Government-backed currencies rule the world. But they could soon face legitimate challengers in the form of private digital currencies, particularly if Facebook or some other big company launches one. How will that affect the financial system?
If history is any guide, then “people aren’t going to like it,” argues James Bullard, president and CEO of the US Federal Reserve Bank of St. Louis.
Bullard, one of 12 regional presidents who run central bank branches across the country, spoke about the topic last week at an academic conference for central bankers in New York. He said the rise of cryptocurrencies is causing a “drift” toward a system of “non-uniform currencies.”
Referring to his own research on the topic, Bullard said we’ve already seen what can happen when there isn’t a uniform currency in the US. In 1830, 90% of the US money supply took the form of private banknotes. But a problem arose: “You would get on your horse with your notes in your satchel and you’d ride over to the other town, but your notes would not trade one for one in the other town,” Bullard said. The exchange rates between different notes fluctuated, often for reasons that were difficult to pin down.
Similar “exchange rate chaos” can be seen in the foreign currency exchange market today, Bullard said. For instance, the exchange rate between the US dollar and the Japanese yen fluctuates by as much as 15% year to year, even though the “fundamentals” of the two economies show much less of a disparity, he said. New entrants to the global currency competition will face this problem too.
Facebook has said that Libra will keep a stable value because it will be backed by a reserve containing mainly cash deposits of US dollars, British pounds, euros, and Japanese yen. The approach takes cues from other so-called stablecoins, an emerging class of digital currencies. But the basic idea underlying stablecoins isn’t new, Bullard said. Nations have tried to “peg” their currency’s value to that of another currency, often the US dollar. In that case, the central bank promises to convert a fixed amount of its nation’s currency for a dollar.
“But fixed-exchange-rate systems have often failed, even amongst very large economies, so that doesn’t seem like a promising solution either,” said Bullard.
According to Bullard, the key factor that keeps a currency stable is the “credibility” of its issuer. For instance, unstable policy in Venezuela in recent years has contributed to its currency’s loss of value relative to the dollar, he argued. “I think cryptocurrencies could be prone to exactly this sort of failing credibility,” he said. “If you are a large firm and you issue coins virtually but your business model declines, or people start to have doubts about the future viability of the company, that’s certainly going to affect the willingness of people to hold your particular currency.” If they lose confidence in it, it could lose value or even collapse.
In that light, “it’s unlikely you’re going to bring some other currency—I don’t care what it is—and knock off the dollar,” he said. “If you are, you’re going to have to have really great credibility about the future value of that currency.”
As for Libra, Katharina Pistor, director of the Center on Global Legal Transformation at Columbia Law School, says it may struggle to maintain its peg, particularly if a financial crisis occurs. With that in mind, she says it is unlikely to challenge stable national currencies.
On the other hand, Libra might be a genuine competitor to government money in places that have less stable currencies, and that could have disruptive effects. Facebook has said that people all over the world will be able to buy Libra using their local currencies. But Pistor, who testified during a Libra-focused hearing in Congress last week, points out that maintaining the full backing of its reserve will have to involve another step: somehow, the local currencies will need to be exchanged for the currencies in the reserve. That could affect local exchange rates, she says.
The result might be a modern version of the type of price volatility that private currencies caused in the US back in the 1830s. Bullard predicts that today’s consumers and businesses won’t like exchange-rate chaos any more today than people did then. He says that system’s unpopularity factored into the government’s decision a few decades later to replace it with a national banking system. Out of that chaos, the dollar was able to rule.
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