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How does crypto influence monetary policy?

Cryptocurrency has the potential to improve citizen welfare and encourage local investment, according to a new academic report.

The study led by professors from New York University asks the question: “How do private digital currencies affect government policy?"

And the conclusion — reached with the help of econometrics and a body of existing research — is that cryptocurrencies like Bitcoin can have a positive impact on the broader economy by restraining monetary policy and creating a more optimal allocation of resources.

But not every cryptocurrency is equal. The report builds on classifications from the SEC’s Analysis of Digital Assets to identify decentralization as the defining characteristic of a private digital currency:

"A digital currency is centralized if it has formal barriers to entry that prevent participation in the software writing and validation process of the network. This definition asks whether the code can be changed through some kind of consensus mechanism. If a party is not prevented from participating in the network or there is no one there to prevent that party from participating, then the network is decentralized."

Central Bank Digital Currencies — which act as instruments of monetary policy, and corporate stablecoins like Libra — where trust is placed in a company or consortium, are excluded by the definition. But private digital currencies like Bitcoin are identified as having real economic benefits.

Unwelcome competition

The paper suggests that decentralized cryptocurrencies have several advantages for the wider economy, but are currently limited by legal and regulatory barriers that prevent unwelcome competition with fiat currency.

"There are several legal barriers to private digital currencies. These barriers demonstrate why they have the potential to impact the sovereign’s monetary policy. Like all monopoly privileges, the rationale behind barriers to entry is to protect incumbents’ rates of return. With respect to monetary policy, barriers to competitive currencies prop up the central bank’s currency."

Legal tender laws are said to be one such barrier to realizing these benefits, along with cumbersome taxes like capital gains that make the use of Bitcoin, gold and other commodities as a medium of exchange more expensive.

The banking regulatory system — including money transmission laws and the Bank Secrecy Act — are said to disadvantage digital currencies by requiring cumbersome and expensive anti-money laundering and know-your-customer programs.

These regulations make it more difficult for cryptocurrency to compete with fiat, preventing the economic benefits from being fully realized.

Nevertheless, even if cryptocurrencies are not in mainstream use, the report suggests that they can still act as a check on "the inflationary monetary tendencies of the sovereign currency”, and generate "welfare gains" — economic speak for improving conditions for the common population.

Welfare gains

By offering an alternative financial system, the report suggests, digital currency imposes discipline upon monetary policy, reducing the government’s ability to devalue people’s funds by printing money.

This is especially valuable in corrupt countries like Venezuela, where there is "high volatility and a government that sets policy based on selfish interests rather than considering the welfare of citizens.”

By reining in monetary policy, and serving as a "hedge asset" for citizens, the report suggests that a decentralized currency may reinvigorate these stilted economies with fresh investment capital.

"The private digital currency serves as a hedge asset and therefore complements investment in the local economy. The increased investment effects are more pronounced when local investment returns correlate negatively with the private digital currency return."

With more funds invested, investors return higher yields, creating a positive feedback loop that results in more investment overall. This, in turn, is said to generate higher tax revenues for the government, creating a net economic gain.

For emerging market economies under corrupt governments, the report concludes, legalizing private digital currencies can be an optimal solution for everyone involved, and "is welcome both from the perspective of the individual and the government as it increases the total welfare of the nation."


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