MICHAEL PETTIS
Facebook seems to think its new digital currency Libra will be used mainly for purchasing goods and services and for current account transactions. But it will probably be used mainly for capital account transactions. Do we really want to eliminate frictional costs on the capital account?
People typically think of money as something that exists mainly to facilitate the buying and selling of goods and services, or current account transactions. But in fact, one of the major uses, if not themajor one, is to facilitate debt, investment, and other capital flows, including across national boundaries. Digital money like Libra, in other words, won’t just be used to buy cups of coffee. Unless strictly regulated, its major use will probably be to facilitate capital flows. This has really important implications—both good and bad—that weren’t addressed in the Libra White Paper . The most important one is that as the digital currency is now structured, the more successful Libra is the more it may facilitate destabilizing capital flows.
I have never been terribly knowledgeable about digital and cryptocurrencies (although like most people living in China, I pay for a lot of things with my WeChat app), but I had drinks at my home earlier this week with the very smart Cristian Gil. He is an old friend who at the turn of the decade started a digital-currency trading company called GSR as a hobby, only to watch the firm morph into a serious business. After our interesting discussion on cryptocurrencies, I decided to read up on Facebook’s new digital currency and try to figure out how it might operate. Here is what the white paper says:
The world truly needs a reliable digital currency and infrastructure that together can deliver on the promise of “the internet of money.” Securing your financial assets on your mobile device should be simple and intuitive. Moving money around globally should be as easy and cost-effective as—and even more safe and secure than—sending a text message or sharing a photo, no matter where you live, what you do, or how much you earn. New product innovation and additional entrants to the ecosystem will enable the lowering of barriers to access and cost of capital for everyone and facilitate frictionless payments for more people.
As far as I understand, the big difference between Libra and cryptocurrencies like Bitcoin is that Libra isn’t directly a fiat currency, whose value rises and falls purely on the basis of whatever value investors choose to give it. Rather, it is backed according to a specific ratio by five major credible fiat currencies (U.S. dollars, euros, yen, sterling, and Swiss francs). The user can pay for or redeem Libra in those currencies or whatever other currency he or she chooses, whether Mexican pesos or South Korean won (as long as that currency is fully convertible). But the value of Libra will always be determined by the weighted value of the aforementioned five currencies.
The issuing agent for Libra is basically a currency board, one that “mints” or “burns” Libra (their words) in direct proportion to the nominal value of the hoard of currencies held by the board. The total value of outstanding Libra is always exactly equal to the total value of currencies the board holds, and this value is enforced by the ability of holders to redeem their Libra any time they want. While these currencies are invested in interest-bearing notes, CDs, and bills, the board retains the interest, and Libra itself does not earn any sort of interest coupon (more on this later).
THE DRAWS AND DRAWBACKS OF DIGITAL CURRENCIES
There are at least four major, and fairly obvious, benefits that a system like Libra might hold for users:
Simpler payments: Like with any digital currency, it will make payments for goods and services simpler, much like things operate in China with WeChat and Alipay. By eliminating transaction costs and the need to carry cash, it makes it much easier to do everything from ordering food, purchasing on impulse, or reimbursing a package delivery to ordering a taxi or paying rent. By itself, this phenomenon is nothing new—after all even a dinosaur like me increasingly uses his phone to pay for things—but the potential advantage Libra might have over lots of other similar systems is its sheer size and scope. If it is adopted by a significant portion of Facebook’s4 billion monthly active users, they will no longer have to ask others if they accept payment by Libra.
Lessened currency volatility: Most other widely used digital payment systems are denominated in a single currency, usually the prevailing domestic currency—renminbi in the case of Alipay in China—and so are subject to single-currency volatility. While it can be purchased or redeemed in any currency that is convertible, the value of the Libra is backed by the previously mentioned five-currency formula, which means that holders of Libra run less inflation or liquidity risk than holders of any of the individual currencies. Obviously, before Libra, anyone seriously worried about this risk could hedge by buying an equivalent basket of currencies, but given the trading costs of doing so, this only makes sense for people who hold large amounts of currency.
Seamless cross-border payments: Because Libra can presumably exist wherever Facebook exists, the Libra payments system will facilitate cross-border payments, an incredibly complicated and very expensive endeavor. Under the Libra system, it seems to me, it makes no difference whether I want to pay my next-door neighbor $3 for picking me up a coffee or if I want to invite my brother in Spain for a $3 cup of coffee, something that I would never think of doing under the current system of money transfers. It would take me several hours and ten times that much money to complete the transaction (assuming I can convince the two banks that neither my brother nor I are drug dealers, tax evaders, or terrorists, which is much harder than you might think).
Reaching underserved users: This system might be especially important for people who are underserved by the financial system, although this would be true only if they are not also underserved by social networks, which isn’t obviouslythe case. Just as nearly everyone in China uses WeChat or Alipay (even, I have heard, street beggars), so can everyone in the world with access to Facebook use Libra to have a place to store their money and make payment transfers even if they cannot afford bank accounts and/or huge fees.
Against the obvious benefits, there are at least three equally obvious costs and risks associated with the structure of the Libra system:
A trust deficit: One cost is simply the issue of trust, which is well covered in a recent Atlantic article that starts off: “Facebook, one of the world’s most distrusted companies, wants us to trust its new Libra cryptocurrency.” Libra will not be controlled by Facebook but rather by a board invited by the company and consisting of a few NGOs and many for-profit entities. There is apparently no mechanism, however, that enforces responsibility or social obligations onto this board besides what Albert Hirschman might have called exit, or the ability of users to abandon the Libra system once they no longer trust the managers. But while this tactic may work in theory, once Libra is widely used and network effects kick in, it might be too costly for users to exit except under the most extreme cases of abuse. In that case, are we happy to have a major global payments system controlled by a group that we cannot control? Could the board of Libra ever become as insulated and impervious to criticism as the IOC or FIFA?
The necessity of some transfer regulations: The great advantage of Libra seems to be that it will allow low-cost digital transfers within a country and, more importantly, between any two countries that have open internet access (so not China). But why are these transfers otherwise so hard and costly, in terms of not just transaction fees but also the time and required information provision? This is partly because a small group of financial institutions controls cross-border transfers and has kept transfer costs high and also partly because of the enormous amount of regulatory requirements aimed at controlling the flow of drug, tax-evading, and terrorist money across borders.
We would all applaud the potential impact of Libra to undermine the former, but to enjoy the latter we have to assume that domestic regulators in the major economies will agree to enforce onerous requirements on international money transfers outside the Libra system while allowing Libra itself to be exempt. This doesn’t seem terribly likely, although I suppose Facebook invented a digital currency rather than simply use the individual currencies mainly because this would allow them legally, at least temporarily, to evade the kinds of regulations that govern transfers in national currencies. In a recent interview with Bloomberg, Facebook’s David Marcus argues that this won’t be an issue.
A temptation to game the system: The board that mints or burns Libra enjoys the profits of carry. This means that when a user buys Libra, the money he or she delivers to the board is then converted into interest-bearing notes, CDs, or bills, but users receives no interest on the Libra in their wallets. As the white paper puts it: “Interest on the reserve assets will be used to cover the costs of the system, ensure low transaction fees, pay dividends to investors who provided capital to jumpstart the ecosystem, and support further growth and adoption. . . . Users of Libra do not receive a return from the reserve.”
While this arrangement can be quite profitable for the “investors,” in itself there is nothing outrageous about it—this is how all currency boards work—but it can lead to a problem that does not occur with currency boards. While interest rates are low, it may not be much of an issue how the currency mix is chosen (for maximum stability, we are told). But if in the future we were ever to shift to a period of high inflation and unstable currency values in some or all the relevant economies, the profits generated by the board could be substantial, depending on how the reserves are indexed and how much Libra is issued: revenues will rise in proportion to the size of the issue and the level of interest rates but costs will barely move.1
This means that not only will it be in the best interest of the board to make it difficult for users to cash out of excess Libra holdings, but it will also be in its best interest to keep the reserve formula and the types of instruments held weighed toward the higher interest currencies and instruments. This problem isn’t insurmountable (for instance, Libra can incorporate an interest-payment scheme on outstanding Libra that sharply reduces the temptation to game the distribution of reserves), but it is useless to pretend that gaming cannot ever become a serious problem for users.
THE CAPITAL ACCOUNT DRIVES THE CURRENT ACCOUNT
Beyond these obvious costs, however, I worry about the impact of Libra mainly as a mechanism that facilitates capital flow transactions, something that doesn’t seem to be an issue for the currency’s creators. As far as I can tell, there is no reference at all in the white paper to Libra’s role on the capital side of the global balance of payments. Here is what the white paper says:
The association envisions a vibrant ecosystem of developers building apps and services to spur the global use of Libra. The association defines success as enabling any person or business globally to have fair, affordable, and instant access to their money. For example, success will mean that a person working abroad has a fast and simple way to send money to family back home, and a college student can pay their rent as easily as they can buy a coffee.
The implicit assumption is that trade in goods and services drives counterbalancing capital flows, implying that the main use of Libra would be to facilitate legitimate current account transactions for a host of users: a Brazilian college student that needs to pay rent in Michigan, for example, a Venezuelan worker in Madrid who wants to remit 100 euros to Grandma in Caracas, or maybe me treating my brother in Malaga, Spain, to a Starbucks cappuccino.
But this isn’t really how the balance of payments works. It has been a long time since capital flow transactions merely balanced out current account transactions (consisting mostly of trade finance). We live in an environment of excess global savings in which the main daily driver of the capital account is not the current account but rather the tens of thousands of independent decisions to transfer money from one country to another. The current account typically adjusts to balance capital account imbalances.
There is no reason to assume that this dynamic won’t be exacerbated by the use of Libra. In that case, we need to consider additional potential issues and problems with a global digital payments system:
Complicating central bank monetary policy: First, to the extent that it is successful at reducing frictional costs associated with capital account transactions, Libra will reduce the ability of central banks to tailor domestic monetary policy. Anyone who understands the impossible trinity in economics also understands that the easier it is to transfer capital across borders, and the lower the frictional costs, the harder it is for the monetary authorities to manage both currency stability and independent monetary policy. To the extent that Libra is successful, in other words, the digital currency will make the work of central banking more difficult than ever. As an aside, this creates an interesting feedback loop: Libra can undermine the abilities of central banks to manage the currencies that underlie Libra.
Some analysts might argue that this is actually a strength, not a weakness, of Libra. They might claim that a global currency that acts like a kind of digital gold will impose much-needed monetary discipline on national central banks and will severely limit their ability to manipulate the value of their currencies for political reasons. While I have some sympathy for this argument, my main point here is not to agree or disagree but simply to point out that this is an important issue that will be taken very seriously by central banks, especially by central banks of smaller or developing countries with vulnerable banking systems.
A procyclical digital currency: Second, while Libra can be described in some sense as a kind of “digital gold,” it is very unlike gold in one important respect. For all of its faults, the gold system enforced a brutal kind of discipline on the ability of central banks to issue money, because ultimately there was no way for them to expand or contract the underlying supply of gold in line with their political objectives or market The global supply of gold is basically stable (subject to random “discovery” shocks) or even mildly countercyclical in that rising and falling prices encourage or discourage gold exploration and mining, which put downward pressure on rising prices and vice versa. When it comes to money supply, credit creation, and balance sheets, countercyclicality is always a good thing, and procyclicality a terrible thing.
But while gold is stable or slightly countercyclical, Libra is probably procyclical, maybe even highly procyclical, because it is so easy to convert holdings of small, illiquid currencies into holdings of this much larger and much more liquid currency, especially when the latter can be used to participate into the bubble du jour. I am sure any good Facebook engineer will dismiss this claim by pointing out that the mining of Libra is perfectly matched by the withdrawal of the currency used to buy Libra, so there is no net impact on the money supply, but this is wrong on two counts.
For one thing, the money used to purchase Libra is not withdrawn: it is used to support the liquidity of the notes, CDs, and bills held by the board, so it has an expansionary monetary impact by increasing the liquidity and prices of the assets the board holds. In addition, as any good Mundellian would know, converting holdings of small, illiquid currencies into holdings of a much larger and much more liquid currency is likely to increase the total moneyness of the global money supply and so, once again, has an expansionary monetary impact. (See, for example, this 1976 paper, which discusses the monetary impact of the creation of artificial currency units.) Libra doesn’t even allow for a countercyclical central bank. We would need to think more carefully about this, but its potential procyclicality could become a substantial risk for economies subject to Libra.
Less locally compartmentalized financial risks: Third, not only is pro-cyclicality potentially an issue but, as anyone with a strong background in finance history might predict, to the extent that Libra is widely used, it is likely that self-reinforcing fads will inevitably develop in terms of the direction of money flows, even to the degree that it will be possible to create global bubbles and Ponzi schemes more efficiently than ever. As a good Minskyite, I don’t have a problem with the idea that financial systems are inherently unstable, but, like Minsky, I much prefer many small, localized crises to a few larger, unified crises across a wider variety of systems and balance sheets. To the extent that Libra becomes a major cross-border currency linking household sectors, it could make it harder to segregate financial risks.
IS FRICTIONLESS CAPITAL FLOW EVEN A GOOD THING?
This leads to the most worrying aspect of a successful Libra, which is also, not surprisingly, its greatest selling point: it makes international capital flows more efficient by eliminating nearly all frictional costs associated with capital transfers. The use of Libra is not totally frictionless: according to TechCrunch’s Josh Costine: “Transactions aren’t entirely free. They incur a tiny fraction of a cent fee to pay for “gas” that covers the cost of processing the transfer of funds similar to with Ethereum. This fee will be negligible to most consumers, but when they add up, the gas charges will deter bad actors from creating millions of transactions to power spam and denial-of-service attacks.”
This transaction cost, however, is tiny, especially when applied to large transactions. We tend to think of easy capital flows, low frictional costs, and the reduction of capital barriers as always a good thing, but in most cases, we do so for ideological reasons. In fact, free capital flows can be a good thing or a bad thing depending on the assumptions we make about underlying economic conditions. In a world in which there are substantial unmet investment needs, mainly because of the scarcity of savings (a fundamental but obsolete assumption in most economic models), high costs of capital, and barriers to investment flows, it is obvious that the distribution of savings into investment is likely to be far from optimal. Savings will flow to where it is able to flow, or to where penalties are lower, and not to where it is most productive.
If that were still the case, there would be a strong argument to be made in favor of eliminating capital constraints and lowering transaction costs. Doing so would automatically improve the abilities of investors to redirect savings from less productive investment into more productive investment. But while this may have been the case for much of history, over the past few decades there have been two conditions that undermine this assumption:
The rise of portfolio capital flows: First, while some portion of international capital flow continues to represent direct investment into productive facilities, most capital flows today consist of portfolio flows, and these are often driven by speculation, investment fads, searches for either yield or safety, and capital flight. During their Bretton-Woods negotiations, John Maynard Keynes and Harry Dexter White disagreed on many things, but they both agreed that while trade flows should be unimpeded, the capital account should be strictly controlled so as to prevent speculative inflows and outflows from overpowering economic fundamentals, driving trade accounts into imbalance, overwhelming fragile or small banking systems, and forcing adverse adjustments onto domestic financial systems that lead to rising debt, among other things. Libra does exactly the opposite.
Massive capital imbalances from excess savings: Second, much of the world—nearly all advanced economies and some developing economies, including China, Vietnam, the Asian Tigers, and Arab OPEC nations—does not suffer from savings shortages but rather from excess savings and weak domestic demand. So rather than see capital flow from advanced economies into those developing economies that need the capital, the global balance of payments is instead dominated by capital flows from advanced and developing nations into advanced economies that don’t need the capital but that have deep and flexible financial systems and excellent governance—the United States and the UK, for the most part. These massive capital imbalances are what, in turn, drive the world’s massive trade imbalances.
I have long argued that the world needs seriously to rethink its attitudes toward free capital flows. Obviously enough—and even the IMF now accepts this position—free capital flows can be risky for developing countries and smaller economies whose financial systems are not deep, robust, and flexible enough to absorb the massive inflows and outflows that characterize the global economy. But free capital flows have also been damaging to the opposite set of countries: large, advanced economies like the United States, the UK, and other Anglo-Saxon economies with deep, robust, and flexible financial systems. I won’t rehash my arguments as to why this is the case (I have discussed it many times before, including here and here), but slowly—albeit much faster than I expected—we are seeing a major shift in the way Americans, including U.S. policymakers, understand the risks of the U.S. dollar’s status as the major reserve currency and of the U.S. financial system as the global safe haven for excess savings.
The world, even the United States, needs less capital mobility, not more. This means that the most important impacts of Libra to the global economy—assuming that it achieves anywhere near the importance Facebook claims it can achieve—are precisely the impacts that have been least discussed by Facebook, Libra, and its proponents:
Democratizing speculative investment: The widespread use of Libra can sharply reduce transaction costs on international capital flows, including precisely the most speculative, faddish, and destabilizing types of capital flows. No longer will it only make sense to participate in the latest emerging-market currency fad if you have at least $500,000, but now you’ll be able to do it easily and quickly even if you only have $5,000. Imagine how much more dire the Mexican financial crisis of 1994, the Asian crisis of 1997, or the more recent Turkish crisis would have been if transaction costs associated with currency speculation and capital flight were reduced to nearly zero, even for tiny transactions.
And the flip side is that during unstable times the United States will not only be forced to absorb the massive capital inflows—with their corresponding massive trade deficits—of rich foreigners fleeing to safety, but also of middle class foreigners doing the same. The already-high cost to the United States of stabilizing global demand and savings imbalances will rise sharply.
No gold standard for market risk: Libra is sometimes called a kind of “digital gold,” but it has none of the disciplinary enforcement that gold brings. In fact, Libra has the potential to become a highly procyclical kind of “gold,” whereby the global money supply automatically expands when markets are hot and automatically contracts when markets begin to cool off, thus turning even mild cycles into more vicious ones.
WE NEED TO THINK CAREFULLY ABOUT GLOBAL DIGITAL CURRENCIES
The point of this essay is not to condemn Libra and demand that it be shut down. Living in China, I know both the convenience and the risks of the increasingly widespread use of digital currencies, and given their tremendous convenience, I have no doubt that the future lies in the greater adoption of Libra or some other form of digital currency. Two months ago, I attended a rock festival in Suzhou to receive a music-industry prize, and as I wandered around the festival, every time I pulled out my cash to buy a beer, the poor kids attending the stalls reacted with total confusion—all they knew how to do was scan phones. The way things are going, I suspect that soon enough young people everywhere will be as confused over how to use cash as they are over how to use rotary telephones.
But—and perhaps this is what happens when you unleash engineers on the problem of currency creation—Facebook seems to think that the only use for money is to buy cups of coffee, pay rent, travel in Egypt, and otherwise pay for goods and services. In fact, the system of money is a vitally important and very dynamic component of a national balance sheet, and at the very least, we should line up monetary dynamics and economic dynamics in ways that don’t create what I called in my second book a volatility machine. It may easily turn out that the main use of Libra is not to pay for coffee, but to create new forms of hidden debt, send money abroad, and participate in investment fads. We have mechanisms, as poor as they are, for dealing with the dynamics of gold-backed money, national currency-backed money, and national fiat money. We should be thinking of the equivalent mechanisms for international digital money.
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