Thoughts on the “Why” (rather than the “How”) of Cryptocurrencies

Reading media articles about Bitcoin and other cryptocurrencies left me frustrated because none of them directly addressed the real question that needs to be asked.  Yes, various articles are correct that Congress has no idea what blockchain is or what a cryptocurrency is.  Yes, other articles are correct that Bitcoin has emerged as a combination Ponzi scheme and money laundering tool.  Yes, cryptocurrencies are hard to comprehend because there appears to be (in Alice Walker’s words) “no there there.”  Against this backdrop of relatively uninformed speculation, there are articles in both financial and academic journals that clearly explain the potential of blockchain technology to create an entirely new type of currency – one that is beyond the control of any single government and which can be freely used by anyone and everyone as a unit of exchange as well as a reserve currency.  What I have not seen (outside some dense academic pieces) is an explanation of why anyone should care.  In other words, why should people around the world abandon their heavy dependence on the US dollar both as a unit of exchange and as a reserve currency in favor of some strange computer bits floating out in “the cloud” (whatever that is).

The potential economic advantage of cryptocurrencies lies in the promise of a genuinely global unit of both reserve and exchange that is no way dependent on the political or economic policies (or whims) of any one government.  Such a currency could facilitate world trade by providing a fair, impartially valued universal unit of exchange and.  It could provide a reserve currency that is not dependent on the economic fortunes of any one nation over which most holders of the currency have no control.  Because the value of a cryptocurrency is determined by global market forces, there is the potential, at least, for a cryptocurrency to become the only currency for which the value is managed by everyone.  While the benefits to many countries around the world are obvious, the emergence of a genuinely globally accepted world currency could also help the US by greatly strengthening the ability of the Federal Reserve to manage the dollar.  While there certainly are advantages to the USA of the US dollar (US$) being the world’s primary reserve currency and unit of exchange, there are downsides as well.  At present, the fact that well over half of all US currency is held outside the USA means that domestic policies implemented by the Fed are watered down.  Looking beyond physical (paper) currency, literally trillions of dollars are held as electronic balances in banks around the world – banks that are outside of the Federal Reserve’s purview.  Both multinational corporations and national governments may choose to trade in dollars for reasons that have nothing to do with, or are even diametrically opposed to, Federal Reserve policy goals.  It’s no wonder that some economists have joked that the Federal Reserve managing the dollar is a bit like the captain of a ship attempting to change course by dipping a teaspoon into the water.

While the Bretton Woods agreement remains the most commonly cited reason why the US Dollar is the leading international reserve currency, in reality the Bretton Woods agreement only explains how the US$ became the world’s primary reserve currency.  It does not explain why the US$ has remained the world’s de facto reserve currency and preferred unit of exchange for over half a century.  The most interesting — and often ignored – question is why the US$ has retained and even deepened its role in the immediate post-WWII world.

The first answer is that for most of the post-WWII era, the US had been kept a remarkably free exchange policy.  Nixon’s decision to (finally) break the formal tie between the dollar and gold represented a decision to keep dollar markets free rather than to limit them in the face of rent-seeking behavior by traders who profited off disparities in the dollar/gold exchange ratio.

Today, there are almost no limits on who can hold dollars, where they can be held, how they are exchanged, etc.  If someone (or corporation or national government) wants to exchange a billion dollars or even issue a billion (or 10 or 100 billion) in US$ bonds, there is nothing to prevent them from doing so.  They don’t even need to come to the USA or involve the USA in any way since dollar exchanges exist around the globe.  While the US$ is not completely uncontrolled, the controls that do exist are light and rarely implemented.  For example, persons carrying more than $10,000 in cash across the US border need to declare it, but there is absolutely no prohibition to transporting $1,000,000 or even $1,000,000,000 with absolutely no duties or taxes. The reporting requirement was implement as an anti-crime (primarily anti-money laundering) measure rather than to restrict the movement of dollars.

To understand how “hands-off” the US government has been toward the US$, remember that there are nations that use it as their national currency even though they have no “permission” or agreement from the US government to do so. They don’t have an agreement because they don’t need one.  There is absolutely nothing in US law to stop anyone from accumulating or using US$ for any purpose or in any location on earth.  For countries (such as Russia and much of the Foreign Soviet Union as well as others) that prefer to hold large quantities of actual paper money rather than electronic bank balances, the NY branch of the US Federal Reserve will even assist them in shipping billions of dollars in currency to wherever it is needed (which is why three-fourths of all paper currency in circulation is in the form of $100 bills).

The second answer to the question of why the US$ has remained the world’s most widely-used unit of exchange for so long is that there have been no real rivals.  While many touted the Euro as a potential rival, eventually the inherent weakness of a single currency that is effectively managed independently (and issued in bonds, etc.) by more than two dozen national banks and governments caught up with the currency.  Until and unless the EU can work out some basic and divisive issues regarding the rights of member states versus the European Central Bank, the fate of the Euro will remain uncertain.  The Japanese Yen was, at one time, thought of as a competitor to the dollar.  The reality is, however, that Japan’s national laws governing currency and exchange are not nearly as liberal as the USA’s.

Countries such as China and Russia sometimes promote their own currencies as units of exchange, but have thus far been unwilling to relinquish control over those currencies.  Anyone dealing in Roubles or Yuan is always at the mercy of Moscow and Beijing.  Exchanging a large quantity (or technically, a small quantity) of currency requires the permission of the government.  If one government or the other decides to declare a devaluation or to limit trading in order to support some national economic policy, there is no appeal.  Similarly, there is no recourse should one of the governments decide to demonetize certain paper bills, something Russia has done repeatedly.  For all its faults, the US government has never, in the post-WWII era, sought to control trading in its currency in the same way that other governments do.

Having cited the laissez-faire policy that the US government takes towards its currency many times, I must also admit that even the US policy is not without limits.  Sanctions on Russia, Iran, and North Korea all represent rare instances in which the US government has deviated from its overall policy of free and open exchange.  More importantly, the value of the US$ is managed (to the extent that management is possible) by the US Federal Reserve for the sole purpose of supporting the US economy.  While the Fed has a stellar reputation among world bankers and is not driven by foreign policy concerns when setting monetary policy, it nonetheless remains committed to the goal of supporting US economic growth.  No one outside the USA, not even other countries that use the US dollar as their currency, has any say in US monetary policy.

Cryptocurrencies hold the potential to break the linkage between a unit of exchange used by the whole world and a currency managed for the benefit of one country.  A theoretically ‘perfect’ cryptocurrency could represent a genuinely independent unit of exchange, the value of which is set by billions of market actors (people, corporations and governments) functioning independently around the world via free market transactions rather than by a group of economists (all of whom were appointed by politicians with often partisan agendas) meeting in DC once a quarter.

Thus far, the reality of cryptocurrencies has fallen fall short of perfect.  Bitcoin, the best known of all cryptocurrencies, made fundamental decisions early in its development that make it not only impossible for governments to control but also make it an ideal medium for money laundering and other criminal pursuits.  World governments – and most ordinary people – will not adopt Bitcoin as their primary reserve currency and unit of global exchange for the simple reason that Bitcoin has already been adopted by the criminal world.  I don’t mean to fault Bitcoin too much; they were among the pioneers.  Like many pioneers, they did not get it right on the first try.  The important point to remember is that the manifold weakness of Bitcoin are not inherent in the blockchain technology on which it and other cryptocurrencies are based.  Instead, Bitcoin’s problems can be traced to policy and marketing decisions that shaped the currency we see today.

If a cryptocurrency is ever to emerge as a genuine rival to the US$ as a unit of global exchange, it must combine the key trait of independence from any one government with the vitally important traits of transparency and accountability.   The simple yet hard to fathom reality is that blockchain technology, along with closely related technologies of distributed or “hyper” ledgers, open the possibility of a currency that is as transparent and resistant to manipulation as it is independent of the political policies of any one government.  If blockchain technology and the enormous networked computational power that supports it had existed in the 1940’s, Bretton Woods may have reached a very different conclusion.  While the technology did not exist at that time, eventually someone is likely to find (or stumble upon) the perfect mix of technologies and policies for creating a unit of exchange and reserve medium that is not just a mode of Ponzi-scheme style speculation or a tool for money laundering.  Once that happens, those who now dismiss cryptocurrencies as a ridiculous passing fad will look just as foolish at the vast majority of 18th century economists and bankers who dismissed fiat currencies as ‘the promises of fairies.’

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