CRYPTOCURRENCIES AND ALL THAT: TWO IDEAS FROM MONETARY ECONOMICS.

• Author: Fernandez-Villaverde, Jesus

The monetary arrangements of societies are the result of the interplay of technology and ideas. Technology determines, for example, which coins can be minted and at what cost. For centuries, minting small-denomination coinage was too costly to induce Western European governments to supply enough small change (Sargent and Velde 2002). Only the arrival of steam-driven presses fixed this problem (Doty 1998). Simultaneously, ideas about private property and the scope of government determined whether private entrepreneurs were allowed to compete with governments in the supply of small change (Selgin 2008). Technology and ideas about money engage dialectically. Technological advances shape our ideas about money by making new monetary arrangements feasible. Ideas about desirable outcomes direct innovators to develop new technologies.

Few moments illustrate the engagement between technology and ideas as pointedly as the last decade. The combination of powerful new cryptographic algorithms (von zur Gather] 2015) and the widespread adoption of high-speed internet has allowed the appearance of cryptocurrencies, issued either by private parties (such as bitcoin and Ether) or, potentially, by central banks (also called central bank digital currencies, or CBDCs; Barrdear and Kumhof 2016). The revolutionary potentialities of those developments (and related advances in artificial intelligence and fintech more in general) are probably bigger than those of any other development in monetary arrangements since the collapse of the classical gold standard during the Great Depression.

Monetary economics must catch up with the new cryptocurrency landscape and help to shape it. While software engineers, financial experts, and entrepreneurs are key players in this process of change, monetary economists have a complementary perspective that can add much to the dialectic process outlined above.

In this article, I want to highlight two ideas from monetary economics that have helped me to organize my drinking about cryptocurrencies. Not only do I believe that these ideas illustrate my assertion regarding the importance of monetary' economics at this crossroads of technological innovation, but also I have often found that these ideas are not sufficiently appreciated by those who look at eryptocurreneies from alternative perspectives such as computer science and the industry.

First, monetary economists are keenly aware that talking about money is talking about frictions. Societies use money because there are essential frictions to trade. Far from participating in an idealized Arrow-Debreu environment, economic agents participate in sequential trades widr varying degrees of anonymity, imperfect monitoring, and lack of commitment. Money appears in societies because agents search for ways to achieve allocations that, in the presence of frictions, could not be achieved without a medium of exchange. In other words, money is essential.

The presence of frictions, however, brings a sharp implication: we cannot assume that the market allocations would be Pareto optimal in the same way that we can work with the presumption of efficiency in textbook Arrow-Debreu environments. (1) Frictions create money, but they also destroy the presumption that private arrangements can be aggregated into desirable outcomes. Therefore, public policy has a potential role to play that does not exist, for instance, in the production of pencils (Friedman and Schwartz 1986). There is no Federal Pencil System, but there is a Federal Reserve System.

The statement regarding the failure of markets in delivering efficient monetary arrangements is more nuanced than it may seem at first sight. While there is a clear role for government intervention, public policies also bring shortcomings of their own due to political economy constraints. The experience of the last 100 years of fiat money, from Weimar Germany to Maduro's Venezuela, demonstrates that governments are perfectly capable of (and often eager to) offering money that is considerably worse than monies created by private parties.

The relevant question is then: under which conditions should a government have a monopoly on money issuance (as we have now)? And, related and important for the topic at hand: has the arrival of cryptocurrencies changed the answer to the previous question?

Second, monetary economists are educated to think in terms of general equilibrium. We spend much time teaching our students that the aggregation of individuals' actions can result in outcomes that are far from those that would hold in isolated decision problems or markets. A famous example (and one particularly relevant for our discussion) is Caplin and Spulber (1987). The authors build an economy with nominal rigidities caused by menu costs in price setting by firms. And, yet, in aggregate, price stickiness disappears and money is neutral. Caplin and Spulber (1987) is a cautionary tale for the implication of cryptocurrencies. For instance, a protocol that issues a cryptocurrency at a speed...