How Cryptocurrencies will upset nation states

Milind Bansia September 20, 2018

Less than 1% of the global population has used a cryptocurrency (pdf). But there are good reasons for the State to take it seriously. Major cryptocurrencies have a global footprint, most have a fixed or predetermined monetary supply, are currently pseudonymous, and their movement is fundamentally uncontrollable.

If adoption grows, they will have a huge impact on the way countries are run, because governments can’t effectively use any of the tools at their disposal without being able to control Money. These include monetary tools like capital controls, money supply, and interest rates as well as law enforcement in the form of anti-money laundering (AML), taxation, and financial investigation. Here’s how.

Losing the tools of control

Central banks around the world control the supply and cost of money using tools like lending rates, statutory reserve and liquidity ratios, and open market operations. To fund these operations, they have the ability to print money. The remit is to steer the economy towards target inflation and promote GDP growth in tandem. In the aftermath of the 2008 economic crisis that started in the US and subsequently spread across the world, we are seeing a unique simultaneous heavy-handed monetary easing (increasing money supply) around the world especially with economic heavyweights like US, Europe and Japan. The move to spur growth by fueling risk in these economies has led to sky-high asset prices almost all across. However, if cryptocurrencies that aren’t backed by states gain traction, these central bank tools will cease to exist. There would be no monetary Keynesian mechanisms available to stimulate or restrain the economy artificially. The impact of this is a matter of debate. Keynesians would argue this could prolong depressions and bubbles. A Monetarist, on the other hand, would argue that stable and predictable money supply (like one enshrined in Bitcoin) would lead to sounder investment decisions and reduce the bursts and bubbles caused by interventional monetary policy.

If cryptocurrencies that aren’t backed by states gain traction, these central bank tools will cease to exist.

If cryptocurrency becomes mainstream, it is likely that its circulation will not be limited to one country. The Eurozone experiment was something similar, with all member states being subject to single monetary policy with the Euro (although it also comprised a single market). The failures of the Eurozone is often attributed to having a single monetary union without fiscal and political unity. With only fiscal tools at their disposal, member states are essentially handicapped when reacting to domestic economic conditions. We saw this playout with Greece, being unable to pay off debt by devaluing its currency, which might also have spurred its economy, as it was instead forced to accept stringent new terms and fiscal austerity. Many scholars and economists, including Nobel Prize-winning economist Joseph Stiglitz, have attributed the Eurozone’s problems to such policy fragmentation. It’s impossible to be certain, but something similar might play out if cryptocurrencies become mainstream. It will be much larger and chaotic.

Also see: In 2-3 years, you could run a parallel crypto Wall Street: Naval Ravikant

Capital Flight to Crypto

A more immediate problem is the circumvention of capital controls. Capital controls are mostly used to prevent people from extracting money from an economy in times of crisis. Greece, for example, tried to prevent the exodus of funds at the height of its sovereign debt crisis in July 2015. However, governments find it more and more difficult to implement such rules with the increasing popularity of cryptocurrencies. Cryptocurrencies are already rumoured to be facilitating capital flight from closed economies like China, Brazil, Argentina and Russia. In fact, a peer-to-peer remittance market using cryptocurrencies is thriving, especially in markets like the Philippines, where regulation is more conducive. Regardless of regulation, the cheaper fees and global nature of cryptocurrencies allows anyone with internet and a partner in the recipient country to use cryptos to provide money transfer services cheaply and with little risk. With this kind of p2p market, capital controls will become fundamentally impossible to impose. Countries with high inflation such as Zimbabwe and Argentina are at higher risk as people will choose a readily available global asset like Bitcoin instead of holding their failing local currency.

Taxing Cryptocurrencies

Another problem is that of taxation. Without a way to map transactions to individuals and companies, authorities don’t have a foolproof way to compute tax. They will either need to take taxpayers on their word (we all know how that will play out) or be able to target wallets from the beginning and have fiat to crypto exchanges perform watertight KYC checks. However, since it’s easy to create wallets and transfer money from one person to another privately, the latter will be a losing battle. Most countries like Japan, South Korea, the US, Australia are rolling out tax laws and AML regulation. But, a completely foolproof way to regulate these cryptocurrencies is yet to be found.

With the stakes this high, there is pressure on regulators to act. However, it seems outside the power of single regulators to truly stop the adoption.

With the stakes this high, there is pressure on regulators to act. However, it seems outside the power of single regulators to truly stop the adoption. To control adoption domestically, the weakest link is the fiat to crypto bridge (crypto-to-crypto would be next to impossible with decentralized exchanges and privacy coins). Thus, centralized fiat to crypto exchanges will be the primary target for governments to ban or track crypto (as India did). Yet, P2P adoption is uncontrollable (without shutting down the internet), even if much slower. Without capital controls, if even one major economy accepts these currencies (and we already have more than that – South Korea and Japan for starters), these currencies will continue to hold value across the globe.

Also see: Can you file tax returns in India for gains from Bitcoin, cryptocurrency trades?

Geopolitical implications of cryptocurrency adoption

As with all global political flashpoints, the acceptance of these technologies can be used by nation states to forward their agendas. Nations have to closely weigh economic and political fallouts inside their own countries as well. For example, if China accepts Bitcoins, it can exacerbate the US dollar’s fall from its perch as the global store of value and trade. Currency dominance is an important tool of power and China has been pushing the Yuan with its inclusion in the IMF reserve basket in late 2016 and the first petroyuan contract coming out in Q1 2018. In fact, China also has the most Bitcoin mining power and thus some potential control over Bitcoin. However, this will also crush the Chinese ruling party’s ability to control its own economy, with huge capital flight being an obvious problem. Another aspect, perhaps less significant from a geopolitical lens, is that of weighing taxes that might be earned as a hotbed of innovation and incoming money versus the capital flight that might take place and the tax collection and corruption problems that might be created. We can expect calculations taking place at all major political powers, like the US, India, China, Russia, UK, Germany etc. With such game theory playoffs going around, and the fact that Japan, Australia and South Korea have already accepted these currencies in some form, it seems unlikely that a blanket global ban will emerge, making it difficult for those in power to truly kill value and stop the adoption.

Also see: We’re going to make our way out of a structured economy and monetary system, says Ethereum co-founder

State-backed cryptocurrencies

Finally, nations could issue their own cryptocurrency. For example, with an aim to secure financing for the failing economy, Venezuela launched a cryptocurrency backed by its oil reserves called the Petro. With such government-backed currencies available, adoption would likely shift from open-source global ones (like Bitcoin) into them more quickly. These currencies would enjoy some of the benefits of being on a blockchain, but also do open up major security risks. An aggressor nation has enough incentive to set up resources to subvert the systems either via the consensus mechanism for a public chain (51% attack) or via cyber or physical attacks. Such a shock would jeopardize the entire domestic economy of the host country. Lastly, such an implementation would need to incorporate taxation, capital controls, and monetary tools, in ways we have not seen done yet.

Milind Bansia currently works as a Fellow at Kstart Capital and is an ex-Investment Banking Analyst with more than 3.5 years’ experience at J.P. Morgan. A graduate of Delhi College of Engineering, Milind also holds 2 IBM Blockchain Certifications. The article is the independent opinion of the author and does not represent those of Kstart, Kalaari or any of the institutions mentioned above.