Cryptos could be a “speculative mania”, says economist Eswar Prasad
Discussions with central bankers at a conference a few years ago prompted economist Eswar Prasad to start writing what he planned to be a small volume on how digital currencies could affect the implementation of monetary policy. As he delved deeper into the world of digital technologies such as blockchain, cryptocurrencies, and stablecoins, he began to realize their potential to revolutionize, and potentially destabilize, financial markets and the international monetary system.
So much for the thin volume. Instead, Prasad wrote the The future of money: how the digital revolution is transforming currencies and finance, a 500-page book that has become a roadmap for fund managers, market strategists and others seeking to understand this new world. With a background in global trade, monetary policy and financial regulation, including a stint as a senior International Monetary Fund official on China, Prasad has spent his career studying the global economic landscape. Currently a professor of economics at Cornell University and a senior fellow at the Brookings Institution, he recently spoke with Barrons on the “speculative mania” that surrounds
and the opportunities and risks inherent in moving away from traditional forms of money and finance. An edited version of our conversation follows.
Barrons: China seems to have taken the lead in launching a digital currency. Does this put the United States at a disadvantage and threaten the reserve status of the dollar?
Esvar Prasad:I don’t see a digital yuan posing a big threat to the US dollar. I don’t think that’s a huge first-mover advantage, nor does it mean that China will set the standard for the world. The traditional use case for a central bank digital currency, or CBDC – to increase financial inclusion – is weak in China as AliPay and WeChat Pay [payment apps owned, respectively, by
Alibaba Group Holding
(ticker: BABA) and
(700.Hong Kong)] do a fantastic job of providing digital payments. China’s motivation for the digital yuan is different. [China] worries that the dominance of these two payment providers is limiting innovation, but also making them economically and politically too powerful for Beijing’s comfort.
As we head into a world [of digital currencies] where China’s cross-border interbank payment system can communicate more effectively with systems in other countries, we can see less need for the US dollar as a currency in international trade. As a payment currency, the US dollar could lose some of its importance, although it will remain the dominant currency. But a reserve currency not only needs economic size and financial might, but also an institutional framework – an independent central bank, rule of law, institutional checks and balances – that preserves the confidence of foreign investors. China has made it clear that it will not undertake any significant institutional reform. Even if the renminbi were to gain some more ground, I don’t see the renminbi seriously threatening the dollar.
How will digital currencies reshape financial markets and central banking?
We are on the threshold of major changes in national and international financial markets. Digital transformation has made it much easier to innovate new products and services at scale and made them widely accessible. This will have major repercussions on the structure of markets and financial institutions. By extension, this will have important implications not only for the nature of money and monetary creation, but also for monetary policy, its transmission and implementation, as well as for financial stability and the international monetary system.
Let’s talk about the details. How will the banking industry fare as a result of this transformation?
Commercial banks face serious challenges to their business models due to these new forms of financial intermediation and new technologies, such as blockchain-based payment systems and other fintech payment platforms, which handle payments international. It’s traditionally been a big profit center for multinational banks, and it’s going to get a lot more competitive.
The emergence of new financial institutions and platforms will improve competition, foster innovation and reduce costs, thereby improving the functioning of the financial system. But it will also pose significant complications for regulation and financial stability. The weakening of banks carries its own risks, given their important role, including in credit creation.
What does this mean for monetary policy?
Traditional instruments in normal times, such as the discount rate and the target federal funds rate, may have less effect if commercial banks have a reduced role in financial systems. When a central bank changes policy rates that it directly controls, it affects interest rates on commercial bank deposits and loans in a reasonably well-understood way. The corresponding effects on the lending rates of other institutions and platforms are much less clear. It is therefore more difficult for a central bank to manage the economic variables that matter to it: inflation, unemployment and [gross domestic product] growth.
It’s also unclear how effective the Fed can be as a lender of last resort if institutions outside its direct regulatory jurisdiction play a bigger role in financial markets. For example, it would be difficult for the Fed to provide access to emergency liquidity facilities for fintech platforms it does not regulate. The rise of digital finance based on decentralized blockchains could accelerate these changes and, for all its benefits, also pose challenges to monetary and financial stability.
What scenario would lead to instability?
We can see Facebook [
; FB] Where
[AMZN] issue stablecoins [digital currencies pegged to a national currency, such as the dollar] which get a lot of traction within their own ecosystem, but they could also issue their own unsecured currencies which could compete with existing fiat currencies. Maybe the dollar will not be threatened, but if you have a digital yuan, a digital dollar, and also a Facebook or Amazon coin available worldwide, it could pose an existential threat to the currencies of small economies or those who don’t. we don’t have a credible central bank. We could have a real upheaval in the international monetary order. There is also the risk that many of these other currencies will be used for illicit trade, and it becomes much more difficult to regulate them. After all, Bitcoin knows no borders.
Cryptocurrencies have lost around $1 trillion in market value since November. Is this the beginning of the end?
Bitcoin was intended to serve as an anonymous medium of exchange that could enable financial transactions without relying on central bank money or trusted third-party intermediaries. Bitcoin failed in this area, so it has no intrinsic value. Its value is based solely on investor confidence, which seems to be based on its scarcity. But scarcity itself cannot be a sustainable source of value for a digital asset. The recent crash in the price of Bitcoin and other cryptocurrencies as the Fed prepares to hike rates clearly shows that Bitcoin is also not a hedge against inflation, as some had assumed. There are legitimate fears that this is a speculative mania that could end badly. More price volatility is a certainty.
Could the sale create wider ripples in the crypto ecosystem?
The prospect of many retail investors being burned is a serious risk. If brilliance emerges from the cryptocurrency revolution, it could deter some of the blockchain-based decentralized finance developments that have significant benefits.
Bitcoin’s true legacy is blockchain technology. It is a wonder. Blockchain technology will give us the potential to improve various aspects of public governance. For example, India is considering putting land ownership records on a digital ledger, providing much greater security, resilience and transparency. [Blockchain] is also initiating the creation of decentralized finance, which has enormous potential to create new products and services and make them easily accessible by connecting savers and borrowers through fintech platforms. This could, for example, lead to tailor-made financial products and services at lower cost for the less well-off. This is going to be a fundamental transformation of finance.
How could this go wrong?
The whole point of decentralized finance is that no one institution becomes very large, but there can be unintended consequences when certain operators dominate the system. [There’s also the risk that] huge disparities in financial and digital access and digital literacy could be exacerbated rather than mitigated. More importantly, if you start having central bank digital currencies and companies such as
by issuing stablecoins gaining traction, governments and big corporations could become even more intrusive in our lives. There’s a lot of promise for better economic outcomes, but also the risk that we’re tipping into a much more dystopian world than the one we already live in.
What are the geopolitical risks created by a world where economies depend on digital currency?
Finance is the engine of any great economy. We could prepare for a world where cyber warfare becomes the primary battleground for geopolitical domination. This creates a huge amount of vulnerabilities because payment and financial systems are vulnerable, and they could wipe out an economy or an entire country if constantly hacked.
Thank you Esvar.
Write to Reshma Kapadia at [email protected]