How can society benefit from cryptocurrency? Since 2008, the SCOR Risk Markets and Value Creation Chair has helped to expand TSE research on sustainable finance, including cutting-edge analysis of the impact of new financial technologies on social welfare. As part of a TSE-HEC collaboration backed by the French prudential regulator (ACPR), a new working paper examines whether digital innovation can realize Friedrich Hayek’s vision of denationalized money.
In which contexts are cryptocurrencies likely to be most useful?
Despite the hype about cryptocurrencies since the launch of Bitcoin in 2009, a genuine revolution in the way people access and control their money has not materialized. Backed by trusted banking institutions and a legal obligation to accept them as a mean of payment, traditional currencies such as the dollar or the euro are generally preferred to cryptocurrencies which suffer from high transaction fees, slow validation processes and substantial volatility.
However, when monetary and financial institutions are dysfunctional, digital assets may provide protection against predatory governments, hyperinflation and high political risk. This may be why ownership and use of cryptocurrencies is very high in countries like Argentina, Egypt, Lebanon, Nigeria, Turkey and Venezuela. In such countries, cryptocurrencies can be seen as a lifeline, as a more reliable store of value than the depreciating official currency.
Why is Friedrich Hayek an inspiration for this research?
High inflation is often blamed on governments that rely on printing money to fund unsustainably high public spending. In particular, researchers have identified excessive money creation as a key causal mechanism for hyperinflation in interwar Europe and in Venezuela. In his 1976 essay entitled “Denationalisation of Money”, Hayek argued that these problems could be avoided with “the replacement of the government monopoly of money by competition in currency supplied by private issuers who, to preserve public confidence, will limit the quantity of their paper issue and thus maintain its value”.
Cryptocurrencies are an interesting laboratory to test Hayek’s proposition. They offer a privately supplied means of payment and store of value. They also rely on a blockchain protocol which is quite difficult to change, allowing for a credible commitment to a predetermined issuance rate which helps maintain the cyptocurrency’s value.
The goal of our paper is to examine whether cryptocurrencies can fulfill the role of denationalized currencies. Can cryptocurrencies be used by private agents when the value of public currencies is undermined by non-benevolent governments’ policies? Can competition from cryptocurrencies discipline non-benevolent governments’ monetary and fiscal policies?
How do you conduct your analysis?
We rely on a simple theoretical model, featuring agents who operate technologies that share some of the main characteristics of cryptocurrencies. The pace of cryptocurrency monetary creation is set in advance by the protocol of the blockchain on which ownership of the cryptocurrency is registered. This shields the cryptocurrency from the excessive inflation risk plaguing the official currency issued by the government. Cryptocurrency is not easily taxed by the government but it is risky and may crash.
With production technologies that are subject to random productivity shocks, the agents value the opportunity to hold a safe asset. This is why money is valuable in our setting, despite having no intrinsic value. In this context, agents decide how much to invest in the risky “crypto” asset and the safe “fiat money” asset. The government chooses how much money to issue, how much agents’ wealth should be taxed, as well as the level of public spending. Its budget constraint is that public spending is funded by the combined revenue from seignorage and the wealth tax.
What are your main findings and their implications?
As a benchmark, we first consider the case in which there is no cryptocurrency, leaving the government with monopoly power on the issuance of money. In this context, a non-benevolent government will run an expansionary monetary policy to extract rents from agents using seignorage. This leads to hyperinflation, as agents are unwilling to hold the public currency.
However, when the official currency faces competition from a cryptocurrency, the non-benevolent government is obliged to follow a more restrained monetary policy. If it allows runaway inflation of the public currency, agents will switch to the cryptocurrency. Thus, the presence of the cryptocurrency effectively caps inflation, raising agents’ welfare by reducing their risk exposure. This result lends support to Hayek’s advocacy for the denationalization of money.
If governments are benevolent, they will avoid pursuing an inflationary policy. Competition from a cryptocurrency then has no impact, as agents will prefer to hold the public currency.
Our findings rationalize the widespread empirical evidence that many countries, governments and central banks oppose the development of cryptocurrencies that compete with the existing national currency. Our paper also offers an explanation for why ownership of cryptocurrencies is greater in countries where high inflation is caused by the dysfunctionality of governments and central banks.
KEY TAKEAWAYS
• Without a cryptocurrency, predatory governments use monetary policy to extract rents from agents. This leads to hyperinflation.
• A competing cryptocurrency can prevent greedy governments from ramping up inflation. If they do, agents will abandon the public currency.
• However, cryptocurrency is useless if the government is benevolent as it will avoid inflationary policies.
FURTHER READING Publications by these researchers are available to view on the TSE website. For research conducted as part of the TSE-SCOR initiative, see the partnership’s dedicated web page.
Article published in TSE Reflect, November 2024
