Tokenomics 7: Dollarisation, currency demand, and CBDCs- does crypto have what it takes to replace fiat in national economies?

If you’ve ever travelled to countries like Vietnam or Cambodia, you might have noticed that aside from their own native currency, many local businesses also accept other forms of payment, quite often US Dollars.

And, if you’ve been paying attention to the stability of the US economy lately, you might rightly notice that trust in the US Dollar is going down, and many countries are starting to get jumpy about their own currencies.

Many Web3 and crypto enthusiasts have been transparent about their visions for a global economy where crypto is the currency of choice- or at least national economies where crypto is the currency of choice.

But how would this transition actually work? And is crypto really suited to replace fiat currencies in national economies?

Dollarisation and its impacts

Financial crises have a habit of wiping out peoples’ savings- especially when citizens have their life savings denoted in the local fiat currency that is rapidly depreciating.

Quite often, this has a ruinous effect on the national economy as well. As production falls, each unit of currency is worth less- resulting in inflationary pressure. If a government continues to print money to spend, especially in pursuit of keynesian policies of market stimulation, it can worsen inflation as money supply outstrips production.

In the worst cases, fiat currency becomes so worthless that citizens refuse to accept the fiat currency as payment, and instead demand other forms of payment. In the past 70 years, this has often been in the form of the trusted US Dollar- used as a reserve currency by basically all central banks.

Dollarisation, therefore, has not often been the choice of governments- it has more often than not been the collective choice of citizens who have lost confidence in the local fiat currency. Zimbabwe, with its infamous 100 trillion dollar bills, is the prime example, but other countries like Vietnam and Cambodia have also seen similar fates befall their currency.

In monetary economics terms, we can say that the currency falls out of use and depreciates in value because of the drastic fall in demand for the currency- no one wants to hold the currency because they no longer have confidence in it.

The reason why a currency like the US Dollar is often selected for use instead of other currencies is that the US Dollar is viewed as stable- given that it functions as a reserve currency for much of the world, demand for the US Dollar is expected to remain high. Therefore, someone accepting the US Dollar can reasonably expect that someone else will also accept the US Dollar as payment in the future.

Now that we have explored the process of Dollarisation and how a country switches currency, we can turn our attention to crypto- and begin answering the question of how well it can replace fiat in national economies.

Can crypto replace fiat?

Looking at the price of cryptocurrencies like Bitcoin and Ethereum, it may seem that they are well-suited to be used as money- after all, rising prices mean that demand for the currency is going up, right?

But not all demand is born equal. Economists divide up money demand into three different types- transaction demand for money, precautionary money balances, and speculative demand for money.

The transaction demand for money refers to demand for money that is needed to complete economic transactions like purchasing of goods and services.

Precautionary money balances are holdings of money kept in case of emergencies- such as funds kept to deal with accidents or unexpected costs.

Speculative demand for money refers to money that is kept as an alternative to interest-earning assets- often bonds or stocks.

Looking at the process of Dollarisation and the reason why people choose the US Dollar to replace currencies experiencing hyperinflation, we see that much of the demand for the US Dollar is not speculative- citizens to not switch over to the US Dollar because they would otherwise put the money into stocks or bonds, but because they require a currency to conduct daily transactions in.

The US Dollar is (or at least it used to be) prized for the stability that was derived from the high transaction demand that it had- international trade agreements were denoted in US Dollars, and crucially, oil could only be paid for with US Dollars.

Not all cryptocurrencies, however, are driven by the same demand. All the talk of Bitcoin going to the moon would suggest that it is speculative demand, rather than transactional demand, that drives its growth.

I have previously discussed the problem with this- but just to recap, a currency that everyone expects to appreciate would be a poor choice to use as a transactional currency because any rational actor would rather hold it rather than use it, since its buying power is expected to increase in the future. Instead, for a currency to be used for transactions, people must expect the currency to have a stable value, or be slightly inflationary.

And a currency that is primarily driven by transactional demand and limited supply is not likely to function well as a currency that is meant for daily transactions.

As such, crypto is unlikely to replace fiat currencies in national economies in the case of financial crises- despite the hopes of crypto enthusiasts.

CBDCs- the new threat to crypto

That being said, blockchain technology is not simply being discarded by governments around the world- many are already working on their own Central Bank Digital Currencies (CBDCs) that will operate on blockchain tech.

After all, blockchain technology does offer benefits when it comes to bookkeeping and tackling financial crime.

Permissioned blockchains, with robust anti-money laundering precautions and enforcement of know-your-customer obligations, can help to reduce forgery and other illegal activities. Unfortunately, the very idea of such a blockchain-based currency would fly in the face of the crypto world’s ethos of decentralisation.

As unpalatable as the reality may be, CBDCs are receiving attention and investment from governments because these projects are best able to meet objectives of financial inclusion and technological innovation without compromising too much on security.

Therefore, they represent crypto’s next benchmark- something that crypto needs to surpass if it hopes to replace fiat currencies in national economies.

The point of CBDCs may not be to destroy crypto, but if CBDCs are able to achieve mass adoption without crypto, crypto may find that a large part of its demand is no longer accessible.

Additionally, the fact that CBDCs will be tied to the same fiat currencies that national economies already use, these CBDCs will already have the demand for them built in, while cryptocurrency ecosystems will have to create demand for their tokens from scratch.

This link, however, can also be a single point of failure for the CBDCs during times of financial crisis.

Given how CBDCs will most likely be based on blockchain technology, users may be onboarded to the Web3 world during times of financial stability, and continue using CBDCs during the good times.

However, when financial crises hit, and fiat currencies devalue, CBDCs are not likely to survive the fall as well given how much they rely on fiat currencies.

Citizens may then choose a different currency to conduct transactions in- and leave central banks no choice but to accept the fait accompli of crypto dollarisation.

The process has not happened before- and I might add that it requires many things to go right for crypto- but if central banks and governments are really as incompetent as some crypto enthusiasts suggest, then they should have nothing to fear from CBDCs- unless they are wrong.

The future of money is virtual- it lies in blockchain technology. But whether that takes the form of CBDCs or the form of cryptocurrencies is yet to be decided. But as of now, cryptocurrencies are not suited to replace national fiat currencies. A time may come when the world abandons fiat currencies for crypto- but crypto must first prove itself better than fiat, and better than the CBDC versions of fiat.