A global digital currency would obliterate the capital control levers that sovereign nations have
Some weeks ago, there was news of Facebook launching a cryptocurrency called Libra, designed to appeal to its global user base of over 2 billion. Unlike Bitcoin, which is a roller coaster, Libra will be backed by a basket of fiat currencies. It is supported by a consortium of large-scale corporate houses, financial services firms and venture capitalists. Net-savvy millennials have little patience for expensive traditional banking methods for cash transactions. They would likely flock to alternatives like Libra. Other Big Tech companies like Google and Amazon are unlikely to stay on the sidelines. At the time, I wrote in this column that governments worry about their sovereign currencies and will eventually regulate Big Tech cryptocurrencies. Governments not only manage their exchange rates and liquidity, they must try to restrict money laundering and terror financing.
I apologize for the heavy reading that is about to ensue. I have simplified some of the concepts here, but as Einstein once said of science: “Everything should be made as simple as possible, but no simpler."
International economics has a concept called the “impossible trinity" or the “trilemma" of monetary policy. It was first defined (independently) by economists John Fleming and Robert Mundell in the early 1960s. It states that it is impossible to have all three of the following conditions fulfilled at the same time: (1) a fixed foreign exchange rate, (2) free capital movement (that is, an absence of capital controls) and (3) an independent monetary policy (which controls domestic money supply, mainly through an interest-rate regime).
Even before cryptocurrencies, governments looking to control the monetary aspects of their economies have been subject to this trilemma, and have thus been forced to implement only two of the three conditions, while jettisoning the third. Simply stated, if you want control over both your exchange rate and monetary policy, you would have to impose controls on free capital movement. Hence the existence of capital controls such as India’s Foreign Exchange Management Act.
The trilemma is a theory based on the “uncovered interest rate parity condition" and is supported by evidence-based studies where governments that have tried to simultaneously pursue all three goals have failed. To explain, the uncovered interest rate parity condition means that if a dollar can only fetch a 1% rate of return in the US, but say 6% in India (at the same levels of risk), investors are bound to move from dollars to rupees. The reason they don’t is that the differential of 5% will likely reduce to zero as a result of a slide in the rupee’s value to the extent of its current interest differential against the dollar.
In 1999, Paul Krugman, the Nobel laureate economist, commented: “The point is that you can’t have it all. A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like most of Europe)."
Strong capital controls have meant that other means of payment have been in use before, such as the infamous “hawala" system. Law enforcement agencies track these down relentlessly. However, the ease of use and the scope of new Big-Tech cryptocurrencies are about to create global currencies of a completely different class. Economists Pierpaolo Benigno, Linda Schilling and Harald Uhlig, in a recent paper, argue that such currencies will inexorably affect the exchange rates and monetary policies of traditional currencies. This is primarily because the introduction of a global digital currency obliterates the capital control levers that sovereign nations have today.
The economists begin with a model that considers a two-country system. Both use their own national currencies as well as a global cryptocurrency. Assuming markets are efficient and complete, and that the global cryptocurrency is freely used in both countries, they show that the interest rates in both countries must necessarily be equal, and that the exchange rate between the two countries becomes what is termed a “martingale". A martingale is a sequence of variable numbers where the next number in the sequence, given all prior numbers, is most likely the same as the present value. Simply put, it means that the best predictor of tomorrow’s value would be today’s value.
Benigno, Schilling and Uhlig call this phenomenon Crypto-Enforced Monetary Policy Synchronization. or Cemps. This adds a further restriction to the impossible trinity, effectively making it a dilemma (where the choice is either one or the other, not any two out of three). The economists then go on to introduce a number of conditions to correct for the fact that nation states and their central banks are likely to try a variety of methods to control exchange rates, interest rates and capital flows. They show, with beautiful mathematical proofs, that in each case, the trilemma is reduced to a dilemma.
For a simpleton like me, the advent of Big Tech cryptocurrencies mean that countries would have one less lever to pull. A scary thought, given the current portents of a global slowdown.
Siddharth Pai is founder of Siana Capital, a venture fund management company focused on tech.