[Feature] Tokenomics 2: What would it take for crypto to be the world's reserve currency?

The world’s financial system is undergoing a sea change. The US Dollar, which has served as the world’s reserve currency for the past 70 years, is in decline. And among crypto enthusiasts, whispers have begun that bitcoin or some other cryptocurrency could eventually come to take the coveted spot at the top, and replace the US Dollar.

Of course, there is much to unpack here. A currency does not become the world’s reserve currency simply by being widely used or widely held. A reserve currency has unique properties that are intrinsically linked to its status and the ways that it is used.

But the question itself is something that is indeed worth delving into- what would it mean for bitcoin, or for that matter any other cryptocurrency, to be the world’s reserve currency?

The USD’s rise to prominence

In order to answer that question, however, we should first unpack what it means for a currency to be given the title of ‘world’s reserve currency’- and the reason why the USD has managed to hold on to that title for a long time.

Let us begin in 1944, during the Second World War, at the Mount Washington Hotel, located in Bretton Woods, New Hampshire. It was here that the foundations of today’s international monetary systems were laid.

The conference was held in order to create the economic institutions of the postwar world, in order to promote economic growth and maintain financial stability.

For our purposes, what we are most interested in was the revival of the Gold Exchange Standard, in a new form, and the debates that created it.

This debate was primarily between the economists John Maynard Keynes and Harry Dexter White. Keynes’ proposal had been to create a new supranational currency, which he called the Bancor, which would be used as the unit of account for international monetary institutions, such as the International Monetary Fund and the World Bank. White, however, rejected this, and instead pushed for the US Dollar to be used for this purpose.

The US, however, was negotiating from a position of strength, while the British were not. The war was not being fought on US soil, and during the war, global demand for food, weapons, and credit meant that the US was emerging as the new superpower of the world.

The resulting agreements that were signed at the end of the Bretton Woods Conference therefore looked far closer to White’s US centric proposals rather than Keynes’ more global approach.

One of these institutions was the Gold Standard, which was revived in a USD-centric way as well. There had been a Gold Standard before the war, in which every central bank held their own stocks of gold, which they used to back their own fiat currency.

After the Bretton Woods agreement, however, only the US did so- everyone else instead backed their fiat currency with the US’ fiat. In other words, the system now boiled down to the US Dollar being redeemable for gold, while all other fiat currencies were redeemable for US Dollars. The Gold Bullion Standard of the pre-war world had given way to the Gold Exchange Standard of the postwar world, and the US had secured the Dollar’s position at the top.

The better the party, the worse the hangover

On the surface, being the world’s reserve currency comes with some clear benefits, especially for the central bank that issues such a currency.

One such benefit is the privilege of seigniorage. In being the world’s reserve currency, the Federal Reserve never really has a concern with insufficient demand for the USD. After all, every central bank in the world is going to be hungry for US Dollars to back their own domestic currency, and defend their currency pegs against speculative attacks. This, to some extent, means that in order for the US to purchase US$100 worth of products, it can simply print a US$100 dollar bill, while other countries must actually produce US$100 worth of goods to exchange if it wants the same amount of USD.

In trading with the rest of the world, therefore, the US is able to profit simply by printing money, and earning the difference between the cost of printing and the value of however much money they print.

But such a system also places burdens on the reserve currency. The first strain on the system was felt in 1971, when French President Charles De Gaulle decided it was better to hold gold to back the French Franc, rather than the USD, and quite literally sent the French navy to the US to exchange french-held USD for gold, and to carry the boat-loads of gold back to France.

As other countries also began to exchange their USD for gold, President Nixon took the USD off the Gold Standard, making the USD inconvertible to gold except through the open market putting an end to the Gold Exchange Standard.

Unfortunately for the Dollar, this was not the end of the story- as other countries continued to use the Dollar as their reserve currency, demand for the Dollar remained high. In addition, it was around this time that OPEC, which controlled the majority of the world’s oil supply, declared that they would only accept USD in exchange for oil, further driving up demand for Dollars.

This has been the system that had come to be accepted for the last 50 years- the USD was valuable because central banks used it to back their own currencies, and because only USD could be used to purchase oil.

But these twin pillars have now come under attack. Firstly, currency blocs have begun emerging in the past 30 years- first with the Euro, then in Southeast Asia with the Chiang Mai Initiative, and now the BRICs nations have also begun exploring their own currency agreements.

Second, and more significantly, the USD will soon lose its privileged status as the only currency that can buy oil.

Last week, China signed a landmark deal with the UAE that priced natural gas in yuan, meaning that the Yuan may soon become an accepted currency when dealing with the UAE, if not the rest of OPEC.

The US Dollar, in other words, will have to compete with the Chinese Yuan when it comes to global prestige, and can no longer assume that it is at the top of the food chain.

But the situation is far worse than that. In making the USD the world’s reserve currency in 1944 while promoting the growth of the world economy, the US implicitly made a choice- it would supply the reserve currency for the world, and allow massive outflows of dollars so that other countries would be able to grow their economies.

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This was the Triffin Dilemma- and it is crucial to understand it if we are to consider what can replace the US Dollar.

The Dilemma points out that all reserve currency issuers face a conflict between short-term domestic and long-term international objectives. Since the US wishes the world to use the USD as a reserve currency, it must be willing to supply large amounts of USD. These Dollars will go towards purchasing foreign goods and services, leading to a trade deficit.

This imbalance would mean that if the USD was the world’s reserve currency, it must be willing to accept such a trade deficit, and allow foreign governments to hold vast amounts of USD in perpetuity.

But, when confidence in the USD’s utility falters, as is the case now, the potential for a Dollar glut flooding the market materialises, with catastrophic consequences for all USD holders if it actually occurs.

While this scenario has not yet materialised, it is a probable ‘what if’ that any currency, crypto or fiat, must recognise and be prepared for if it wishes to be a global reserve currency.

Is Bitcoin fit to be king?

Bitcoin has been called digital gold before- and indeed, many crypto enthusiasts now take this quite literally and suggest that it will be the new Gold Standard.

But a closer look will show that cryptocurrencies like Bitcoin are not exactly well-suited for this purpose.

Firstly, the Triffin Dilemma would suggest that for Bitcoin to be used as a reserve currency, it must be available in large quantities. While the supply of Bitcoin is slowly increasing, there will only ever be 21 million Bitcoin in the world. Such a hard cap on supply would mean that Bitcoin would be ill-suited to replace the USD in a Gold-Exchange Standard style system.

Such a system only worked because the US allowed for large scale Dollar outflows, and if Bitcoin were to replace the USD in such a system, it would almost necessarily mean doing away with any hard cap on token supply. Ethereum, on the other hand, has no fixed maximum supply- and this might make it a better choice to replace the USD in a Gold-Exchange Standard style system.

Of course, there is some argument to be made that Bitcoin can be used to back other currencies, and that it can replace gold in a Gold Bullion Standard style system. But such a system would run counter to the ethos of decentralisation. Under such a system, central banks and governments would hoard Bitcoin or any other crypto that were used to replace gold, and almost certainly would forbid private individuals from holding cryptocurrency, and instead insist on continued usage of their own fiat currency.

There is also the issue of Gresham’s law- which states that in a situation when two different currencies are acceptable as payment, bad money drives out good- which is to say that people would rather use overvalued or depreciating currency in transactions, and hoard any undervalued or appreciating currency for the inevitable future scenario when the market corrects the exchange rates.

In such a scenario, given that production of goods and services continually increases, while the supply of Bitcoin will eventually stop, it is likely that people stop spending their Bitcoin as they expect to be able to buy more with their Bitcoin in the future.

Take May 22, Bitcoin Pizza Day for an example. A man used 10000 bitcoin to buy a couple of pizzas in 2010- which might have seemed a fair trade at the time. But that 10000 bitcoin is now worth 300 million today. Any rational person will understand that this is not a transaction you want to be involved in, unless you were the one who was receiving the 10000 bitcoin.

In other words, the value of any currency being used for transactions should either be kept constant, or depreciate in relation to the value of goods and services if it is to be used as a currency.

So if bitcoin or any other crypto is not likely to take the place of gold, does that mean that fiat will still rule the day? Perhaps not.

Before we had the Gold Bullion Standard, there was another form in which gold was used- gold coins, and sometimes silver as well, were circulated and used as money. This was the Gold Specie Standard, and it relied upon a commodity being trusted for its value, and being minted into standardised shapes and sizes, made to represent specific values.

But such a system eventually fell out of fashion because of multiple problems- commodity money is heavy, and like cash, not exactly the most secure to transport. Cryptocurrencies, however, have solved many of these issues.

It costs almost nothing to transport, except some minor gas fees, and while hacks are still a problem, transactions on the blockchain can be tracked, unlike when cash goes missing.

Why then, would we require a global reserve currency, and for one currency to be given that status?

The final remaining sticking point will be the inflation problem- where people refuse to spend currency if it appreciates. But perhaps this is where the beauty of crypto can come into play.

While Bitcoin may not be suitable for everyday transactions, plenty of other cryptocurrencies might be. A currency like Ethereum, which has the potential to increase its supply indefinitely, could very well serve as a currency for everyday transactions.

Alternatively, international trade or central bank transactions may take place through accepted layer 1s or blue chip cryptocurrencies only, with other cryptocurrencies serving more niche markets or groups.

There is, however, also a question of how such a transition might occur- but to fully explore that question would be beyond the scope of this article, which only seeks to explore the feasibility and mechanics of a global cryptocurrency-based economy and the implications of reserve currency status.

But it is a question worth exploring- and one that would yield some answers as to the path forward for the cryptocurrency world as a whole.

As of now, however, crypto has been presented with a golden opportunity- old institutions are crumbling, and the opportunity for a new financial world order is upon us. And if crypto harbours hopes of replacing the USD and gold as money, it must also be prepared to bear the burdens of such a coveted status.