[Feature] Tokenomics 5: Is the age of central banks over?

It’s no secret that much of what has fuelled the development of cryptocurrencies over the past decade is an opposition to government and regulation.

Cryptocurrencies are designed not to require a central authority: they are not issued by a centralised institution, and they function without rules set by any such institution.

Instead, each cryptocurrency has its own rules that control money supply and bookkeeping.

Indeed, there might be good reasons for this scepticism of central banks and traditional financial institutions. Regulators did not save the world economy from the 2008 housing crisis, when banks got so greedy for profit that they neglected to do their due diligence and made bad loans, only for taxpayers to foot the bill.

And this is not, by any stretch, the only case where central banks have received flak.

Mismanagement of money supply has resulted in people losing their life savings when hyperinflation hits, and capital controls have also meant that people are unable to move their money freely. And of course, the Federal Reserve’s interest rate policies have been widely criticised as a key reason for the developing banking crisis, as well as the failure of several crypto-friendly banks.

But what do central banks actually do? What is their purpose in the global and domestic economy? And does the recent spate of criticism and catastrophe suggest that the end of central banks as institutions are near?

Why do central banks exist, and what do they do?

Countries began to create central banks around the same time when paper money began to become widespread. Without a centralised bank to control the printing of banknotes, each bank printed its own banknotes. It was common for smaller banks servicing a particular region, called ‘country banks’, to issue banknotes to their depositors, with the promise that whoever held those banknotes could use them to redeem a certain amount of gold or silver that the bank held.

But while depositors could use these banknotes to pay for goods and services purchased in other cities and other regions, those accepting the notes would have to travel to the country bank to redeem the notes. As such, many began to accept the notes only at a discount, in order to cover the risk and hassle of such transportation.

Naturally, this was not a good deal for anyone- and central banks began to take over the issuance of banknotes, ensuring that all banknotes that were circulated within the economy were made redeemable at all banks within the country at face value.

Eventually, central banks also took on other roles- including as a lender of last resort for banks in the country, and as a financial regulator charged with maintaining the currency’s value, promoting economic growth, and ensuring financial stability.

Central banks are also supposed to be independent from partisan politics and political influence, and act independently- though how much they actually do so is often questioned.

As we can see, many of these goals are national goals- oriented around a particular economy, intended to achieve certain outcomes that a centralised government deems desirable.

So really, a central bank exists because it needs to serve a group of people, with certain objectives.

The automated central bank

In the Web3 world, cryptocurrencies such as Bitcoin are not controlled by any central bank- the amount of currency that is created is literally written into the program itself, with rules that will not change unless the community that controls it decides to change it.

Unlike central banks that set interest rates, capital controls, or exchange rate targets, cryptocurrencies often do not have such a target- instead, they are simply left to the market to decide.

How much Bitcoin, Ethereum, Cardano, Binance Coin, and even stablecoins like UST and USDC are worth only as much as the market values them.

These coins have no monetary policy to speak of in the traditional sense- there is not interest rate target to hit, nor capital controls to implement or enforce, nor exchange rate to maintain.

For most cryptocurrencies, making these changes would require a monumental effort in convincing a majority of their users that the changes would benefit them and the community.

As such, it can mostly be assumed that barring some significant event, the original code will remain the only code throughout the blockchain’s life.

The functions of a central bank, therefore, are automated- money supply follows ironclad rules, and exchange rates are free floating, while capital controls are essentially non-existent.

But is there really no problem when it comes to automating these functions? Let us take a closer look at the reasons behind central bank moves- and why certain outcomes are considered desirable for a national economy.

Are we ready for a world without central banks?

Firstly, a national economy is often geared for economic growth- as such, an undervalued exchange rate is often regarded as desirable in order to reduce imports by making them more expensive, and making exports cheaper and more attractive.

In the Web3 world, we can consider an economy to be similar to a crypto ecosystem- if an economy is defined as a base of consumers, businesses, and institutions that use a particular currency as the standard currency for transactions, then a crypto ecosystem will be any business, wallet, or organisation that uses a particular cryptocurrency as its native token or native cryptocurrency.

Given that there is no artificial control of exchange rates, a crypto ecosystem cannot use a favourable exchange rate to draw in new investors to develop the ecosystem as a whole.

Investment into the ecosystem would be reliant on whatever protocols are already part of the ecosystem, or the blockchain’s inherent utility. Ethereum, for example, saw a great increase in interest not because there was a favourable exchange rate- but instead because there was huge potential to be tapped into when it came to NFTs, smart contracts, and more.

An ecosystem without utility, therefore, will find it difficult to attract new investors, unless it controls interest rates to attract capital, or implements capital controls to stop the outflow of investors.

Another target that central banks often set is that inflation should actually be low but positive. At first, this may seem strange- why would a central bank be in favour of devaluing the value of paper currency, which not only national reserves, but citizen savings and business assets are denoted in?

The answer, again, is to promote economic growth. If you could spend a dollar to get, say, a bottle of water today, but the same dollar would buy you two bottles of water tomorrow, why would you buy the bottle of water now? Any rational consumer would wait for consumer item prices to drop before buying.

On a large scale, a reluctance to spend money in the current time period would lead to a drop in demand- resulting in businesses shutting down and leaving the economy.

In a crypto ecosystem, this can have mixed effects- and Bitcoin is one such example. Bitcoin is expected to rally, and as such, many people are buying in. But how many are willing to spend in Bitcoin? Not many.

In the meantime, this is not a major issue since holders are confident that the future price of Bitcoin will continue to rise, and investors continue to come in. For now, there are no serious blue-chip crypto competitors for Bitcoin. But when other ecosystems start developing and token prices start rising, whether Bitcoin will still be king is more questionable.

If there was a central bank that could regulate Bitcoin’s demand, this might be alleviated with lower interest rates or an increase in the money supply- and result in a much more healthy and sustainable ecosystem.

Centralised decision-making in the crypto world may not yet exist in the Web3 world- after all, it was built to be decentralised.

But a central bank performs some important functions when it comes to growing an economy- while the growth of the crypto industry has been all kinds of amazing, it is also not without its flaws. And these are significant flaws that may one day bring down some of the largest cryptocurrencies in the world.

The dream of a decentralised world is laudable- but it is not one that should be pursued for the sake of pure disdain of the centralised economies that remain the reality of today. Central banks, for all their flaws, still have valuable lessons for the decentralised world- and we must learn them fully before discarding the old model.