• David Skeie, Professor of Finance at Gillmore Centre for Financial Technology


• 19.10.2023 09:45 am
#cryptocurrencies

Long before the advent of Bitcoin, one of the most influential free market economists of the 20th century, Milton Friedman, forecast the arrival of a decentralised digital currency:

“I think that the internet is going to be one of the major forces for reducing the role of government. The one thing that is missing, but will soon be developed is a reliable e-cash, a method whereby on the internet you can transfer funds from A to B without A knowing B or B knowing A.”

In other words, this digital currency would exist beyond the control of national authorities – and anyone else. 

Fast forward two decades, and we are now confronting the reality – and risks – of cryptocurrencies leading us to question: What kind of a threat do they pose to traditional money and the wider economy? And what does this mean for central banks?

The Clash of Currencies

Crypto and traditional currencies are not like for like. National currencies should inspire trust, serving as a unit of account, a medium of exchange and a store of value, with central banks as the monopoly supplier. 

This means that they more or less control the quantity of money in circulation and have the power to put down or kickstart the economy, via interest rates, with the ultimate aim of controlling inflation. Because central banks back a currency and maintain its credibility, despite wavering levels of confidence in national authorities, faith in its longer-term value is largely steady.

By contrast, cryptocurrencies are a new form of currency envisaged by Friedman – privately issued, digital and decentralised – and beyond the control of authorities. This means they are free from poor economic judgement and political manipulation, but unlike sovereign currencies, they have no backing – no entity is liable for their value, and there is no lender of last resort. 

The Potential Threats

Bitcoin and the like, as witnessed over the past few years, are worth only what buyers will pay for them. Their value can plummet or soar depending on the confidence of their users, and behave more like volatile assets than a means to buy or sell. It is rare that anyone asks for the cost of anything in Bitcoin in comparison to what they are worth in dollars.

Whether cryptocurrencies will assume greater importance as a workable currency free of central – or any – control is looking more doubtful since their dramatic plunges. But economic authorities must at least be aware of the potential threats.

What’s the worst that could happen?

The absolute worst-case scenario – the ‘asteroid-destroying-earth’ scenario – for a central bank would be the loss of control of monetary policy. 

This could happen if cryptocurrencies were to outstrip that of a sovereign currency, which would first involve cryptos becoming more mainstream and trusted than the country’s national currency. 

This would also require a crypto that is less costly, less volatile and more liquid to transact than Bitcoin. In such a case, traditional money could cease to operate as the national unit of account, rendered irrelevant by a decentralised digital currency. 

Powerless to steer the economy, a central bank would no longer have any control over the nation’s main currency in this scenario, with any interest rate tweaks or the release of more cash having zero impact. Dependency on another currency is not unheard of – some developing economies with rampant inflation rely on the US dollar rather than their own currency. 

Practical Risks and Failures

For example, Ecuador adopted the dollar in 2000, but despite their subsequent loss of ability to fine tune their own economies, they are still pegged to a relatively stable and managed currency. By design, cryptocurrencies are unbacked and have an uncontrolled value. 

Such risk requires those in charge to consistently monitor the ecosystem for any impending disasters.

There are also lesser, more practical risks than the Armageddon scenario, thanks to a thread of crypto-related failures which threaten wider repercussions. 

Since the collapse of Terra, a stablecoin formerly linked to the dollar, last year and the linked currency Luna, the wider crypto market crashed, no longer appealing as a potential hedge against inflation. 

Late 2022 also saw the bankruptcy of the crypto exchange FTX, leaving around a million crypto owners facing losses costing billions of dollars. 

These paths could spill over into the ‘real’ economy, and upset traditional banking with profound effects upon national financial systems. So far, traditional banks have largely weathered the storm.

Closing Thoughts

For a brief amount of time, some cryptocurrencies seemed to be nipping at the heels of traditional currencies. However, since the initial peak of 2018, their ability to challenge the monopoly of central banks no longer appears feasible.

Their possession of numerous structural flaws, including their lack of a stable anchor, slow and costly transaction processes, and reliance on unregulated exchanges means that consumers have not yet experienced the advantages of decentralised finance.

Moreover, their value has proven to be highly volatile, preventing them from becoming widely accepted as an exchange unit.

As a result, the benefits that are often spoken about in relation to cryptocurrencies, such as providing financial services to the underprivileged and facilitating faster and cheaper global transactions, have yet to materialise.

For now, national currencies are far from becoming obsolete, but central banks must remain vigilant, as the control of monetary policy hinges on it.