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Facebook’s Libra: A Deep-Dive Economic Analysis

How Facebook’s cryptocurrency will affect markets, economies and everyday life.

Libra. A zodiac sign and an ancient Roman unit of weight used for weighing gold and silver in commercial transactions. Now, Facebook hopes that Libra will become a stable coin, a cryptocurrency, and a digital version of money for economic empowerment. That being said, only about 8% of money today is physical cash money and the rest of it (92%) is digital…

The success or failure of any currency/money really comes down to the fundamentals of what money really is. Google will define it simply as “a current medium of exchange in the form of coins and banknotes”. That doesn’t really explain why other cryptocurrencies like Bitcoin have essentially failed as money substitutes. The critical issue of the crypto or even Monopoly money is in their inability to act as a store of value. Economists define money as “something that serves as a medium of exchange, a unit of accounting and a store of value.” These three components really highlight the failings of other crypto but highlight the potential of Facebook’s Libra.

Simplistically but critically, money is all about trust. Money is often explained as being an “IOU”. In exchange for this coin, you will be able to get a given amount of goods and services. If the trust is broken then the value and use of the money disappears. This collapse in trust has been seen repeatedly through history but in recent history, Zimbabwe resorted to using U.S. dollars as people lost all faith in the local currency. The intriguing thing here is that according to a recent survey by Verge only 31% of Americans trust Facebook; so with that in mind, let’s take this opportunity to deep dive into Facebook's cryptocurrency — Libra.

What Is Libra?

Libra is a cryptocurrency being created by Facebook for digital transactions. That is, Facebook is creating its own currency (money) to be used online. There are a few attributes that make the Libra proposition unique:

  1. The currency will be fully backed by a basket of low-risk currencies and assets.
  2. There will be a Libra Association, Council and Board governing the currency.
  3. The currency will be launched on a truly global and large scale platform such as Facebook which boasts 2.38 billion monthly active users.
  4. There will be no fixed amount of Libra. The number of Libra will expand and contract with demand — much like the supply of exchange-traded fund (ETF) shares is regulated through a mechanism known as creation and redemption.
  5. Libra will not impose or adopt monetary policy however it will have use of reserves.

Essentially, Libra is a large scale cryptocurrency governed by a group of institutions and supported by a reserve and basket of assets. Libra is best compared to being an ETF that follows the index of the IMF’s SDR. The SDR is a basket of currencies comprised of USD, EUR, GBP, YEN, and RMB. This is because Libra, like an ETF, adjusts the number of shares to demand and its price reflects the collective value of the underlying currencies.

Tech idealists like Elon Musk and economists like F.A. Hayek have long dreamt of such a currency, but the big question is; will it work?

The Economics Of ‘Pegged’ Currencies

Digital currencies aren’t new and neither are currencies that are backed by assets like gold or ‘pegged’ to the value of other currencies like the ‘Bretton Woods’ system. Even today a number of national currencies are fixed/pegged to the U.S. dollar.

Libra has stated that it will be ‘fully backing each coin’ with a basket of low-risk currencies and securities. Unfortunately, both the White Paper and the Reserve Paper Libra produced contradict themselves about how mining and burning of coins will be managed. The papers initially state that user demand will drive liquidity and backing, but then go on to state that authorized resellers will be the drive liquidity and backing, so that definitely needs to be clarified.

Regardless of whether users or resellers drive supply these aspects will exist.

  • Supply of Libra will be driven by demand. That is coins will be ‘minted’ and ‘burned’ depending on the amount of demand for Libra.
  • Every Libra will be backed, and will presumably reflect the value of a basket of currencies and assets.
  • Libra will be redeemable at ATM’s, stores and for transactions.
  • Authorized Resellers will use the reserve to engage with exchanges to buy and sell Libra, currencies, and assets to maintain price stability, liquidity, and backing.

The way Libra intends for these attributes to function is that the user goes to Libra and trades their local currency for Libra coin at the prevailing exchange rate. Libra then places that currency in the reserve for the Authorised Resellers to engage with broader markets and purchase the requisite backing. The currencies, resellers, and exchanges will be spread throughout the globe to minimize sovereign risk.

The history of fixed currencies isn’t that great and there are obvious reasons why countries moved away from fixed currencies to floating currencies. A fixed currency is susceptible to a Currency Crisis also known as a Balance of Payments Crisis, which in recent years were elements of the crises in 1994 Mexico, 1997 Asia, 1998 Russia, 1999 Brazil, 2000 Argentina, 2007 Eurozone and 2016 Venezuela.

Why Does Currency Crisis Occur?

The typical reasons currency crisis occur are because a government devalues or debases its currency which triggers a collapse of confidence and an outflow of capital. This is usually seen in emerging markets that are heavily reliant and exposed to international trade and in currencies that are pegged or even quasi-pegged to another currency.

Take the ’97 Asian Financial Crisis for example.

Developing Asian nations like Thailand, Indonesia, South Korea and Malaysia were displaying strong growth, high savings rates, and there was belief in the exchange as currencies were pegged to the U.S. dollar. The countries appeared to have relatively low risk and the prospect of excellent returns so international capital flowed in. The capital inflow increased demand for local currencies which meant the government needed to use reserves to buy foreign currencies and maintain the exchange rate. This continued until the inevitable occurred, the reserves began to run low and people lost confidence in the government's ability to maintain the exchange.

The Asian governments could print more money which would lead to higher inflation but potentially delay the collapse in confidence or they could remove the pegging and float the currency. The uncertainty and precariousness caused panic and as capital rushed from the countries the reserves were all but exhausted and the government had no choice but to float the currency and default on loans.

This is not unique. This is not unusual. The currency crisis has repeated throughout history and are typically followed by high inflation and sovereign default — check out This Time Is Different by Reinhart and Rogoff to learn more.

A key risk of the Asian financial crisis was financial contagion. As so many countries within Asia began to struggle and default there were significant fears that it would spread across the globe. This would be a taste of the global financial contagion that would eventually arrive with the GFC. It has to be noted that the mass adoption of Libra would result in a huge risk of financial contagion.

How Libra Could Experience A Currency Crisis?

Libra is set to be launched with immediate use on platforms like Facebook, Uber, and Spotify. These three platforms have colossal volumes of users. Facebook boasts over 2.38 billion monthly active users alone. If all the monthly users on Facebook were to buy $500 worth of Libra then that would total $1.19 trillion. The U.S. Federal Reserve currently has a balance sheet of about $3.84 trillion and before the GFC it had $886 billion. The Australian Reserve Bank only has $79.91 billion. So Libra and its reserve system will be absolutely massive.

The potential scale of this currency is truly mind-boggling and incredibly scary. Remember that every Libra is going to ‘fully backed’?
Well, that means that there could be trillions of dollars being used purely as backing for the Libra platform.

There are two elements to operating a system of this scale that could be seriously damaging and we’ll look at each of them.

  1. Confidence and market perception
  2. The scale of demand and its impact on real economies

ONE: Confidence is a fickle thing and is prone to swings. The promising IPO of a Tech Unicorn could instantly turn to dashed dreams and bankruptcy. The same applies to currencies, just look at the epic rise and fall of Bitcoin or the historic crashes of sovereign currencies.

What could and I expect would happen with Libra is that it would build hype. People would start buying up the currencies that Libra will use as reserves with the expectation the demand for Libra will cause these currencies to rise in price. The beast will feed itself. Users will come to Libra and more backing will be required, the Libra reserves will be deployed and currencies bought up and more speculators will arrive.

This will also drive the price of the Libra up as the backing assets increase in value. People will begin to buy Libra to speculate as they see that when they go to the ATM they can withdraw more money than they initially put in. But it will also make it harder and harder for the non-backing currencies to get onto and access the Libra platform as more of their local currency will be required to get Libra. That is the currencies that Libra won’t be buying to back the coins with. For example, they could use the SDR which are USD, EUR, GBP, YEN, and RMB but you might be in Australian and using the Aussie dollar AUD which is a non-backing currency.

Ultimately, the speculation has to stop. Confidence wanes, and then the exit happens. People stampede to get to the doors and the whole thing collapses, creating a global financial crisis. Maybe.

TWO: The scale of demand and potential influence may have drastic effects on real economies. Wall St and Main St are inextricably linked, and now Silicon Valley is linked too. Libra could generate so much demand for government securities that it may induce permanent low-interest environments (not that we aren’t already experiencing that) or absorb all available liquidity for the backing.

Libra would continue to purchase securities as users migrate to the currency and due to its potential scale, it may be more influential than Central Banks. The scale of demand may not just be impactful to interest rates but also to currency values. As Libra purchases and holds currencies for backing the Libra, the designated currencies will appreciate. The currency appreciation will in turn impact importing and exporting. National exports will fall as products become too expensive on international markets and imports may rise. This has the potential to inflict structural change on national economies and potentially induce recessions as the pivot unfolds.

No doubt the media would be involved and a collapse in the acceptance or confidence of Libra may occur, or government regulation could intervene. Government intervention could be in the form of controls and regulation or it could be in the form of currency devaluation. Both of which would be severely damaging to Libra.

The other issue of Libra’s potential scale is in locating enough liquidity and low-risk assets for backing. The huge size of Libra may cause the price growth of the assets to outpace the ability of Authorised Resellers to secure backing. Once a gap begins to form it will most likely not be able to be closed again.

If Libra runs out of assets that are low enough risk to purchase then it may have to resort to higher volatility and risk assets which could put further strain on the currencies ability to remain pegged to the basket. I have to say it is easy to imagine a scenario in which Libra could require more liquidity than any state would be able to provide as well. It could feasibly be twice the size of some nations and you only have to look at Ireland to know that a country can have debt bigger than itself. What happens when a currency that large can’t support its size? It becomes too big to fail on a global scale and requires a joint effort from governments to manage.

So all in all, the global diversification of backing and Authorised Resellers probably won’t be sufficient in preventing a collapse in the Libra. However, there is no guarantee that a collapse would ever even occur. The Australian, Canadian, and U.S. dollars have all demonstrated great resilience and reliability.

How Libra Could Inflict A Currency Crisis?

It’s more likely that Libra will inflict a currency crisis on a sovereign country than experience one itself. Its goals of economic empowerment have huge potential to be economically crippling in emerging economies.

First adopters and young people will likely move to Libra while the majority remain on the sovereign currency. Digital transactions continue to progress and young people are enjoying the economic empowerment that Libra is bringing them; but then there’s political, economic and social instability of developing countries and emerging markets.

Let’s use Turkey as an example.

From peak to trough during this 12 month period is a 28.6% fall in the Turkish Lira. Inflation rockets up, markets start to short Turkey, confidence continues to fall and the economy faces all sorts of headwinds.

What happens if Libra is available to the Turkish citizens?

I’d expect the Turkish people to flock to ‘safe haven’ currencies as fear of inflation and an economic downturn heighten. This will further the currency falls in the Turkish Lira and the international shorting of Turkish stocks. A downward spiral would commence and the economy could collapse.

The deliberate accessibility and low barriers to access Libra are what makes it appealing but also what makes it a massive threat and risk to sovereignty. If governments fear that people will flee to Libra they may create firewalls and blocking systems to prevent them from ever accessing it.

What Does Libra Mean For Money Supply?

Libra doesn’t technically create any more money, as when a user exchanges their local currency for Libra, Libra uses the currency for backing. Libra has stated that it will use banks and Authorised Deposit-Taking Institutions for backing the crypto. This means that the money stays within the money supply.

It may seem counterintuitive that the money supply doesn’t change but realistically the only thing that changes is where the money is being held. From the consumers account to the Libra account.

Well, that’s not entirely true.

The behavior of the money changes and this is important. As consumers switch to Libra and Libra deposits the money, we can expect consumers will begin to transact in Libra rather than local currency. The velocity of local money will fall but the ‘sticky-factor’ of deposits will increase. That is, Libra will be holding the money in bank accounts longer than normal consumers would as the average person is usually out spending the money and moving it on.

As deposits remain in accounts for longer they become more eligible and likely to be lent out, which increases the total money supply. The increase in money supply in the form of credit may stimulate the economy and/or create inflationary pressures but either way, we would expect money supply to increase in countries that Libra holds deposits and decrease supply in places that the money is flowing out from.

So if Libra doesn’t hold any money in your national banks then you may see some higher interest rates.

What Does Libra Means For Central Banks And Governments?

Libra will have a profound effect on governments and central banks. Assuming governments actually allow Libra to launch then I’d expect significant regulation, as I can’t imagine any politician handing over power and the keys to the kingdom to anyone else.

Libra would render most central banks useless in monetary policy and the risks of global financial contagion would be paramount. The reason the central bankers would be ineffective is that they would most likely have insufficient capital to affect the significant impact on financial markets. The levers of interest rates and currency are typically pulled by the biggest player in the room, which may not be them. The alternative, and in my mind preferable would be for central banks to focus on access to credit rather than the supply and price of money. People will get credit regardless of the price, so control the access to it instead.

Central banks may inflict things like QE and negative rates to curb the impact of Libra on their systems. This would definitely throw a spanner in the works for Zuckerberg as he is counting on interest on Libra’s deposits and holdings to pay for the operations and provide investors dividends. The central banks may also, and I’d expect this to be the case, require Libra to hold reserves with them. This would bolster the central bank's balance sheet and may help mitigate the influence and scale of Libra.

The other governmental concerns would be whether you tax people on capital gains that may be achieved from using Libra, does the government apply any guarantees on deposits held in Libra and how do you tax transactions that take place in Libra. Some really big questions there.

What Does This Mean For Consumers?

Consumers should be excited about the prospect of Libra. Even if you don’t and never intend to use it. The currency will develop new technology and put pressure on existing banks, platforms and systems to improve.

We can expect that international transaction costs will continue to fall. The rise of online shopping is already pushing this but international co-operation between banks will increase. Blockchain payments are currently used for interbank payments globally and the pressure Libra will place on the financial industry may accelerate the pace in which the incumbents adapt.

On the downside though, Libra will become an ideal place for fraud and terrorism financing. Libra states that users will be able to register multiple addresses with no relation to the user's real identity. Financial crime, fraud, scams and terrorism financing are big and scary businesses. These bad actors are currently able to exploit weaknesses in highly regulated systems and if there is an option to go to an online currency with access and ability to withdraw from ATM’s then I fear what will happen.

Not only is there the serious threat of criminal activity but Facebook itself has a sketchy history with privacy and securing customer information. Libra appears to be a high-risk currency for consumers and governments to engage with.

There is a counterfactual to this though, an alternative path that Libra could feasibly take.

Quick Counter-Factual

  1. Libra could become a truly global payments platform that uses blockchain to submit and process payments for its users. It could be a great upgrade from platforms like WeChat, PayPal Visa, etc. The platform would enable customers to use their local currency and funds in a secure and widely used online payments platform.
  2. Libra may not achieve scale. It could disappoint and only achieve a few hundred thousand or million users. This would create some risks but not as many and would still apply pressure on financial incumbents. I believe this is the most likely scenario. Libra will launch, and have a modest reception with many consumers sitting and waiting for others to test Libra out. During this slow adoption phase, governments will have time to learn, adapt and regulate and in 10 years time it may become an overnight success with a huge global presence or be underlying infrastructure to support existing banks. I say this is the most probable outcome because trust is hard to build and people don’t risk their money lightly.

I hope you’ve enjoyed the article and learned a little about Libra and economics. If you’d really like to get into this then I’d recommend reading or watching The Ascent of Money: A Financial History of the World by Harvard professor Niall Ferguson.

If you have any questions then please feel free to comment, and if there is anything you’d like to see analysis on or read about in the future then let me know.

Also, please note that this article does not represent financial advice or the views of any organization; it is only the opinion and analysis of the writer.

Thank you for reading.

Yours,
Chris Leeson

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Chris Leeson

Chris Leeson

Bringing finance and economics to you with a focus on in-depth analysis and everyday life.

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