Are cryptocurrencies any closer to ending central banks' control?

Long before the advent of Bitcoin, one of the most influential free market economists of the 20^th century forecast the arrival of a decentralised digital currency.

“I think that the internet is going to be one of the major forces for reducing the role of government,” Milton Friedman declared back in 1999.

“The one thing that is missing but will soon be developed is a reliable e-cash, a method whereby on the internet you can transfer funds from A to B without A knowing B or B knowing A.”

In other words, this digital currency would exist beyond the control of national authorities – and anyone else.

Fast forward a couple of decades, and we are now confronting the reality – and risks – of cryptocurrencies. What kind of a threat do they pose to traditional money and the wider economy? And what does this mean for central banks?

Crypto and traditional currencies are not like for like. National currencies should inspire trust – they serve as a unit of account, a medium of exchange and a store of value, and central banks are the monopoly supplier.

This means they more or less control the quantity of money in circulation and have the power to quell or kickstart the economy, via interest rates, with the ultimate aim of controlling inflation. Because central banks back a currency and maintain its credibility, despite wavering levels of confidence in national authorities, faith in its longer-term value is largely steady.

By contrast, cryptocurrencies are a new form of currency in the guise envisaged by Friedman – privately issued, digital and decentralised – and beyond the control of authorities. This means they are free from political manipulation and poor economic judgement, but unlike sovereign currencies, they have no backing – no entity is liable for their value, and there is no lender of last resort.

As witnessed over the past years, Bitcoin and the like are worth only what buyers will pay for them. Their value can soar or plummet depending on the confidence of their users. They behave more like volatile assets than a means to buy or sell. Rarely does anyone ask the cost of anything in Bitcoin, but rather what they are worth in dollars.

Whether cryptocurrencies will assume greater importance as a workable currency free of central – or any – control is looking more doubtful since their dramatic plunges. But economic authorities must at least be aware of what could go wrong.

What’s the worst that could happen?

Absolute catastrophe – the ‘asteroid-destroying-earth’ scenario – for a central bank would be the loss of control of monetary policy.

What would happen if cryptos became a country's main currency?

This could happen if use of cryptocurrencies were to outstrip that of a sovereign currency – if cryptos were to become more mainstream and trusted than the country’s national currency.

But this would require a crypto that is less costly, less volatile and more liquid to transact than Bitcoin. In this case, traditional money could cease to operate as the national unit of account, rendered irrelevant by a decentralised digital currency.

In this scenario, a central bank would be powerless to steer the economy, as it would no longer have any control over the nation’s main currency. Interest rate tweaks or the release of more cash would have no impact. Dependency on another currency isn’t unheard of – some wobbly developing economies with rampant inflation rely on the US dollar rather than their own currency.

Ecuador adopted the dollar in 2000. But despite their subsequent loss of ability to fine tune their own economies, they are still pegged to a relatively stable and managed currency. Cryptocurrencies are by design unbacked and have an uncontrolled value.

This is the kind of risk which requires those in charge to monitor the solar system for impending disaster.

There are also lesser, more practical risks than the Armageddon scenario, thanks to a string of crypto-related failures which threaten wider repercussions.

Since the collapse last year of crypto Terra (a stablecoin formerly linked to the dollar) and the linked currency Luna, the wider crypto market crashed, no longer appealing as a potential hedge against inflation.

Late last year saw the bankruptcy of the crypto exchange FTX, leaving an estimated million crypto owners facing losses totalling billions of dollars.

These routs could spill over into the ‘real’ economy, and upset traditional banking, potentially with profound effects upon national financial systems. To date, traditional banks have largely weathered the storm.

For a brief period, some cryptos appeared to be snapping at the heels of traditional currencies. But since the initial peak of 2018, their potential to threaten the monopoly of central banks no longer appears plausible.

Their structural flaws are many – they are unanchored, slow and expensive to transact, and they are traded through unregulated exchanges, meaning that consumers don’t yet enjoy the benefits of decentralised finance.

And as we’ve seen, their value can seesaw, so they’ve yet to enter mainstream use as a unit of exchange.

This means their much-touted benefits, such as finance for people too impoverished to own a bank account, or faster, cheaper global transactions, have yet to materialise.

National currencies are far from obsolete – for now. But central banks need to remain vigilant; control of monetary policy depends on it.

David Skeie is Professor of Finance, a visiting Senior Economist at the US Federal Reserve Board of Governors and a member of the Gillmore Centre for Financial Technology. He teaches Corporate Finance on the Global Online MBA, Executive MBA and Executive MBA (London).

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