Cryptoliquidity: The Blockchain and Monetary Stability∗ James L. Catony September 27, 2018 Abstract The development of blockchain and cryptocurrency may alleviate the economic strain associated with recession. Economic recessions tend to be aggregate demand driven, meaning that they are caused by fluctuations in the supply of or demand for money. Holding mone- tary policy as solution assumes that stability must arise from outside of the economic system. Under a policy regime that allows innova- tions in blockchain to develop, blockchain technology may promote a money supply that is responsive to changes in demand to hold money. This work suggests that cryptocurrencies present an opportunity to profitably implement rules that promote macroeconomic stability. In particular, cryptocurrency that is asset-backed may provide a means for cheaply attaining liquidity during a crisis. JEL Codes: E40, E41, E42 Keywords: blockchain, cryptocurrency, endogenous money, liquidity, dise- quilibrium AIER Sound Money Project Working Paper No. 2018{15 ∗I owe gratitude to Cameron Harwick for his comments on an early draft. I also bene- fitted greatly from conversations with attendees at the Fargo Bitcoin meetings. Without help from these individuals, this paper would not have been possible. yDepartment of Agribusiness and Applied Economics, North Dakota State University, Fargo, ND 58102 [email protected] 1 Introduction In the last decade, the value and significance of blockchain technology has gained recognition among entrepreneurs, policy makers, and academics. What appeared to the casual observer to be simply a monetary phenomenon has been recognized as a new means of organizing social activity, particularly exchanges and ownership (Davidson, Filippi, and Potts 2016; Antonopou- los 2016). Blockchain technology enables secure transactions on distributed networks, showing potential to reduce transaction costs and transform the structure of economic activity. Focus has begun to shift from cryptocurrency to other uses of blockchain technology. While this is understandable, the following argument will show that the blockchain has only just begun to change our conception of money, banking, and liquidity. The blockchain has potential enable a money stock that is responsive to fluctuations in demand for money and greatly reduce the cost of monetizing existing or future assets. This can reduce inefficiencies that arise from aggregate-demand driven macroeconomic disequilibrium (Yeager 1956; Leijonhufvud and Clower 1981; Horwitz 2000). In the least, it may prevent extreme macroeconomic fluctuations that are produced by erratic macroeconomic policies, such as those observed during the Great Depression (Glasner 1989; Hawtrey 1947; Sumner 2015a; Vedder and Galloway 1997). 1 I begin by describing money, the blockchain, and the relationship between the two and follow by showing 1) how monetary theory informs our under- standing of money creation through the blockchain, 2) how competitive forces make the creation and adoption of a high-quality cryptocurrency practically inevitable even if one cannot predict beforehand which blockchain structure will be adopted for this purpose, and 3) how regulatory and tax policies can either enable or inhibit these developments. 2 Money and the Blockchain In order to discuss the relationship between money and the blockchain requires an adequate description of both. Money is a commonly accepted medium of exchange. It serves as an intermediate good that is typically accepted by a community of buyers and sellers of goods. Although particular details vary across blockchains, a blockchain can be described generally as an accounting ledger comprised of different nodes { accounts { whose records cannot be altered without approval of at least a majority of votes allocated to nodes in the system. Cryptocurrency is an electronic money. It is produced and secured on a blockchain. 2.1 Money Although money operates fundamentally as a medium of exchange, great benefit lies in its enabling of accounting. Money itself must necessarily have 2 been preceded by reciprocal favors through relatively small networks of social bonds (Bourdieu 1990; Harwick 2017). Such a system does not scale as transaction costs of developing a relationship are relatively high and the span of affiliation is constrained as a result. Before money arises, there exists no low-cost common numeraire { unit of account { that allow economic actors to compare the value of goods in fine detail. Money enables this, allowing producers of goods to compare costs and revenues and thereby evaluate their contribution or diminishment of value in the economy and, therefore, to their own wealth. It allows these same actors to hold their wealth in an asset whose value is highly stable and easily saleable (Menger 1892). By lowering transaction costs, money enables development of a broader network of exchange by lowering the level of trust required to engage in trade (Horwitz 2008). Increases in the efficiency of exchange make society wealthier and allows for the development of more expansive trade networks. Finally, money enables banking. Money lowers the cost of lending since money can be lent to investors who wish to purchase physical assets rather than lending the physical assets themselves, a process much more costly to coordinate. 2.2 Blockchain Like money, a blockchain is a means of accounting. Ownership of money represents a claim to resources in an economic system in light of the prefer- ences of agents who own each. Even without an accounting ledger, a money of stable value enables accounting of claims to value. The blockchain is an 3 accounting ledger whose transactions are public to other nodes in the net- work. A functional blockchain network enables convergence of every account to a true representation of agreements in the system. This is achieved demo- cratically. Nodes are allocated votes, perhaps on a one-to-one basis or on a basis tied to productivity or participation in the network.1 These votes legitimate changes in the public ledger according to whichever standard has been adopted for the system. The ledger allows agents to stake claim to particular assets recognized by the blockchain. The Bitcoin blockchain allows owners to stake claim to Bitcoins and ensures the secure transfer of these assets between exchanging parties (Nakamoto 2008). For Bitcoin's blockchain and many other, the ledger of these nodes are encrypted, with miners competing to ascertain the correct key that grants access to changed ledger for the reward of new currency and for the greater purpose of democratically confirming the new state of the ledger among successful mining nodes. A blockchain may recognize a wide variety of assets. The Ethereum blockchain, for example enables the creation of smart-contracts whose terms are executed once the criteria of the contract are met (Ethereum White Pa- per). Since blockchain ledgers are secure, there is no need for a third party to intermediate the transfer of goods and funds entailed in the contract. More 1The latter two of these mechanisms allocating voting rights concerning legitimacy of new accounting records are referred to as \proof-of-work" and \proof-of-stake". 4 generally, blockchains that securely and automatically manage the exchange of assets are referred to as decentralized autonomous organizations (DAOs). 2.3 Cryptocurrency Cryptocurrency is necessarily linked to the blockchain. In the case of Bit- coin, it is the only alienable asset associated with the blockchain. Other blockchains, like Ethereum, operate like Bitcoin but also allow for the regis- tration of other assets on the blockchain. Still others enable the creation of cryptocurrency through the tokenization of assets. Asset owners can register their assets on the blockchain and receive, directly or indirectly, cryptocur- rency in exchange. The growth path of cryptocurrencies like Bitcoin are constrained by an algorithm that determines that rate at which new currency units are made available. With a predetermined growth path, these cryptocurrencies are un- able to respond to changes in demand for money that accompany changes in the rate of economic growth as well as economic crises. Blockchains that al- low the quantity of currency created to change with demand for the currency will improve the ability of the market to stabilize economic fluctuations. 5 3 Dynamics of Money Creation The quantity of money under a commodity regime is determined in light of demand for money and the elasticity of the supply of money.2 The response of the money supply alleviates pressure that is otherwise placed on prices. For the promotion of macroeconomic equilibrium, the case of economic recession is of special interest. During a depression, demand for money tend to exceed it supply, thus promoting a general fall in prices. This fall in prices may lead to discoordination in credit markets that might be alleviated by the creation of money and money substitutes. Using the theoretical framework below, the role of cryptocurrency as base money as well as near money will be considered. Near money is a catego- rization refers to an asset with a high level of liquidity. Such assets alleviate demand for base money during a crisis and thus serve the function of stabiliz- ing the value of total expenditures (aggregate demand) much as the creation of new money does. 3.1 Money and Macroeconomic Disequilibrium Macroeconomic disequilibrium arises when there is a discrepancy between the value of total expenditures and the aggregate value of goods and services that are available for sale and which would be sold in macroeconomic equilib- rium. For the sake of analytical simplicity, let us assume that there is some 2The foundations of the analysis below are presented in the appendix. 6 level of growth of real income in the long-run.3 This value anchors analysis, allowing for the description of macroeconomic equilibrium, and therefore, macroeconomic disequilibrium. Anlaysis begin again with the equation of exchange. Real level of economic growth in the long-run is defined as y0. The value of the other variables at any time are defined by the subscript t.