Cryptocurrencies: Financial (In)stability and (Un)fairness


By Jon Danielsson, Director of the ESRC funded Systemic Risk Centre, London School of Economics. Originally published at VoxEU

Cryptocurrencies are controversial.  Advocates see them as a better form of money that imparts freedom, useful economic functions, fabulous riches and hedges against bad government policies. The sceptics worry about investor protection and environmental impact.

Cryptocurrencies today do not pose much threat to financial stability, as noted by den Haan et al. (2017) and a recent Financial Stability Board report (Financial Stability Board 2018).

That will change if cryptocurrencies find widespread economic use, either coexisting with or fully displacing fiat money.  They will then have a strong and negative impact on financial stability, equality and social cohesion, as I discuss in Danielsson (2018c).

Financial Stability

Some cryptocurrencies promise to replace fiat money with private money whose integrity is underpinned by algorithms, not government guarantees. This includes the most prominent, Bitcoin, and many of the cryptocurrencies aiming to improve on Bitcoin.

Do such cryptocurrencies pose financial stability threats?

Most observers do not think so. After all, an asset class that amounts to less than $200 billion is quite small compared to the overall asset markets, especially since cryptocurrencies are primarily held for speculative reasons and see trivial economic use outside of that. Cryptocurrencies do not threaten financial stability today.

However, supposing that cryptocurrencies like Bitcoin were to succeed in the marketplace for money and see widespread use in day-to-day economic activities. Would there be financial stability consequences?

Yes. A cryptocurrency-based monetary system (‘cryptosystem’) is subject to the same forces of financial instability as the current fiat system, while further adding new forms of instability.

The same fundamental forces are behind almost every financial crisis, regardless of the underlying monetary system (gold, fiat, or cryptos) – excessive amounts of endogenous risk (Danielsson et al. 2012) that is hidden until it is too late, only to manifest itself once a crisis is underway when it is too late to do anything except react.

All serious financial risk is endogenous, caused by the interaction of the human beings that make up the financial system. They are prone to act as a procyclical herd and are subject to a variety of constraints and biases affecting decisions, and hence outcomes. In boom times, behaviour is more idiosyncratic than during crisis when the self-preservation instincts kick in. This is why booms build up slowly and deflate rapidly – prices go up the escalator and down the elevator.

Fundamental to financial instability is the creation of money. In the current fiat system, the central bank creates base money and the financial system creates higher forms of money such as M1 and M2. The primary damage from financial crises is when the process goes in reverse due to rapid deleveraging.

The same applies to cryptosystems. The mining process only controls the creation of base money (the number of coins), while the supply of money is crypto M1 and M2, and just like with fiat, the creation of such money is under nobody’s control. While some cryptoadvocates argue this would not happen because a cryptosystem would be a full reserve system, that is unlikely. Some people will want to lend out coins and others to borrow, and if such claims get traded, crypto M1 and M2 is created. Similarly, some crypto banks will find it more profitable to operate as the fractional reserve institutions of today.

At the same time, a cryptosystem has additional forms of systemic risk not present in fiat systems. Most of the money in a cryptosystem, crypto M1 and M2, is only claims on coins. In times of crisis when confidence evaporates, that can by itself lead to a panic since if economic agents start to worry their money is not equivalent to coins, they will run their financial institutions.

We can’t resolve such cryptosystem crises because we can’t create new base money (coins), at least if money is like Bitcoin with a fixed mining schedule. While we can certainly conceive of a cryptocurrency with an algorithm that creates new coins during a crisis, such a currency would be an anathema to the cryptoadvocates of today who explicitly do not want the supply of money to be adjusted based on economic conditions.

While fiat systems are affected by the same endogenous risk, they have a safety valve. Because the fiat system can create infinite amounts of liquidity when needed, the central bank can guarantee shock and awe. It can tell the financial markets that no matter what the demand for liquidity, it can meet it, minimising deleveraging, keeping the economy going, and preventing the disastrous failures of the financial institutions without whom the economy cannot function.

Such credible demonstration is stabilising by itself. Once the markets know the central bank will do what it takes, a crisis can be mitigated; we saw that in action with the ECB’s “we will do whatever it takes” announcement in 2012. The failure of the Federal Reserve to do the same during the Great Depression was the reason a financial crisis and economic recession became a depression. The globally coordinated liquidity creation in the autumn of 2008 is the reason why that crisis did not become a depression.

Ultimately, this means that a monetary system based on the private cryptocurrencies of today would suffer from higher systemic risk than a well-managed fiat system.

Fairness

If privately issued cryptocurrencies become real competitors to fiat money, someone is going to make a profit.

The current market value of all cryptocurrencies is around $200 billion; the total value of M1 in the G20 economies is $31 trillion. If we fully replace fiat money with cryptocurrencies, a $31 trillion profit will be transferred to a handful of crypto-speculators, equivalent almost to the annual GDP of the US and China combined (at $34.5 trillion). That is the upper bound; private cryptocurrencies may end up coexisting with fiat money, so the market value of cryptocurrencies may end up being somewhere between $200 billion and $31 trillion.

The success of privately cryptocurrencies implies a substantial transfer of a public good to private speculators. It would dwarf the largest historical expropriations of public goods, including the Inclosure Acts in England and Wales when 2,800,000 hectares of common land were transferred to private ownership, the Highland Clearances in Scotland, the confiscation of Native American land in the US and Aboriginal land in Australia, and the more recent Russian and Chinese privatisations.

Would the $31 trillion (or any amount significantly higher than the current $200 billion) switchover from M1 to cryptocurrencies be of the same nature? The wealth transfers in the examples above happen at the instigation of the sovereign, which deliberately enriched some citizens and impoverished others. By contrast, current transfers to crypto-speculators are entirely voluntary. I buy Bitcoin at my own volition.

However, for cryptocurrencies to displace fiat money, the sovereign has to acquiesce, to make the deliberate decision that Bitcoin is to be used along side, or instead of, dollars. The reason is that fiat money is legal tender, and the sovereign needs to permit the displacement of fiat.

Consequently, the transfer of up to $31 trillion to a handful of private speculators would dwarf any historical antecedents to become the largest expropriation of a public good in human history.

This is strongly disputed by crypto-advocates, who find such notions Marxist and that it does not recognise the just return to an entrepreneur taking risk. Such counterarguments miss the point. There is widespread support for the idea that the entrepreneur should benefit from the fruits of their labour, accomplished in a competitive marketplace, not by expropriation.

Unlike entrepreneurial wealth, the crypto-fortunes would be created by inclosing a public good and it would be fundamentally unfair to transfer the public money supply to crypto-speculators.

Conclusion

While I think that cryptocurrencies do not make much sense and are destined to end up worthless, (Danielsson 2018a, 2018b), suppose I am wrong. The success of privately issued cryptocurrencies like Bitcoin would come at a considerable cost. It would increase financial instability and wealth inequality, while bringing no discernible benefits.

If we are to transit from a fiat monetary system to a crypto-based one, the only right way is for all created coins to be under public ownership from the outset.

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