(Crypto) A Breakdown of the IMF June Monetary Policy Report

Crypto Assets are again in the spotlight with the publication of the IMF June Monetary Policy Report. The report, written by Dong He illustrates the continued interest and monitoring of digital assets by traditional institutions, highlighting potential risks and future use cases. In this piece I address the report’s notable excerpts from the perspective of a crypto-enthusiast. I find areas of common ground and disagreement that are worth noting for future discussion. I compare crypto supporters who align more with Austrian style economic theory and contrast that theory to the New Keynesian approach taken by most central bankers. The variation in philosophies in regards to money leads to starkly different viewpoints on this asset class and its proliferation. My core thesis is that crypto-assets offer much needed competition to traditional fiat regimes, re-introducing sound money principles to a system categorized by diminishing purchasing power and increased regulatory mismanagement.

“continued technological innovation may be able to address some of these deficiencies. To fend off potential competitive pressure from crypto assets, central banks must continue to carry out effective monetary policies”
This is the most understated benefit of crypto-assets: the encouragement of healthy competition in currency markets. Traditional fiat currencies exhibit a cartel-like market dominance, with sovereign nations wielding the unique power to issue and influence currency. Until the creation of Bitcoin, no exogenous system was able to effectively create competition to centrally issued monetary regimes. The advent of the internet democratized access and enables users to share and send money and information almost anywhere, effectively eliminating the jurisdictional monopoly governments hold on currency. If nothing else, crypto-assets reinforce the theory of contestable markets; even if crypto does not become a world-wide phenomenon, it moves the market towards equilibrium by pressuring fiat towards more sound monetary principles. Money in this case should be viewed like any other good, subject to supply and demand. If a competitor can offer the same product or better at a more attractive price, the incumbent firm must adapt or it will lose its market share. If crypto-assets are competitors to Dollars and Euros, it stands to reason that if competition is allowed the better product will capture market demand. This is not to say that crypto-assets will become our next currency, but to highlight that competition makes the market more robust and would benefit all users. I believe we have yet to see any real implications of this competition but should follow closely how central banks react in the coming years.
“Unlike the value of fiat currencies, which is anchored by monetary policy and their status as legal tender, the value of crypto assets rests solely on the expectation that others will also value and use them.”
The value attributes He lists for fiat are superficial, working only when central banks utilize market efficient monetary policy, which they currently do not. Sound money exhibits the characteristics of scarcity, fungibility, divisibility, widespread usage, and strong storage of value. Legal status and the ability to influence the business cycle are secondary effects of sound money, not value propositions unto themselves. Crypto-asset’s strength derives from the phenomenon of emergent order, meaning they are market driven solutions rather than state sponsored ones. They are popular because they exhibit the values of sound money at a time where there is ample market demand. Yes, fiat currencies have an inherent advantage by bootstrapping user sentiment to government sponsorship, but this only works as long as policy is married with sound monetary principles. As the two have diverged over the past century, especially in response to the crisis of 2008, it is without surprise that the market has responded with crypto-currency alternatives.
With no centralized issuer, crypto assets like Bitcoin transcend political manipulation through their digital nature and decentralized issuance; Bitcoin is beholden to no jurisdiction. Bitcoin, unlike fiat, is untethered to any monetary policy risk since its rules are transparent and relatively unalterable. For better or worse, an un-commoditized fiat system is subject to the systematic risk of human error in monetary policy. I contend in another article that fiat currencies suffer from a transitional gains trap that leads to the ultimate over-inflation and devaluation of fiat over time. This trap, created by incentives to prioritize government policy objectives creates a philosophy of “short termism” where central bankers discount future economic stability for short term output. The result has been a growing issue of overleverage and fiscal misconduct which has weakened central banks’ abilities to use policy tools like interest rates to deal with future economic difficulties.
Legality is a strength until continued monetary mismanagement erodes faith in a currency. Cases such as Venezuela and Zimbabwe quickly come to mind, where dollars and Bitcoins trade at premiums to the local cash, and it is difficult to coerce consumers to use fiat which holds little value. If people are assumed to be rationally self-interested, it makes sense that at a certain point they will abandon a poor currency system for another regardless legality. If the trade-off is between sticking with an incumbent system that continuously erodes the value of your efforts through inflation or shifting to an alternative that is outside of the regulatory framework, substitution to the alternative will occur the more egregious the value loss. Legality therefore is a mechanism of enforcement rather than one of efficiency.
“crypto assets, such as Bitcoin, in principle have limited inflation risk because supply is limited. However, they lack three critical functions that stable monetary regimes are expected to fulfill: protection against the risk of structural deflation, the ability to respond flexibly to temporary shocks to money demand and thus smooth the business cycle, and the capacity to function as a lender of last resort.”
This statement is where the differences between Austrian and New Keynesian economics emerge. Of all the purported functions of stable monetary regimes, none are directly present in an asset like Bitcoin, and yet it has grown in adoption for nearly a decade. This indicates that He’s value propositions for traditional monetary regimes are not universal maxims to live by, but rather assumed necessities in a Keynesian model so heavily reliant on interest rate manipulation.
The key difference in theory is that one school (Austrian) assumes money to be a social construct that facilitates efficiencies in transactions, while the other (New Keynesian) views money as a government construct to manipulate business cycles with the goal of limiting economic turmoil. It boils down to whether money should be governed by the market or a central bank. Crypto supporters generally fall into the camp of market governance, where the objective is to prioritize a free and unmanipulated system of value. New Keynesian supporters generally agree that quantitative analysis and open market operations by a central bank can curb vicious business cycles. These are two major philosophical differences; Austrians would say that curbing the business cycle doesn’t allow for accurate price discovery due to decentralized knowledge, while New Keynesians believe that targeted growth is achievable and desirable to limit economic disruption.
The risks of structural deflation and that of lending at last resort represent the difficulties of intertwining politics and money. The inherent assumption of a lender of last resort is that a country’s central bank can lend to avoid catastrophic failure in various sectors. In 2008, this created the “too big to fail” moniker for major banking institutions, marrying the financial sector to the health of the entire currency system. Furthermore, the fiscal responsibility of the federal government or lack thereof is also included in the systematic risk of sovereign currency. The result of poor policy is high inflation and poor store of value characteristics for un-commoditized fiat at the expense of tax payers who have to foot the bill. Inflation is essentially a tax on savings.
To reference my other article, political incentives create a culture of unchecked fiscal spending which is facilitated through devaluation and inflation. The result has been long term value loss in the dollar over the past decades with increasing debt and liabilities. The challenge for current fiat systems is that they attempt to achieve too many disparate ends under one roof. A currency meant to facilitate credit, growth, and government programs cannot also act as a long-term store of value without commoditization. Perhaps crypto assets will fulfill the store of value use case while fiat facilitates the others.
Crypto assets, specifically Bitcoin represent an experimentation in deflationary currency. Though a relatively untested field, deflationary currency in theory puts power back in the hands of the consumer, rewarding delayed gratification and allowing individuals to spend at their reservation price. Inflationary currency is much the opposite, incentivizing short term spending at the expense of saving. The former allows for more realistic and sustainable growth while the latter creates massive growth at the expense of currency stability. Pure fiat currency is still in an experimental phase; it has been less than 50 years since we left the gold standard under president Nixon. In the history of currency this is still early days, and we are still learning as we go.
Despite differences between traditional and crypto economists, I laud the efforts on behalf of the IMF and others to better understand and recognize crypto assets. Many agree that blockchain implementations will be profoundly impactful, though it remains to be seen whether currency will shift to a decentralized medium. Realistically there is room for both. Cryptocurrencies possess store of value characteristics that are increasingly hard to find in fiat. Fiat on the other hand better facilitates the use of credit and lending without jeopardizing economic output. The untangling of these two functions is paramount to limiting systematic risks we face under the current fiat regime. As crypto assets continue to proliferate and create disruption in traditional markets, we will see how these new innovations encourage sound money principles. We would all do well not to reactionarily disregard them. In truth, only the market will determine what it accepts as a unit of transaction, and it seems that fiat and crypto can play a dual role for the time being.