Crypto and the global financial system

Are we headed for financial anarchy?

The global financial system is something that humanity controls but doesn’t really understand. There are plenty of theories out there as to how the system works, but they’re all pretty abstract. And yet we have to have a global financial system, because without one, it’s very difficult to have international trade, international borrowing and lending, bailouts for countries in crisis, and a bunch of other stuff that’s necessary for the economy to function. So we set up rules and institutions without really knowing whether they’re optimal or when they’ll break down. It’s not surprising, therefore, that the system experiences crises and major disruptions every once in a while.

Recently, there’s been some talk of cryptocurrency disrupting the global financial system. For example, Balaji Srinivasan and Parag Khanna recently wrote an op-ed that got a lot of attention, in which they assert that cryptocurrency, along with other internet technologies, will disrupt the nation-state system itself. Here’s what they wrote about the financial aspect:

Already, national currencies compete with cryptocurrencies because individuals and institutions hold digital wallets filled with various assets that can be traded against one another…

We are about to enter an age of global monetary competition, where national currencies must earn their place in someone’s wallet portfolio every hour of every day, even among citizens of their own countries. The digital version of the Japanese yen will be plunged into head-to-head global competition with the Swiss franc, the Brazilian real, and any other asset with an open capital account, including Bitcoin. Everyone becomes a foreign-exchange trader, all the time, and only the best national currencies—or cryptocurrencies—are ever held by anyone.

Rather than the current environment of unchecked inflation and competitive devaluation, the defi [decentralized finance] matrix imposes a new kind of discipline on national currencies, as billions of people make individual choices regarding which currencies to hold—or not hold.

Srinivasan and Khanna’s vision of the future is very different and more sophisticated than the traditional “Bitcoin maximalist” view. Briefly, the Bitcoin maximalist view is that because Bitcoin is artificially scarce and thus tends to appreciate rather than depreciate, it represents better money than inflationary fiat currencies, therefore people will switch from fiat to Bitcoin. This is wrong because what people want out of their money is not long-term appreciation but rather short-term stability; that’s why no one uses gold, Apple stock, or Bitcoin to buy a loaf of bread or a gallon of gas.

But crypto isn’t just Bitcoin anymore. Indeed, Bitcoin itself may eventually become a sort of beloved obsolete appendage of the crypto world, as more sophisticated systems (Ether, Solana, etc.) exploit more of the technological potential of blockchains. Srinivasan and Khanna actually envision government-supported cryptocurrencies competing with each other. And out there in the market, stablecoins are blurring the line between fiat and crypto.

Given this technological ferment, it’s worth asking how crypto might change the global financial system. Which is a difficult thing to ask, because not only do we not know what crypto is doing right now, let alone what it’ll be doing in 20 years, there’s plenty we don’t even know how the global financial system works in the first place!

But we can certainly start…um…speculating.

The status quo: Bretton Woods II

First, let’s talk a little bit about how the global financial system currently works (we don’t know everything, but we know a few details). Usually there’s a “reserve currency” — one currency that the central banks of most or all of the major economies keep a lot of in reserve. They do this for two reasons: First, because it makes international transactions easy; globally traded commodities like oil are typically priced in dollars. Second, if a country has a financial crisis, it can sell those reserves to stop its currency from crashing, so it can keep importing necessities. The reserve currency thus functions as both a facilitator of global commerce and as a safe haven.

In the 19th and early 20th centuries, it was the British pound. Right now, it’s the U.S. dollar. This system is sometimes called “Bretton Woods 2”, which is a reference to the postwar Bretton Woods system in which major economies agreed to use dollars as the reserve currency. Bretton Woods was scrapped in 1973, and the dollar share of global currency reserves plummeted from around 84% to around 46%. But the dollar made a comeback in the late 90s and early 00s, rising back above 70%. Hence, “Bretton Woods 2”.

Since the mid-00s, however, the Bretton Woods 2 system has come under increasing pressure. The main cause is the rise of China. As China’s economy grows — it’s now either bigger than the U.S. or almost as big, depending on what measure you use — its potential to either suck in capital from overseas or send capital overseas becomes larger. For example, China exported a ton of capital in the 00s when its central bank bought a ton of U.S. bonds (in order to keep its currency cheap and pump up exports). It also exported a ton of capital in 2015-16, when a bunch of investors moved their money out of the country following a stock market crash.

Those capital flows have to be absorbed by the U.S. economy, which no longer dwarfs China’s the way it used to. And that can be destabilizing. Chinese capital inflows during the 00s are sometimes blamed for the U.S. housing bubble, for example. The dollar’s reserve currency status also causes the U.S. to run persistent trade deficits — everyone wants to hold dollars, so demand for dollars goes up, dollars get more expensive, and U.S.-made goods thus become unaffordable in world markets.

The less dominant the U.S. economy is, the less the dollar can function as a stable anchor for the global financial system. It was still intact in 2008-10, when a global financial crisis sent capital flooding to the safe haven of U.S. government bonds. But in recent years, people have begun to question whether Bretton Woods 2 is finally on the way out. The share of U.S. dollars in global reserves has been falling for years, and this fall has accelerated since the start of the pandemic.

But what can replace Bretton Woods 2? The obvious answer would be for the Chinese yuan to either take over as reserve currency the way the dollar took over from the pound, or to share duties with the dollar and euro. But China seems to have zero intent of ever relaxing its capital controls and allowing the world to buy as much yuan as they like. That means the yuan can’t fill the dollar’s shoes.

So this might someday open the door to cryptocurrencies acting as reserve currencies in some respect. Probably not this year, maybe not this decade, but perhaps in 20 years? Even more radically, crypto might do away with the need for a reserve currency at all.

Stablecoins, the dollar, and the new reserve currency

One big innovation in crypto is the stablecoin. The most famous of these is Tether, but USD Coin is also gaining popularity, and there are a bunch of others as well. Stablecoins are cryptocurrencies whose value is pegged to the value of a fiat currency (actually there are some different kinds, but Tether and USD Coin are this kind). That means that 1 Tether or 1 USD Coin is always supposed to be worth US$1.