What a Cryptocurrency Needs to Replace the Dollar
Less volatility and the Fed printing tons of money are not tipping points
The Fed’s printing machine is working 24/7. To the surprise of many, myself included, its money supply has increased by 70% in 4 months in response to the COVID crisis.
This increase has sparked questions on the future of the dollar and how cryptocurrencies will stand against it:
Shouldn’t all this Fed printing bring on high inflation? Lower the dollar’s value and wash away its global dominance? And put a cryptocurrency with a fixed supply, like Bitcoin’s, in its place to avoid repeating a massive government printing?
What follows gets into these questions and shows what a cryptocurrency needs to be a replacement.
1. Will the Fed’s printing bring on high inflation?
Yes, it will, if the Fed swamps the market with more dollars than people and firms, people for short, want to hold. This overflow could happen during the crisis or its aftermath, though it is too early to tell if it will happen at all.
Why is too early to tell? People find shelter by holding safer and more liquid assets in times of uncertainty and volatility as we have today; the FT story below is just one example. Among global assets, the dollar ranks higher in safety and liquidity, and therefore, people are rushing to hold it. However, we don’t know whether this higher demand for dollars will continue.
On the supply side, the Fed is buying assets with the money it prints. So, potentially it could sell part of those assets to “buy back” unwanted dollars and avoid high inflation.
How liquid is the dollar? Very liquid. Daily global currency trading stands at $6.6 trillion! and 90% of that is dollars being exchanged for other currencies.
A safe asset? For the dollar, “safety” means keeping inflation low and markets are betting on it. The straightforward indicator “10-Year Breakeven Inflation Rate” testifies to that effect.
There is a self-fulfilling aspect too. The more people think the dollar is safe and liquid, the more they demand and trade it in uncertain times, resulting in less unwanted dollars, less risk of inflation, and more liquidity. This self-fulfilling aspect is, to some degree, present in any currency.
We have seen a similar story unfold before
The Fed increased its money supply by 150% in 2008, in response to the subprime crisis. In the 10 years of recovery that followed, it increased it by another 200%. Inflation? Just 1.8% annually during 2008–18. People felt uncertainty and hoarded enough cash, that there weren’t unwanted dollars.
However, that does not mean that the Fed’s current printing will end in low inflation; as said, it’s too early to tell.
It’s better to look at the fiscal side for clues on future inflation.
Betting on low inflation means relying on the strength that the US has shown to collect taxes and reduce spending when it needs to lower fiscal deficit. Clinton’s and Obama’s fiscal policies are examples of this strength at play.
If fiscal spending gets out of control in the next two years, however, the US could lose its strength to lower fiscal deficits. The market could become less willing to lend to the US government, which would damage the Fed’s autonomy, the value of its assets, and its ability to “buy back” the unwanted dollars. Triggering government debt monetization and high inflation.
2) Will the value of the dollar decrease, washing away its global dominance?
High inflation will significantly reduce the dollar’s global dominance. Especially, if there are alternative global assets perceived as safe and liquid. As said, however, it’s too early to tell if we will have high inflation at all.
Which leads us to the final question…
3) Can a cryptocurrency with a fixed-supply, like Bitcoin’s, be a safe and liquid alternative to the dollar?
To be an alternative, a cryptocurrency would need key computational features, which have been widely discussed. In addition, it would need key macro-stability features, which have been widely undiscussed.
The computational features: Such a cryptocurrency would need a scalable and robust consensus protocol, to fluently and safely process a volume of transactions much larger than what cryptocurrencies are processing today. Plus, it would need people’s confidence in that its network will have an uninterrupted supply of electricity, atomized independent nodes to keep 51% attacks at bay, and a strategy to deal with quantum computing.
The macro-stability features: Such a cryptocurrency would also need to provide people with more cryptocurrency if they demand it in uncertain times, as is currently happening with the dollar, and be able to withdraw that extra supply when its demand goes back to normal. A cryptocurrency with a fixed-supply sounds good for avoiding high inflation but becomes a straitjacket that causes high deflation when people hoard cash. People and the economy suffer with deflation like it happened during the Great Depression.
Why a fixed-supply cause deflation? If a currency is more demanded and its supply doesn’t increase, then it becomes scarcer and its value increases relative to the value of goods. Thus, the prices of goods priced in that currency fall. Deflation.
Such a cryptocurrency would also need to move its interest rate to smooth boom-bust business cycles caused by animal spirits; the way the Fed does in normal times.
In short, the Fed’s record printing should raise eyebrows, but it is too early to tell if that will cause high inflation. The fiscal side can give more clues. An out-of-control fiscal spending could slip us into government debt monetization and high inflation. In any case, a cryptocurrency would need more than high inflation to get a chance to replace the dollar. It will also need macro-stabilizing features that cryptocurrencies with fixed-supply lack. A cryptocurrency that achieves both features (people’s confidence that it will avoid high inflation and the macro-stabilizing features) would lead to a new paradigm. Time will tell if such a new paradigm will ever exist.
Disclaimer: This article doesn’t constitute investment advice and its author doesn’t have a long or short position in any cryptocurrency.