Tokenomics 7: Dollarization, currency demand and CBDC- does crypto have what it takes to replace fiat in the national economy?

If you have ever traveled to countries such as Vietnam or Cambodia, you may have noticed that in addition to their own native currency, many local businesses also accept other forms of payment, often in US Dollars.

And, if you have been paying attention to the stability of the US economy lately, you may have noticed that confidence in the US Dollar is falling, and many countries are starting to get nervous about their own currencies.

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

But how does this transition actually work? And is crypto really suitable to replace fiat currency in the national economy?

Dollarization and its impact

Financial crises have a habit of depleting people’s savings – especially when citizens have their lifetime savings expressed in local fiat currency which quickly depreciate.

Not infrequently, this also has a negative impact on the national economy. When production falls, each unit of currency is worth less resulting in inflationary pressures. If the government continues to print money to spend, especially in pursuing Keynesian policies of market stimulation, it could exacerbate inflation as the money supply exceeds production.

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

Dollarization, therefore, is not often the choice of governments – it is more often the choice of collective citizens who have lost faith in local fiat currencies. Zimbabwe, with its famous 100 trillion dollar note, is a prime example, but other countries such as Vietnam and Cambodia have also suffered a similar fate befell their currencies.

In terms of monetary economics, we can say that currency is falling out of use and depreciating in value due to a drastic reduction in the demand for currency – nobody wants to hold currency because they no longer have faith in it.

The reason why currencies like the US Dollar are often chosen to use over other currencies is because the US Dollar is seen as stable – as it serves as a reserve currency for most of the world, demand for US Dollars is expected to increase. stay high. Therefore, someone who accepts US Dollars can expect that other people will also receive US Dollars as payment in the future.

Now that we’ve explored the process of Dollarization and how countries exchange currency, we can turn our attention to crypto- and begin to answer the question of how well it can replace fiat in national economies.

Can crypto replace fiat?

Looking at the prices of cryptocurrencies like Bitcoin and Ethereum, it seems they are perfectly suited to be used as money – after all, an increase in price means an increase in demand for those currencies, right?

But not all requests are born equal. Economists divide the demand for money into three distinct types – transaction money demand, preventive money balances, and speculative money demand.

Transaction money demand refers to the demand for money needed to complete economic transactions such as the purchase of goods and services.

A precautionary cash balance is money saved for emergencies – such as a fund saved to deal with an accident or unexpected expense.

Speculative demand for money refers to money held as an alternative to interest-bearing assets – often bonds or stocks.

Looking at the process of Dollarization and the reasons why people are choosing the US Dollar to replace a hyperinflationary currency, we see that most of the demand for US Dollars is not speculative – citizens do not switch to US Dollars because otherwise they would be putting money into stocks or bonds, but because they need the currency to carry out day-to-day transactions.

The US Dollar is (or at least was) valued for the stability that comes from the high demand for transactions it has – international trade agreements are denoted in US Dollars, and most importantly, oil can only be paid for in US Dollars.

However, not all cryptocurrencies are driven by the same demand. All the talk about Bitcoin going to the moon would suggest that it was speculative demand, not transactional demand, that fueled its growth.

I’ve previously addressed the problem with this- but just to recap, a currency that everyone expects to value would be a poor choice to use as a transactional currency because any rational actor would rather hold it than use it, as its purchasing power is expected to increase in future. Conversely, for a currency to be used for transactions, one must expect it to have a stable value, or little inflation.

And a currency primarily driven by transactional demand and limited supply is unlikely to do well as a currency meant for daily transactions.

Thus, crypto is unlikely to replace fiat currency in the national economy in the event of a financial crisis – despite the hopes of crypto enthusiasts.

CBDCs- a new threat to crypto

That being said, blockchain technology is not just being dumped by governments around the world – many are already working on their own Central Bank Digital Currencies (CBDC) that will operate on blockchain technology.

After all, blockchain technology does offer advantages when it comes to accounting and dealing with financial crimes.

A permissioned blockchain, with strong anti-money laundering precautions and enforcement of know-your-customer obligations, can help reduce counterfeiting and other illegal activity. Unfortunately, the idea of ​​such a blockchain-based currency would fly in the face of the crypto world’s decentralized ethos.

However unpalatable the reality may be, CBDCs receive attention and investment from governments because these projects are best able to meet the goals of financial inclusion and technological innovation without sacrificing security too much.

As such, they represent the next crypto benchmark – something crypto needs to surpass if it hopes to replace fiat currency in national economies.

CBDC’s intention may not be to destroy crypto, but if CBDC can achieve mass adoption without crypto, crypto may find that most of its demand is no longer accessible.

Add to that the fact that CBDCs will be tied to the same fiat currencies that national economies already use, these CBDCs will have demand for them, 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 a CBDC during times of financial crisis.

Given how CBDCs are likely to be based on blockchain technology, users can join the Web3 world during times of financial stability, and continue to use CBDCs during good times.

However, when the financial crisis hits, and fiat currency devalues, CBDCs are unlikely to survive the fall either given how dependent they are on fiat currency.

Citizens could then choose a different currency to make incoming transactions and leave the central bank no choice but to accept a fait accompli of the dollarization of crypto.

The process is unprecedented- and I might add that it takes a lot to get right for crypto- but if central banks and governments are truly as incompetent as some crypto enthusiasts suggest, then they should have nothing to fear from CBDCs- except they are wrong.

The future of money is virtual – it lies in blockchain technology. But whether it will take the form of a CBDC or some form of cryptocurrency is still undecided. But until now, cryptocurrencies were not suitable to replace national fiat currencies. There may come a time when the world ditches fiat currency for crypto- but first crypto has to prove itself better than fiat, and better than the CBDC version of fiat.