Tag Archives: Reputation

How Does the Blockchain Transform Central Banking?

The blockchain technology opens up new possibilities for financial market participants. It allows to get rid of middle men and thus, to save cost, speed up clearing and settlement (possibly lowering capital requirements), protect privacy, avoid operational risks and improve the bargaining position of customers.

Internet based technologies have rendered it cheap to collect information and to network. This lies at the foundation of business models in the “sharing economy.” It also lets fintech companies seize intermediation business from banks and degrade them to utilities, now that the financial crisis has severely damaged banks’ reputation. But both fintech and sharing-economy companies continue to manage information centrally.

The blockchain technology undermines the middle-men business model. It renders cheating in transactions much harder and thereby reduces the value of credibility lent by middle men. The fact that counter parties do not know and trust each other becomes less of an impediment to trade.

The blockchain may lend credibility to a plethora of transactions, including payments denominated in traditional fiat monies like the US dollar or virtual krypto currencies like Bitcoin. An advantage of krypto currencies over traditional currencies concerns the commitment power lent by “smart contracts.” Unlike the money supply of fiat monies that hinges on discretionary decisions by monetary policy makers, the supply of krypto currencies can in principle be insulated against human interference ex post and at the same time conditioned on arbitrary verifiable outcomes (if done properly). This opens the way for resolving commitment problems in monetary economics. (Currently, however, most krypto currencies do not exploit this opportunity; they allow ex post interference by a “monetary policy committee.”) A disadvantage of krypto currencies concerns their limited liquidity and thus, exchange rate variability relative to traditional currencies if only few transactions are conducted using the krypto currency.

Whether blockchain payments are denominated in traditional fiat monies or krypto currencies, they are always of relevance for central banks. Transactions denominated in a krypto currency affect the central bank in similar ways as US dollar transactions, say, affect the monetary authority in a dollarized economy: The central bank looses control over the money supply, and its power to intervene as lender of last resort may be diminished as well. The underlying causes for the crowding out of the legal tender also are familiar from dollarization episodes: Loss of trust in the central bank and the stability of the legal tender, or a desire of the transacting parties to hide their identity if the central bank can monitor payments in the domestic currency but not otherwise.

Blockchain facilitated transactions denominated in domestic currency have the potential to affect central bank operations much more directly. To leverage the efficiency of domestic currency denominated blockchain transactions between financial institutions it is in the interest of banks to have the central bank on board: The domestic currency denominated krypto currency should ideally be base money or a perfect substitute to it, directly exchangeable against central bank reserves. For when perfect substitutability is not guaranteed then the payment associated with the transaction eventually requires clearing through the traditional central bank managed clearing mechanism and as a consequence, the gain in speed and efficiency is relinquished. Of course, building an interface between the blockchain and the central bank’s clearing system could constitute a first step towards completely dismantling the latter and shifting all central bank managed clearing to the former.

Why would central banks want to join forces? If they don’t, they risk being cut out from transactions denominated in domestic currency and to end up monitoring only a fraction of the clearing between market participants. Central banks are under pressure to keep “their” currencies attractive. For the same reason (as well as for others), I propose “Reserves for All”—letting the general public and not only banks access central bank reserves (here, here, here, and here).

Why Do Sovereigns Repay External Debt?

In a Vox blog post (that complements another post on Greece), Jeremy Bulow and Ken Rogoff review the academic discussion on a long-standing question—why sovereigns repay their external debt.

Bulow and Rogoff distinguish between

[t]he ‘reputation approach’ pioneered by Eaton and Gersovitz (1981) which builds on Hellwig (1977);
and the ‘direct punishments’ bargaining-theoretic approach of Bulow and Rogoff (1988b, 1989a) which in turn builds on Cohen and Sachs (1986).

They argue that the latter approach—attributing enforceable rights in foreign country courts to creditors—better explains observed outcomes.

[The] direct punishment/bargaining approach lends itself very naturally to incorporating moral hazard; …
reputation models suggest [counter factually] that the governing law of the debt is irrelevant;
[i]n standard reputation for repayment models, write-downs are decided unilaterally—creditors’ particular concerns do not really matter; …
[t]he interests and welfare of unrelated third parties does not matter in standard reputation models; …
[r]eputational debtors borrow in bad times and re-pay in good times, for purposes of income smoothing; [d]efaults, if they are to take place, occur in good times … In reality, many countries borrow as much as they can whenever they can. … Debt crises occur when countries do badly and creditors decide they want to reduce their loan exposure. To some extent, this issue can be addressed by assuming that income shocks are permanent and not transitory, but it remains difficult to rationalise country borrowing only on the threat of lost consumption smoothing. …
[c]reditor identity doesn’t matter; …
[u]nder … general assumptions, the existence of [the option to put savings abroad] leads to the unravelling of any purely reputational equilibrium.

Bulow and Rogoff add that

[a]nother important issue … is that in practice, sovereign debt renegotiations focus very much on the flow of repayments, and much less on how the stock of debt evolves. This is precisely because all sides realise that any future promises can be renegotiated.