Cryptoliquidity: The Blockchain and

Monetary Stability∗
James L. Caton†
September 27, 2018

Abstract
The development of blockchain and cryptocurrency may alleviate the
economic strain associated with recession. Economic recessions tend
to be aggregate demand driven, meaning that they are caused by
fluctuations in the supply of or demand for money. Holding mone-
tary policy as solution assumes that stability must arise from outside
of the economic system. Under a policy regime that allows innova-
tions in blockchain to develop, blockchain technology may promote a
money supply that is responsive to changes in demand to hold money.
This work suggests that cryptocurrencies present an opportunity to
profitably implement rules that promote macroeconomic stability. In
particular, cryptocurrency that is asset-backed may provide a means
for cheaply attaining liquidity during a crisis.

JEL Codes: E40, E41, E42

Keywords: blockchain, cryptocurrency, endogenous money, liquidity, dise-
quilibrium

AIER Sound Money Project

Working Paper No. 2018–15
∗
I owe gratitude to Cameron Harwick for his comments on an early draft. I also bene-
fitted greatly from conversations with attendees at the Fargo Bitcoin meetings. Without
help from these individuals, this paper would not have been possible.
†
Department of Agribusiness and Applied Economics, North Dakota State University,
Fargo, ND 58102 james.caton@ndsu.edu

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1 Introduction

In the last decade, the value and significance of blockchain technology

has gained recognition among entrepreneurs, policy makers, and academics.
What appeared to the casual observer to be simply a monetary phenomenon
has been recognized as a new means of organizing social activity, particularly
exchanges and ownership (Davidson, Filippi, and Potts 2016; Antonopou-
los 2016). Blockchain technology enables secure transactions on distributed
networks, showing potential to reduce transaction costs and transform the
structure of economic activity.

Focus has begun to shift from cryptocurrency to other uses of blockchain

technology. While this is understandable, the following argument will show
that the blockchain has only just begun to change our conception of money,
banking, and liquidity. The blockchain has potential enable a money stock
that is responsive to fluctuations in demand for money and greatly reduce the
cost of monetizing existing or future assets. This can reduce inefficiencies that
arise from aggregate-demand driven macroeconomic disequilibrium (Yeager
1956; Leijonhufvud and Clower 1981; Horwitz 2000). In the least, it may
prevent extreme macroeconomic fluctuations that are produced by erratic
macroeconomic policies, such as those observed during the Great Depression
(Glasner 1989; Hawtrey 1947; Sumner 2015a; Vedder and Galloway 1997).

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 I begin by describing money, the blockchain, and the relationship between
the two and follow by showing 1) how monetary theory informs our under-
standing of money creation through the blockchain, 2) how competitive forces
make the creation and adoption of a high-quality cryptocurrency practically
inevitable even if one cannot predict beforehand which blockchain structure
will be adopted for this purpose, and 3) how regulatory and tax policies can
either enable or inhibit these developments.

2 Money and the Blockchain

In order to discuss the relationship between money and the blockchain

requires an adequate description of both. Money is a commonly accepted
medium of exchange. It serves as an intermediate good that is typically
accepted by a community of buyers and sellers of goods. Although particular
details vary across blockchains, a blockchain can be described generally as
an accounting ledger comprised of different nodes – accounts – whose records
cannot be altered without approval of at least a majority of votes allocated to
nodes in the system. Cryptocurrency is an electronic money. It is produced
and secured on a blockchain.

2.1 Money

Although money operates fundamentally as a medium of exchange, great

benefit lies in its enabling of accounting. Money itself must necessarily have

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been preceded by reciprocal favors through relatively small networks of social
bonds (Bourdieu 1990; Harwick 2017). Such a system does not scale as
transaction costs of developing a relationship are relatively high and the span
of affiliation is constrained as a result. Before money arises, there exists no
low-cost common numeraire – unit of account – that allow economic actors
to compare the value of goods in fine detail. Money enables this, allowing
producers of goods to compare costs and revenues and thereby evaluate their
contribution or diminishment of value in the economy and, therefore, to
their own wealth. It allows these same actors to hold their wealth in an
asset whose value is highly stable and easily saleable (Menger 1892). By
lowering transaction costs, money enables development of a broader network
of exchange by lowering the level of trust required to engage in trade (Horwitz
2008). Increases in the efficiency of exchange make society wealthier and
allows for the development of more expansive trade networks. Finally, money
enables banking. Money lowers the cost of lending since money can be lent
to investors who wish to purchase physical assets rather than lending the
physical assets themselves, a process much more costly to coordinate.

2.2 Blockchain

Like money, a blockchain is a means of accounting. Ownership of money

represents a claim to resources in an economic system in light of the prefer-
ences of agents who own each. Even without an accounting ledger, a money
of stable value enables accounting of claims to value. The blockchain is an

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accounting ledger whose transactions are public to other nodes in the net-
work. A functional blockchain network enables convergence of every account
to a true representation of agreements in the system. This is achieved demo-
cratically. Nodes are allocated votes, perhaps on a one-to-one basis or on
a basis tied to productivity or participation in the network.1 These votes
legitimate changes in the public ledger according to whichever standard has
been adopted for the system.

The ledger allows agents to stake claim to particular assets recognized

by the blockchain. The Bitcoin blockchain allows owners to stake claim to
Bitcoins and ensures the secure transfer of these assets between exchanging
parties (Nakamoto 2008). For Bitcoin’s blockchain and many other, the
ledger of these nodes are encrypted, with miners competing to ascertain
the correct key that grants access to changed ledger for the reward of new
currency and for the greater purpose of democratically confirming the new
state of the ledger among successful mining nodes.

A blockchain may recognize a wide variety of assets. The Ethereum

blockchain, for example enables the creation of smart-contracts whose terms
are executed once the criteria of the contract are met (Ethereum White Pa-
per). Since blockchain ledgers are secure, there is no need for a third party to
intermediate the transfer of goods and funds entailed in the contract. More
1
The latter two of these mechanisms allocating voting rights concerning legitimacy of
new accounting records are referred to as “proof-of-work” and “proof-of-stake”.

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generally, blockchains that securely and automatically manage the exchange
of assets are referred to as decentralized autonomous organizations (DAOs).

2.3 Cryptocurrency

Cryptocurrency is necessarily linked to the blockchain. In the case of Bit-

coin, it is the only alienable asset associated with the blockchain. Other
blockchains, like Ethereum, operate like Bitcoin but also allow for the regis-
tration of other assets on the blockchain. Still others enable the creation of
cryptocurrency through the tokenization of assets. Asset owners can register
their assets on the blockchain and receive, directly or indirectly, cryptocur-
rency in exchange.

The growth path of cryptocurrencies like Bitcoin are constrained by an

algorithm that determines that rate at which new currency units are made
available. With a predetermined growth path, these cryptocurrencies are un-
able to respond to changes in demand for money that accompany changes in
the rate of economic growth as well as economic crises. Blockchains that al-
low the quantity of currency created to change with demand for the currency
will improve the ability of the market to stabilize economic fluctuations.

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3 Dynamics of Money Creation

The quantity of money under a commodity regime is determined in light of

demand for money and the elasticity of the supply of money.2 The response of
the money supply alleviates pressure that is otherwise placed on prices. For
the promotion of macroeconomic equilibrium, the case of economic recession
is of special interest. During a depression, demand for money tend to exceed
it supply, thus promoting a general fall in prices. This fall in prices may lead
to discoordination in credit markets that might be alleviated by the creation
of money and money substitutes.

Using the theoretical framework below, the role of cryptocurrency as base

money as well as near money will be considered. Near money is a catego-
rization refers to an asset with a high level of liquidity. Such assets alleviate
demand for base money during a crisis and thus serve the function of stabiliz-
ing the value of total expenditures (aggregate demand) much as the creation
of new money does.

3.1 Money and Macroeconomic Disequilibrium

Macroeconomic disequilibrium arises when there is a discrepancy between

the value of total expenditures and the aggregate value of goods and services
that are available for sale and which would be sold in macroeconomic equilib-
rium. For the sake of analytical simplicity, let us assume that there is some
2
The foundations of the analysis below are presented in the appendix.

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level of growth of real income in the long-run.3 This value anchors analysis,
allowing for the description of macroeconomic equilibrium, and therefore,
macroeconomic disequilibrium. Anlaysis begin again with the equation of
exchange. Real level of economic growth in the long-run is defined as y0 .
The value of the other variables at any time are defined by the subscript t.
At any time, we define the macroeconomy by:

Mt Vt = Pt yt (1)

The function can be rearranged to isolate yt :

Mt Vt
yt = (2)
Pt

In equilibrium the observed value of real income is equal to the value that is
sustainable in the long-run:

yt = y0 (3)

yt can be replaced with its equivalent in terms of Mt , Vt , and Pt and rear-

range to restate the equation of exchange in terms of aggregate supply and
aggregate demand:

Mt Vt = Pt y0 (4)
3
Long-run is defined as the state that will be reach absent exogenous shocks to the
model. It is not a reference to a particular or even a potential range of time.

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Macroeconomic disequilibrium is defined as any case where not all available
goods are sold or where more goods are produced than is economically sus-
tainable in the long-run. In disequilibrium:

yt 6= y0 (5)

And therefore:

Mt Vt 6= Pt y0 (6)

In order for the market to clear, the classical macroeconomic model (see
Snowdon and Vane 2005; Clower and Leijonhufvud 1981) demands that the
price level adjust to offset the discrepancy between Mt Vt and Pt y0 .

3.2 Economic Recession

The case of economic recession is of prime interest to the cryptocurrency
markets and merits further description. The National Bureau of Economic
Research defines a recession:

a significant decline in economic activity spread across the economy,

lasting more than a few months, normally visible in real GDP, real
income, employment, industrial production, and wholesale-retail sales.
(2008)

This situation where there remain unsold goods is described as:

y0 − yt > 0 (7)

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There exists an excess supply of goods whose real value is equal to the dif-
ference between y0 and yt .

For the purpose of describing economic recession, Equation 7 requires fur-

ther elaboration. A recession occurs when there is a significant and sustained
discrepancy between y0 and yt . Given agent preferences to hold money in
the long-run, which is autonomous, there does not exist enough money for
these goods to be sold at the current price level, Pt . The price level must
fall. If the price level falls, the value of money increases and producers of the
commodity that serves as money may increase profits by providing a greater
quantity of the good to the market. Thus, increases in real cash balances
tend to translate to changes in M in the long-run.

Since yt can be described in terms of Mt , Vt , and Pt , a recession may also

be described as occurring when the nominal value of total expenditures is less
than the value of available goods at price level Pt , such that prices cannot
quickly adjust to offset this equilibrium:

Mt Vt < Pt y0 (8)

Not all goods available for sale are purchased in this case so that there exists
an excess supply of non-money goods where, Pt yt , the nominal value of goods
purchased is less than Pt y0 , the nominal value required to purchase all goods
at price level Pt .

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 By identity, this means that there exists an excess demand for money where
the quantity of money in circulation is less than the quantity demanded at
price Pt given available supply of non-money goods y0 :

Pt y 0
Mt < (9)
Vt
1
Substitute kt for Vt
:

Mt < Pt y0 kt (10)

Read left to right, this states that the existing stock of money is less than
quantity of money demanded as defined by a combination of transaction
demand for money, Pt y0 , and portfolio demand for money, kt . In the case of
an aggregate demand driven recession, the existing money stock is insufficient
to purchase all goods available for sale in light of the preference of the average
agent to hold money. If Equation 10 is divided by the price level (as in
equation 5A), either M must increase or P fall for all goods to be sold, thus
allowing yt to rise to the level y0 .

4 Monetary Rules in Economics

Discussion of the role of crypto currencies as money and in promoting

macroeconomic stability can be informed work on monetary rules intended
to constrain central bank decision-making. Rules governing the expansion of

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the money stock with intent to offset shocks to money and credit markets
hold prominent place in discussions of macroeconomic theory. A good mon-
etary rule must consider the role of money in contributing to and alleviating
macroeconomic disequilibrium. Some popular rules promoted for constrain-
ing central bank decision-making include Milton Friedman’s k-percent rule
(Salter 2014), John Taylor’s “Taylor rule” (Taylor 1993; Woodford 2001),
and nominal income targeting (Sumner 2014; 2015b). Broadly, each of these
rules attempt to maintain a non-negative, if not positive, rate of inflation.
The idea being that a negative inflation rate is correlated with positive de-
mand for money not offset by monetary growth (Equation 10). The k-percent
rule targets a positive and constant growth rate of the money stock. The
Taylor attempts to offset discrepancies between target and actual inflation
rates, real interest rates, and rates of growth of real income. Nominal income
targeting follows most closely the above presentation. It attempts to offset
changes in portfolio demand for money (i.e., velocity) in order to maintain a
targeted growth rate of nominal income.

A different sort of rule would require that a nation’s currency be backed

by tangible assets, as under the gold standard. The history of money en-
tails the selection of assets that are used as money and the development of
instruments backed by those assets, the most significant such case being the
gold standard. Paper currency represented claims to gold and tended to be
created by private competitors, though in many cases, particularly in the

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19th and early 20th centuries, government notes backed by gold reserves at
the central bank circulated as money (Hawtrey 1947). Under such standards,
the backing of legal tender with gold served as the monetary rule, though
the ratio of this backing was not always strictly defined or enforced. In the
U.S. colonies, it was not uncommon for state notes to be backed by tobacco
(Rothbard 2002).4

While each of these proposals, if consistently implemented, might produce

superior results to a discretionary regime, the gulf between theory and prac-
tice is quite significant. For an executive at a central bank, his or her job
seems to oppose the simple operation of a rule (White 2010). Otherwise, a
well-chosen rule could essentially replace the head of a central bank. The job
of the central banker would be to watch the system evolve according to the
monetary rule.
Since changes in the quantity of a cryptocurrency are necessarily rule-constrained,
4
The idea of an asset-backed, national currency did not die with the gold standard. In
1943, having been disillusioned by the failure an international gold standard managed by
poorly coordinated central banks, F. A. Hayek wrote, “A Commodity Reserve Currency”
where he detailed the functioning of a commodity backed reserve currency whose operation
would be subject to a rule structure. Hayek’s article followed the suggestion of Benjamin
Graham (1937) and Frank D. Graham (1942), which both followed a proposal “by the
Dutch economist, Professor J. Goudrian, in a pamphlet, How to Stop Deflation (London,
1932).” Hayek’s proposal argued that monetary authorities employ a basket of commodities
as reserves. This authority would target the price of the basket, such that when the basket
is below the target price, the monetary authority increases its holdings of commodities in
the basket through purchase enabled by an expansion of the money stock. When the price
of the basket is above the target, the monetary authority sells its holdings of the basket
of commodities. With a basket of commodities that is sufficiently broad, this would allow
the relative prices of these commodities to fluctuate while overall demand for the basket
is sustained. Consistent with our discussion of regulation of the money stock, changes in
the quantity of money under such standards are governed by rules.

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they are well-suited for the adoption of rules that promote macroeconomic
stability. Political concerns hold less influence over a rule’s selection and
implementation for cryptocurrency. The expansion of each cryptocurrency is
subject to unique protocol. Unlike the rules discussed in monetary theory, the
rules governing the expansion of cryptocurrency are not necessarily aimed at
promoting macroeconomic stability. Rather, they are aimed at maintaining
scarcity of the money stock and predictability of its expansion.

4.1 Monetary Rules for Cryptocurrencies

Next we consider the mechanisms governing the growth of Bitcoin, Ripple’s

XRP, and cyrptocurrencies like ATLANT that are generated through the
registration and tokenization of assets on a blockchain. The key feature
of a good monetary rule is that it adjusts the quantity of money in light
of changes in demand for it. It is not necessary that the monetary rule
perfectly or automatically offset changes in demand for money. It is sufficient
that actors in the market can profit from offsetting the shortfall in aggregate
demand at a given price level. A cryptocurrency that enables creation of
currency to adjust to changes in demand for money will create value for
parties demanding new money and exploit value creation potentiated by a
surge of demand for currency.

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4.1.1 Bitcoin5

Bitcoin was the first cryptocurrency to market. Its maximum quantity

was prestated. Nearly 21 million bitcoin will be released through a process
of mining, with the final bitcoin being mined in 2040.6 A block as added to
Bitcoin’s blockchain each time a miner solves the hash associated with the
block. Bitcoin are released with each block mined. A new block is mined
every ten minutes. The new block contains a record of every new transaction
that has occurred since the creation of the previous block.

The blockchain itself is a series of blocks that contain a history of trans-

actions. Each block is identified by a hash that links to the block’s key. The
hash is generated algorithmically with a pseudo-random number generator.
A correct hash is discovered by competing miners. Bitcoin are released every
time a miner generates the correct hash. To account for improvements in
processing power associated with Moore’s law, the hashes become increas-
ingly difficult to solve as the rate at which blocks are mined increases above
the long-run rate stipulated by bitcoin protocol.

The protocol for increase in the quantity of bitcoin has features similar to
the k-percent rule. Although the quantity of bitcoin does not increase by
some percent, it does grow at a constant rate in terms of units of bitcoin.
5
For discussion of Bitcoin protocol, see Antonopoulos (2014)
6
GitHub: https://github.com/bitcoin/bitcoin/blob/08a7316c144f9f2516db8fa62400893f4358c5ae/src/amount.h
(Accessed June 5, 2018)

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This rate, changes over time. It started as 50 bitcoin per block and is halved
every 4 years until all bitcoin have been issued. The current rate of release is
12.5 bitcoin per block. Miners also receive a fee for each block mined.. Once
all Bitcoin are released, successful miners will receive only the fee for the
service of de-encrypting and confirming the record of transactions recorded
in each block.

4.1.2 Ripple’s XRP

Ripple’s currency, XRP, is unique compared to many cryptocurrencies.

XRP are not mined. Rather, a fixed number of XRP have already been
created. Currently there are just over 39 billion XRP in circulation while
there actually exist 100 billion XRP. Of the over 60 billion remaining XRP,
the vast majority will be released systematically. According to Ripple CEO
David Schwartz:

The escrow consists of independent on ledger escrows that release a total

of one billion XRP each month over the next 55 months. This provides an
upper limit on the amount of new XRP that can be brought into circulation.
The amount of XRP actually released into circulation will likely be much less
than this. Any additional XRP leftover each month will be placed into a new
escrow to release in the first month in which no escrow currently releases.
(Schwartz 2017)

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 If the full 1 billion XRP are released each month, this would initially
amount to a monthly expansion rate of over 2.5% with the final monthly re-
lease amounting to a monthly rate of just over 1%. Once all XRP have been
released, stock of XRP will actually begin to shrink. With every transaction,
a small quantity of XRP, 0.00001, is destroyed.7 This transaction cost is
intended to prevent any user from overloading the network with transaction
requests. At this rate, there will be no XRP left in existence after 10 quin-
tillion transactions. Many expect that those in control of validator nodes on
the blockchain, which have voting rights, will vote to change the transaction
fees if this becomes prohibitive to adoption (XRP Ledger Documentation:
Fee Voting).8

4.1.3 Asset Backed Cryptocurrencies

Cryptocurrency protocol can require that cryptocurrency be backed by as-

sets registered on the blockchain. Asset-backed cryptocurrencies operate in
two ways. They either trade on a blockchain that is tied directly to assets,
but with the creation of coins being linked to an initial coin offering rather
than assets themselves. Kodak’s KODAKCoin will operate in this manner.
Although it is yet to launch, KODAKOne users will pay to use photos up-
loaded on the platform. KOKDAKOne recently signed an agreement that will
allow several sports arenas to participate in the system (Kim 2018). Another
7
XRP Ledger Documentation. “Transaction Cost.” Accessed June 5, 2018:
https://developers.ripple.com/transaction-cost.html
8
XRP Ledger Documentation. “Fee Voting.” Accessed June 5, 2018:
https://developers.ripple.com/fee-voting.html

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cryptocurrency of this variety, ATLANT, allows users to use cryptocurrency
to buy claims to real estate. Investors gain voting rights over management
of real estate and a claim to future revenues earned by the asset. The value
of cryptocurrencies such as these can be thought of as representing at least
the value of the assets registered on the blockchain.

The second type of asset backed cryptocurrencies are generated by the

registration of assets on the blockchain. A number of gold backed cryptocur-
rencies have taken on just this strategy. Many of these create one coin for
every unit of gold that is registered on the blockchain. Thus, the instruments
operate as an asset backed ETF. Royal Mint Gold (RMG), developed and
managed by the United Kingdom’s Royal Mint, offers sells gold that is held
securely and may even be delivered on request.9 The Royal Mint plans to
register RMG on exchanges so that it can be traded for other currency.

Cryptocurrencies, such as RMG, which require an asset to offset the cryp-

tocurrency, offer the benefit that assets can be monetized at low cost. For
cryptocurrencies that are backed by non-liquid assets, such as real estate,
this serves to make the money stock much more responsive to changes in
demand. Reminiscent of early bank notes, asset backed cryptocurrencies are
highly liquid securities that can even be used directly in exchange.
9
The Royal Mint: https://www.royalmint.com/invest/bullion/digital-gold/ (Accessed
June 10, 2018)

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5 Near-moneys, Liquidity, and Demand for

Money

It is not necessary that any cryptocurrencies be broadly adopted as money

in order for these to serve a stabilizing service. A crypto currency might
have stable demand in niche markets – e.g., exchanges on the “deep web”
(Hardy and Norgaard 2016; Norgaard, Walbert, and Hardy 2018), KO-
DAKOne’s platform, or in nations that have an unstable monetary regime
(The Economist, April 3, 2018). To this extent, the crypto currency will be
able to alleviate some of the burden to purchase goods that would otherwise
be borne by the commonly accepted medium of exchange. Even if this is not
the case, cryptocurrency may play a role in alleviating demand for money as
a near money: a highly liquid store of value. If a cryptocurrency is accepted
broadly by investors, it may be employed as a means to liquidity and a hedge
in the face of market instability. The following reviews the concept of liquid-
ity and near moneys and then consider the usefulness of crypto currencies in
this respect.

Money may exist as base money or as substitutes for base money like de-
posit accounts or other highly liquid assets. Standard analysis describes the
creation of credit money and near-moneys in terms of higher level monetary
aggregates (M1 , M2 , etc. . . ). In this case one may think of cryptocurrencies
as supplementing the existing stock of money. It is useful to think of the de-

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velopment of cryptocurrency markets as a response to an increase in demand
for currency that neutralizes the price level effect of that increase in demand.
While cryptocurrency functions as money among relatively small networks,
major positions in cryptocurrency currently tend to be speculative (Luther
and White 2014; Baur et al., 2018). Despite significance of speculation in the
early life of cryptocurrencies, Bitcoin and other cryptocurrencies might also
be used as a hedge against other financial instruments and indices (Dyhrberg
2016). Even if cryptocurrencies do not become accepted by all actors in an
economy, the asset class can meet demands for liquidity.

The quickness with which these money substitutes can be created makes
cryptocurrency a valuable asset for those seeking liquidity. As the quantity
of substitutes for base money increases, the velocity of base money also in-
creases. This is significant for the mitigation of short-run disequilibrium. A
long tradition of research in macroeconomics recognizes the significance of
liquidity costs in affecting the value of financial instruments (Keynes 1930;
Glasner 1989, 144; Hicks 1989, 55-79; White 1999, 14) and liquidity shortage
driving crisis dynamics (Keynes 1936; Diamond and Dybvig 1983; Yeager
1956, 444-446).

It is tempting to think of an increase in financial instruments as represent-

ing an increase in the money stock. We differentiate between base money
and broader moneys. Base money is MB and the total money stock, which
includes broader moneys is MT . These can be weighted according to liquidity

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as in the case of Divisia (Barnett, Offenbacher, and Spindt 1984) such that
the contribution of a financial instrument to the overall money stock is some
fraction of it’s market value. The base money stock and total money stock
are both subject to different velocities: VB and VT .

The velocity of the base, or equivalently, portfolio demand for base money
is itself a function of the credit stock. An net increase in the credit stock tends
negatively influences demand for base money. Money that is not base money
is itself a substitute for base money. Thus, a shift in money holdings from
base money to non-base money is equivalent to a shifting of demand away
from base money. Financial markets tend to respond to such a demand by
creation of new instruments. Assuming that the base is static, an increase
in the quantity (MT − MB ) translates directly to an increase in VB and,
equivalently, a fall in kB .

Deposit and money market accounts along with highly liquid securities
like U.S. treasury notes service demand for liquidity. It is not uncommon for
interest rates on highly liquid instruments to become depressed preceding a
recession (Chinn and Kucko 2015; Longstaff 2001). This occurred during the
Great Recession with the rate of return on U.S. Treasuries beginning a steep
decline more than 6 months before the last recession.10 This represented a
10
Erdogan, et al., (2015) note:

The use of a US government yield curve arguably makes sense for pre-
dicting crises or recessions because it is forward looking and implicitly

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swift reversal in the yield curve inversion that had preceded this and most
other recessions (Estrella and Trubin 2006, 4). While intervention in this
overnight lending market explains the near-zero rates that followed the re-
cession, the initial fall was a response of an increased demand for liquidity
(Erdogan, et al., 2015). There was a similar rise in the price of commodities
in the face of volatility as the move to electronic trading has greatly increased
investor exposure to commodity backed instruments (Irwin and Sanders 2011;
2012; Gilbert 2010). The quantity of these contracts are highly sensitive to
increases in demand for them.

Assets that serve as a store of value and are also a low cost means to
accessing money can help alleviate a fall in demand for money. The existence
of near-moneys, money-like assets, may offset autonomous changes in demand
to hold money. The cost of holding money is the gain foregone by not holding
other assets (Friedman 1956). For example, the holding of money in a savings
account yields a small amount of interest with very low cost in terms of loss
projects future risk-free interest rates, in the context of a highly liquid
and informationally efficient market. . . Lower forward interest rates
indicate current market expectations of falling future short-term in-
terest rates. This in turn could reflect lower expected inflation premia
or, more relevant to the topic at hand, lower expected real interest
rates (or lower required risk-free real returns) associated with a slack
economic environment, or both. A closely related interpretation is
that government securities provide a haven from prospective credit
problems in the event of a recession, causing the prices of treasuries
to rise as investors flee risk, accepting low or even negative interest
rates as the price of safety. (408)

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of liquidity. One can leave their money in a checking account and treat funds
in the account as being available for expenditure. While it is appropriate to
treat funds in a deposit accounts or invested in near-moneys as money, it is
useful for our purpose this analysis to treat a these instruments as alleviating
portfolio demand for base money or, equivalently, increasing the velocity of
base money.

5.1 Demand for Money and Supply of Cryptocurrency

Although cryptocurrencies are not credit money, they can operate accord-
ing to the same dynamics as the financial instruments discussed above. With
the appropriate monetary rules, they can even be more effective than stan-
dard financial markets in responding to increases in demand for currency,
especially during a crisis.

During an economic crisis, demand to hold money increases such that not
all available goods can be sold (Equations 7-10). Cryptocurrencies that can
increase the money stock during a crisis serve can both increase their adoption
and stabilize aggregate demand purely through market mechanisms. Given
the rules that are reviewed above, the most promising in this respect are
asset backed currencies. While the particular details of any cryptocurrency
protocol differ, these currencies can promote monetary expansion to the ex-
tent that assets can be registered on a blockchain and, presumably, there
exist no competing claim for the portion of the assets value that is converted

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to cryptocurrency. If there exists no need to repay the claim against the
asset, the conversion of the asset’s value into cryptocurrency amounts to an
interest free loan.

6 Competition, Entrepreneurship, and the Blockchain

It’s tough to make predictions, especially about the future. - Yogi

Bera

Cryptocurrency can serve as a substitute for legal tender, either through

networks that use them directly or as near moneys that can provide low-cost
access to legal tender. This claim pertains to the potential of cryptocur-
rencies, not the current state of cryptocurrencies. Two things remain to be
discovered. 1) Which cryptocurrencies structures will bring the most value
to cryptocurrency users. 2) What effect will the regulatory environment have
on the development and application of blockchain technology?

6.1 Entrepreneurial Discovery and the Blockchain

The explosion in the variety of blockchain technlogy is an ideal example

of combinatorial creativity (Potts 2000; Koppl, et al., 2015). Different net-
work structure, encryption technology, asset classes, protocol for creation
and release of cryptocurrency, and so forth. This makes prediction of which
cryptocurrencies will be successful exceedingly difficult. While the analysis

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suggests asset-backed crypto currencies can promote macroeconomic equilib-
rium during a crisis, the success of a given blockchain and cryptocurrency is
dependent upon many other factors. Which manifestation of blockchain tech-
nology will benefit users well enough to gain widespread adoption remains
an open question.

Innovation gains widespread adoption as entrepreneurs lower the cost of

providing technology and make that technology accessible to the user. For
example, Steve Jobs provided just this with the development of relatively
cheap desktop computers with graphical user interfaces (Isaacson 2011). Bill
Gates accomplished a similar feat by concentrating on dramatically reduc-
ing costs of operating systems and easy to use programs with widespread
applicability like Microsoft Word and Excel. The choice of the appropriate
product and the cost-efficient means of providing that product is no small
task. It requires a willingness to experiment, fail, and, ultimately, to learn
(Kirzner 1973; Harford 2011). Competition in markets tend to produce the
lowest cost strategies.

The role of the entrepreneur is to overcome uncertainty and bear the cost
of doing so (Knight 1921; Foss and Klein 2012). It is to learn in the broadest
sense of the word. Entrepreneurship In his classic article, “Uncertainty, Evo-
lution, and Economic Theory”, Alchian (1950) reasons that economic agents
need not be perfectly knowledgeable and, in fact, cannot know beforehand
the solutions that the market will generate. Competitive processes, through

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a process competition and selection, generate outcomes that are highly func-
tional, if not perfectly efficient (Caton 2017).

Blockchain technology is already disrupting banking as the Ripple network

has greatly reduced the costs of transactions, especially cross border transac-
tions (Arnold 2018). Over 100 banks have adopted the Ripple Network. Even
SWIFT, the dominant player in this market, has begun to make changes to a
model that had remained unchanged for decades. Unlike Bitcoin’s blockchain
and many others, Ripple’s blockchain does not require making the task of
miner’s increasingly difficult as processing speed improves. Instead, changes
in Ripple’s ledger depend upon and 80% consensus amongst nodes on the
same server. This democratic structure allows for low computational costs
while still maintaining the security of the ledger.

Blockchain technology is developing in precisely this fashion. Companies

have quickly begun to integrate blockchain technology into their operations.
Kodak’s use of blockchain to secure rights over photographs and create a
market for their purchase certainly counts as one such innovation. Louis
Dreyfus Company recently executed the first transaction in agriculture that
uses blockchain technology to reduce “time spent on processing documents
and data from hours to minutes (Louis Dreyfus Company 2018).” Examples
exist of blockchain application exist and are emerging in many areas, includ-
ing supply chain management, contracts, and healthcare (The Enterprisers
Project, July 2 2018; Berg et al., 2018).

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 Even applications of blockchain that are not in the field of finance or do
not need to explicitly include cryptocurrency might benefit from the inclusion
of cryptocurrency. A blockchain that manages a supply chain, for example,
might create cryptocurrency linked to assets produced in it and thereby limit
price volatility as well as distortions in relative prices. Co-movements among
the prices of inputs and outputs would be offset by similar fluctuations in
the value of the cryptocurrency. The potential for an industry currency has
been recognized in the marijuana industry, a grey market where legal bar-
riers prevent banks and financial firms from trading directly with producers
(Meyers 2018).

7 Cryptocurrencies and Public Policy

Given the variety of cryptocurrencies due to the broad application of

blockchain technology, it is possible that the massive expansion of liquid-
ity provided by cryptocurrencies may themselves promote macroeconomic
stability. Still, the ability to create new units of money or near-moneys for
low cost during a crisis seem a most promising solution who implications
deserve working out. Whatever set of solutions may be efficient, economic
improvements provided by blockchain technology and cryptocurrency may
be obstructed by regulatory policies (Kirzner 1997). Next will consider in-
efficiencies that arise due the categorical treatment of blockchain technology
by regulating and taxing authorities.

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7.1 Securities Regulation

Cryptocurrencies represent an area of ambiguity for regulators, partly due

to uncertainty concerning the nature and development of the asset (Fillippi
2014). At the present time, the U.S. Securities and Exchange Commission’s
website advises that “ICOs, based on specific facts, may be securities of-
ferings, and fall under the SEC’s jurisdiction of enforcing federal securities
law.” A recent announcement, while not officially binding, has provided the
market with some expectations concerning the legal status of cryptocurren-
cies. William Hinman, the Direct of the Division of Corporate Finance at
the Securities and Exchange Commission advised that ether, the cryptocur-
rency used on the Ethereum network, should not be regulated like stocks
and bonds (Matsakis 2018). Investments in initial coin offerings (ICOs), the
first sale of cryptocurrencies, may still be subject to regulation as officials
claim that initial investments are made with an expected return. There is
some irony in this reasoning as economic theory suggests that all investments
are made with an expected return and that agents economize on holdings of
money, money-like assets, and other physical assets in light of expected re-
turns (Friedman 1956). Limits set by regulatory agencies are looming as
cryptocurrencies linked to assets and assets linked to cryptocurrencies are
facing fierce resistance from the SEC (Pisani 2018). Although a Bitcoin fu-
tures market is in operation, the SEC has refused to approve a Bitcoin ETF.
To the extent that the SEC limits expansion in these markets, so too will the
liquidity provided by these new instruments be limited.

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7.2 Capital Gains Tax

Whether due to conscious preference or evolutionary selection, agents who

economize on asset holdings according to expected return per dollar invested
will tend to invest less in an asset as transaction costs required for dealing in
the asset increase. The remarkable fall in transaction costs over the last few
decades has resulted in a massive expansion of liquidity in financial markets.
One cost is difficult, if not impossible, to avoid: capital gains taxes. Where
there exist differentials in tax treatment in light of asset class or realization
of loss, there also exist noticeable differences in investor behavior. Investors
attempt to minimize these costs. This takes on many forms as cryptocurren-
cies are inheriting a problem that has beset financial markets for as long as
financial assets have been taxed and regulated.

Fiscal policy in the form of the tax code can create disjunctions in finan-
cial markets. Investors may demand a premium for stocks acquired in an
acquisition in order to offset losses that will be incurred by a capital gains
tax (Ayers, Lefanowicz, and Robinson 2003). More commonly, investors in
the U.S. tend to sell stocks that have incurred a loss during the year in De-
cember. The tax code incentivizes this as investors can write off losses from
these sales and pay less in taxes as a result (Blouin, Raedy, Shackelford 2003;
Mello, Ferris, and Hwang 2003; Jin 2006). Other financial instruments that
provide more liquidity to the market, like ETFs, are subject to similar tax
treatment.

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 By the same logic, the development of and investment in cryptocurren-
cies will impacted by tax policy. Currently in the U.S., cryptocurrencies are
subject to the capital gains tax. This is true for every transaction, whether
cryptocurrencies are trade for other cryptocurrencies or they are sold for dol-
lars. Failure to register such transactions on tax documents are subject to
“a penalty of $50 to $250 per unreported transaction (Burton and Michel
2017).” Either paying the tax or risking payment of penalty for unregistered
transactions makes using cryptocurrency as money an especially costly prac-
tice.

The Australian government has been heralded as a leader in blockchain

technology (Pollock, April 15, 2018). According to the Australian tax code,
those who acquire cryptocurrency with the intent to use it in transactions are
not subject to capital gains tax. Ambiguity between investors and those who
primarily transact in a cryptocurrency, and therefore are long-term hold-
ers, will need to be confronted. The code also treats those who trade be-
tween cryptocurrencies subject to capital gains tax, thus not ameliorating
the liquidity constraints that these instruments might offset. Despite this,
the transformation of Australia’s legal framework is encouraging relative to
the response of other governments and may set precedent for policy makers.

Regulation and taxation may, by no intention of policy makers, inhibit

the development of markets that can promote macroeconomic stability. No
matter how useful a technology, its full potential may not be realized if there

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exists inefficient regulatory and tax frameworks. If existing codes in indus-
trialized countries do not allow room for development of these instruments,
potential for these technologies might be realized in areas where government
are least prepared or able to regulate them.

8 Conclusion

To review, the potential of cryptocurrency is vast and, therefore, cannot

be fully described ex ante. Macroeconomic theory provides us insight into
a niche that cryptocurrencies might fill. Monetary instability that is often
associated with economic depression might be offset by the adoption of cryp-
tocurrencies, especially if those cryptocurrencies adopted allow for expansion
of the money stock for those willing to pay for new units of currency during
an economic crisis. Markets that allow for widespread competition enable
the discovery and implementation of these uses so long as regulation does
not prevent this.

The blockchain shows potential to monetize illiquid assets; both those

existing and those scheduled to exist in the future. If the full potential of
blockchain and cryptocurrency is to be realized, the ability of this technology
to monetize assets and thus offset macroeconomic instability must not be
prohibited by inefficiency-inducing regulations and tax policies.

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A Appendix

The dynamics of money creation illustrate that the quantity of money,

when determined by the market, is determined by demand for money. For
the sake of clarity, we will only consider commodity base money with the
parallel that cryptocurrency is a “synthetic commodity” (Selgin 2015).

A.1 Supply of and Demand for Money

Money, as the commonly accepted medium of exchange, is unique among

goods in that it is the common unit of account of non-money goods. The price
of money is whatever one is willing to trade for it. Given the variety of money
prices that exist across markets, money’s price is conveniently approximated
as the inverse of the average price of non-money goods (i.e., the price level).
Thus, the average price of money, PM , relates to the price level P as:

1
PM = (1A)
P

The average price of money is the inverse of the price level. As the price of
money goes up, the price level goes down and vice versa.

Supply and demand for money work much as supply and demand for other
goods. However, since money represents half of every exchange, we find that
demand for money is a function of demand for other goods in addition to
demand to hold money over a given period of time. The demand function

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for money is implied by the equation of exchange:

MV = P y (2A)

In its elementary form, the equation equates aggregate demand, total expen-
ditures, with aggregate supply, the value of marketable non-money goods in
the economy. In the long-run , all goods available for sale will be purchased.
The product of the existing stock of money (M ) and the average rate at
which each dollar is spent (V ) is equal to the real value of goods (y) adjusted
for changes in the price level (P ).

The equation can be rewritten such that the existing stock, or supply, of
money is a function of the remaining variables P ,y and V , which together
comprise the total demand for money.

Py
M= (3A)
V
1
V
can be rewritten as k, portfolio demand for money which is the average
portion of one’s money holdings that he or she withholds from expenditure.
The other form of demand for money, transactions demand, is represented
by P y, the product of the price level and stock of real goods. The supply of
money is a function of demand to spend money and demand to hold money

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on reserve:

M = P yk (4A)

This description of money demand must be nuanced further given the long-
run endogeneity of the price level. The price level is a function of the money
stock in the long run (Friedman 1970) as portfolio demand tends to be stable
over long periods of time. Even if portfolio demand for money is not perfectly
stable, the velocity of the effective base tends to move much more slowly than
the money stock. In a commodity money economy, the price level is mean
reverting (Mazumder and Wood 2013; White 1999) with the rate of growth
of the nominal money stock tending to match the real rate of growth in the
long-run.

To account for the possibility of a changing price level, we describe the level
of real cash balances by accounting for changes in the price level. We rewrite
to isolate the two factors driving demand for money in a system where the
money stock is not a choice variable for policy makers :

M
= yk (5A)
P

The supply of real cash balances is a function of real income and portfolio
demand for money, both of which are determined by autonomous factors.
This value can increase either by a change in the money stock, (M), or by

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a change in the price level (P). Initially, a change in demand for money will
lead to a change in the price level, therefore impacting the price of money in
the inverse direction. Changes in the price level exert a real balance effect;
the real value of money holdings moves inversely with changes in the price
level (Patinkin 1989). This may promote macroeconomic equilibrium if the
change does not lead to structural effects such as imbalances in credit markets
that lead to systemic effects, as was the case during the great depression and
the most recent crisis in 2008.

If the supply of money is not perfectly inelastic, the quantity of money

responds to changes in demand for it through changes or expected changes
in the average price of goods. The change in the price level will reverse to the
extent that the quantity of money produced changes in the opposite direction.
If the price level under a commodity standard is truly mean reverting, then
entirety of falls in P will reversed by increases in M.

We are interested in the effect of a fall in the price level and its effect on
the money stock as deflations are commonly associated with dislocations in
credit markets and falls in productivity. The supply of real cash balances is a
function of demand for money to purchase real goods and portfolio demand
for money. Increases in demand for money exert a negative force on the
price level, which is an increase in the value of money. Under a commodity
money regime with an upward sloping supply curve, the nominal money stock
will increase as either quantity of real goods or demand to hold money (k)

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increases.

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(Accessed June 5, 2018)
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Electronic copy available at: https://ssrn.com/abstract=3211745