The Next Interest Rate Policy Pickle: Cryptocurrencies

I previously wrote about the interest policy pickle in which our central bankers find themselves (https://medium.com/@barrongati/the-interest-rate-policy-pickle-e0b0b96947b9.

• My previous article noted that the new economic environment makes the trade off between potential future inflation and current growth difficult to manage.
• The data showed two different trends that contradict what we’d normally observe at this point in the business cycle, which makes setting rates even harder).

In this current article, I’ll be talking about another future threat to monetary policy interest rate setting: cryptocurrencies. I’ll also provide justification for why global central banks should begin studying the best way to regulate, participate in, join, or support the cryptocurrency market.

First, if you haven’t heard about cryptocurrencies, then you should definitely read up on them. As a quick primer, cryptocurrencies are mediums of exchange that do not rely on any country’s government and are instead verified and tracked by an online, extremely secure, decentralized, and public ledger system called a blockchain. The way that this works is that every single transaction ever conducted in a given cryptocurrency is publicly verified as the next link on a blockchain. A blockchain is a continuously increasing list of records (in this case, transactions), that are secured using cryptography. If you’ve heard of Bitcoin, it is an example of how one such currency works.

When Bitcoin was launched, a certain number of coins were originally created for trading on cryptocurrency exchanges and conversion into traditional currencies (dollars, pounds, euros, yen, etc.). In order to prove that the transactions were secured, “miners” were responsible for verifying and posting transactions from all over the world using their own computer power and paying for the electricity to generate the secure cryptography. Miners are individuals who dedicate time, electricity, and computational work to verifying transactions along the blockchain. Since mining costs electricity, time, and work, these people are paid in Bitcoins, which increases the supply of the cryptocurrency.

Since Bitcoin’s founding in 2013, dozens of other cryptocurrencies have emerged. The most popular of these besides Bitcoin are Etherium, Ripple, Bitcoin Cash, Litecoin, and these six have the largest market capitalizations. These currencies have recently (over the past few years, and especially this year) become increasingly popular to the point of going from an initial total market capitalization of just $1.5 billion in April, 2013 to a current market capitalization of nearly $150 billion, which it reached just this week. Here’s a chart of the market capitalization of the top six cryptocurrencies (which represent about 90%+ of the total cryptocurrency market):

When looking at this graph, the first thing you may notice is how recently the increase in market capitalization was. Second, you may notice how extremely volatile it has been. Tens of billions of dollars are created or lost on a nearly daily basis. In addition, there’s virtually no regulation of these currencies as there is with all government backed currencies. You can trade these cryptocurrencies freely for other currencies nearly instantaneously and it is here that we see where monetary policy may be weakened by this new medium of exchange.

Since central bankers around the world seek to regulate interest rates by adjusting each currency’s money supply, their ability to do so would be severely hampered if the fiat currency money supply was only, say, half of the total money supply in the world, which would be the case when cryptocurrencies reach a market capitalization in the $30 trillion range. In fact, even a market capitalization of $5–10 trillion will be transformative. If we used a reasonable growth rate of 250% per year (much less than the 750% growth rate experienced to date), it would take just six years for the market capitalization of these cryptocurrencies to reach just over $36 trillion, and four years to reach $5 trillion.

However, since growth rates tend to decrease as market capitalization increases, it would be more prudent to use a lower growth rate of, say, 50%. Using the latter growth rate, the market capitalization of cryptocurrencies will reach $30 trillion by 2030 and $5 trillion by 2025. Regardless of the exact time by when the cryptocurrency markets materially grow, the ability of governments to regulate their money supplies will be weakened. That will lead to potentially much more volatile business cycles, larger booms and busts (larger periods of economic growth and depressions), and a completely different overall business landscape.

Therefore even though we may be anywhere from six to 20 years away from this potential pickle, it’s wise to think through today what would help us in the future.

• If central banks and governments wait until the market capitalization of crytpocurrencies reaches the trillions of dollars, it may be too late to implement a low-cost and low-friction solution. Therefore I believe that governments should start funding studies into how cryptocurrencies and blockchain businesses might impact the future monetary landscape as soon as possible. Then using these studies, they should map out how our current understanding of interest rate setting and monetary policy drivers might be optimized by government participation in the market.
• If these studies find that government participation in the cryptocurrency markets should be limited, then governments should consider how to mitigate potential currency devaluations in blockchain businesses and cryptocurrencies. Severe downturns would have very real and very deleterious effects on the global economy.
• On the other hand, if these studies find that government participation in the cryptorcurrency markets is warranted, then planning should begin immediately for how best to regulate or generate government-based cryptocurrencies.

As a result, I recommend planning strategies, such as the equivalent of quantitative easing (or purchasing certain cryptocurrencies or businesses to help prevent extreme contractions), or developing an interest rate setting mechanism within the cryptocurrency market, to help ensure the stability of the upcoming landscape far into the future.