During a confirmation hearing with the US Senate this week, Fed chairman Jerome Powell was asked about whether or not a digital currency issued by a central bank could exist side by side with private cryptocurrencies. Powell responded that there is nothing that would prevent private cryptos from “coexisting” with a “digital dollar.”
This, of course, is obviously true so long as federal regulators do not decide to ban the usage of cryptocurrencies.
Business Insider meanwhile has reported that Powell’s comments “appeared to be a shift” from his earlier comments stating that “you wouldn’t need” cryptocurrencies in a world of central bank digital currencies (CBDCs).
It’s not clear that this is a “shift,” however. Powell’s earlier comments simply communicated Powell’s apparent position that the Fed’s CBDC would be preferred by the users of these currencies. If the central bank’s digital currencies are wonderful, there no “need” to have any other.
Central Banks Plan to Outcompete Crypto
Indeed, Powell’s two statements on this matter likely reflect the fact that the central bank apparently plans to outcompete private cryptocurrencies. This would be a reasonable goal for the Fed given the central bank’s vast regulatory power and legal privileges. Because the central bank directly regulates banks and is so entrenched in the financial sector overall, it could more easily facilitate a virtually seamless introduction of its own digital currencies into the financial sector and make its digital currency more convenient than others. Moreover, the Congress can use its powers to “encourage” the public to favor the regime’s currency, digital or otherwise.
Does the Higher-Quality Currency Necessarily Win Out?
This doesn’t worry many supporters of cryptocurrencies, who are generally confident that their currencies are higher quality than anything a central bank can offer. When they say “higher quality” these private crypto backers—especially those backing bitcoin—often mean that their currency cannot be inflated as can fiat currencies. Thus, these private currencies do not lose their value as fiat currencies do. Presumably the public would flock to the higher-quality currency.
It is debatable, however, whether this sort of quality really determines the use of a currency as a general medium of exchange. Indeed, if anything, experience suggests otherwise, and this has long been seen in the workings of Gresham’s law. When competing against “lower quality”—that is, more inflation-prone—currencies, “higher quality” currencies tend to become hoarded rather than used as money. This is reflected in the “HODL” movement, in which it is assumed that it is better to hold on to cryptos indefinitely rather than convert them into “inferior” assets, whether dollars or anything else. So long as this thinking prevails, it’s difficult to see how a crypto can make the transition to a general medium of exchange—i.e., money. Even if the inferiority of the government’s fiat currency is not in dispute, this does not necessarily lead to widespread use of the “superior” currency for daily use.
How to “Convince” People to Use Fiat Currency
Yet one could also define “quality” as the ease with which one can use a currency. Bitcoin advocates, for instance, have pointed to the relative ease with which bitcoin can be used in purchases without the need for intermediate institutions. Even in this arena, though, inflationary currencies controlled by central banks may nonetheless be competitive, even if inferior in terms of maintaining value.
This, of course, is one of the purposes of issuing new CBDCs. It’s to more fully and directly co-opt and compete with private digital currencies. Presumably, payments using CBDCs need not go through intermediary institutions either. Will these CBDCs be “better” than private digital currencies? Perhaps not by many metrics. But to stay relevant, fiat currencies need not be the best money. They only need to be good enough. Government regulations can do the rest.
After all, when it comes to propping up the official currency, a regime or central bank has several tools. For one, the regime can continue to make a certain currency legal tender. Contrary to what many believe, this does not force people to use a certain currency for all transactions. Nevertheless, legal tender laws do impel users of money to favor one specific money over others for the repayment of loans and other uses. Moreover, a regime can mandate that tax bills be paid in the currency of the regime’s choosing. Borrowers would continue to pay back loans in devalued dollars—and this would likely include many huge institutional borrowers.
In an inflationary atmosphere, this can continue to offer significant support to at least some use of a currency—or a digital version thereof—even in the face of steeply declining value. Imagine, for example, a world in which every employer must pay withholding taxes in dollars and in which every homeowner must pay property taxes in dollars. Imagine a world in which every commercial and residential real estate lender—lenders heavily regulated by federal policymakers—must accept repayment in depreciating dollars. This is no small advantage for a currency—even one in decline.
Using Coercion to Protect Fiat Currency
And then there are more crude methods of protecting the official currency. Beyond legal tender laws, the regime could use the tax code to punish the use of private currencies in other ways. Charging capital gains taxes on alternative money is just one method. Regimes have been known to become quite creative when it comes to punitive taxes against activities the regime does not like.
There is also always the “nuclear option,” which is banning these currencies altogether. Let it never be forgotten that the US regime once banned the private ownership of gold bullion, punishable by draconian fines and by imprisonment.
None of this contradicts economic arguments that in an unhampered market, certain private cryptocurrencies are far superior to fiat money in terms of value retention. Those are economic questions, though. The political questions are different, and once government regimes become involved, the calculus can change considerably. States have long jealously guarded their prerogatives over the money supply and are likely to resort to any number of violent, dangerous, or risky policies when these privileges are threatened.
But What If the Regime’s Money Hyperinflates?
On the other hand, states, with all their vast coercive power, sometimes lose their ability to ensure the continued usage of the state’s official currency.
As Daniel Lacalle recently noted, sometimes a government’s currency ceases to be money altogether:
If the private sector does not accept this currency as a unit of measure, a generalized means of payment, and a store of value backed by reserves and demand from the mentioned private sector, the currency becomes worthless and ceases to be money. Ultimately, it becomes useless paper.
This happens when a currency devalues so completely and so rapidly, that neither convenience nor legal status can save the currency’s status as money.
Extreme hyperinflation, however, appears to be the only scenario—short of big ideological changes undermining the state overall—under which a private cryptocurrency is likely to become the general medium of exchange. Government currencies would likely have to implode and not just slowly depreciate at a rate of, say, 5 or 10 percent per year. It has already been demonstrated for more than a century that deflationary fiat currencies can go on for many decades so long as inflation rates are within what the public considers to be a tolerable range. Unfortunately, the public also appears to have a high threshold for what is tolerable.
The Importance of a Competing Store of Value
But even if regimes manage to prop up their currencies indefinitely, the existence of cryptocurrencies nonetheless has the potential for offering a valuable service. That is, the existence of private cryptocurrencies could work to force greater discipline on regimes in terms of deficit spending and other activities that lead to the debasement of government currencies. If users of fiat currency can more easily flee to some other store of value, this will put greater pressure on inflationary currency and force regimes to think twice about indulging in high levels of deficit spending and the all-but-inevitable money printing that follows. That is, if savers can easily sit on their savings in some form other than fiat currencies, this raises the political risk to regimes in terms of triggering dangerously high inflation rates. This means cryptocurrencies could serve a helpful political function even if they don’t lead to a scenario in which government fiat currencies are fully abandoned any time in the foreseeable future.
Yes, states have many tools to push the public to use the government’s money. But governments also know there are limits to this and they fear hyperinflationary scenarios. These situations have a tendency to bring extreme political and monetary instability. Cryptocurrencies may help make that fear more acute and immediate. If that’s the case, it’s good news.
