March 3, 2020

The Future of Money: Part 3 of 4

A four-part series on the future of money. The third part focuses on different base money types: national currencies, gold, bitcoin and other cryptoassets.

With the development of technology, the range of possible "money concepts" for base money has expanded. Roughly speaking, four different concepts can be distinguished:

  • Politically, legally orchestrated money in the form of national currencies

  • Money limited in supply by nature in the form of gold

  • Algorithmically absolutely limited, disinflationary money in the form of Bitcoin

  • Algorithmic money with constant inflation in the form of another cryptoasset 

Because of its disinflationary nature and absolute supply constraints, Bitcoin is often seen as the counterpart to national currencies, which are currently subject to institutionalized money creation. According to the narrative, it all comes down to the juxtaposition between deflationary (actually disinflationary) and inflationary money.

However, bluntly juxtaposing the two might be too simple of an approach. Depending on the ideological sense of belonging, either one or the other is demonized. In fact, both "money concepts" are likely to have their inherent disadvantages. For example, inflationary money has distributional and distorting effects, which can be all the more serious and unfair the more the institution of "money" is politicized. Disinflationary money, by contrast, hardly reacts at all to demand shocks, which is why its natural volatility is higher on average. In the case of Bitcoin, the question also arises as to whether its suitability as a monetary hoard, its disinflationary supply curve and a security budget provided by the free market in the form of transaction fees for the miners to maintain the blockchain network are not contradictory? 

This is also a question that ultimately only the future can answer. However, the possibility cannot be ruled out that in an imperfect world like ours, for money to function in the long run, it will always need inflation. In such a case, money that is subject to a constant (because it is algorithmically determined), calculable inflation would be "as good as it gets" and for some a bitter pill to swallow. Of course, this money would also be subject to distribution and distortion effects, such as the Cantillon effect. If the influence were minimized due to the reduction of the human element and the scope for cronyism, this type of inflation would probably be more just, since it is algorithmically and not politically controlled.

As mentioned above, the above "money concepts" are so-called base money. Money is always to be understood in several layers. Although national currencies such as the dollar, the Swiss franc, but also gold or Bitcoin can be used as an everyday medium of exchange, they are increasingly unsuitable in their purest form as base money. Gold seems to be the worst in this regard, as the precious metal is simply too heavy, unhandy and inflexible. But even the digital Bitcoin on the mainchain level is not particularly suitable due to rising transaction fees with increased use. National currencies are still most useful. But even these are increasingly being used at a higher level of abstraction today, for example via credit cards or in the form of bank deposits as book money – and not as cash representing base money.

In the case of Bitcoin, such a higher level could be represented by the Lighting Network. Here, Bitcoin surrogates in the form of Bitcoin Lightning units are exchanged off-chain, i.e. not on the blockchain itself. These off-chain transactions can, however, be written down onto the blockchain at any time in order to settle the Lightning Bitcoin surrogates with reference to who owns what on the blockchain. As a second layer, the Bitcoin Lightning network is therefore comparable to the Visa or Mastercard payment system.

Stability might be wanted

The Lightning Network could make Bitcoin fit as a suitable means of payment and thus make the original idea, a peer-to-peer-electronic cash system, laid out in the Bitcoin white paper more likely to become reality. Technically, this additional layer enables faster, cheaper Bitcoin transactions. The Internet should finally get its native money. Economically, however, question marks remain as to whether Bitcoin can ever establish itself as a suitable, generally accepted, price-stable medium of exchange. Due to its supply limitations, price stability hardly ever seems guaranteed, since certain volatility can always be a consequence of unexpected demand shocks.

So-called stablecoins attempt to be a remedy in this regard. The Libra project already mentioned falls into this gap. Many other resourceful companies are also in the process of finding the Holy Grail of price-stable private currencies. Stablecoins, which are secured - i.e. over-collateralized - by other cryptoassets in as decentralized a manner as possible, are of particular interest here. Examples are MakerDao on Ethereum and Money On Chain, a similar project planned on Bitcoin. In addition, there are other attempts to imitate a decentralized central bank, which want to enforce price stability without collateralization, but by means of a sophisticated algorithmic monetary policy.

The most prominent stablecoins at present are those that are conventionally tied to and backed by a national currency. Tether, USD coin, Paxos Standard or TrueUSD are the best known and most of them operate out of the USA. Stablecoins also come from Switzerland, most notably the XCHF issued by Bitcoin Suisse AG.

Stablecoins currently allow mainly what can be described as permissioned pseudonymity. It is an open secret that companies from China, Russia or Brazil use stablecoins to circumvent capital controls. The G20 sees clear risks with stablecoins: Money laundering, financing crime, and violation of investor and consumer rights. The EU is apparently currently preparing for regulation in order to take stronger action against stablecoins, which represent the euro.

So while regulators are likely to take a somewhat tougher approach to Stablecoins in the future, central banks seem to be keeping a watchful eye on this development. According to their mandate and nature, they are keeping a low profile and are not revealing much about their own intentions. The main speculation is that the first central banks will soon become their own "Central Bank Digital Currencies or CBDC

For cryptoassets such as Bitcoin, these are not direct competitors, as both operate from opposite premises. The assumption that CBDCs issued directly by central banks will be relevant as a retail product for citizens seems unconvincing in the short term. If central banks were to bring their digital currency directly to the end-user without going through commercial banks, they would turn the current financial and banking system upside down. If then commercial banks based on a CBDC would be allowed to put money surrogates into circulation - just as before, the risk management of money creation would continue to be outsourced to private enterprise.

What path central banks will actually take is still in the stars. There is some speculation that central banks will wait for the next major crisis before letting distressed commercial banks go bankrupt and then credit customers in the new digital central bank currency in accordance with the amount on their old bank accounts. If this were to happen, a sovereign money system would be a reality


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