27 July 2017
Record valuations of Bitcoin suggest that cryptocurrencies are coming of age. The proliferation of cryptocurrencies or digital currencies seems to advertise a new era of money. In fact, their underlying ideas are rather old. Cryptocurrencies, herein referred to only as not having legal tender status, aim for a world—abstracting from their profound technological impact on recording, anonymising and administering monetary transactions—of rigid monetary rules and private monies and without central banks. There were many good reasons of why monetary systems moved forward. While this may not diminish the appeal of cryptocurrencies, to represent a monetary innovation they must look far beyond the traditional functions of money.
The main motivation for cryptocurrencies, as is well known, lies in a fundamental mistrust in the existing arrangements and institutions that dominate monetary systems. Bitcoin—used as a proxy for cryptocurrencies herein—is about eliminating governments, banks and other financial intermediaries and dispensing of “trusted parties” to vet monetary transactions. Its emergence has been attributed to the financial dislocations following the collapse of Lehman Brothers in 2008. The challenges today of bringing about some sort of “normalisation” of monetary policies in the advanced economies and unwinding of near unprecedented monetary expansions now pose new risks to the monetary system (Figure). Bitcoin asserts that the financial crisis brought a considerable erosion of trust and that attempts to restore trust in the existing system would fail. The key assumption is that a decentralised system and an inviolable algorithm-based money issuance rule are superior to the present monetary order.
Money had been like cryptocurrencies for centuries. It had been made of rare commodities. The supply of e.g. silver or gold determined the money supply. Monetary exchange was peer-to-peer-based amid the absence of banks. A multitude of monies were often used in the same territory. While money was subject to recurrent government abuses through debasement and government standards mostly through minting provisions, the very commodity property ensured that money supply was to a large extent exogenous.
The great monetary innovation during the eighteenth and in particular nineteenth century was the advent of paper money mostly issued by private banks of issue or similar entities (paper currencies in China go back to at least the eleventh century). The awkwardness of dealing in metal coins made paper currencies a desirable medium to facilitate payments and support rapidly growing economies. In some countries, notably in Germany, the unification of coinage was believed to bring important advantages to promote economic integration. Modern commercial banking appeared during the nineteenth century.
Naturally, the proliferation of paper currencies brought new concerns. During the nineteenth century, central banks were established or assumed modern central banking features mostly to bring order to paper currencies through strict regulation and consolidation of issuance including in 1844 the Bank of England, in 1848 the Bank of France, in 1875 the German Imperial Bank, in 1888 the Bank of Japan, in 1897 the State Bank of the Russian Empire.
The adoption of the gold standard from the 1870s announced a new monetary era. It was associated with a period of stable monetary conditions, significant international integration and elevated economic growth and became an international standard. Under the gold standard, paper currencies were backed by gold mostly under fractional reserve requirements that offered some though circumscribed issuance flexibility. Central banks enjoyed limited if any policy discretion pursuing policies geared towards maintaining the gold standard often restricting their ability to accommodate adverse liquidity shocks. In 1913 in the United States, the Federal Reserve was established explicitly to offer “elastic currency” to help support banks in distress as lender of last resort.
The introduction of flexible exchange rates was the great monetary innovation of the twentieth century. During the 1970s, money issuance especially in the advanced economies became a function entirely of the discretion of monetary policy authorities. This has allowed for monetary policy to play a critical role in economic adjustment. However, in many countries, it has also rightly raised repeated concerns about monetary instability.
The strict and immutable issuance or minting rules of cryptocurrencies, as is commonly understood, restore the rigidity of metal standards. Rigid rules also do not require central banks and consequently monetary policy. The return of private monies and thereby possible fragmentation of monetary standards may further complicate exchanges. This would in essence imply a return to the eighteenth century money-wise digitally or other.
The traditional functions of money—medium of exchange, store of value, unit of account—need to be extended to include unfettered liquidity. The ability to increase the money supply in times of distress has become an essential property of money. The impracticality of rigid monetary rules and suspension of central banks seem to make cryptocurrencies hard to be reconcilable with the requirements of modern economies.
Money evolved with the circumstances and requirements of prevailing economic conditions. Since World War I, money was mostly about moving from a rules-based system of monetary control through metal backing to a system reliant on policy discretion. There have of course been many reversals. Countries at times reverted to rigid issuance rules, e.g. with the adoption of fixed exchange rates or currency boards, to stabilise their economies. The introduction of the euro in the European Union and the currency board in Hong Kong affirm that monetary discretion has not been universally adopted.
Cryptocurrencies may be simple supplements. As such they may of course fulfil many useful monetary functions. There is nothing intrinsic about money to preserve its present format. Many of the claims though in favour of cryptocurrencies, to overcome centralisation, the need of “trusted” third parties and erosion of privacy, seem to be external to money and more a matter of existing banking and capital markets arrangements and regulations.
If cryptocurrencies were to substitute existing monies they would need to be able to adapt to changing economic and financial conditions. This in theory is of course possible. In practice though it would be highly complex. The introduction of needed discretion in money issuance seems to defy the very essence of cryptocurrencies today. Notwithstanding, learning cryptocurrencies seem entirely possible. New institutions, possibly replacing central banks, could also be imagined to facilitate and order implied monetary changes and intermediation. To become a serious threat to existing monies, cryptocurrencies would need to be far more sophisticated than the current designs. What matters is not what money is but what one can do with it.