The Collapse of Crypto - An Inevitable Decline for a Reserve Currency Contender?

The cryptocurrency bubble has finally popped. Crypto investors have been hit with large losses, FTX (a crypto exchange) has collapsed and arrests have been made; the world is filled with news articles about crypto being a fraud.

Whilst I will not go into the details of the technology of cryptocurrency, I will go into the economics of crypto and why there may be more to this story than meets the eye.

Crypto is supposed to be more trustworthy and reliable than keeping money in any one currency. If inflation increases in a particular country, crypto remains relatively unaffected. This also means that when governments engage in quantitative easing, i.e. pump money into the economy and decrease the purchasing power of the currency, crypto remains unaffected.

It is decentralised, not controlled by any one government, and this means that the purchasing power theoretically remains fairly stable compared to a hard currency. However, the value of crypto is volatile due to the speculative nature of not being backed by an asset, such as gold. Therefore, the value of crypto is solely based on what people believe it to be worth.

By comparison, the USD is the global reserve currency. People generally believe the USD is strong and will not experience any significant changes in value over time. However, the USD is also a speculative currency, not backed by anything and can be volatile in nature, as we have observed in 2022. The USD was on the gold standard until the 1970's, when the promise to turn USD to gold was removed and a fiat (non-backed) currency emerged.

Having reserve currency status is a significant advantage for a country, it allows that country to dominate financial markets. We have seen reserve currency status change many times throughout history, most recently the British Empire with the GBP, which was overtaken by the USD after WW1, due to the UK having far more war debt than the US.

Being the country with the world's reserve currency is a privileged status to hold. Countries with volatile exchange rates are eager to execute transactions in the most stable currency in the world. Purchasing government debt from the reserve currency country, in the form of bonds, is viewed as a sensible investment with minimal volatility to returns.

However, recently we have seen the alliance between Russia and China solidify. Both have been stockpiling significant quantities of gold, as they plan to launch their own currency in the future, backed by gold. Being on the gold standard is a lucrative incentive for countries looking to trade with a stable and reliable currency, which may prove enough to sway some countries away from using USD for transactions and towards using this gold standard currency.

Being backed by gold provides a significant advantage for this new currency, as it may be seen as more reliable and less volatile, therefore potentially presenting future competition to the US for their reserve currency status.

However, there is a third contender in the form of cryptocurrency.

Cryptocurrency is a threat to any government. It takes money out of their own country's economy and puts it in a place where it cannot be controlled, managed, etc. If everybody in the world suddenly switched to using cryptocurrency, governments would be unable to effectively manage the economy in the way that they currently can, i.e. by monetary and fiscal policy.

Central banks currently have the ability to print money (quantitative easing), tighten credit and subsequently control inflation. By having this control, it allows money/credit to flow freely around the economy when it is suitable, and enables tighter money control when necessary. Credit is not always a bad thing, having increased credit generally leads to more growth in the economy. When credit is invested suitably, it can help to fund businesses, which leads to increased innovation, new developments and an overall growth in GDP for the country.

The problem with cryptocurrency is that governments are not able to control it. By being unable to control the availability of money and credit in a country, the government is unable to control the economy. One of the main levers a central bank will use to control the economy is by using quantitative easing, aka printing money. When GDP growth is low, the government can print money to assist in increasing growth and production, which is beneficial for the economy. If inflation is too high, they can limit the availability and supply of money to control inflation. Therefore, cryptocurrency threatens to take away the most significant levers available to central banks in controlling the supply and availability of money and credit.

So, there are three horses in the metaphorical race for reserve currency status: The US, China/Russia and cryptocurrency.

To conclude, a country with the global reserve currency status will experience many significant financial advantages, which makes for a lucrative position to be in. Crypto poses the threat of not only being a contender for reserve currency status, but also the threat of removing a government's ability to even effectively manage their own economy.

I will finish this article by paying tribute to the unexpected and devastating deaths of three young cryptocurrency entrepreneurs during 2022: Nikolai Mushegian (29) on 28th October, Tiantian Kullander (30) on 23rd November and Vyacheslav Taran (53) on 25th November.