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Stable Coin: Economics Perspective

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Debunking 4 myths

Saw plenty of “opinions” on LinkedIn on stable coins and I’d love to debunk 4 myths of stable coins with facts and case studies.

1) Not An Illusion

Stable coin is not an illusion. Stable coin is a type of monetary policy a project chooses. For instance, to peg the cryptocurrency to something (e.g. USD).

When we talk about cryptocurrencies, we have to talk about the different types of monetary policy. One of them is fixing exchange rates. Other options are inflation targeting, price level targeting, mixed policies, etc.

Case in point:

(compare it to the fiat-world) You have countries like Panama, Ecuador, El Salvador using a 1:1 exchange rate with USD. For other countries, they peg their currency to USD like Belize, Barbados, Hong Kong, UAE. (Source)

2) Types of Monetary Policy

When we talk about international monetary policy, we have to mention the impossible trilemma. Basically, central banks/currencies have to choose 2 out of 3 options to create their currency. They are

  • fixed exchange rate

  • free capital flow

  • sovereign monetary policy

Many of the stable coins (e.g. USDC, Tether) collect 1 USD to create 1 USD equivalent of their token, hence the “stable-ness” relative to USD. This means they give up control of their own monetary policy.

This seems fine right now, but as the economy grows, monetary policy becomes very important because we are talking about inflation rates and interest rates (if any). If the stable coin is only controlled by the US-FED (external control), it is a risk for the internal environment to operate.

Case in point:

Greece crisis in 2012. Greece, being part of EU, had to give up their monetary policy control, and follow the ECB. Greece needed an expansionary monetary policy. But since it uses Euros and linked to the other Euro-nations like Germany, the expansionary policy suitable for Greece is NOT suitable for Germany at that time. Hence, Greece wanted to get out to resolve their economy.

Cryptoeconomics is all about the long-term sustainability of the project with minimal speculation.

If this were to happen in the stable coin universe in the foreseeable future as the internal economy grows, the dependent monetary policy will pose as a risk to the stable coin’s economy.

3) Stable doesn’t mean it does not change.

Stable means it is stable relative to something. E.g. gold, USD, GBP.

The point of stable coin is to reduce velocity of the currency, hence reduce the risk associated with it. A new technology (DLT, blockchain) is risky enough if we can mitigate the risk with stable coins, that is a huge bonus.

In our instant-gratification society, we want to see results now and fast. The fastest way to reduce velocity is to create a pegged 1:1 coin – my point #2.

There are other ways to create a more stable type of currency that works in the long-term. The downside: it takes time to perfect the monetary policy (mechanism design) & other tokenomics pillars.

4) “Stable coins don’t exist because fiat currencies are not stable.”

Okay… … but what do you mean by “stable”?

But there are other ways to create a stable currency using other monetary policy and nominal anchors.

*Quick crash course: nominal anchors in the fiat-world is what the government provides to increase stability to the economy at the expense of the government’s autonomy. They are the single variable to pun down the expectations of private agents (e.g. USD holders, token holders) about nominal price levels (not price levels less inflation).

Case in point:

USD does not have an exchange rate target. We learnt that from the failed Bretton Wood System. USD is also the global currency, so it doesn’t make sense for them to fix their exchange rate to something else. Instead, they use other methods, e.g. inflation rate targeting. US Fed does that. (Source) Bank of England does that too.

Conclusion

  • Stable coins are useful. It is real. It is not an illusion.

  • The idea of using a 1:1 peg is good in the short-term. For long-term success, I have my worries.

  • There are other ways to manage the monetary policy apart from exchange rate targeting.

Sources/Further reading:

  • General international macroeconomics: Feenstra, Robert C., and Alan M. Taylor. International

  • Macroeconomics OR Krugman, Obstfeld, Melitz International Economics

  • US Central Bank: https://www.federalreserve.gov/monetarypolicy.htm

  • EU Central Bank: https://www.ecb.europa.eu/home/html/index.en.html

  • UK Central Bank: https://www.bankofengland.co.uk

  • Bretton Woods System: https://www.imf.org/external/about/histend.htm

  • Inflation rate targeting using Fisher Effect: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=521402

  • Impossible Trinity: Oxelheim, L. (1990), International Financial Integration, Heidelberg

  • General Wikipedia page: https://en.wikipedia.org/wiki/Monetary_policy

  • Interesting area of further research: optimal currency area – optimal monetary and fiscal policy.

This article first appeared on LinkedIn.