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The monetary and fiscal policy challenges of cryptocurrency

Summary:
Sajjid Chinoy, Chief Economist JP Morgain India in this Indian Express article points to challenges cryptos will pose on mon and fiscal policy. On mon policy, he says this will be akin to dollarisation where home central banks lose their importance: For starters, how would monetary policy be impacted if a private digital currency was competing with fiat currencies? Think of this as “dollarisation” by another name, but with a crucial difference as enumerated below. Latin America is replete with economies becoming “dollarised”. As domestic nationals lost faith in their own currency as a store of value, they shifted into and began transacting in US dollars for the security and stability it accorded. What this did was to render domestic monetary policy ineffective, because domestic

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Sajjid Chinoy, Chief Economist JP Morgain India in this Indian Express article points to challenges cryptos will pose on mon and fiscal policy.

On mon policy, he says this will be akin to dollarisation where home central banks lose their importance:

For starters, how would monetary policy be impacted if a private digital currency was competing with fiat currencies? Think of this as “dollarisation” by another name, but with a crucial difference as enumerated below. Latin America is replete with economies becoming “dollarised”. As domestic nationals lost faith in their own currency as a store of value, they shifted into and began transacting in US dollars for the security and stability it accorded. What this did was to render domestic monetary policy ineffective, because domestic central banks cannot set interest rates and inject liquidity in a foreign currency. The greater the substitution into US dollars, the lower the potency of monetary policy. In effect, these economies were importing the monetary policy of the US Fed.

Widespread adoption of privately issued digital currencies as a medium of exchange will have much the same impact. The larger the monetary base they cannibalise, the less potent will be domestic monetary policy in responding to business cycle needs and external shocks.

In this speech, Fabio Panetta of ECB also spoke on how central banks will lose their monetary anchor which is cash.

What about fiscal policy? In backdrop of loss of mon pol, focus comes to fiscal policy:

What about fiscal policy? The implications are more straightforward. The greater the substitution into digital currencies the more the loss of seigniorage revenues to governments from the monopoly issuance of fiat currency. Separately, fiscal revenues can also be adversely impacted by the increased tax evasion opportunities that crypto-currencies can facilitate.

To the extent that increased substitution into cryptos reduces the efficacy of monetary policy, the onus on fiscal policy to respond to economic shocks will commensurately rise. This could create challenges in a post-Covid world. The pandemic has left a legacy of elevated public debt around the world. Fiscal policy, especially in emerging markets, will have the least space to act when it is most needed.

On external account, he says demand for bitcoins/cryptos will lead to money flowing out which is like capital outflows:

Finally, what are the implications for the Rupee? To the extent that cryptos are mined abroad, demand for them — whether for transactions or speculative purposes — will be akin to capital outflows. In turn, if cryptos begin to get mined onshore, they will induce capital inflows. These dynamics will increase capital account volatility and, to the extent that these cross-border flows circumvent capital flow measures, they de facto increase capital account convertibility, accentuating the policy trilemma that emerging markets confront.

This will also directly impact the currency market. As the 2021 Global Financial Stability Report underscores, there must exist a triangular arbitrage between, say, the local Rupee-Bitcoin market, the Dollar-Bitcoin markets and the Rupee-Dollar market. Consequently, changes in the Rupee-Bitcoin markets will inevitably spill over into the Rupee-Dollar markets for markets to clear.

In the end, policymakers need to prepare for the crypto future:

All told, the macro implications of widespread crypto adoption are complex and interlinked. For now, there is justifiable angst about growing household attraction for cryptos as speculative assets, with its attendant regulatory implications. But the true macro challenge will emerge and compound if and when unbacked private digital currencies are seen as viable mediums of exchange. That’s what policy must anticipate and prepare for.

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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