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Thursday, August 03, 2017

Cryptocurrencies: Some Lessons from Monetary Economics

Jesús Fernández-Villaverde at VoxEU:

On the economics of currency competition: In 1976, Friedrich Hayek published a short pamphlet, The Denationalization of Money. Worried that political constraints in developed countries prevented central banks from tackling the high inflation at that time, he argued that money-issuing should be opened to market forces, and the government monopoly on the provision of means of exchange should be abolished. Hayek envisioned a system of private monies in which the forces of competition would induce banks to provide a stable means of exchange (Hayek 1999). Despite some attention (e.g. Salin 1984), for decades Hayek’s proposal was considered more a curiosity than a workable idea.

Technological developments over the last few years have made Hayek’s proposal a reality. This is the result of many individual decisions, rather than the outcome of a planned policy change (a process that Hayek would have appreciated). Nowadays it is straightforward to create privately issued money as a cryptocurrency. Thanks to fascinating advances in cryptography and computer science, cryptocurrencies are robust to over-issuing, the double-spending problem, and counterfeiting (Narayanan et al. 2016). Cryptocurrencies are different from the notes issued by financial institutions during times of free banking (Dowd 1992) for three reasons:

  • Most cryptocurrencies are fully fiduciary. Notes in the free banking era usually represented claims against deposits in gold or other assets.
  • Cryptocurrencies are not directly related to credit. They are issued by computer networks.
  • Cryptocurrencies such as Ethereum can also work as a sophisticated automatic escrow account. It is effortless to add to the code a condition that states: “Peter will pay Mary 10 ethereum if, tomorrow at noon, the temperature in Philadelphia according to weatherunderground.com is above 80 degrees.” Once that code is in place, the verification of the condition and the payment, if the condition is satisfied, would automatically be implemented.

Today, any person with internet access can use a bewildering array of cryptocurrencies as means of exchange. Everyone has heard about Bitcoin, whose market capitalisation (the price per unit times the circulating supply), as of 6 July 2017, exceeds $42 billion. This is only slightly below the market capitalisation of Ford Motor Company. Six other cryptocurrencies (Ethereum, Ripple, Litecoin, Ethereum Classic, NEM, and Dash) have market caps of more than $1 billion, and another 37 have market caps between $100 and $999.99 million. Cryptocurrencies still represent a trivial fraction of all payments in the world economy, but these shares may perhaps increase exponentially over the next few years. Cryptocurrencies may even become widespread in emerging economies with dysfunctional government monies.

How will currency competition work?

This raises positive questions. Will a system of private money deliver price stability? Will one currency drive all others from the market, or will several of these currencies coexist along the equilibrium path? Do private monies require commodity backing? Will the market provide the socially optimum amount of money? Can private monies and a government-issued money compete? Can a unit of account be separated from a medium of exchange?

It also raises normative questions. Should governments prevent the circulation of private monies? Should the private monies be taxed? Should we revisit the role of governments as issuers of money?

There are even questions relevant for entrepreneurs. What is the best strategy to jump-start the circulation of a currency? How do you maximise the seigniorage that comes from it?

Surely, we need a formal theory of currency competition. In a recnet paper, my co-author and I take a first pass at this problem (Fernández-Villaverde and Sanches 2016). We build a model of competition among privately issued fiduciary currencies by extending Lagos and Wright’s (2005) environment, which is a workhorse of modern monetary economics. The standard Lagos–Wright model has been augmented by including entrepreneurs who can issue their own currencies to maximise profits or by automata following a predetermined algorithm (as in Bitcoin). Otherwise, the model is standard. In this framework, competition is perfect. All private currencies have the same ability to settle payments, and each entrepreneur behaves parametrically with respect to prices.

Despite its simplicity, our analysis offers several valuable insights.

  • In general, a monetary equilibrium with private monies will not deliver price stability. When money is issued by a profit-maximising entrepreneur, that person will try to maximise the real value of seigniorage. There are many cost functions when minting money, so this maximisation does not imply that the entrepreneur delivers a stable currency. For example, if the cost function is strictly convex, entrepreneurs will always have an incentive to mint additional units of the currency. When Hayek conjectured that a system of private monies competing among themselves would provide a stable means of exchange, he was, in general, wrong. When money is issued by an automaton, there is no particular reason why the quantity of money will be compatible with price stability (except by coincidence). Bitcoin has already decided how many new units of currency will be issued in 2022, even though nobody knows what the demand for currency will be in that year.
  • Even when the cost function of minting money is such that we have an equilibrium with price stability, there is a continuum of equilibrium trajectories where the value of private monies monotonically converges to zero. The self-fulfilling inflationary episodes construed by Obstfeld and Rogoff (1983) and Lagos and Wright (2003) in economies with government-issued money are not an exclusive feature of public monies. Self-fulfilling inflationary episodes are, instead, the consequence of using intrinsically useless tokens (even if they are electronic and issued by private profit-maximising, long-lived entrepreneurs), whose valuation can change depending on expectations about the future.

But, as economists, we do not care about price stability per se. The goal of a well-behaved monetary system must be to achieve some efficiency goal. There is a third, and perhaps most important, result:

  • A purely private monetary system does not provide the socially optimum quantity of money even in the equilibrium with stable prices. Despite having entrepreneurs that take prices parametrically, competition cannot provide an optimal outcome because entrepreneurs do not internalise, by minting additional tokens, the pecuniary externalities they create in the market with trading frictions at the core of all essential models of money (Wallace 2001). These pecuniary externalities mean that, at a fundamental level, the market for currencies is very different from the market for goods such as wheat, and the forces that drive optimal outcomes under perfect competition in the market for wheat will fail in the market for money. The ‘price’ of money itself does not play a fully-allocative role: if one believes that money is used because there are frictions in transactions, one should not believe that the market can provide the right amount of money. (This argument slightly modifies the ideas in Friedman 1960.)

These three results cast serious doubts on Hayek’s proposal of currency competition. In most cases, a system of private monies will not deliver price stability and, even when it does, it will always be subject to self-fulfilling inflationary episodes, and it will supply a suboptimal amount of money. Currency competition works only sometimes, and partially.

How can Hayek be vindicated? A simple possibility is to think about the existence of productive capital. If entrepreneurs use the seigniorage to purchase productive capital, and this capital is sufficiently productive, then there is an equilibrium in which a system of private monies may achieve social efficiency. Other possibilities would include the presence of market power (different currencies are slightly different from each other in their ability to make payments) and, thus, a franchise value that a private entrepreneur may want to preserve (allegedly, this environment may be closer to what Hayek envisioned than our perfect competition world). We also know, however, that long-run market power does not necessarily deliver the right outcomes and that incentives to cheat always exist (Mailath and Samuelson 2006).

The impact on monetary policy

Finally, given that government-issued money is different from private money because it has fiscal backing, what are the effects of cryptocurrencies on government monetary policy? How is monetary policy changed by the presence of alternative means of exchange? The first case of interest is when the government follows a standard money-growth rule. Under this policy, profit-maximising entrepreneurs will frustrate the government's attempt to implement a positive real return on money through deflation when the public is willing to hold private currencies. There are, fortunately, alternative policies that can simultaneously promote stability and efficiency. For example, the government may peg the real value of its money. Under this rule, the government can implement an efficient allocation (supply the amount of money that maximises social welfare) as the unique equilibrium outcome, although it would imply that the government drives private money out of the economy.

There is an important lesson here: the threat of competition from private monies imposes market discipline on any government that issues currency. If a central bank, for example, does not provide a sufficiently ‘good’ money, then it will have difficulties in implementing allocations. This may be the best feature of cryptocurrencies. In a world in which we can switch to Bitcoin or Ethereum, central banks need to provide, paraphrasing Adam Smith, a tolerable administration of money. Currency competition may have a large upside for human welfare after all.

Author’s note: This column borrows heavily from my remarks ‘Cryptocurrencies: Some Lessons from Monetary Economics’ given at ‘The Structural Foundations of Monetary Policy’ conference at the Hoover Institution, Stanford University, May 2017.


Dowd, K (1992), The Experience of Free Banking, Routledge.

Fernández-Villaverde, J and D Sanches (2016), "Can Currency Competition Work?", CEPR Discussion Paper 11095.

Friedman, M (1960), A Program for Monetary Stability, Fordham University Press.

Hayek, F (1999), "The denationalization of money: An analysis of the theory and practice of concurrent currencies", in S Kresge (ed.) The Collected Works of F A Hayek, Good Money, Part 2, The University of Chicago Press.

Lagos, R and R Wright (2003), "Dynamics, cycles, and sunspot equilibria in “genuinely dynamic, fundamentally disaggregative” models of money", Journal of Economic Theory, 109(2): 156–171.

Lagos, R and R Wright (2005), "A unified framework for monetary theory and policy analysis", Journal of Political Economy, 113(3): 463–484.

Mailath, G and L Samuelson (2006), Repeated Games and Reputation, Oxford University Press.

Narayanan, A, J Bonneau, E Felten, A Miller, and S Goldfeder (2016), Bitcoin and Cryptocurrency Technologies, Princeton University Press.

Obstfeld, M, and K Rogoff (1983), "Speculative hyperinflations in maximizing models: Can we rule them out?", Journal of Political Economy, 91(4): 675–87.

Salin, P (1984), Currency Competition and Monetary Union. Martinus Nijhoff Publishers.

Wallace, N (2001), "Whither monetary economics?", International Economic Review, 42(4): 847–69.

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