My guest this week is Cristian Popa, the well-known and highly esteemed deputy governor of the National Bank of Romania between 1998 and 2014.

RC: Cristi, thank you for the kindness of accepting my invitation. In your opinion, are cryptocurrencies an economic or a social phenomenon?

CP: They are primarily an economic phenomenon because they have become so widely used due mainly to the higher yields caused by rising prices. Unfortunately, one issue is that too many people mistake them for money. They are not money, but rather speculative financial assets, resembling more alternative investments that undergo extreme bouts of volatility. Let me now explain why they are not money.

Let us go back to the economics textbook that lists the three main functions of money: a medium of exchange, a unit of account, and a store of value. Let`s take them one by one.

Are cryptocurrencies a medium of exchange? They may be. It is true that they are more widely spread now than they were a few years back (there are even ATMs that exchange bitcoins for cash, they can be used to make payments – Visa and Mastercard have recently announced that they accept Bitcoin payments), but most investors buy cryptocurrencies to beef up capital gains, not to broker transactions. So the jury is in with a negative, albeit less clear verdict.

Can it be a unit of account? Definitely not, because a unit of account is normally a standard which requires some stability. Clearly, any floating currency fluctuates against other currencies, but not to the point to destroy the meaning  of the measurement in that monetary unit. This test is failed  – and not only Bitcoin.

Are they an instrument that stores value? Let us not forget that there is nothing backing cryptocurrencies other than scarce supply and the difficulty of the algorithmic ‘mining’ of bitcoins. Their value can rise far beyond what it is today, but it can also sink to zero. There are no assets pledged as collateral.

And if we think in terms of monetary reference, the currency issued by central banks is recognized as liability on their balance sheet which includes the monetary base, the hard core of all monetary aggregates. And there are plenty of items on the asset side of central bank balance sheet, in particular foreign reserves: gold, foreign currency, securities. In other words, conventional money benefits from the reputation of the central bank that makes sure that its product (currency irrespective of the form it comes in, as we mainly refer to the currency of account) retains its value over time by keeping inflation low and predictable to meet its primary objective of price stability. It is also backed by the significant assets that a reliable central bank possesses.

RC: Is it me, or are you suggesting that cryptocurrencies actually do not feature the right characteristics to be dubbed an economic phenomenon? So could it be still a social phenomenon?

CP: I think I understand better what you meant. My message was that conventional currencies cannot be substituted for cryptocurrencies (Jerome Powell, the Fed Chairman, recently compared them to gold, not to the dollar). On the social aspect of it, when they emerged, almost ten years ago, they were also the result of their creators’ protest against centralized establishment which included central banks. I don’t think that cryptocurrency investors, a larger group, have that in mind.

RC: Maybe it was not an accident that they appeared 10 years ago, given central banks’ eagerness to issue money during that crisis. And here we are, in a setting where money printing is sharpening again the appetite for cryptocurrency. Trust in conventional money, generously printed by central banks is fading.

CP: What happened ten years ago also was to do with technological maturity and availability which cryptocurrencies rely on. On the other hand, it depends on which group we are referring to when we talk about appetite for conventional money. The FED statistics shows that in the past decade one to two thirds of the US currency in circulation was outside of the US. To my knowledge, this percentage hasn’t gone down, so a share of the population worldwide prefers to hold cash in dollars.

Coming back to cryptocurrencies, I would like to point out two concerns that they raise. Firstly, they also facilitate illegal transactions, from tax evasion and money laundering to criminal activities, due diligence and know-your-customer checks are not frequently performed; these are usually applied to conventional money transactions through regulated brokers. Hence the restrictions many regulators apply to brokers, in particular banks, given the multiple risks they would be exposed to – credit-related, market and liquidity risks, etc. – if they held considerable positions in cryptocurrencies.

Secondly, their carbon footprint is larger than that of printing conventional currencies. This type of digital assets functions on huge amounts of energy which is rising. I was recently reading that, mining Bitcoin and validating Bitcoin transactions uses up about 121.36 TWh of electricity, close to Norway’s annual consumption and exceeding the Netherlands’ or Argentina’s energy consumption (placing Bitcoin among the largest energy consumers in the world, if it were a country).

RC: Which one do you think will be the cryptocurrency of the future? How will the winner be decided in a contest with tens of participants?

CP: There will be most likely several cryptocurrencies. Bitcoin will continue to have the largest share as a higher profile helped it achieve economies of scale. On the other hand, if the price plummets people might try their luck elsewhere, like in Lottery draws. Ethereum is also well-positioned and more visible now thanks to the frenetic use of non-fungible tokens (NFT) to buy digital art. But, if my understanding is correct, new third-generation cryptocurrencies are being launched as we speak. So don’t overlook the new contenders.

My piece of advice, though, is “tread carefully because this is a speculative and volatile financial asset”. They are not for everybody. They are suited more to diversified investor’s portfolios with a risk appetite to match and ability to cope with losses. Moreover, as it stands, there are many bubble-like features.

RC: One heck of an asset – risky and dangerous …

CP: And unregulated!

RC: Ok but then, what are central banks after in this area?

CP: The are not “after” anything. They do not speak of cryptocurrencies, but digital currency.

RC: This is an important distinction to make. Central banks are not after creating their own cryptocurrency, but digital currency.

CP: There are several differences here. Firstly, it will be issued by a central bank which means that it is similar to the fiat money central banks already issue. Secondly, the goal is to phase out cash and promote 1:1 transactions settled through the accounts that the eligible individual or business may have at the central bank. The process becomes much cheaper and faster if retail banks are circumvented. Digital currencies will also promote social inclusion because anyone, irrespective of their financial situation, can open an account at the central bank for transactions.

RC: I understood the benefits of central bank digital currency. However, strictly psychologically speaking, don’t you think that currency digitization proponents like these days exactly this lack of central bank involvement given the ultra-loose monetary policies over the past decade – the money printing?

CP: There is more to it than that. In a cashless economy, interest rates applied by central bank issuing digital currency will have more traction. Tracking participants in transactions will decrease the possibilities for tax evasion, etc. Moreover, people are increasingly talking about multilateral arrangements on trading in various digital currencies, a new framework for making and settling cross-border payments.

On the other hand, they are still looking into how this is bound to impact the financing fundamentals of the banking system and financial institutions in a broader sense. Creating vulnerabilities that will indirectly damage financial stability is to be avoided. This is why I think that the major central banks will continue to be cautious about introducing digital currencies. A working group bringing together several important central banks (ECB, the Fed, the Bank of England, the National Bank of Switzerland, the Bank of Japan, the Bank of Canada and the International Settlement Bank) has been looking into this for some time, and the ECB has the same cautious approach on adopting a digital euro, a development also watched closely by the National Bank of Romania, if I am not mistaken.

RC: What requirements should a digital currency meet to become a rival to the US dollar on the international scene?

It is a tall order in the medium term. The volume of transactions by third parties in that economy (both for business and financial purposes) should justify the large-scale use of that digital currency. This comes as a result not only of the size of that economy but also of investor confidence in the reputation of the issuing central bank and how it interacts with other institutions in that country or region.

RC: Could a digital yuan compete with the Us dollar?

China is now conducting a digital currency experiment in the urban area in the region. We are seeing a natural desire for the yuan to assert itself that reflects the global reach of the Chinese economy. We are also witnessing a gradual liberalization of inflows of foreign capital invested in sovereign and corporate bonds issued in China. We would do well to remember, however, that owners of digital currencies qualify as account holders and they are subject to centralized monitoring.

It is actually very difficult to pay cash or by credit card in China, the phone (which also acts as ID) being the predominant method of payment. And the digital yuan doesn’t even exist yet. On the flip side, though, bonds denominated in renminbi continue to carry positive nominal interest rates. So I do expect that the currency will play a bigger role, just as it happened and is happening with the euro, but I don’t see a complete replacement of the US dollar within the timeframe that we are talking about.

RC: At the end, I would like to look into a somewhat extreme scenario. Can central banks’ enthrallment with digital currencies be explained by the need of a “nuclear bomb” to have in the event of galloping inflation spiraling out of control? A mechanism of monetary stabilization in case the money supply deceases abruptly in a hyper-inflation setting where only a limited amount of conventional money would be allowed to be converted into digital money? How generous the limits should be is another story. I am only discussing the principle.

CP: I think this is an unlikely scenario. Firstly, after 2008-2009, the major central banks started using the balance sheet as an instrument on a large scale, i.e. quantitative easing. Despite the big numbers and the duration, these economies have not so far been at risk to see inflation exceed medium-term targets. Meanwhile they avoided the aftermath of a deeper recession or significant slowdown when securities would have decreased and yields would have increased if central banks hadn’t stepped in.

We are seeing changes in sovereign bonds yields, brought about partly by investor fears of future inflation, but we also have the Fed’s opposite approach of letting the inflation rate go above target in the medium term compared to the reference course. Something similar can also be seen in the ECB’s approach. For both central banks reputation and credibility are valuable assets and I doubt they would easily put them at risk.

We can, however, talk about the many challenges and unknown turns of events to be expected when the current monetary policy is reversed and the quantity of security purchases is either decreased, or stopped or reversed or policy interest rate increases to supplement higher yield as a result of quantitative tightening. Are these changes symmetrical? Do they generate effects of comparable magnitude as far as economic operators’ expectations and business volumes are concerned? Is it possible to implement them while ending the fiscal relaxation?

We are talking about a possible tax dominance and narrower central bank room for maneuver or even an implicitly impaired independence in the event of such a scenario. More radical voices suggest that inflation is the way to erode debt burdens into sustainability. Actually it is advisable to escape from debt through sustainable growth of the economy and potential GDP, the pre-requisite of which is price stability.

Let us not forget that taxing inflation has never proven to work in the long term. The 1970s and 1980s provide us with considerable literature that argues convincingly against inflation-related surprises (central bank independence is not a whim) and, as in many financial markets central banks are market makers, a possible investor reluctance to trade on a massive scale would be a major risk.

Annual inflation rates in large economies that remain above target for a while (although there is a risk of de-anchoring inflation expectations) seems a more likely scenario than stabilization that would equal forfeiture. That would only work in a closed system, with stringent and comprehensive capital controls with more costs than benefits. Even almost three generations on, people find it difficult to forget similar measures which were partly for political reasons – just like today’s Germany is extremely averse to inflation because the 1920s hyperinflation.

RC: Thank you for this discussion, Cristi.

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