In a blog post earlier this week I briefly argued that “government-controlled
cryptocurrency” was a contradiction in terms. It depends on what is meant by
“cryptocurrency”, but now that I’ve done some more research on the subject I
understand how a central bank could make use of blockchain technology and why
the government would want to implement a type of cryptocurrency.
My understanding of the subject was improved by reading the white paper on the “Fedcoin” published a few months ago
by Yale University. I also read about the difference between “permissioned” and “permissionless” blockchains.
As a result, I now understand that a blockchain is a data structure that can
be either distributed, as is the case with Bitcoin, or centrally controlled,
as would be the case with a “cryptocurrency” issued by a central bank.
I also understand how the commercial banks could profit from the advent of
a centrally-controlled cryptocurrency. This is an important consideration
because the way the world currently works it is unrealistic to expect the
introduction of a new form of official money that would result in
substantially-reduced profits for the major banks.
The Fedcoin paper linked above lays out how a state-sponsored
cryptocurrency could work. Here are some of the salient aspects:
1. The system comprises a central ledger of all transactions (the blockchain)
maintained by the Fed, nodes (commercial banks) and users (anyone who wants
to spend or receive a Fedcoin).
2. A user of Fedcoins must have an account at the Fed. Opening an account
would involve providing the KYC (Know Your Customer) identity information
that anyone who has dealt with a financial institution over the past few
years would be familiar with.
3. Users would have digital wallets that held encrypted funds and all
transactions would have to be digitally signed, so in this respect the term
“cryptocurrency” would apply. However, the Fed and the government would be
able to determine the identity of the users involved in any/every transaction
(due to item 2 above), so the encryption would not result in genuine privacy.
Moreover, the government would have the power to “blacklist” a Fedcoin
account, effectively freezing the account.
4. Commercial banks (the “nodes” of the system) would maintain copies of
the central ledger and would verify transactions to ensure no double
spending. Also, all Fedcoin transactions would be announced to the network of
nodes.
5. The Fed would audit and allocate fees to the nodes, with bonuses going
to the fastest nodes. I suspect that the payments would be high enough to
make this a lucrative business for the nodes (the banks).
6. Nodes would send sealed low-level blocks to the Fed for incorporation
into high-level blocks that get added to the blockchain.
7. The Fed would guarantee that one Fedcoin could be converted into one
dollar. This would ensure that the Fedcoin had the same stability as the
dollar.
8. From an accounting perspective, a Fedcoin would be equivalent to a
dollar note. In particular, like physical notes and coins, Fedcoins would be
liabilities on the Fed’s balance sheet.
9. The Fed would have total control over the supply of Fedcoins, so the
advent of this cryptocurrency would not reduce the central bank’s ability to
manipulate the money supply and interest rates. On the contrary, the central
bank’s ability to manipulate would be enhanced, because it’s likely that the
Fedcoin would replace physical cash. Among other things, this would simplify
the imposition of negative interest rates should such a policy be deemed
necessary by central planners.
What would be the advantages and disadvantages of a government-controlled
cryptocurrency such as Fedcoin?
According to the Bank of England (BOE), digital currency could permanently
raise GDP by up to 3% due to reductions in real interest rates and monetary
transaction costs. Also, the central bank would be more able to stabilise the
business cycle.
The BOE’s arguments amount to unadulterated hogwash, for reasons that many
of my readers already know and that I won’t rehash at this time.
Clearly, the driving force behind a centrally-controlled cryptocurrency
would be the maximisation of tax revenue, in that the replacement of physical
cash with a digital system that enabled every transaction to be monitored
would eliminate a popular means of doing business below the government radar.
Fighting crime and promoting economic growth would be nothing more than
pretexts.
That being said, a currency such as Fedcoin would offer one significant
advantage to the average person, which is that people could do on-line
transfers and payments without having an account with a commercial bank. This
is because currency transfers could be done directly between digital wallets.
Also, an official cryptocurrency such as Fedcoin would offer some
advantages over Bitcoin, the most popular unofficial cryptocurrency. First,
Fedcoin would not have the Bitcoin volatility problem. Second, Fedcoin would
be vastly more efficient.
With regard to the efficiency issue, the Proof of Work (POW) aspect of
Bitcoin is a massive waste of resources (electricity, mainly). Furthermore,
Bitcoin’s inefficiency is deliberately built into the system to limit the
rate of supply increase. To explain using an analogy, the high and
steadily-increasing costs deliberately imposed on Bitcoin transaction
verification and the resultant creation of new coins would be akin to forcing
all gold mining to be done by hand, and then, after a certain amount of gold
was extracted, making a new rule that required all gold mining to be manually
done by crippled miners.
In a way, Bitcoin and the “altcoins” constitute a large and rapidly-expanding
Keynesian make-work project. Too bad that such projects result in long-term
wealth destruction.
Given the benefits that the government, the central bank and the most
influential economists (all of whom are Keynesian) would perceive, it’s a
good bet that state-sponsored cryptocurrencies are on the way. For the
private sector the introduction of such currencies would lead to cost savings
in the money-transfer area, but enhancing the ability of the government to
divert resources to itself and enabling even greater central bank control of
money definitely would be a barrier to economic progress.
