Cryptocurrencies: The Classic Problems of Inside and Outside Money

Cryptocurrency is new in some ways, but in other ways, if it’s going to be “money” then it will share some of the problems of money in the past.

Daniel Sanches discussed the traditional division between “outside” and “inside” money, and the inherent flaws of each one, in “New Moneys in the Digital Era” (Economic Insights: Federal Reserve Bank of Philadelphia, Q2 2023, pp. 2-10).

“Outside money” refers to money that is either not backed by anything (“fiat money”) or backed by something that is not a liability for anyone in the private sector, as in the case of money backed by government-held supplies of gold. “Inside money” is created “when two private parties engage in a transaction that involves the issuance of a liquid debt claim (that is, a claim that can circulate as a medium of exchange).” For example, when the two parties are me and my bank, and I deposit money in the bank, then we have created inside money that can be used to buy. Sanches writes:

To sum up, in the modern monetary system, central banks control the amount of outside money created in the economy, and private financial firms issue inside money to facilitate private transactions. Inside money is usually a promise to pay outside money, and each dollar of outside money is backing several dollars of inside money.

The classic problem with outside money arises when the quantity available of such money doesn’t adjust to economic conditions. For money to work well as a medium of exchange, it needs to have a (roughly) fixed value–that is, not much inflation or deflation. But there are historical examples (during the gold standard, the Great Depression) where the US economy dramatically slowed down because the supply of outside money was limited or declined, which caused the economy to slow as well.

Some major cryptocurrencies like Bitcoin have an outside money problem. The quantity of these currencies in circulation is governed by the software behind the currencies themselves (that runs the “blockchain). As a result, the quantity of these currencies can’t adjust to demand. When demand goes up or down, the price of Bitcoin also zooms up or down. If you are serious about having money that has a more-or-less stable value, then this inability to adjust to demand makes Bitcoin unsuitable as money. Sanches writes: “Based on the accumulated experience and the theoretical research in monetary economics, it is hard to believe that any existing cryptocurrency will soon emerge as a sound monetary system, as opposed to a speculative investment vehicle.”

Some cryptocurrencies instead have tried to be inside money. For example, a “stablecoin” is a cryptocurrency backed by a US dollar-denominated financial asset. The quantity of this currency can rise if the market so desires–just buy more financial assets to back the new currency. It can also contract if the market so desires. However, there is no regulation or guarantee of exactly what assets are being used to back these stablecoins. Are the assets something very safe and easy to sell, but with a low rate of return, like US Treasury bonds, or something riskier which pays a higher return? Sanches writes:

In reality, it is not clear what types of assets stablecoin issuers hold as collateral for their tokens. Many stablecoin issuers claim that their tokens are fully backed by U.S. dollars, but the issuers do not specify the types of dollar assets it holds, so it is not clear whether all dollar assets backing stablecoins are safe assets, such as bank deposits and government bonds, or risky assets, such as commercial paper. No regulatory mechanism verifies the types of assets and corresponding balances in custodial accounts.

As a result of this kind of uncertainty the issue for inside money stablecoins is bank runs. What happens if investors fear that the financial backing of the stablecoin is insufficient, and start pulling out their money? Sanches tells the recent story:

The recent run on two major stablecoin issuers demonstrates the problems associated with creating inside money outside of the regulated financial system. TerraUSD is a stablecoin hosted by the Terra Network and created by South Korea’s Terraform Labs. Investors were attracted to TerraUSD because they could earn returns of nearly 20 percent annually by lending their TerraUSD holdings via Anchor Protocol, a decentralized bank for crypto investors. Until May 2022, TerraUSD’s value remained very close to $1, as intended by its issuer, and it was the third-largest stablecoin, with a market capitalization of $18 billion. But on May 9, its value declined suddenly to 90 cents following large withdrawals from Anchor Protocol. As in a typical bank run, the initial withdrawals on May 9 led to further withdrawals, and within a few days TerraUSD was trading at approximately 20 cents. TerraUSD has not recovered from that crisis and, as of the writing of this article, was trading at roughly 2 cents.

If you are a short-term investor looking for newfangled financial assets that might make big moves up or down–so that you can capitalize on these changes–crypto makes sense. But if these kinds of financial instruments are going to eventually become a form of money that is in widespread use, these classic problems need to be addressed. Sanches sums up this way:

It is likely that in the not-so-distant future, our money will be entirely digital, and cryptocurrencies will likely play an important role in this new monetary system. However, this transition will inevitably be slow and bumpy, requiring both experimentation and prudence. At the very least, a stable cryptocurrency standard requires that unbacked digital tokens—which are, despite their novelty, just another outside money—acquire the properties of an elastic currency, as defined in this article. And without government regulation, such as a requirement that stablecoins be fully backed by short-term government bonds, digital tokens that take the form of demand deposits via currency pegs—which, despite their novelty, are just another inside money—are likely to suffer runs.