Context

Facebook announced launching a cryptocurrency called Libra, designed to appeal to its global user base of over 2 billion. 

Libra

• It will be backed by a basket of fiat currencies. 

• It is supported by a consortium of large-scale corporate houses, financial services firms, and venture capitalists. 

• Millennials have little patience for expensive traditional banking methods for cash transactions. They would likely flock to alternatives like Libra.

Impossible trinity

• It is the “trilemma” of monetary policy. It states that it is impossible to have all three of the following conditions fulfilled at the same time: 

  1. a fixed foreign exchange rate

  2. free capital movement

  3. an independent monetary policy 

• Even before cryptocurrencies, governments looking to control the monetary aspects of their economies have been subject to this trilemma, and have been forced to implement only two of the three conditions.

• If you want control over both your exchange rate and monetary policy, you would have to impose controls on free capital movement. 

• Hence the existence of capital controls such as India’s Foreign Exchange Management Act.

• The trilemma is a theory based on the “uncovered interest rate parity condition”.

• It is supported by evidence-based studies where governments that have tried to simultaneously pursue all three goals have failed. 

• Uncovered interest rate parity condition means that if a dollar can only fetch a 1% rate of return in the US, but 6% in India, investors are bound to move from dollars to rupees. The reason they don’t is that the differential of 5% will likely reduce to zero as a result of a slide in the rupee’s value to the extent of its current interest differential against the dollar.

• Strong capital controls have meant that other means of payment have been in use before, such as the infamous “hawala” system. 

• The ease of use and the scope of new Big-Tech cryptocurrencies are about to create global currencies of a completely different class. 

• Economists argue that such currencies will affect the exchange rates and monetary policies of traditional currencies. This is because the introduction of a global digital currency removes the capital control levers that sovereign nations have today.

A case

• If we assume a two-country system, both using their own national currencies as well as a global cryptocurrency.

• Assuming markets are efficient and complete, and that the global cryptocurrency is freely used in both countries, they show that the interest rates in both countries must necessarily be equal, and the exchange rate between the two countries becomes a “martingale” – the best predictor of tomorrow’s value is today’s value.

• This adds a further restriction to the impossible trinity, making it a dilemma. 

CONCLUSION

Thus the advent of Big Tech cryptocurrencies means that countries would have one less lever to pull.