On May 9th, 2019, Representative Bradley Sherman, member of the House Banking Committee, made an impassioned speech in Congress about cryptocurrency. In his speech, the mask typically worn by policymakers slipped: his words betrayed the threat that cryptocurrencies pose to the state.
CoinDesk columnist Nic Carter is a partner at Castle Island Ventures, a public blockchain-focused venture fund based in Cambridge, MA.
He is also the cofounder of Coin Metrics, a blockchain analytics startup.
“An awful lot of our international power comes from the fact that the dollar is the standard unit of international finance and transactions. Clearing through the NY Fed is critical for major oil and other transactions, and it is the announced purpose of the supporters of cryptocurrency to take that power away from us, to put us in a position where the most significant sanctions we have on Iran for example would become irrelevant.”
But does cryptocurrency really pose a threat to America’s monetary dominance? I’d like to propose an alternative. Far from compromising the dollar’s mighty advantage internationally, cryptocurrency, and the infrastructure built to support it, may well entrench its position. To assess this possibility, one must understand cases where the dollar has already infiltrated foreign countries. This is commonly called dollarization.
Dollarization refers to the process of adopting a foreign currency (typically but, confusingly, not always, the US dollar) in lieu of a local sovereign currency. It happens both in an informal, bottom-up way, and a top-down manner, when the local central bank capitulates and adopts the dollar as legal tender. The bottom-up model occurs in a spontaneous manner, as citizens flee a depreciating local currency and adopt the dollar, even when dollar holdings might be criminalized or where capital controls exist. In some cases, this kicks off a feedback loop, further depreciating the local currency, and forcing the hand of the central bank which capitulates and officially adopts the dollar standard. The monetary economist Lawrence White calls this dolarización popular.
The Educador dollarization phenomenon in 1999-2000 is a prime example of individuals freely making economic choices which overpowered their local government monopoly.
In White’s words:
The dollarization of Ecuador was not chosen by policymakers. It was chosen by the people. It grew from free choices people made between dollars and sucres. The people preferred a relatively sound money to a clearly unsound money. By their actions to dollarize themselves, they dislodged the rapidly depreciating sucre and spontaneously established a de facto US dollar standard.
Currently, several countries have entirely abandoned monetary discretion and outsourced this task to the U.S. The largest among these, the so-called fully dollarized states, include Ecuador, Panama, El Salvador, the British Virgin Islands, and a smattering of other mostly island nations. However, many countries are also soft-dollarized; that is, dollars widely circulate in the economy as a preferred form of hard money. Soft dollarized countries may have a soft or crawling peg relative to the dollar or may not treat it as legal tender at all; regardless it has widespread usage due to its desirable properties. Countries in this category include Venezuela, Argentina, Cambodia, Costa Rica, Honduras, Iraq, Lebanon, Liberia, Somalia, Uruguay, Zimbabwe, and many others.
In these countries, dollars are understood as a superior form of money and active measures are made to import and retain them. Indeed, visitors to Costa Rica will know that it’s common to pay for goods on the street with dollars and receive change in the local currency, the colón. This is essentially the inverse of Gresham’s law. This phenomenon is sometimes referred to as Thiers’ law – the idea that, when given the choice, transactors will generally prefer to receive a harder rather than a softer currency.
Dollarization events generally follow specific catalysts: in Ecuador, users adopted the dollar in response to the devaluation of the sucre following a banking crisis, and the government ultimately capitulated. Cambodia’s effective dollar economy was kickstarted by the flow of capital into the country after the UN intervened in 1992 following the reign of the Khmer Rouge. Following the collapse of the Soviet Union, virtually the entirety of Eastern Europe, the Baltics, the Caucuses, and Central Asia dollarized in a partial way, with the dollar penetrating 20-30 percent of the money supply in these regions in 1993, and growing to the 30-40 percent range in 2001 (Havrylyshyn 2003). In the wake of political and monetary collapse in Venezuela, the country is now at least 50 percent dollarized. Panama officially dollarized in 1904 when they seceded from Colombia and the U.S. began their decade-long canal building project in the country. Generally, ready access to dollars and a trade relationship with the U.S. is a necessary condition for successful dollarization, which explains why so many dollarized countries are in Latin America or states with current or prior U.S. influence.
Opinions differ on the track record of dollarization. Free market economists tend to like it and the IMF and Bank for International Settlements tend not to. Key datapoints point to its success as a policy, however. The Misery Index, popularized by economist Steve Hanke, combines interest rates, inflation, unemployment, and GDP growth rates to derive a unified economic quality of life score. Venezuela and Argentina top the global misery index thanks to ruinous inflation (Venezuela has held that ignominious title for four straight years); Brazil is fourth worldwide. Their local neighbors Panama, Ecuador, and El Salvador (all dollarized) rank best – i.e., least miserable – for Latin America, and fall in the middle of the pack globally.
There is good evidence that abandoning an inflationary currency and establishing a dollar standard tends to index local inflation to the (generally low) U.S. rate, increase foreign domestic investment (thanks to an elimination of exchange risk), and increase local lending and financial sector activity. Hanke describes dollarization as a means to import property rights and rule of law from better-governed countries (with the implication that devaluation is an unfair confiscation from savers). Perhaps most importantly, it entirely eliminates monetary discretion from the hands of the government, forcing them to rely solely on fiscal policy. Irresponsible monetary policy and reckless spending is normally the reason countries are forced to dollarize, after all. This monetary straightjacket is part of the reason governments often rebel against the policy, only adopting it in dire circumstances.
Today, the dollar accounts for about 60 percent of foreign exchange reserves globally, and denominates about 70 percent of international trade, even in cases where neither counterparty is U.S.-based. Money doesn’t just possess network effects: money is a network. Dollarizing tends to reduce frictions in international trade, as transactions no longer require a forex component. Despite its apparent benefits, however, dollarization is no panacea. Through the banking system, the state still ultimately exerts control over depositors.
Zimbabwe in an indicative case study. In response to hyperinflation, the government officially dollarized in January 2009 – but following this decision, U.S. dollars became virtually absent from the transactional economy. The reason? According to American Institute for Economic Research, the Zimbabwe government essentially confiscated dollars in bank accounts by forcing commercial banks to swap dollar deposits for “Zimbabwe bonds.” After ATMs and banks stopped dispensing cash, a mismatch between these electronic pseudo-dollars and the value of physical dollar banknotes developed. These unbacked bond-dollars ended up trading at a discount to par.
“For people working in the formal economy – accountants, retail workers, engineers and so on, everyone now uses electronic dollars, which are simply represented by numbers in a bank account. These electronic dollars are worth about half what a U.S. dollar is worth on the street, according to local observers.”
American Institute for Economic Research
Argentina’s pseudo-dollarization in the early 90s is another telling example. As Steve Hanke documents, Argentina’s pledge to peg the peso to the dollar ended up being a ploy to confiscate deposits from savers:
“Under the convertibility system, which was established on April 1, 1991, the government made an explicit redemption pledge. Each person who owned an Argentine peso was guaranteed the right to convert a peso for a U.S. dollar. … When the Convertibility Law was revoked by decree on January 6, 2002, the peso was devalued; the peso was allowed to float; and the redemption pledge was rendered null and void. In consequence, the government confiscated $17.8 billion of central bank reserves that had been the property of people who held pesos at the time of the devaluation.”
So historically, the potential for confiscation of dollar deposits in the banking system by capricious governments has interfered with dollarization. Since holding cash is risky and difficult, depositors rely on banks. But if banks are a confiscation vector, merely dollarizing doesn’t do savers any good. Interestingly, the crypto world may well offer a solution in the form of cryptographic, dollar-denominated bearer assets.
These are commonly referred to as “stablecoins”: crypto-assets serving as an IOU representing a dollar in a bank account (with a convertibility promise). They freely circulate on public ledgers and are generally unconstrained. They can be sent without restriction to a digital wallet in just the same manner as bitcoin. And importantly, stablecoins represent a base monetary asset which can be directly held by an end user, rather than a financial institution on their behalf.
The insurgent crop of stablecoins represent a possible vector for a crypto-dollarization phenomenon. Piggybacking on the infrastructure built to support public blockchains like bitcoin and ethereum – and circulating on those protocols themselves – stablecoins have achieved apparent critical mass. According to Coin Metrics, the largest stablecoin, Tether, has a monetary base of $4.5 billion and an annualized on-chain transaction volume of around $200 billion. That’s a monetary velocity of about 44 – meaning each unit of Tether changes hands, on average, 44 times in a given year. This compares to velocity figures of about 5 for bitcoin, 6.2 for ethereum, and 5.5 for M1 Money Stock in the U.S. While this is a rough science, it’s quite apparent that stablecoins are used in a transactional manner while their non-fiat-denominated cryptocurrency counterparts turn over less frequently.
The growth of bitcoin, and subsequently other monetary protocols like ethereum, has also funded, as a side effect, a global industry of exchanges, hardware and software wallets, and financial services which stablecoins are now leveraging to reach a mass market audience. New keyless setups mean that users no longer need to write down a 24-word seed phrase or a private key; they can simply control their wealth with biometrics and a smartphone. The emergence of hundreds of local exchanges and ‘fiat onramps’ means that crypto-assets are ubiquitously available, even in frontier markets. And the budding crypto-financial ecosystem gives users a reason to transact with and hold these assets.
Now, stablecoins rely for the most part on trusted issuers and administrators who must hold dollars in a bank account somewhere. This counterparty risk accompanies all of the dollar-backed coins, and may ultimately be their undoing. But these are private banks, generally outside the jurisdiction of states that may object to their issuance of private money. Regulators may also realize, to their horror, that the interior of the stablecoin transactional graph is mostly un-surveilled, as JP Koning has pointed out. Issuers appear to be following an informal don’t ask (users), don’t tell (regulators) policy. This could prove unsustainable.
However, newer issuers like Libra, should they pass through the regulatory gauntlet, offer a potentially more salubrious, mostly dollar-backed product. Regardless, the crop of dollar-backed coins is growing at a hefty clip. The implications for U.S. policymakers should be clear. Far from compromising the dollar’s mighty advantage internationally, cryptocurrency, and the infrastructure built to support it, will most likely entrench its position. Clearly, individuals living with inflationary currencies have a demonstrated demand for (relatively) hard money, and a hodgepodge of private issuers have begun to fill this need by creating crypto-eurodollars. Instead of fearing this, policymakers would do well to evaluate this phenomenon and its potential implications for U.S. soft power.
Why am I writing this now? Two reasons. First, I was startled to discover that LocalBitcoins traders in Venezuela were using bitcoin not simply as a means of mere exposure to BTC, but also as a passthrough currency in order to more easily import dollars into the country. Second, stablecoin transactional volumes have taken off, to the point where they have eclipsed every cryptocurrency aside from bitcoin in on-chain transactional value. It may well be the case that the crypto industry’s most impactful contribution in the near term is to near-frictionlessly distribute dollars on a direct-to-consumer basis to the world’s population – whether their governments like it or not.