IMF Official Thinks Crypto Competes With Central Bank Money
Dong He, a deputy director for the International Monetary Fund’s (IMF) Monetary and Capital Markets Department, recently published an article which expresses a belief that cryptocurrency and digital assets are a threat to central bank money. The article explores the opportunities, threats, and implications of cryptocurrency to central banks and the economy as a whole. The primary ideas that Dong He argues in the article are that crypto reduces demand for central bank money, and that central banks should utilize their own form of digital currencies to compete and maintain control over the economy.
The deputy director notes that, in their current state, crypto assets are too volatile to really threaten fiat currencies; however, he believes that they may in the future. One of the major risks He points out should crypto assets become widely adopted is deflation risk. Deflation is a decline in goods and services prices, which causes the purchasing power of money to increase. It normally occurs when an economy’s aggregate money supply is fixed or capped. In the case of bitcoin and most other cryptocurrencies, their maximum supply is fixed (21 million for bitcoin), making them inherently deflationary assets. That is, if demand for them keeps increasing, so will their price, because a shortage will develop. This is complicated by the fact that most cryptocurrencies are divisible into many smaller parts (e.g. 1 bitcoin = 100 million satoshis), but the main relationship holds.
Deflation can be caused by two factors: a reduction in aggregate demand for goods and services, or increases in productivity (rate of output per unit of input). If crypto assets were to be widely adopted as a form of commodity money to be spent on goods and services, aggregate demand would decrease in a roundabout way due to the fixed supply of the crypto assets being transacted. Since many people would recognize that they can expect the purchasing power of their cryptocurrency to increase in the future, they would have less incentive to spend it on goods and services. With regard to productivity, it can be said that cryptocurrency increases productivity and efficiency, and reduces costs in the domain of transaction settlements and transfers of value. Tokenized assets also have the potential to remove friction and improve productivity in a wide range of other business areas. Ultimately, these factors will lead to economic deflation, which causes bond yields to rise and thus reduces access to and demand for credit. This directly affects central banks and the broader economy because a higher Federal discount rate (the rate at which central banks lend to commercial banks and depository institutions) makes it more expensive for banks to borrow money, who in-turn make it more expensive for businesses and households to borrow money. This may cause economic growth to slow, since businesses will have diminished access to capital for investment, especially in debt-intensive industries. (Note that deflation also increases the value of equity-based financing.)
Another economic and central bank risk is “a shift from an account-based payment system to one that is value or token based.” In the paper, a distinction is made between credit money and commodity money. Credit money is value recorded in accounts with centralized intermediaries, such as banks, which transfers via claims. This is money based on credit relationships, such as the relationship between a central bank and a commercial bank, or between a commercial bank and an individual account-holder. Commodity money is simply based on objects which represent value, such as paper currency, or in this case cryptocurrency. The predominant system of payments around the world has been utilizing credit money and centralized banking institutions for centuries, though a shift to crypto assets as the primary means of payment for goods and services would change that. The complete implications of this are uncertain at this point, but one thing is clear: crypto asset adoption will decrease the demand for central bank money.
Financial analysts have discussed the effects of a declining need for central banks and other depository institutions before, and the consensus is that this creates structural threats to economic stability. IMF deputy director Dong He and others have proposed that central banks develop their own decentralized digital currencies to combat these threats, though they may introduce some threats of their own. Central bank digital currencies (CBDCs) are digital fiat currencies issued by governments, which hold legal tender status. They are not the same as cryptocurrencies since they are issued by centralized governments and hold legal tender status, but, functionally, they do operate similarly to cryptocurrencies – they are decentralized and can offer real-time settlement via a distributed ledger. Proponents of CBDCs, such as Norway’s Central Bank, believe that they can effectively supplement central bank money and provide additional flexibility in the management of money supply and monetary policy. On the other hand, critics of CBDCs, such as the Bank of Japan, think they can destabilize the financial system by disrupting private banks’ balance sheets and fractional reserve lending practices, which undermines central banks’ ability to control the economy.
Dong He discusses how crypto assets can affect central banks’ ability to control the economy in his paper. He explains that if central banks are not monopoly suppliers of money, they cannot easily set short-term interest rates using open market operations, which strips them of their ability to execute monetary policy. He elaborates on this further:
“. . . if central bank money no longer defines the unit of account for most economic activities – and if those units of account are instead provided by crypto assets – then the central bank’s monetary policy becomes irrelevant. Dollarization in some developing economies provides an analogy. When a large part of the domestic financial system operates with a foreign currency, monetary policy for the local currency becomes disconnected from the local economy.”
He provides several suggestions to help central banks cope with the competitive pressures introduced by crypto assets. First, he believes that “Central banks should strive to make fiat currencies better and more stable units of account.” Second, he believes that regulation of the use of crypto assets is an effective way to prevent destabilization of the money supply. Last, he thinks that “central banks should continue to make their money attractive for use as a settlement vehicle” by introducing central bank digital tokens to supplement fiat cash and bank reserves. Dong He even considers a solution where central banks can set policy interest rates for the economy by issuing an interest-carrying CBDC.
Clearly, the emergence of crypto assets and digital tokens is complicating an already convoluted financial system. The concepts of decentralization and peer-to-peer transfers of value represent both opportunities and threats for economies. Central banks and financial institutions will have to adapt by developing policies that consider the interactions between traditional fiat currencies, public permissionless cryptocurrencies, and central bank digital currencies.