A Facebook announcement on June 18 that it is sponsoring the non-profit Libra Association to launch the blockchain-based digital currency, Libra, in 2020 has opened a Pandora’s box on the digital currency dollarization challenge to existing national currencies.
In contrast to the laid-back attitude on bitcoin and other cryptocurrencies, the response of regulators in the US and Europe was swift. They criticized the idea and threatened regulatory sanction against Facebook and other members of the Libra Association if they will launch the digital currency without first securing approval from regulators.
The fierce public regulatory pushback forced seven of the 28 original members: Paypal, Mastercard, Visa, eBay, Stripe, Mercado Pago and Bookings Holding to back out from the Libra Association before its first board meeting last October 15.
The high-profile defections have not deterred Facebook from pushing Libra. The company is stepping up lobbying work in Washington as well as continuing its development work on Libra. The Libra Association appointed its inaugural five-member board of directors in Geneva also last October 15 and a former PayPal executive, Bertrand Perez, was named the interim managing director.
The association announced that 1,500 organizations had expressed interest in joining the project—where 180 of those meet eligibility requirements to become members. The new crop of potential recruits could help the Libra Association to reach its 100-member goal ahead of the original scheduled 2020 launch; the launching timeline, however, now looks likely to be delayed by intense regulatory pushback and the possibility that regulators might kill the project outright is looming.
The structure of Libra as a digital currency with issuance fully backed by liquid asset denominated in reserve currencies makes it a valuable reserve-backed digital currency with inherent value anchored on the underlying reserve currencies. The arrangement is similar to the direct convertibility of the US dollar to gold under the Bretton Woods system before the Nixon suspension on August 15, 1971.
The only difference between the US dollar before 1971 and the proposed Libra is that the US dollar was then backed by gold convertibility promise, while Libra is supported by its underlying reserve currencies. The full reserve currency backing feature immediately sets Libra apart from most of the other national currencies, which are fiat money with backing based on the faith at the government issuing it.
The blockchain-based technology run by the centralized Libra Association also minimizes issues such as money laundering, tax evasion and terrorist financing challenges. The digital currency’s full backing feature limits the risk of over-issuance and relieves its holders from worry over debasement problem arising from concerns such as quantitative easing. The digital feature also significantly drops transaction cost in using it as a medium of exchange and improves the inclusiveness of the financial systems among the poor.
The exemplary features of Libra exposed the weakness of the current global currency system and raised many issues as well. Foremost of which is whether a private organization such as the Libra Association should be allowed to act as “a de facto central bank” in managing the digital currency and how Libra will affect the ability of the different central banks in conducting monetary policies in the modern world.
The historical lesson that we learned in the 1930s Great Depression and the 2008 Global Financial Crisis is that the fiat money system allows monetary expansion, and enables Keynesian economics to create demands to solve the aggregate demand collapse crisis triggered by economic shocks. If the world is reverting to reserve backed money creation system, the current economic structure will face adjustment issues as species backing such as gold are insufficient to meet economic expansion demand. And if the reserve backing is anchored on a selection of reserve currencies, these reserve currencies will assume “the exorbitant privilege” of the US dollar and come to dictate to the world.
In the 1944 Bretton Woods conference, Keynes of the UK proposed a global monetary system run by a global currency issued by a supranational body such as the IMF. His co-convenor, Harry White of the US, promptly rejected the idea and insisted on using the US dollar anchored on the promise of convertibility to gold, at a fixed rate of 35 US dollars per ounce of gold, as the anchor of the post-war monetary system. The move started the exorbitant privilege of the US dollar since the end of the World War 2.
For most developing countries whose money does not enjoy reserve currency status, the debut of Libra raises the lurking possibility of “digital currency dollarization.”
Dollarization is the term used to describe the situation when a foreign currency is used in addition to (or instead of) the domestic currency as legal tender in a country. This process can also be called currency substitution and since the US dollar is the predominant foreign currency to be used, hence the term currency dollarization. Dollarization does not always involve the US dollar as the adopted foreign currency. The euro has also been adopted by four non-EU European member countries such as Monaco and 14 African countries as their domestic currency.
Dollarization usually occurs in developing countries with a weak central government that fails to run a credible macroeconomic program, or that has an unstable economic environment, or one that is undergoing rampant inflation. The advantage for dollarization includes: greater price stability derived from the stable value of the foreign currency over a country’s domestic currency, a firm basis for a more efficient and sound financial sector and a lower interest rate. The downside of dollarization includes the loss of monetary autonomy, seigniorage and greater vulnerability to foreign influence, in addition to the surrendering of an important national symbol.
If Libra is allowed to come to the market, the enormous installed base of Facebook enjoys the advantage of network effects, besides the convenience of digital transaction, near-zero digital transaction cost and higher user trust on social media companies than banks in developing countries. All these help in spreading currency usage. The moving away from the national currency will pose a severe challenge to the economic regulating power of the monetary and fiscal authority of the developing countries affected. In economics, there is a phenomenon named Thiers’ Law that describes the risk of good money to drive out bad money as the case of Libra.
The potential disruption raised by Libra is now a challenge to central banks around the world, be it developed or developing countries. How to handle disruptions brought by digital technology disruption will test the ability of the central bankers. Whether Libra will debut in 2020 is not an issue anywhere, as there is little doubt that digital currencies such as the central bank digital currency will surface sometime in the future and that reserve-currency issuing country will likely take the lead. Developing countries’ central banks will face digital currency dollarization threats earlier than what people would like to believe. Central bankers should realize that financial crises often happen in tandem with financial innovations; and they must make sure that the new financial technology will not trigger another crisis.
Dr. Henry Chan is an internationally recognized development economist based in Singapore. He is also a senior visiting research fellow at the Cambodia Institute for Cooperation and Peace and adjunct research fellow at the Integrated Development Studies Institute (IDSI). His primary research interest includes global economic development, Asean-China relations and the Fourth Industrial Revolution.
New Worlds by think-tank Integrated Development Studies Institute (IDSI) works with a global network of institutions studying innovations and events to propose integrated, implementable frameworks. It is non-profit, not politically aligned, emphasizing rigor and practicality (email@example.com).