Dario Perkins of Lombard St Research got me thinking about whether Bitcoin – or some other digital cryptocurrency – would obviate the need for or possibility for a lender of last resort. Without implicating him in any bad thinking here, what follows came out of our conversation.
Some [for example, see this by Axel Weber] see that the impossibility of a lender of last resort will prevent Bitcoin from becoming, or being allowed to become the medium of exchange/unit of account.
Others relish a future in which Bitcoin replaces fiat currency precisely because it eliminates the evil lender of last resort function operated by a corrupt, meddling and misguided state, a step towards a libertarian utopia.
To progress, here are two scenarios in which fiat currency is displaced by digital.
One scenario is that central banks pre-empt a crypto currency takeover by supplying their own digital currency. They offer digital accounts at the central bank to individuals and firms. Paper currency is withdrawn or withers. As central bankers have recognised, this may well entirely disintermediate private banks.
However, there will still be the same job to do that exists in the fiat currency economy of intermediating between those who have funds to save, and are happy to postpone consumption until tomorrow, and those who have projects to finance and need funds today, but who cannot raise equity or issue bonds directly.
Banks will finance lending by issuing equity themselves, or selling non-retail-deposit bonds, and borrowing wholesale at short maturities from the same counterparties as they do now. Just as now, those institutions will be undertaking maturity transformation, making money out of it, but taking risks in so doing for themselves and the wider financial system.
Is there a motivation for LOLR in this economy? Is it possible if there is?
There is a motivation for LOLR. For starters, it’s entirely possible to envisage a run on a maturity transforming bank here. And one that, because of interlocking exposures to those who are engaging in risky investment projects, could bring down all the banks. [Let’s plausibly assume away the possibility that central banks can figure out how to eliminate systemic risk]. Although the payments system will not collapse – one of the fears in the face of a bank run in a fiat currency system – since payments in currency are transacted across the central bank balance sheet, there is still a risk of a systemic collapse in credit.
Is a LOLR possible? Of course. The central bank/government makes a loan of digital currency to the ailing bank or banks, financed by either creating new digital currency, or selling government debt.
In a second scenario, a private cryptocurrency like Bitcoin takes over as the unit of account and medium of exchange.
Is this economy, banks operate just like banks do now, intermediating between those who have BTC to lend, and those who need it. Just like now, they take risks and transform maturity. Just like now, there is a possibility of a bank run. I might find it profitable to ‘deposit’ my BTC in a bank by temporarily signing it over to them on the distributed ledger. And they will ‘lend’ the funds by signing over my BTC to an entrepreneur. If I get spooked by rumours about my bank, I will call them, asking them to transfer back my BTC, and, if enough others do the same, they will refuse. If banks have interlocking or common exposures, one bank failure will be the harbinger or the trigger for others, motivating lending in the last resort.
In this economy the central bank can’t create the medium of exchange. [That’s why some people like it so much]. BTC is a private construct, and whose creation is governed by an agreed protocol. But the central bank is not powerless. For starters, unless the entire world is in the grip of a liquidity shortage [this was not true even in 2009] the consolidated central bank/govt can issue debt, obtain BTC from those who are not short of it, and lend it to a bank that is. This is a lender of last resort function that is proscribed to some degree, but it is not so far removed from the actual LOLR in Western economies. That function is usually not wielded independently of the Treasury; and there is an expectation that the inflation target that pins down monetary policy is to be adhered to. So LOLR operations are not monetary financing, and since they are fiscal operations, they happen with the consent of the fiscal authority.
LOLR under private Bitcoin carries a risk of deflation to the extent that the loan is large relative to the global market [or rather the sum total of such operations across the world is large]. In that case the central bank/govt debt issue will bid up the value of BTC relative to goods, which is what deflation means in this economy. And that could make the credit crisis they are fighting worse. [For example if I take out a loan that requires me to repay a defined quantity of BTC, yet my wages are regularly renegotiated, then a deflation will reduce my wages in BTC, raising the real value of my BTC loan, making me more likely to default, impairing my bank’s balance sheet, etc].
So, in sum, it’s possible to imagine digital currencies, private or public, coexisting with banks that fail, and may have to be loaned to by the public sector; and ways in which that can happen effectively. We can get rid of the lender of last resort function if we want, but proactively supplying digital currency, or allowing it to take over, won’t achieve it for us. Nor should we avoid going digital because we think LOLR will be impossible.