Can cryptocurrencies like Bitcoin wreck central banking? “The short answer is yes,” wrote Pierpaolo Benigno, a professor of economics at Rome’s Libera Università Internazionale degli Studi Sociali (LUISS), in an article published on April 26, 2019.
On August 19, 2019, Benigno and two other economists, Linda M. Schilling and Harald Uhlig, published a paper expanding on this short answer, “Cryptocurrencies, Currency Competition and the Impossible Trinity,” attempting to mathematically prove it to be true.
Citing a range of economic thought — from the authors’ previous work; to Fredrick Hayek, the renowned thinker of the Austiran School of Economics; and Nobel prize winning crypto skeptic Paul Krugman — the paper applies Bitcoin research to economic standards of international monetary policy with the end goal of examining how monies issued outside of governments (including truly decentralized cryptocurrency like Bitcoin and centrally-issued digital currencies like Facebook’s libra) would impact traditional currencies.
Through a series of string theory-like calculations, the paper highlights a general question that Bitcoiners, media wonks and economists have speculated on for years: What does the introduction of cryptocurrency mean for the world’s central bank economies? This paper’s approach is in line with a similar paper recently covered by Bitcoin Magazine, with more of a predictive lens of what characteristics a truly “global (crypto)currency” would require.
In essence, the researchers argue that the presence of global cryptocurrencies make the “impossible trinity” — an international economic concept that argues it is impossible to maintain a 1) fixed foreign exchange rate, 2) free capital movement free of capital controls and 3) an independent monetary policy — even less possible.
Motivation and Method
Although the authors argue that global currencies are not a new phenomenon (for example, “Spanish Dollar in the 17th and 18th century, gold during the gold standard period, and the U.S. Dollar since then”), cryptocurrencies are a new phenomenon because they seek to become a means of payment. At even levels of liquidity — i.e., usability and acceptance — this will put them in direct competition with national currencies for transactional purposes.
Under these assumptions, the research analyzes a “two-country economy featuring a home, a foreign and a global (crypto)currency.” The paper also assumes that the aforementioned global cryptocurrency is used in both countries, that the markets for each currency is complete and each currency’s “liquidity services are rendered immediately.”
Based on standard approaches to economic policy, the model shows that, eventually, the global cryptocurrency would equalize interest rates and the exchange rate between the home and the foreign currency would become “a risk-adjusted martingale,” meaning predictable.
Because it is used in both countries, this economic phenomenon would come from the global cryptocurrency creating a kind of tether between all domestic and foreign currencies, what the authors’ call a “Crypto-Enforced Monetary Policy Synchronization (CEMPS).”
According to the paper, once this synchronization occurs, central banks would have an extremely difficult time regaining an independent monetary policy — this is where, the researchers argue, the impossible trinity becomes more impossible.
The impossible trinity argues that, if you’re managing a central bank, you have three options:
- Setting a fixed currency exchange rate (for instance, the pound and dollar were pegged several times throughout the 20th century; and in 2018, Iran reportedly set a fixed exchange rate of 42,000 rials to the USD.
- Allowing capital to flow freely without an exchange rate.
- Creating an independent monetary policy.
The trick behind the impossible trinity is that only one side of the triangle can be achieved at any given time. Once a global cryptocurrency comes into play, Bitcoin or something else, each individual country’s currency must compete with the global cryptocurrency within its own financial market. As the paper states, “this shows that nominal interest rates must be equal and the exchange rate would have to be risk-adjusted.”
The only way for a central bank to make its domestic currency more attractive than the global cryptocurrency, what the paper calls the “escape hatch,” ends in a race to the bottom. Theoretically, one country lowers the interest rate of its own currency in order to lower the opportunity cost for holding that currency and make it more attractive than the global cryptocurrency as a means of payment.
“This escape hatch is not particularly attractive, however,” states the authors. “Nominal interest rates can only be lowered to zero. Furthermore, a rat race between the two central banks may then eventually force both to stick at…