The macroeconomic impact of cryptocurrency

Author: Jack Pollard, Research assistant, RAND Europe

Over the past year cryptocurrencies, Bitcoin in particular, have been hitting headlines around the world. At the beginning of 2018, the global market value of cryptocurrencies surpassed $700 billion dollars, with growth of more than 1,300% between November 2016 and November 2017. The meteoric rise of cryptocurrency has led many to question whether it may one day replace government-backed money as we know it today.

How might a cryptocurrency economy look?

A Bank of Canada working paper considered the implications of a world where countries are on the Bitcoin standard, i.e. a financial system in which all media of exchange take place in or are backed by Bitcoin. Such a system would be similar to that of the gold standard between 1880 and 1913, where the supply of money was not in the control of central banks but instead relied on the physical mining of gold. In much the same way, the supply of Bitcoin relies on the digital mining of the currency. Digital miners verify Bitcoin transactions using powerful computers to solve complex algorithms, receiving payment in Bitcoin for each transaction verified.

Under the Bitcoin standard, three clear media of exchange would exist: 1) Bitcoin, 2) currency issued by countries’ central banks, and 3) money issued by commercial banks. In this world central banks would only function as lenders of last resort, as the virtually costless arbitrage (buying and selling of currency in different markets to take advantage of differing prices for the same asset) of Bitcoin across nations would render central banks unable to implement domestic interest rate policies.

Essentially, the scope of monetary policy would be greatly limited. Based on lessons learnt from the gold standard period, this would lead to mild deflation and constant exchange rates. However, if the Bitcoin standard were to ever come about, the paper claims that it would not last long. Firstly, the author envisages new technological innovation rendering Bitcoin costly and outdated. Secondly, there would be significant political pressure to return to a monetary system as we know it today, allowing monetary policy to regain its significance.

A similar sentiment arose from a ‘Currency and Future of Transacting’ consultation featured in the recent Corsham Institute Thought Leadership programme. Participants of the consultation acknowledged that cryptocurrency may challenge the central bank’s position as a guarantor of currency, but felt that central bank backed currency would still have benefits for the foreseeable future.

How realistic is a cryptocurrency economy?

This begs the question, just how realistic is a cryptocurrency economy? A Bank of England bulletin from the end of 2014 concluded that cryptocurrency did not pose a risk to the monetary or financial stability of the UK. The use of cryptocurrencies is still relatively small in scale, with the Bank of England estimating (with major uncertainty) that as few as 300 transactions occurred daily in the UK in 2014. The bulletin argues that the underlying design of cryptocurrency limits the extent to which usage can become widespread. Currently, cryptocurrency transaction costs are typically lower than retail and international transaction equivalents. These low transaction costs are driven by the rewards miners receive for verifying Bitcoin transactions.

However, in the long run the supply of cryptocurrencies is typically fixed, due to the underlying coding of the technology. Eventually miners will receive lower and lower rewards as the supply of cryptocurrency approaches capacity, and the costs of mining will outweigh the benefits. This could lead to a situation where cryptocurrencies only remain competitive through the continual reduction of miners, to a point where there may only be one. Such an outcome would undermine the founding objectives of cryptocurrency and leave the system exposed to system-wide fraud.

However, a paper considering Banking Systems in an Economy Dominated by Cryptocurrencies does envisage a future with cryptocurrencies as the main medium of exchange, although not as we know them today. The authors argue that cryptocurrencies are much more likely to flourish in the form of ‘Regulated and Sovereign Backed Cryptocurrencies’ (RSBCs). RSCBs are government backed cryptocurrencies, similar to paper currency as we know it today but in digital form. Such a scenario overcomes the issues surrounding the fixed supply of current cryptocurrencies, allowing individual governments to control the supply of money and maintain an effective monetary policy. Importantly, commercial banks will still have a significant role to play under RSBCs.

Banks will act as a ‘Trusted Fourth Party’, regulating cryptocurrency instruments by underwriting and guaranteeing the creditworthiness of investors, lenders and borrowers. Interestingly, it is claimed that the introduction of RSBCs would bring about substantial global savings running into hundreds of billions of dollars by 2025, compared to the current paper currency based economy. Such savings would be realised through reductions in the time and resources devoted to maintaining and operating the paper money infrastructure. There has even been talk of the Bank of England introducing a cryptocurrency of their own, although plans appear to be shelved for now.

Overall, a world where cryptocurrency (as we know it today) is the standard media of exchange would be considerably different to our own. Central banks would only become useful as lenders of last resort, we would experience continued mild deflation and exchange rates would be constant the world over. However, it does not appear that such a system will ever be realised. Instead, a middle ground appears much more realistic, in the form of RSBCs for example. And while the central bank’s position may be threatened by cryptocurrency, a central bank backed currency is still likely to be beneficial for the foreseeable future.