Here’s Why the President’s Economic Advisors Don’t Understand Crypto
Examining the Challenges and Opportunities of the Digital Economy: Insights from the Economic Report of the President
By Eric Nemeth, investment associate
"The greater our knowledge increases, the greater our ignorance unfolds. No man can fully grasp how far and how fast we have come." - President John F. Kennedy
Introduction
Every year, the Council of Economic Advisors (CEA) releases ‘The Economic Report of the President’ (ERP), a comprehensive analysis of economic matters that guides policymakers.
Of particular interest in this ERP is the section on Digital Assets, which explores the functions of money and the evolution of our understanding of it, as well as the institutions responsible for its circulation. The CEA addresses the rise of crypto in a dismissive manner to demonstrate the inability of crypto to augment the US Dollar or existing financial institutions. However, the CEA's approach falls short of substantiated constructive criticism.
The criticism is largely focused on the speculative nature of crypto, its viability as money, the risks it poses to stablecoins and the potential harm to consumers and investors. This narrow perspective fails to acknowledge the potential benefits of the technology and does not provide credible feedback to the market. To fully understand and harness the potential of digital assets, it is essential that policymakers take a more nuanced and open-minded approach.
Speculative Nature
Their criticism of speculation is not unique to crypto; speculation is fundamentally an inherent aspect of financial markets when innovation occurs. Not only is speculation a byproduct of innovation, but speculation and risk-taking help drive innovation, a point emphasized by economist Mariana Mazzucato in her work on the public financing of innovation.
Mazzucato argues that governments play a critical role in shaping markets by setting ambitious missions and providing strategic financing to support research and development in areas that are important for societal and environmental goals. This approach drives sustainable and inclusive growth and promotes the public interest.
Without the coordination of regulations and fiscal policy to secure funding for NASA, the United States may never have made the major technological breakthrough in order to put a man on the moon. While this strategic objective was important for national security at the time, it also catalyzed tremendous innovation in the private sector, leading to significant research and investments into advancing computing power and developing new materials ubiquitous across all manufactured goods.
Imagine if we had decided to outsource the research and development of the space race, a critical endeavor for national security, because a small group of unelected officials sued companies seeking to participate in the industry.
Meanwhile, elected officials are mired by other matters of national security but have become misinformed about blockchain such that they cannot see the groundbreaking potential this technology has to disrupt the very fabric which underpins our economy - the US Dollar.
Fundamentally, the United States enjoys success in the world because of the innovations from private market businesses that significantly advanced our nation's economy. But what's critically important was the formation of the capital markets which proliferated the use of US Dollars around the world and introduced the ultimate source of net new money added into the economy.
The dollar is a dominant force in global finance, with about 60% of global reserves and 45% of international transfers denominated in dollars. Its influence is such that one could see it as the operating system of the global economy, with the capital markets it underpins acting as the hardware that enables transactions and investments around the world.
Why would we willingly prohibit the crypto-digital economy from being denominated in Dollars?
The United States' ability to continuously innovate originates from the ability for net new dollars to be injected into the economy through our capital markets to fund entrepreneurs.
The digital economy is the penultimate economic frontier for mankind to explore before becoming space-faring. If we don't develop the infrastructure in the digital economy, it is an open field for anyone else to develop.
As technology evolves and digital financial markets become more efficient, the importance of the US dollar as the global reserve currency could diminish. If other systems can make capital more efficient than our traditional financial markets, the dependence on the dollar may wane, but this would require significant innovation in market infrastructure to enable atomic swapping of assets or securities.
An even bigger threat to dollar dependency, albeit on a longer time horizon, is the development of sovereignless stablecoin designs through the collateralization of tokenized assets. While the probability of this happening is low, it is not zero, and the current financial system has shown vulnerabilities that could be exploited. Those with vested interests in decoupling their financial systems from the US dollar now have tools and network effects to evade US regulatory oversight.
Without a push to be a market leader in developing market infrastructure and enabling the financing of assets on-chain, other countries or entities could come to market and design the digital financial markets without the US.
The Risks Are Not Unique
As we've seen in the past month with Silicon Valley Bank, run risks are not limited to crypto but are a real risk the US financial economy faces today. Because the US financial system is fiat, regulators are able to swiftly change regulations to prevent a liquidity crisis leading to a systemic crisis.
However, the oversight being proposed by US Secretary of Treasury Janet Yellen includes broadening the Financial Stability Oversight Council's (FSOC) scope of regulations to include non-bank financial institutions. The attempt of this is to reel these institutions into the financial market infrastructure to regulate these markets more effectively.
The reasons these markets appear are explained in Zoltan Pozsar’s paper on the topic which highlights institutions' desire for principal safety and liquidity over yield from markets. The institutional cash pools' demand for insured deposits exceeds the amount of government instruments which causes this shadow banking market to arise.
While broadening regulations to these markets may increase transparency, it comes at a cost of compliance for the institutions in these markets which would make the cost of capital more expensive, inevitably to other regulatory arbitrage venues.
Enforcing compliance with evermore regulations without a scalable way for institutions to comply with them is a surefire way to increase regulatory arbitrage.
Without a digitally native approach to finance, the oversight of regulators will only broaden and create more centralization within the financial system as large institutions are the only firms that can comply with these regulations.
A Way “Forward”
The authors suggest that the FedNow Service can address the challenges posed by crypto. This payment system promises to improve the speed and convenience of dollar transactions, but there is a catch: it is only available through participating financial institutions, which require consumers to have depository accounts.
FedNow will likely significantly modernize domestic payment settlements as most people know today. With a highly regulated and centralized banking system, it would be challenging for crypto to offer a more competitive currency.
While FedNow will likely lead to a lot of change in the financial system now, it is less likely to significantly innovate clearance and settlement of securities, derivatives, and other financial instruments. Certainly, faster settlement of cash will help with efficiencies in most fintech applications, but the core clearing houses will also have to innovate for comparable efficiency gains in secondary markets.
Conclusion
The current narrative push for crypto is too polar and one-dimensional for the increasingly multi-polar and fragmented world we are evolving into. The context where crypto innovates is relative to the entrenched control the sovereign has over their fiat currency and subsequent financial markets.
Where do we go from here?
The dismissive approach of the Council of Economic Advisors (CEA) to digital assets falls short of providing credible feedback to the market. The criticism of crypto assets surrounding speculation, viability, stablecoins, harm to consumers and investors, and other financial risks is flawed in misunderstanding the technology.
The digital economy is the ultimate economic frontier for mankind to explore, and the US needs to develop the infrastructure to remain a market leader. Failure to do so may result in competition coming to market and designing digital financial markets without the US, and the US losing its ability to innovate, fund entrepreneurs, exert influence, and inject net new money into the economy.
It is essential to coordinate regulations and fiscal policy to secure funding for innovation in the digital economy, similar to the role of the government in driving sustainable and inclusive growth in private sector innovation.
There needs to be more dialogue and regulatory certainty for the US to participate in crypto going forward. The current regulatory approach falls short in addressing the real risks in crypto and sidelines the US from further participation in the development of this digital economy.
As a step towards addressing these issues, we at SGC recently replied to the United States Office of Science and Technology's request for information on developing a policy agenda for research and development into blockchain. We hope to see more engagement and dialogue in the legislative branch on these issues, and a more informed and constructive approach to regulating and promoting the development of digital assets and the digital economy.