Opinion | National monetary authorities should wake up to the Libra challenge4 min read . Updated: 25 Jun 2019, 02:16 PM IST
With cryptocurrency here to stay, the big question for the authorities will be how to embrace this new means of exchange
Facebook has announced plans for a new digital currency that has raised hackles worldwide. The social networking company hopes to offer an alternative to money issued by governments. Libra has been unveiled at a time when the Bitcoin mania has petered out, its recent bounce notwithstanding. Bitcoin may have been an attractive investment asset for early investors, but this column has earlier pointed out some fatal flaws in its design that make it unviable as an alternative monetary unit.
Modern economies are built on the bedrock of monetary stability. You will enter into a long-term contract only if you are pretty certain that the unit of currency you will be paid in will have the same value at a later date. Bitcoin prices have bounced around with gay abandon. Would you sign an annual wage contract with your employer in a cryptocurrency if you are not certain what its purchasing power will be through the period?
It is well known that the supply of Bitcoins is fixed by an algorithm rather than a central bank. So Bitcoin prices swing wildly, depending on swings in demand. This is quite unlike the world of modern central banking where money supply is adjusted depending on anticipated changes in money demand. Bitcoin supply is capped at 21 million units. The fixed monetary base makes Bitcoins resemble the gold standard, where money supply is based on rules but the monetary system is too rigid to deal with the inevitable economic fluctuations. Money supply is completely dependent on the stock of gold available.
It appears that the new Facebook currency will bypass some of these problems. A user will first have to sign up for its Calibra digital wallet. He may then link it to his bank account. Libras can be sent to other users via a mobile phone. People can switch back to official currencies whenever they want to. The money held by Calibra will be backed by major currencies, government bonds and deposits.
The Facebook currency will thus be linked to the official financial system in two ways—the banks and the currencies issued by sovereign governments. This is quite different from the libertarian promise of Bitcoin that sought to build a monetary unit with no formal links to fiat money. Libra has deep links with the existing monetary system. If Bitcoins resemble the gold standard, the Libra resembles the system of pegged currencies that was introduced after World War II.
It is not quite clear how the supply of Libra will be adjusted to deal with fluctuations in money demand. It appears that the money supply will depend on how much hard currency the companies partnering Facebook in this venture put into the pot. Think of that as the monetary base of the Libra system. Money supply will thus not be endogenous as is the case with Bitcoin, where miners have incentives to add to money supply when Bitcoin prices rise as a result of strong demand.
Monetary systems are not just about economics. They are central to the power of modern nation states, perhaps as much as an army is. The bigger question is whether governments will, or even should, allow private companies to muscle into such sovereign territory. The challenge is perhaps more acute in emerging markets such as India, where the choice will be between the local currency and a digital currency backed by major global currencies. Private money is especially attractive when fiat money has failed because of monetary mismanagement, as in the case of a Zimbabwe or a Venezuela.
There are other profound challenges as well. As Columbia Law School professor Katharina Pistor wrote in a recent essay on Libra: “The idea of a private, frictionless payment system with 2.6 billion active users may sound attractive. But as every banker and monetary policymaker knows, payment systems require a level of liquidity backstopping that no private entity can provide. Unlike states, private parties must operate within their means and cannot unilaterally impose financial obligations on others as needed. That means they cannot rescue themselves. They must be bailed out by states, or be permitted to fail."
Facebook is launching a form of private money that is profoundly dependent on the existing financial system for convertibility, stability and liquidity. Yet, it seeks to be outside the regulatory system that makes all three possible. It will thus be riding a system while pretending to be an outsider for regulatory purposes.
However, national monetary authorities have to wake up to the fact that the cryptocurrency challenge is here to stay. The big question before them will be how to embrace the new technology. Even a cryptocurrency issued by a central bank will have a profound influence on the financial system, as citizens will be able to directly own base money with the central bank and may not need banks for settlements, even as the focus of monetary policy shifts back from interest rates to money supply. This column has run out of space, but readers who are interested in these arcane matters can go back to an earlier instalment on the cryptocurrency challenge to monetary policy.
Niranjan Rajadhyaksha is member of the academic board of Meghnad Desai Academy of Economics. Read Niranjan’s previous Mint columns at www.livemint.com/cafeeconomics