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BW Businessworld

Book Extract: New Currency

With all due respect to promising security advances offered by public ledger technology and the ingenious algorithms embodied in some of the new “currencies,” the view that Bitcoin — or any other cryptocurrency — is going to replace the dollar anytime soon is quite naive

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When I suggest to people that there might be benefits to phasing out paper currency, they almost invariably assume I am advocating a cryptocurrency like Bitcoin and are a bit disappointed to find out otherwise. No doubt anyone who looks at distributed-ledger technologies has to be excited about their potential applications in financial services and record keeping in general. For the foreseeable future, however, the best system is one in which a government-issued currency is the unit of account, though of course it will eventually morph into a fully electronic one.

I appreciate that many leaders in the alternative payment space hold the libertarian view that new web-based transaction technologies can free people from the tyranny of government currency and regulation. They have deep conviction that with encrypted digital currencies like Bitcoin, someday no one will have to trust banks, either. For true believers in the promise of cryptocurrencies, trying to find ways of improving the current system, as this book aims to do, is a waste of time. Better to fast-forward to the brave new world where governments are no longer in the payments picture and no longer even control the unit of account.

With all due respect to promising security advances offered by public ledger technology and the ingenious algorithms embodied in some of the new “currencies,” the view that Bitcoin — or any other cryptocurrency — is going to replace the dollar anytime soon is quite naive. As currency innovators have learned over the millennia, it is hard to stay on top of the government indefinitely in a game where the latter can keep adjusting the rules until it wins. If the private sector comes up with a much better way of doing things, the government will eventually adapt and regulate as necessary to eventually win out. Even if (for argument’s sake), cryptocurrency technology proved unstoppable, the winner (say, Bitcoin 3.0) would only end up being a precursor to a government-controlled “Bencoin” (after Benjamin Franklin, who now adorns the US $100 bill).

It is not because modern-day governments are so worried about seigniorage revenues from currency; at least that should not be their main concern. The real issues involve the ability to use monetary policy to (1) stabilize the private economy, (2) issue credit in response to financial crises (act as a lender of last resort), and (3) be able to inflate the price level in an emergency where it is necessary to engage in partial default (in real terms) on government debt. To achieve these ends effectively, it is extremely helpful for the government to control the unit of account and the currency to which most private contracts are indexed.

If the world ends up on a private-sector currency standard, and there is a run on banks, who is going to bail out the banks? Yes, historically, the private sector has occasionally organized bailouts. New York banker J. P. Morgan famously helped stem the panic of 1907, which occurred before the Federal Reserve was created in 1913. Morgan pledged large sums of his own money and convinced other New York bankers to do the same, enabling them to shore up the banks. This is just not going to work in today’s globalized world, certainly not in a really deep systemic crisis. The government is going to have to step in, if not to bail out financial markets, then to organize an orderly default.

It is critical that the government be able to draw on large pools of liquidity in the event of a war, pandemic, or other crisis that creates large unexpected short-term funding needs. There are several dimensions to maintaining “fiscal space,” including prudent debt management, but being able to control the unit of account is an extremely important safety valve. It is especially useful if a country’s debt is denominated in its own currency, giving the government the option of partial default through inflation. On top of dealing with outright catastrophes, a country that does not control its own currency is unable to use modern monetary stabilization policy.

Multiple units of account may coexist, and one can find many small economies where both the local currency and the dollar (or euro) are widely accepted. But, in general, the unit of account is a natural monopoly that a well-run government with strong legal and fiscal institutions is uniquely well poised to control. If the US government ever decides to oversee a Bencoin, it can use seigniorage profits to help defray costs of maintaining the system, and it can use tax revenues to ensure that the system never becomes insolvent.

These are advantages a private currency cannot compete with. Even more importantly, it can use laws, regulations, and outright coercion to come out on top: a determined government is always going to win the battle for currency supremacy, at least in the long run. Other transaction media may thrive, but the government currency will be at the centre.

Regardless of whether the first generation of cryptocurrencies survives the next decade, the public ledger encryption technology they pioneer just might provide a road map to better security over a broad range of financial transactions. The basic idea, in a nutshell, is to create a system in which diverse private-sector individuals (or entities) are incentivised to maintain independent ledgers of transaction trees (or blockchains), and new transactions cannot clear the books without achieving a critical mass of third-party acceptance. A fair dose of encryption technology is also included, and in Bitcoin, for example, individuals are allowed to use aliases with passcode-protected accounts to make it difficult to determine their identities. A lot of truly fascinating science supports the different systems, and one can find many excellent treatments.

Governments around the world have already begun regulating cryptocurrencies more aggressively. In the United States, Bitcoin wallets must now comply with anti-money-laundering rules, and the Internal Revenue Service has begun to issue rulings on how Bitcoin earnings should be taxed. The European Union, too, is in the process of intensifying its regulations. Where governments have the greatest leverage is in regulating how financial institutions interact with cryptocurrencies... .

By controlling the gateway into the financial system and the legal economy, governments have tremendous leverage to undermine the value and liquidity of any alternative currency scheme that attempts to avoid regulation permanently.