Amid the harsh conditions of this year’s “crypto winter,” one category of blockchain currency has fared better than others: stablecoins, which are pegged to an existing currency such as the U.S. dollar or the Euro. As its counterparts stumbled, the largest stablecoin, Tether, briefly became unshackled from the dollar but managed to hang on. “They weathered the storm,” says Gary Gorton of Yale SOM.
But that doesn’t mean the coast is clear. In several recent publications, Gorton highlights the systemic risks stablecoins pose by comparing them to the private currencies of the past. Those historical analogues ultimately created more problems than they solved and failed to improve on money issued by governments. The very same problems, Gorton argues, are true of stablecoins today.
In a paper co-authored with Sharon Y. Ross of the US Treasury and Chase B. Ross of the Federal Reserve Board of Governors (both Yale SOM alumni), Gorton shows that stablecoins are following patterns similar to the privately issued banknotes of the “free banking” era in American history.
During this period, from 1837 to 1863, banks could issue their own money, ostensibly backed by state bonds. The challenge was that merchants in one region were understandably wary of banknotes from another—resulting in a complex system where currency grew less valuable as the distance from its issuer increased. Lax regulation also made these private notes vulnerable to bank runs. Eventually, to control the chaos, the federal government stepped in and became the exclusive issuer of a uniform national currency.
To Gorton, the complex technology behind stablecoins has prevented us from seeing a simple truth: they are no different from the private currencies of the free banking era. “That’s the last time there was privately produced circulating money,” he says. “And stablecoins are also privately produced circulating money.”
In the paper, Gorton and his co-authors find that private banknotes and stablecoins are following similar trajectories. The researchers created a variable called D that captures the “moneyness” of a currency: qualities including its price, how easy it is to use in practice, and the likelihood that another party would accept it with no questions asked. Over time, D decreased for private banknotes, meaning that they became more money-like. The researchers found that same is happening for stablecoins, although it’s still early days.
Decreases in D, they argue, stem partly from technological shifts. For private banknotes, “it was mostly because of the railroad, which allowed you to get notes back to the issuing banks faster,” Gorton explains—creating less uncertainty about whether they could be redeemed successfully at face value. In the case of stablecoins, improved graphics processing units have made it faster to mine Etherium and convert it to, say, Tether, resulting in greater efficiency.
Reputation formation also reduces D, the researchers note. In the free banking era, notes from newer banks traded at a discount relative to those from established banks in a given region—a testament to the role of trust and track record in currency systems. To build its reputation and demonstrate stability, Tether has begun issuing regular reports about its reserves. These kinds of disclosures are likely to make stablecoins more reputable and therefore more money-like.
But stablecoins becoming more money-like doesn’t mean they improve on government-issued currency, Gorton and Jeffrey Zhang of the University of Michigan Law School write in another recent publication. They argue that—time and again, and across many countries—a government monopoly on issuing money has been shown to provide needed financial stability and allows for necessary control over the money supply.
“We’ve been through this all before, and I think the answer should be the same. Every country on Earth decided that the state should have a monopoly over the creation of a circulating currency.”
By analyzing the financial history of countries including England, Canada, the U.S., and Sweden, Gorton and Zhang show why monopolies are a better strategy than allowing private currencies to compete with government currencies. Many countries adopted the strategy of coexistence—until a major financial trauma convinced them to clamp down. In 19th century Sweden, for example, the central bank twice had to bail out private banks after their currencies collapsed.
Regrettably, in Gorton’s view, the U.S. seems to be headed toward a strategy of coexistence once again. Congress has introduced legislation that would require more transparency from stablecoin issuers, signaling that they have tacitly accepted the presence of private currency in the U.S. financial system and are choosing to regulate rather than ban it.
He sees that as a mistake—especially because it’s possible to eliminate the risks of private money while enjoying the upsides of digital currency. Central banks could issue their own digital currency, with “potentially huge benefits for cross-border trade,” Gorton and Zhang write in a third paper. Today, moving money between jurisdictions is both slow and costly. A global digital currency system could reduce those frictions—something cryptocurrency advocates have long argued. Gorton and Zhang simply think that central banks, not private banks or companies, should be in charge of the system.
“We’ve been through this all before, and I think the answer should be the same,” Gorton says. “Every country on Earth decided that the state should have a monopoly over the creation of a circulating currency.” The technology has changed, but the underlying issues are the same: “It’s not any different now.”