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What is the value of digital currency?

In the previous article, we explored the question ‘what is digital currency?’  In this article, we will examine the value of digital currency. Why would anyone want to use one? What benefits do they bring?

Digital currency derives its value primarily from confidence.  If people have faith that the currency will be accepted by others, they will be willing to use it.  Digital currency may also help to lower transaction costs, and make it easier for central banks to intervene in the economy.

Trust and Confidence

Confidence in a currency comes from three main sources:

  1. Acceptability as a means of payment – If people believe that the currency will be generally accepted in payment for goods and services or in the repayment of debts they will be willing to use it,
  2. Reliability as a store of value – If people believe that the currency will maintain its purchasing power over time they will be willing to hold on to it, and
  3. Intrinsic value – People’s confidence may be inspired by the nature of the asset itself.

Gold is the reference point against which digital and fiat currency should be judged. Gold has intrinsic value due to its natural scarcity and usefulness both as money as well as in multiple other applications such as jewelry, dentistry, medicine, electronics, and aerospace. Gold is a reliable store of value since it is both scarce and durable.  While it is not explicitly used in the monetary system, it is widely held by central banks, and is easily convertible into cash.

The value of fiat currency comes from social convention and government decree, which makes it acceptable as a means of payment. However, fiat currency has no intrinsic value and is generally not a reliable store of value over time.  Central banks are committed to debasing national fiat currencies by around 2% per year.  This means that fiat currencies lose roughly half of their purchasing power every 30 years or so.  Since 1971, when Richard Nixon took the US dollar off the gold standard, market commentators have worried about the ability of the US dollar to act as a reliable store of value.  The global financial crisis redoubled these concerns, and it is no coincidence that Bitcoin was launched in 2008.

Bitcoin is touted as ‘digital gold’ as it is seen as a more reliable store of value than national fiat currencies.  The main reason for this view is that, according to the Bitcoin protocol, the supply of Bitcoin is limited to 21 million bitcoins.  Fiat currencies typically lose their value because central banks print too much of them.  With Bitcoin, this problem does not appear to exist.  Unlike gold, however, Bitcoin has no intrinsic value as a useful asset that exists independently of the Bitcoin network.  Bitcoin is also not widely accepted as a means of payment.

Demand for Bitcoin instead comes from hype and interest generated by the Bitcoin community. According to Metcalfe’s law, the value of a network is proportional to the square of its number of users.  This means that as interest grows, the Bitcoin network becomes exponentially more valuable.  However, it also means that if a better cryptocurrency were to be developed, a new technological paradigm were to emerge, or if the Bitcoin community were to become less enthusiastic, demand for Bitcoin could also plummet exponentially. Many people who buy Bitcoin are speculators, hoping to get rich by selling their Bitcoin for a higher price in future, others are citizens of countries experiencing rapid currency devaluation like Venezuela or Lebanon.

Although the technology underpinning central bank digital currencies (CBDCs) and unregulated digital currencies like Bitcoin may be similar, CBDCs are likely to become much more widely used as they will have three clear advantages as a means of payment.

  1. Government debts will likely be denominated in CBDC currency units, which will make them useful for investors who can use them to invest in large liquid government debt markets.
  2. Taxes will likely need to be paid using CBDCs, which will make it necessary for businesses and individuals to use them.
  3. CBDCs will enjoy legal tender status, which means they will be legally recognised and protected.

Despite these advantages, however, CBDCs will still suffer from the same problem that plagues fiat currencies. Central banks will have the ability to print too much of them.

Given that each digital currency will have slightly different features, it is possible that people will choose to use more than one of them.  CBDCs could function as ‘digital silver’, being most useful as a means of payment.  While Bitcoin or a similar decentralised digital currency could play the role of ‘digital gold’.

Lower transaction costs

Transaction costs represent a drag on economic activity.  Credit cards have a merchant fee of around 2%, debit cards may have a merchant fee of up to 0.8%, and there are also costs associated with handling cash.  If we assume that merchant fees chew up around 1% of economic activity, and global GDP is around $81 trillion, then that amounts to an annual global transaction cost of $810 billion.

Digital currency offers the potential to significantly reduce or eliminate transaction costs by bypassing commercial banks and other payments providers.  Payments with digital currency could be made on a peer-to-peer basis, with zero transaction costs, or settled on a centralized national ledger, which would have extremely low transaction costs due to massive economies of scale.

Expanded central bank power

Traditionally, central banks are limited in their power to control monetary policy.  In the event of a weak economy, a central bank’s primary tool is to buy financial securities through open market operations in order to increase the money supply and push down interest rates.

Conventional monetary policy involves targeting the Federal Funds rate, which is the overnight rate at which commercial banks borrow and lend their excess reserves held at the Federal Reserve.  Lowering the Federal Funds rate makes it cheaper for banks to obtain funds, and it is hoped that banks will pass this lower cost of funding on to customers.  However, when short term rates approach zero, the Federal Reserve faces a liquidity trap, and cannot lower the Federal Funds rate any further.

Quantitative easing (QE), an unconventional monetary policy embraced by the Federal Reserve since 2008, involves purchasing longer-term securities including government bonds and mortgage-backed securities. The basic goal is to stimulate economic activity by lowering longer term rates, which makes it cheaper for governments and businesses to borrow and spend.  However, people cannot be forced to borrow. When debt levels become too high, QE also becomes ineffective, and cannot be used to further pump prime the economy.

In many countries, QE and conventional monetary policy have reached their limit. In this situation, there is a real possibility of deflation as people stop taking out new loans and divert spending in order to service and repay existing debts.  Deflation is a nightmare scenario for central banks because it increases the real cost of servicing existing debts, and would lead many borrowers on a path towards bankruptcy, including the US Treasury whose debts exceed $27 trillion.

Digital currency would allow central banks to adopt even more ‘heterodox’ monetary policy in a bid to further stimulate the economy.  Here are two examples of what this could mean:

1. Helicopter money

Aggregate demand could be boosted by directly funding government spending (also known as Modern Monetary Theory) or directly funding consumption spending (also known as Universal Basic Income). Since CBDCs will be centrally controlled, the central bank would be able to directly credit peoples’ digital wallets, and control not only the amount of new spending but also what can be purchased and when.

2. Negative interest rates

During a period of severe deflation, real interest rates could be high even if nominal interest rates are zero (if you are unfamiliar with how this works, review the Fisher Effect).

High real interest rates provide people with a strong disincentive to borrow and spend, which means less economic activity. Economists view this a problem, and see negative interest rates as a potential solution.

Although a number of central banks – European Central Bank, Swiss National Bank, Bank of Japan – have started experimenting with negative interest rates, the policy is unusual.  Basically, negative interest rates mean that borrowers receive interest rather than paying interest to lenders.  This has traditionally been viewed as impossible since deposit holders can withdraw cash from the bank, banks can hoard rather than lend excess reserves, and investors can buy real assets like gold instead of negative yielding government bonds.

Despite the obvious problems associated with negative interest rates, central banks appear to be committed to the idea.  By introducing digital currency, and thereby removing cash from the system, it would become possible for banks to impose negative rates on deposit holders.

Final thoughts

Digital currency derives its value primarily from confidence.  Given the different features of each distinct digital currency, the world’s future payments ecosystem may be composed of multiple digital currencies, each competing to serve a slightly different purpose.

Digital currency is likely to benefit the economy by reducing transaction costs, while at the same time expanding the power of central banks to intervene in the economy via helicopter money and negative interest rates.

In the next article we will explore the potential risks of digital currency.

Image: Pexels

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