The rational crypto-expectations revolution

My RMIT colleagues Chris Berg, Jason Potts and I have a new idea up as a Medium post looking at money.

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Will governments adopt their own cryptocurrencies? No.

Will cryptocurrencies affect government currencies? Yes.

In fact, cryptocurrencies will make fiat currency better for its users — for citizens, for businesses, for markets. Here’s why.

Why do we have fiat currency?

Governments provide fiat currencies to finance discretionary spending (through inflation), control the macroeconomy through monetary policy, and avoid the exchange rate risk they would have to bear if everybody paid taxes in different currencies.

As George Selgin, Larry White and others have shown, many historical societies had systems of private money — free banking — where the institution of money was provided by the market.

But for the most part, private monies have been displaced by fiat currencies, and live on as a historical curiosity.

We can explain this with an ‘institutional possibility frontier’; a framework developed first by Harvard economist Andrei Shleifer and his various co-authors. Shleifer and colleagues array social institutions according to how they trade-off the risks of disorder (that is, private fraud and theft) against the risk of dictatorship (that is, government expropriation, oppression, etc.) along the frontier.

As the graph shows, for money these risks are counterfeiting (disorder) and unexpected inflation (dictatorship). The free banking era taught us that private currencies are vulnerable to counterfeiting, but due to competitive market pressure, minimise the risk of inflation.

By contrast, fiat currencies are less susceptible to counterfeiting. Governments are a trusted third party that aggressively prosecutes currency fraud. The tradeoff though is that governments get the power of inflating the currency.

The fact that fiat currencies seem to be widely preferred in the world isn’t only because of fiat currency laws. It’s that citizens seem to be relatively happy with this tradeoff. They would prefer to take the risk of inflation over the risk of counterfeiting.

One reason why this might be the case is because they can both diversify and hedge against the likelihood of inflation by holding assets such as gold, or foreign currency.

The dictatorship costs of fiat currency are apparently not as high as ‘hard money’ theorists imagine.

Introducing cryptocurrencies

Cryptocurrencies significantly change this dynamic.

Cryptocurrencies are a form of private money that substantially, if not entirely, eliminate the risk of counterfeiting. Blockchains underpin cryptocurrency tokens as a secure, decentralised digital asset.

They’re not just an asset to diversify away from inflationary fiat currency, or a hedge to protect against unwanted dictatorship. Cryptocurrencies are a (near — and increasing) substitute for fiat currency.

This means that the disorder costs of private money drop dramatically.

In fact, the counterfeiting risk for mature cryptocurrencies like Bitcoin is currently less than fiat currency. Fiat currency can still be counterfeited. A stable and secure blockchain eliminates the risk of counterfeiting entirely.

So why have fiat at all?

Here we see the rational crypto-expectations revolution. Our question is what does a monetary and payments system look like when we have cryptocurrencies competing against fiat currencies?

And our argument is that it fiat currencies will survive — even thrive! — but the threat of cryptocurrency adoption will make central bankers much, much more responsible and vigilant against inflation.

Recall that governments like fiat currency not only because of the power it gives them over the economy but because they prefer taxes to be remitted in a single denomination.

This is a transactions cost story of fiat currency — it makes interactions between citizens and the government easier if it is done with a trusted government money.

In the rational expectations model of economic behaviour, we map our expectations about the future state of the world from a rational assessment of past and current trends.

Cryptocurrencies will reduce government power over the economy through competitive pressure. To counter this, central bankers and politicians will rail against cryptocurrency. They will love the technology, but hate the cryptocurrency.

Those business models and practices that rely on modest inflation will find themselves struggling. The competitive threat that cryptocurrency imposes on government and rent-seekers will benefit everyone else.

It turns out that Bitcoin maximalists are wrong. Bitcoin won’t take over the world. But we need Bitcoin maximalists to keep on maximalising. The stability of the global macroeconomy may come to rely on the credible threat of a counterfeit-proof private money being rapidly and near-costlessly substituting for fiat money under conditions of high inflation.

A Hardness Tether

Most discussion about the role of cryptocurrency in the monetary ecology has focused on how cryptocurrencies will interact with fiat. The Holy Grail is to create a cryptocurrency that is pegged to fiat — a so-called stable-coin (such as Tether or MakerDAO).

But our argument is that the evolution of the global monetary system will actually run the other way: the existence of hard (near zero inflation, near zero counterfeit) cryptocurrency will tether any viable fiat currency to its hardness. No viable fiat currency will be able to depart from the cryptocurrency hardness tether without experiencing degradation.

This in effect tethers fiscal policy — and the ability of politicians to engage in deficit spending in the expectation of monetising that debt through an inflation tax — to the hardness of cryptocurrency.

The existence of a viable cryptocurrency exit tethers monetary and fiscal policy to its algorithmic discipline. This may be the most profound macroeconomic effect of cryptocurrency, and it will be almost entirely invisible.

Cryptocurrency is to discretionary public spending what tax havens are to national corporate tax rates.

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10 Responses to The rational crypto-expectations revolution

  1. Spring is coming

    Yes, yes I get all that but how do I get rich … quick?

  2. Sinclair Davidson

    … how do I get rich … quick?

    Buy low – sell high.

  3. Spring is coming

    Thank you I have written that down.

  4. So, if blockchain, is so secure, why does every second con artist try to ply their trade with Bitcoin? Could they still be in trouble sometime down the track if Plod gets his collective brain into gear?

  5. GoTiges

    Will governments adopt their own cryptocurrencies? No.

    The Marshall Islands seems to have legislated its own cryptocurrency

  6. Speedbox

    The Marshall Islands seems to have legislated its own

    Yes, and so has Venezuela, called the Petrocoin (I think) in which case it is an act of desperation by the Government, is completely useless and a Government initiated scam. The Marshall Islands proposal is different in that they are going to create a local sovereign currency (which they don’t have) because they use the US dollar and it is, de facto, their sovereign currency. But, the Marshall Islands are not, strictly speaking, a US territory – they are more like a protectorate.

    The US dollar will continue to be used and traded – its just that the local Marshall Islands sovereign currency will be ‘electronic’ – no coins or paper notes. If you think about it, it makes sense in “why do we actually need coins/notes?” As an example, some developing countries hardly used rotary dial telephones – the majority of the population went directly to mobile phones. The idea that a phone would be fixed to a wall is absurd to the younger generations.

    If you are creating a sovereign currency from scratch, it is clever forward thinking.

  7. Speedbox

    The fact that fiat currencies seem to be widely preferred in the world isn’t only because of fiat currency laws. It’s that citizens seem to be relatively happy with this tradeoff. They would prefer to take the risk of inflation over the risk of counterfeiting.

    I am not certain that many citizen are thinking that deeply. More likely that they see no choice but to use fiat currency and the idea that “money” could be “entirely electronic”, probably isn’t on their radar yet. But, whether unwittingly or not, the use of cash is rapidly diminishing as any number of formal analysis will attest. Conducting a simple observation at your local Woolies or Coles on the weekend will show the prevalence of payment via electronic means. Very few people will pay with cash. At a guess, I would expect cash to be virtually eliminated from day-to-day payments within the next 15-20 years. The Aussie dollar will survive, you just won’t see it very often.

    Recall that governments like fiat currency not only because of the power it gives them over the economy but because they prefer taxes to be remitted in a single denomination.

    Which brings us to blockchain. If a sovereign currency is largely or entirely electronic, this allows the Government to exercise much greater oversight of the payment, and consequent taxation, activities. Tax avoidance will be almost impossible. Tax collection will be simplified (from a Government perspective). Every dollar will be logged and accounted for.

    If cash is an exceptional/rare sight, the use of cash (particularly large amounts) becomes even more problematic for criminals. Imagine if all cash transactions greater than, say, $250, had to be reported. Every bank and business had a reporting responsibility. Your local drug dealer may be sitting on tens/hundreds of thousands of cash dollars but moving it or spending it is as much interest to the authorities as the drugs themselves.

    It turns out that Bitcoin maximalists are wrong. Bitcoin won’t take over the world. But we need Bitcoin maximalists to keep on maximalising. The stability of the global macroeconomy may come to rely on the credible threat of a counterfeit-proof private money being rapidly and near-costlessly substituting for fiat money under conditions of high inflation.

    Yep. Bitcoin will never, ever, be the currency of a sovereign nation principally because the nation can not control it. Imagine the chaos if Bitcoin had a fork!! Old Bitcoin, new Bitcoin, differing conversion rates. Laugh. Jeezus on a bike. What a colossal stuff up.

  8. JohnA

    Speedbox #2768322, posted on July 20, 2018, at 10:53 am

    Which brings us to blockchain. If a sovereign currency is largely or entirely electronic, this allows the Government to exercise much greater oversight of the payment, and consequent taxation, activities. Tax avoidance will be almost impossible. Tax collection will be simplified (from a Government perspective). Every dollar will be logged and accounted for.

    Precisely.

    The blockchain concept represents decentralised central control (if you will pardon the apparent contradiction).

    It appears to be decentralised and distributed but is, in fact, removing local control from an individual to an amorphous “body” representing everybody else (= society at large) who has signed the blockchain.

    The use of “chain” conjures up images of slavery – loss of personal autonomy/responsibility, increasing dependence upon everyone else in the community/society/country/world…

    Sorry, I don’t buy it.

  9. I remember reading an SF story many years ago where a bloke gets his hands on an alien AI that he gets into the world banking system. His aim is to find out where the bribe/blackmail/contract skimming money is being channeled. The AI finds it and starts diverting it to an account, but the bloke then realises he can get richer with less risk of Russian Mafia types waking him up at zero dark hundred, by just collecting the rounding errors instead.
    Amusing story.
    Governments will never outlaw cash, because it is how they get bribes.

  10. .

    Yep. Bitcoin will never, ever, be the currency of a sovereign nation principally because the nation can not control it. Imagine the chaos if Bitcoin had a fork!! Old Bitcoin, new Bitcoin, differing conversion rates. Laugh. Jeezus on a bike. What a colossal stuff up.

    If BTC can stop the stupid bloody forks and the Lightning Network gets up, it is absolutely a goer.

    If not, it might remain just a novelty and existential threat to inflationist central bankers.

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