On the built-in instability of cryptocurrencies

The fall in valuation of Bitcoin has led to a debate over whether decentralised currencies can be reliably stable. This column argues that in contrast to the success of inflation-targeting regimes, there is no feasible path towards stability of a decentralised currency. The instability of cryptocurrencies is the outcome of a systemic 'tragedy of the commons' coordination failure. This is inherent in their design.

The drop in the valuation of Bitcoins and other cryptocurrencies during 2018 may be a validation of the critical assessments of Roubini (2018) and Eichengreen (2018), or it may just be a blip in the development of a decentralised currency. The growing number of cryptocurrencies illustrates the large private demand for anonymised, decentralised financial innovations. It has led to discussions about ways central banks may – or should – react to these developments. The recent proposal from Christine Lagarde, IMF managing director, called Winds of Change: The Case for New Digital Currency (Lagarde 2018), exemplifies this debate.

This price volatility has intensified the debate about the stability problems of decentralised currencies. Believers argue that smarter software to manage cryptocurrencies will solve these issues, and that it is only a matter of time until a stable, decentralised currency emerges. Inflation targeting has illustrated the viability of currency regimes, they say. True, inflation in most countries has fallen to stable single-digit levels, leading Rose (2007) to conclude that inflation targeting “was not planned and does not rely on international coordination”.

But an extrapolation from inflation targeting to the feasibility of a stable cryptocurrency suffers from the fallacy of composition. Due to a systemic coordination failure (akin to the tragedy of the commons), there is no feasible path towards a global central bank that would ensure the stability of a decentralised currency.

How inflation targeting succeeded

The successful diffusion of inflation targeting has shown that a nation state has the ability to stabilise the purchasing power value of its currency in terms of the country’s price level. This is done by competent and relatively independent central banks. Presently, most of global GDP is produced in countries applying successful inflation targeting. In contrast, countries that have limited the independence of their central banks have found, with a lag, that their currencies lost value. This increases the likelihood of capital flight, financial fragility and banking crises (Zimbabwe, Venezuela, Argentina, and Turkey are examples). Under inflation targeting, the national central bank has clear ownership and the duty to stabilise the national currency, using the tools under its control. It can adjust the policy interest rate to keep inflation low, manage key monetary aggregates, and communicate the central bank’s policies.

In contrast, there is no clear central ownership and management of a decentralised cryptocurrency with the duty of keeping it stable, and responsibility for it. Consequently, its valuation is unstable, as gaming among various stakeholders may lead to multiple equilibria, bubbles and crashes.

This instability reflects the tragedy of the commons associated with cryptocurrencies – the public good of stable valuation conflicts with the interests of anonymous large holders of the currency (‘whales’) who can influence its value. Whales may benefit from the endogenous instability associated with exploiting their market influence (Gandal et al. 2017). Instability may also reflect the multiple equilibria associated with gaming decentralised cryptocurrencies (Biais et al. 2018).

Cryptocurrencies do not change the rules of private finance. Their valuations are exposed to the excessive optimism or pessimism of traders, and possible market manipulation. National currencies are, of course, exposed to similar speculative attacks. Yet, the clear allocation of duties to the central bank, and the bank's willingness to adopt policies for financial stability and stable currency valuation, provide the public good services associated with scalable safe currency.

This is part of a complex system that may include deposit insurance schemes (akin to the FDIC), backstopped by the nation’s taxpayers.1 Again, there is no comparable allocation of duties and ‘property rights’ in a decentralised currency. Therefore, we can expect relative instability to be the rule, not the exception.

Why decentralised currencies are different

The combination of a decentralised currency, and anonymity associated with cryptocurrencies, makes the use of stabilising forces, as used by large players during the era of ‘free banking’ in the US, impossible. To recall, during the financial panic of 1907, J P Morgan pledged large sums of his own money, and convinced other New York bankers to do the same, to shore up the banking system. They operated as de facto lenders of last resort.

The whales of that time clearly owned of the rents associated with stable financial intermediation, and so they chose to provide stabilisation services as long as that would minimise their expected losses. The crisis of 1907 also illustrated the risks of private bailouts – their credibility was constrained by the balance sheets of financial institutions, and required a leader who could convince other financial whales to join the bailout.

Furthermore, private bailouts reflect the wish of whales to maximise their rents, not concerns about national welfare, and not the impact of bailouts on households, small banks and small firms. Indeed, the dynamics of the 1907 crisis led to the formation of the Federal Reserve System, created by the Federal Reserve Act of 1913. In contrast to the bailout coordinated by J P Morgan, the anonymity of cryptocurrency holders means there is a lack of agency, and there are no stabilising forces of the type exhibited in the 1907 private bailout.

It is not a surprise that there is no clear path towards a global central bank with responsibility for the price stability of a decentralised currency. Among national central banks there is a reluctance to cooperate in normal times, as the mandate of each central bank prioritises domestic goals that focus on domestic price stability, not on the global value of its currency. This coordination failure is compounded by the observation that in normal times, deeper macro cooperation among countries is associated with welfare gains akin to Harberger’s second-order magnitude triangle, thus making the odds of cooperation low. When bad tail events induce imminent threats of financial collapse, the perceived losses have a first-order magnitude of terminating the total Marshallian surpluses.

The apprehension of these losses in perilous times may elicit rare and beneficial macro cooperation Aizenman (2016). In contrast, the anonymity of cryptocurrency owners may magnify the volatility, as there is no reason to expect the cryptocurrency’s whales to provide stabilisation in bad times.2

Scalability breeds failure

The successful scalability of decentralised cryptocurrencies would breed its private failure – the nation state may ignore niche financial innovations, but would regulate or even ‘nationalise’ them if their size and instability became a systemic threat. Efficient scalability of a successful decentralised currency is possible as long as the private sector coordinates its policies with the nation state.

Scalable financial innovations that challenge the nation state’s ability to enforce law and order would trigger an ‘arms race’ between users and the nation state’s law enforcement. A well-functioning nation state has access to deep, scalable resources. OECD countries, China and other efficient centralised regimes find ways to control scalable financial innovations.

If the decentralised currency is scalable, nation states and central banks will face growing competition. They will react by either imposing regulations or reducing scalability and encryption. Either course of action crushes the emerging competition. Alternatively, they may compete directly with cryptocurrencies by offering their own e-money, as articulated by Lagarde (2018).