that central banks would not be able to utilise monetary policy to influence their economy, resulting in greater economic instability and unpredictability and potentially a less productive economy.

Possible solutions

Cryptocurrency is likely here to stay, and governments will need to respond to this potential paradigm shift in order to maintain the controls they currently have. Some in the crypto community have predicted that central banks may begin buying into major cryptocurrencies, for use in hedging as a substitute for gold [2].  While Bitcoin could potentially be used for this purpose, the volatility of its price makes it unlikely that central banks would consider holding significant crypto reserves anytime soon.

At the moment, there seems to be three main options for governments. The first is obvious: ban cryptocurrency. Countries such as China and India have cracked down on crypto, declaring trading and related activities illegal [3] [4].  However, this is unlikely to be a valid long-term solution, as it prevents the country from reaping any of the benefits of this new technology. The second option is to adopt and legislate for existing, decentralised cryptocurrencies alongside the existing fiat currency. While this may currently work for stable and trusted governments, it does not take advantage of the strengths of digital currencies, and as new alternatives become more widely used it is possible that demand for fiat currencies falls. The third is to establish a centralised cryptocurrency, which allows for a government to maintain many existing controls while capitalising on some of the strengths of digital currency. Unlike decentralised options, this state-sponsored crypto would suffer from the same trust requirements as a traditional paper currency. It would, however, allow a central bank even greater control of interest rates, as a monetary policy could be directly implemented at the point of trade without requiring financial institutions to act as effectors[5]. The Bank of Korea is one such authority actively exploring this idea.[6]

The economic implications of decentralised cryptocurrency are significant, and as the foundational technology is still young, we may not know the full extent of these for some time. But as public understanding of blockchain and cryptocurrency increases, one thing is certain: Blockchain technology has the potential to dramatically change the way our economic and financial authorities operate, and we will be seeing more economic discussion in this space in the years to come.

References

[i] India’s cash crisis explained. (2016, November 17). BBC. Retrieved from http://www.bbc.com/news/world-asia-india-37983834

[ii] Kharpal, A. (2017, December 18). Central banks could hold bitcoin and ether for the first time in 2018, cryptocurrency CEO says. CNBC. Retrieved from https://www.cnbc.com/2017/12/18/central-banks-will-hold-bitcoin-and-ether-in-2018-blockchain-ceo.html

[iii] India bans crypto-currency trades. (2018, April 6). BBC. Retrieved from http://www.bbc.com/news/world-asia-india-43669730

[iv] Perper, R. (2018, February 6). China is moving to eliminate all cryptocurrency trading with a ban on foreign exchanges. Business Insider Australia. Retrieved from https://www.businessinsider.com.au/china-eliminates-all-cryptocurrency-trading-2018-2?r=US&IR=T

[v] Martin, W. (2018, May 11). MORGAN STANLEY: Here’s how the rise of cryptocurrencies could change the way central banks deal with future financial crises. Business Insider Australia. Retrieved from https://www.businessinsider.com.au/morgan-stanley-cryptocurrencies-next-financial-crisis-negative-interest-rates-2018-5?r=US&IR=T

[vi] Kim, Y.-C. (2018, May 2). BOK eyeing digital currencies. The Korea Times. Retrieved from http://koreatimes.co.kr/www/news/biz/2018/05/602_248317.html