Crypto — a threat to the US dollar?
How to mitigate the risk…
Team Biden announced on March 9 that the president would sign an Executive Order on digital finance — a whole-of-government strategy to manage the risks and rewards of cryptocurrencies and blockchain technology.
The unfolding transformation of banking and finance online — underscored by the figure of $3 trillion in digital assets — has caught the attention of the great powers, from DC to Brussels to Beijing. Life online has intensified during the pandemic — and commerce is at the center of it.
US policymakers should address the following questions:
- Are digital currencies and decentralized finance (DeFi) a threat to the dominant role currently played by the US dollar in global affairs?
- What are the likely impacts of crypto on US financial institutions and markets and the security of the savings of American households?
- What should the US government do? China has banned crypto trading. But this is not America’s way.
Short answer: the US should issue an e-dollar (carefully) to compete with crypto, and should regulate DeFi in order to ensure financial stability.
US Dollar’s Global Role
The US dollar is the de facto global currency. It dominates transactions around the world and is unlikely to be dethroned by a competitor currency in the near term — not the euro nor the Chinese yuan (CNY) nor the yen or any other. See chart below.
Nearly 60% of central bank foreign exchange reserves (the foreign cash that central banks hold for a rainy day) are invested in US dollar assets. And the bulk of that goes into US treasury securities, creating an automatic global demand for the debt of the US government.
Nearly 90% of all foreign exchange transactions (largely conducted in the private sector) involve the US dollar on one side of the transaction. A good deal of this private cash is likewise held in US treasuries.
The euro — the currency with the second greatest global demand — only represents just over 20% of FX reserves and almost one-third of FX transactions. In addition, commodities, such as oil, and other tradable goods are often priced in US dollars, reinforcing the dominance of the dollar.
The CNY remains a little used currency for international transactions, responsible for under 3% of central bank reserves and under 5% of FX transactions. That said, China — along with the EU and the US — is among the three largest exporters in the world, so economic agents demand CNY to purchase Chinese goods.
Furthermore, China is a nation of 1.4 billion people who use CNY, compared to America’s 331 million who use the USD, plus the populations of countries that have adopted the dollar. So, CNY’s FX reserves / FX transactions figures likely understate the Chinese currency’s importance… and certainly its future potential as a global currency.
Why does the US dollar dominate? In part, for legacy reasons.
At the end of World War II, the US stood athwart the globe as the dominant economic and military power, responsible for over half of the world’s manufacturing and possessing nearly two-thirds of its gold, as well as dominating exports and armaments production (see Paul Kennedy).
The US had led the coalition that defeated Germany and Japan in WWII — with the contest won in large part because of the sizable productivity advantage of the American worker.
The US reconstructed world order by way of international institutions — such as the UN, IMF, World Bank and WTO — a rules-based system that underpinned unprecedented and relatively broad-based prosperity around the world.
The US led the coalition (NATO) that opposed the main threat to this global order (the Russia-led Soviet bloc). As a result, the US and its allies were in large part responsible for producing a period of history that was comparatively peaceful.
After WWII, the US initially ran current account surpluses (including trade surpluses and other items), exporting more than it imported, as war-ravaged countries needed US goods — notably, food and energy. Countries around the world also needed US capital to rebuild industry destroyed by the war.
So, the dollar was in demand around the world and was initially quite scarce.
The US obliged its partners. It provided dollars by way of economic aid (e.g. the Marshall Plan), investment overseas, and increased spending on the goods and services of other countries. As the post-war period progressed, the US remained competitive but other countries — notably, Japan and Germany — caught up.
As the decades after the war passed, the US did not retrench its free-spending ways — the government ran budget deficits, which drove ongoing current account deficits and borrowing from foreigners. The US spent freely on “guns and butter,” that is on national defense and social programs.
Ultimately, American politics contributed to the poor management of government finances. The ideological rigidity shown on both sides of the aisle yielded tax cuts and spending hikes and ongoing government deficits that have ballooned over the last two decades.
Republican governments cut taxes when they could, and Democratic governments increased spending, with some exceptions. (In fairness, Ds also cut taxes — notably, on the poor and middle class; and, Rs increased spending — notably, on defense.)
As a result, America’s Net International Investment Position (NIIP) — US foreign assets less US foreign liabilities — is a whopping, large negative number, -70% of US GDP. This metric is only surpassed among large countries by Spain’s -77%, though that country’s metric has been narrowing, while America’s continues to widen.
By contrast, Germany — which lends more than it borrows overseas — has a large positive NIIP, equal to 66% of German GDP. Germany is therefore in better financial shape than the US. See the chart below. (That said, Germany’s contingent liabilities include money owed by other euro area countries, such as Italy and Spain. If Germany were compelled to bail out such partner countries in order to prevent a collapse of the euro, then these debts could revert to Germany, resulting in a deterioration in its NIIP and government debt metrics.)
Still, the US dollar remains the linchpin of global finance.
Strong global demand for dollars has resulted in what French politicians once called America’s “exorbitant privilege.” They were referring to the privilege of drawing on the world’s savings to finance US deficits. Fifty years ago, the US could fund the Vietnam War and troop deployments around the world, as well as Great Society social spending to address racial and income inequities.
This uniquely American ability to draw on foreign savings to finance deficits has continued into the 21st century. From the spending and tax cutting episodes during George W. Bush’s War on Terror through the Global Financial Crisis during the Obama years, and most recently, into the pandemic, America has been able to run up debt like no other country can. With little incentive to adjust, the US keeps on borrowing.
The US retains an innovative, large and robust economy—featuring free and open markets, leading technology companies, and robust GDP growth. Demand for dollars continues to be supported by America’s impressive institutions — a stable democracy, rule of law, contract enforcement, a credible monetary policy, and liberal rules on capital flows. As a result, investors around the world are confident that they can move freely in and out of the US dollar, which remains relatively stable.
There are currently no challengers to the US dollar, folks.
No other currency — not the euro nor the yen nor the CNY — offer an attractive alternative. Not yet.
Doubts about the commitment of every country in the euro area to follow sustainable economic policies in order to stay in the euro emerged during the sovereign debt crisis of 2010–16.
China restricts capital flows into and out of its country (maintaining what economists call a closed capital account). The country features widespread state involvement in the economy (notably state ownership of banks). And, concerns about its authoritarian politics and the rule of law persist among investors.
Yet trust in the US dollar is not eternal. The US must be careful not to squander its privilege. Eventually, an uncontrolled runup in US debt could undermine the confidence investors have in the dollar.
It’s a lot to lose and it takes time to lose it. But, it can be lost.
The UK — and its vaunted pound sterling — dominated international finance for a century through the first quarter of the 20th century. The runup in UK government debt from 27% of GDP in 1914 to 270% in 1946, due to two world wars, was followed by multiple currency crises after WWII. US debt totals ~130% of GDP today, vs. Germany’s ~70%, having risen dramatically since the early 2000s.
As a result, without a medium-term debt and deficit reduction plan put forward soon by the US government, the US dollar could begin to lose its luster. Over time, its role as the world’s investment and payment vehicle could be supplanted by another currency or currencies.
Enter crypto.
Crypto’s Challenge
Blockchain is cool, folks. But, like all innovations it presents challenges.
Crypto could provide benefits to society, such as lower cost, greater efficiency, and broader access to financial services and other commerce. Banking and finance will increasingly go online. Blockchain could transform how we do business, impacting nearly everything we do, including how we use the dollar.
By its nature, cryptocurrency blockchain is decentralized, involving numerous players, none exercising an overwhelming power over others, and all having access to information and value. This gives it a utopian appeal — though to paraphrase Orwell, some crypto participants are more equal than others. And, beware of bad actors.
Time will tell how concentrated power will become in digital finance. Will there be a Rockefeller (or a Jeff Bezos) who will buy up all the “oil wells”? Already cryptocurrency exchange owners, backed by startup cash from giants like BlackRock, are billionaires, so where’s the egalitarian utopia?
The “distributed consensus” of blockchain refers to when a large group of participants in an activity — say, trading cryptocurrencies — establish trust without a central authority, such as a bank, a clearing house, a private internet platform like Amazon, or the Federal Reserve. Crypto is peer-to-peer (P2P).
Trust is achieved through faith in the computer code. Faith that blockchain technology can establish unique ownership — title to an asset — so that disputes and double-spending by participants are avoided. This is accomplished through cryptography, which is a fancy term for the “secret code”.
Each cryptocurrency “token” — that is, each bitcoin or ether — is unique. The blockchain code produces protocols (rules) that all users follow in order to make sure ownership of digital assets is secure.
Math algorithms, computer coding, and brute force computer processing drive the mechanism that verifies transactions and adds new “blocks” of transactions to the chain — hence the name “blockchain”.
It is a publicly “distributed ledger” of transactions, a database, available to every computer in the network (thousands of them), providing proof of who owns what. Some blockchains — such as Ethereum, a decentralized finance (DeFi) system involving trading, borrowing and lending — also publish the computer code, so that participants are guaranteed that the platform operates as it is written.
Smart mathematicians and computer scientists have found this technology — the cryptography — to be rock solid, ever since Satoshi Nakamoto (an alias) rolled out the bitcoin whitepaper in 2009. They say that no one has poked holes in it. The code hasn’t failed.
On the other hand, there have been hacks of exchanges where customers’ crypto was stolen, 54 such events since 2014 in which nearly $2.5 billion of value has been lost, according to one source. In one recent case the hacker returned the stolen tokens, stating that the intent was to “expose the vulnerability” in the crypto system.
It remains unclear how hacks succeed. It may be a combination of compromising people as well as code — that is, getting confidential information on cryptographic codes directly from people with inside information, and/or crypto participants unsafely storing key codes online, as well as the time-honored practice of skilled bad actors exploiting weaknesses in the system.
Crypto enthusiasts argue that while hacks occur, theft is more difficult on the blockchain than in traditional finance.
From a Chainalysis report on the August 2021 hack of crypto exchange Poly Network:
“…cryptocurrency theft is more difficult to get away with than theft of fiat funds. This is due in part to the inherent transparency of blockchains. Whereas criminally obtained fiat currency can be moved through shady bank accounts, with authorities relying on subpoenas and cooperation of financial institutions to trace its path, anyone in the world can view cryptocurrency transactions made on public blockchains.”
When a hack occurs, platforms can freeze assets and blacklist internet addresses, limiting the capacity of hackers to move wealth “off-chain,” that is, to a traditional bank in the real world in a currency like the dollar. In the August 2021 hack cited above, the “cryptocurrency ecosystem,” including Poly, Tether, and Binance, acted to quarantine the hack. This is when the hacker came clean.
Such arguments are made as well for why crypto might not be effective for terrorism financing, money laundering, or sanctions evasion. Clearly, this needs to be studied.
Cryptocurrencies like bitcoin and ether are speculative assets, not money.
Cryptocurrency tokens are created — that is, more coin is “mined” — when coders do the complex computations required to add the next block of transactions to the chain, verifying these new transactions and owners. More assets are created because coders — in exchange for solving such challenging math problems — receive new cryptocurrency tokens for their work. Coders often compete to solve equations that verify the next block of transactions, and whoever wins, gets more tokens.
Blockchains have rewarded early users and code writers who have received additional tokens and whose tokens have gone up in value. So again, it is no utopia. There is inequality on the blockchain.
You read that correctly: assets are created on the blockchain. If crypto were money, money would be created on the blockchain.
Wait — I thought only central banks create money?!
That is true.
Crypto is not money. Not yet. It is a speculative asset, but could become money. And therein lies the challenge to the United States, to the Federal Reserve and the dollar.
Bitcoin and ether are cryptocurrencies not backed by any other currency or asset, so they are volatile (see chart below). Value goes up and down (a lot).
Dollar value of Bitcoin and Ether (from Yahoo Finance)
On the other hand, “stablecoins” are a type of cryptocurrency that, instead of fluctuating wildly, provide an external anchor of value — such as a currency basket or a reserve currency like the US dollar.
Stablecoins, because they are digital and stable, have become quite popular, catching the attention of central banks.
Tether is a cryptocurrency that claims to be fully collateralized by short-term US dollar assets like cash and corporate commercial paper (held in reserve off-chain). Tether has been valued at $80 billion, a large portion of the total stablecoin market capitalization.
If Tether and other stablecoins are fully collateralized, then they are not similar to traditional money, which can be created by central banks. This is because the collateral backing stablecoin — the dollars, if you will — is effectively limited and controlled by central banks — by monetary policy. The supply of US dollar assets available to back Tether is driven by the Federal Reserve’s decisions on interest rates and the money supply.
(Note: the NYS Attorney General found that Tether was not fully collateralized in 2017–18, and the company was fined.)
Still, central banks are concerned about stablecoins. This was pointed up by comments made recently by Fed Chair Jerome Powell as well as pronouncements by the European Central Bank, both calling for regulation of stablecoin issuers.
Fed Chair Powell said: “Stablecoins function similarly to money market funds. They’re similar to bank deposits… and it is reasonable for them to be controlled similarly, same activity, same regulation.”
Crypto blockchains that issue and hold stablecoin for their participants will likely be required to obtain a banking license.
Stablecoin connects the crypto-asset world with the traditional financial system, via collateral, so stablecoin trading has become widespread. It is a conduit by which financial stability risks can spread from volatile crypto markets to the wider financial system.
This is why Chair Powell has said that, while DeFi could result in a more competitive and efficient financial system, the regulatory system needs to be upgraded and expanded to cover these new activities.
Crypto and DeFi are changing rapidly. If some stablecoins don’t fluctuate wildly like bitcoin or ether, demand for them could continue to increase. This would make them a more liquid and safer investment. Such stablecoins could then start to be considered digital money substitutes.
Money’s characteristics have been defined as: a store of value, a medium of exchange, and a unit of account. Via stablecoin, crypto could get there and begin to threaten the dollar.
The deposit-quality of stablecoin can make it a store of value, as Chair Powell suggested. Digital payment systems are disrupting traditional finance. Paypal, Alipay and others have moved cash payments online. Stablecoin, when paired with such digital payment systems (or similar systems on DeFi), could take on money’s function as a medium of exchange.
And, if eventually products, services and assets are quoted in stablecoin, i.e. it becomes a unit of account, then that’s three for three, folks.
Some stablecoins are backed by fiat currencies (currencies controlled by central banks). Similarly, today’s fiat currencies — the US dollar, the British pound sterling — were once backed by gold. Today, they are not backed by gold or any other asset, and they function as money.
So, imagine a very stable digital stablecoin in the not-to-distant future in such high demand that it no longer needs to be fully backed by, say, the dollar.
Now, you have a competitor to the dollar… and the euro… and CNY.
But, who will create them? Presumably, the decentralized blockchain, according to protocols set by coders, as well as the owners of exchanges and/or other powerful players in DeFi.
Private internet platforms — such as Facebook — are muscling in as well.
Diem, Facebook’s attempt to launch a payments system and a digital currency that would harness its unparalleled network of 2.9 billion users, was kibashed by US and EU regulators (for the time being). They have been clear that FB’s business model should exclude it from getting into this space — for antitrust reasons. Diem would represent an undue concentration of business activity on a private internet platform and present a threat to the monetary sovereignty of nations.
To stay relevant, fiat money such as the dollar has to go digital (i.e. a digital representation of the dollar), so it can also be an online payments vehicle, a deposit option on DeFi, and a currency in which prices of digital assets are quoted.
If not, the dollar could still dominate traditional payments, deposits, and price quotes for some time, but could increasingly be eclipsed by e-currencies.
DeFi threatens to upend global finance by connecting to the real world of stocks and bonds, currencies, real estate, and goods and services.
The Economist said the following on DeFi: “The ultimate goal is to replace intermediaries like global banks and tech platforms with software built on top of networks that direct the value they generate back to the users who own and run them.” That is, more software to move the full panoply of financial services onto the blockchain.
Regulating DeFi might be an end in itself in order to avoid the hemorrhaging of deposits from traditional banks to crypto institutions. By competing with DeFi on a level playing field, traditional financial institutions could offer digital assets profitably as well.
Question: as a regulator how hard do you want to come down on this sector? It promises to produce innovation important to the general public.
Crypto and DeFi have a natural motor of self-improvement, attracting the best software engineers. For example, there is a new multi-chain technology that scans crypto-exchanges for best practices, keeping them on their toes. Non-fungible tokens (NFTs) are representations of creative work that can empower artists and musicians and other creators to control their work. NFTs could likewise represent claims on real-world assets such as real estate.
Smart contracts self-execute. They contain conditional code that triggers actions. These contracts could improve efficiency by eliminating high-priced intermediaries and armies of lawyers. Stock, bond and currency exchanges could be automated. Smart contracts on blockchain would compete with the oligopolistic internet platforms — FB, Apple, Amazon, Google, Alibaba — and reduce their excessive markups.
Another innovation that remains to be invented is a libertarian’s dream: zero-knowledge proof. This is a technology where you retain control over your personal data. You can complete a transaction on DeFi by providing very limited information, which is all your counterparty will need to know in order to be secure in the transaction. No personal data are unnecessarily divulged, which is a common complaint about the private internet platforms.
This may, however, create a Know Your Customer (KYC) problem, making it difficult for firms and governments to crack down on bad actors.
Is crypto really new?
We have seen innovation in banking and finance for nearly 4000 years, since deposit-taking and lending were codified in law in ancient Babylon in the Code of Hammurabi.
Is “distributed consensus” really new? To a certain extent, we’ve been working with “distributed consensus” for centuries, millennia even.
Blockchain is not entirely unlike the “distributed consensus” of users that underpins trust in a reputable bank, say JPMorgan Chase, in a country with a reputable government, strong institutions and a safe currency, say the US. Without a consensus distributed among the public, banks and countries could not function. Yes, trust in the blockchain code is different, but not that different, because trust in human beings is still required.
A US Action Plan
Technology is moving fast. Young people want online transactions — low cost, fast and private. So, demand for digital finance — and the currencies that facilitate it — will increase. The US government must strike a balance between fostering innovation and retaining sovereign control.
If the Federal Reserve were to take a laissez-faire attitude toward crypto and let it develop on its own and not issue a central bank digital currency (CBDC), then much of finance could, over time, migrate from traditional US banks and even from US capital markets to DeFi and digital currencies. This could also involve cross-border flows out of the US dollar.
This could impair the Fed’s control over monetary policy and perhaps ultimately undermine the US dollar’s role as the world’s reserve (and chief transactional) currency.
The Fed is not sitting idle. It plans to roll out FedNow in 2023, an instant payments system to be deployed broadly across US banks, individuals and businesses. It will operate 24x7x365 and be secure in terms of payments integrity and data, while providing users with fraud prevention tools.
FedNow could prevent further migration of payments to private digital networks. It will support the traditional US banking system and capital markets, because it utilizes the Fed’s infrastructure and relationships to facilitate interbank clearing and settlement. Expect FedNow to be an attractive payments option and perhaps a critical step toward issuing a CBDC.
The Federal Reserve should issue an e-dollar to compete with crypto and other CBDCs and should regulate DeFi in the interest of safeguarding household savings.
Within a year of the FedNow rollout, the US central bank should begin initiating its e-dollar rollout.
The existence of a sizable crypto-DeFi world independent of the US dollar could be like living in a partially dollarized economy today like Peru’s. There, dollarization limits the central bank’s ability to control monetary policy, because it only controls that part of the economy operating in Peruvian soles. A scenario where there is a dollar portion and a crypto portion of the US economy is not out of the question. Control over inflation, unemployment, and financial stability would be hampered.
Implementation of an e-dollar must be done carefully, with policymakers thinking through the logistics and the involvement of the banking system. This is in order to avoid the CBDC flopping (i.e. spurring little interest in the e-dollar because it is not as nimble as crypto) or harming the US financial system.
It’s tricky because the creation of an e-dollar, which the public would keep on deposit at the Fed, could well undermine US banks. Full backing by the Fed, which the e-dollar would have, is better than FDIC insurance. So why not move all your deposits into e-dollars at the Fed?
In theory, the full ~$17 trillion of US deposits could move to the Fed’s balance sheet, suddenly putting the US central bank in charge of credit allocation (which it has already become significantly involved in given QE). So, the Fed should only issue a couple of trillion dollars of e-dollars, sufficient to compete with crypto, and see if it can on-lend these funds back to US banks, so they could continue to manage credit allocation.
This would would put an asset — a dollar backed by the Fed — in direct competition with cryptocurrencies. The e-dollar would offer greater stability. The imperative for stablecoin — that is, the stability of fiat currencies combined with the digital dexterity of crypto — would also become less compelling.
Bitcoin and ether (and others like them) would remain speculative assets. With no intrinsic value, these cryptos might even wither on the vine. E-dollar and other CBDCs could populate e-wallets and become a medium of exchange in the DeFi universe.
This would ensure that:
- the Fed and the dollar remain central to the disruptive financial and economic forces at play with DeFi;
- the public benefits from the efficiency gains of blockchain and DeFi; and,
- all new financial entities associated with DeFI such as Ethereum would be regulated and relatively clear of bad actors.
Effectively, crypto and DeFi would drive innovation. But, the Fed (in concert with other monetary authorities) would make sure that this does not create a competitor to central banks. Monetary policy setting, the lender of last resort function, and oversight of financial stability would remain roles under the purview of the world’s central banks.
Disclaimer: this subject is new, constantly changing, and highly technical. So, upfront, apologies, if I got some things wrong…
Notes:
- Protocols for adding blocks of transactions seek to ensure that bad actors can’t subvert the mechanism by becoming false verifiers of transactions. Two protocols are deployed: 1) “proof of work,” where the transaction validator proves s/he is real by demonstrating s/he is engaged in substantial computational activity; and, 2) “proof of stake,” where the validator must hold a lot of cryptocurrency already in order to validate a block. Proof of work is energy-intensive and therefore less “green” than proof of stake, while the downside of proof of stake is that it is less democratic. It rewards wealthy blockchain participants. Hence, both methods of securing the system and mining crypto subvert the utopian ideal.
- Public goods: Crypto and DeFi, like banks, clearly have a “public goods” aspect to them. There is social value in making sure these goods and services are provided, and regulated. There are certain goods you don’t want the private sector to provide, such as national defense and a police force. We don’t want private armies and police forces, but nor do we want private currencies. Some goods have public goods aspects but are better provided by the private sector. Banking is a case in point. You want banks to be private, to have the profit motive, to compete, but you don’t want them to take excessive risk with household savings, like they did just before the Global Financial Crisis in 2008. So you regulate them. Same is true to for crypto and DeFi. Public goods tend to be underprovided, because consumption of these goods is non-excludable and non-rivalrous. That is, you can’t keep people from free-riding and consuming public goods without paying for them, like with a “lighthouse”.
Other Sources (in addition to links):
Conversations with Jonathan Lewis, a software engineer
Lairson & Skidmore, International Political Economy (3rd edition), Ch. 4
Paul Kennedy, The Rise and Fall of the Great Powers, p. 358
IMF historical debt statistics
Economist crypto articles (various)
US Government & ECB pronouncements
