How Broken Monetary Policy Fuels Instability

The world’s economic and societal structures aren’t very stable at the moment — or very safe. Supply chains aren’t working and the global energy shortage is growing — causing cycles of hoarding and unrest.

This economic and political instability, though, did not arise in a vacuum. It is rooted in the monetary system underpinning the post-industrial age. In short, it’s broken — and for many reasons. But fundamentally, instability is increasing across the world because the value of money is increasingly unstable. As people suffer from bank runs and hyperinflation, they turn against the authorities who failed to protect their wealth. It’s why people in Lebanon are robbing their own banks and the Chinese government has redoubled efforts to squash bank protests with Covid restrictions.

If we want to fix the world by fixing our money, we have to make it stable. This core problem is why governments, institutions, and innovators in DeFi are increasingly looking to stablecoins as a solution. And it is why Reserve is partnering with Blockworks in producing this series on stabilizing the world. They believe that stable money is asset-backed money.

In part one of this four part series, we will explain why money lost its backing and why we need a stable alternative.

Stabilize Money Stabilize the World

Part 1: What’s broken
Why unstable money isn’t safe for the world and how to understand monetary policy
Part 2: What are people doing today about it?
A dive deep into the types of monetary policy alternatives that stablecoins offer
Part 3: What is the right way forward?
A guide to the various inflation hedging tactics and how they can be used in stablecoins
Part 4: What will the future look like?
A look at how tokenization will change the stablecoin ecosystem
About our sponsor: Reserve
A video explaining the Reserve Protocol

Why money lost its backing

Bretton Woods Monetary System

The Bretton Woods system of monetary management was the last time any country issued a currency that was backed by an asset. It was called the gold standard. And from 1941 to 1971, other countries could redeem $35 for an ounce of gold.

The reason it ended was simple. The Vietnam War led the US to spend more than it had. And like depositors during the era of free banking, nations lost faith in the US government’s ability to honor withdrawals. But as requests to redeem US notes for gold started to increase, the Federal Reserve ended the policy to honor those redemptions. In principle, the decision is not very different from a centralized crypto exchange freezing withdrawals when it is on the brink of insolvency. It needed time to find a solution.

This decision combined with a decade of running unsustainable budget deficits for the war contributed to an economic recession and historic levels of inflation — peaking in 1976 at 12%. And while it was dialed back by the end of the decade, the damage to the US dollar was done. It has lost 86% of its purchasing power since 1971.

The buying power of one dollar over time

Source Officialdata.org

Rise of the petro-dollar

In June 1974, shortly after removing the dollar from the gold standard, the US made a deal with Saudi Arabia to price oil in US dollars. This agreement created a de-facto oil peg for the US dollar. In return, the US agreed to a military alliance that promised weapons and military aid to the Saudis.

This trade agreement increased global demand for dollars, which set in motion a series of network effects that solidified it as the world’s reserve currency.

How the US exports inflation to other countries

Because the US has been able to keep its status as the world reserve currency, its inflationary monetary policy influenced economies around the world.

At a GDP of $20+ trillion, the US is estimated to have the largest economy. Many countries such as China and Turkey have built their economic growth on the US’ increasing demand for exports. The global demand for US dollars as a reserve currency combined with US consumer demand for lower prices pressures these export dependent economies to devalue their currency to compete for US imports. So if US inflation increases as it has over the past year, it becomes more difficult for these countries to keep the cost of their goods low. To stay competitive, they end up enacting new monetary policies that increase inflation at a higher rate than the US.

For example, Turkish annual inflation climbed to a new 24-year high of 85.51% in October 2022. This was in large part the result of rate hikes and a long history of monetary policy geared at keeping export prices low. Countries around the world have felt similar pressures as fears of insolvency have triggered violent bank runs in Lebanon, China, Venezuela and Argentina.

Each spike in inflation has a lasting effect on a currency’s purchasing power. Like with the US inflation in the 1970s, it is difficult to reverse course. With no promise of returning to a monetary policy of asset-backed currency, the fiat system will continue to erode the purchasing power and safety of money around the world.

How one central bank changed money

The root problem to this story is not simply that the dollar lost its backing, it is the mechanism that enables it. The erosion of purchasing power and safety across the world is directly linked to the unbridled ability for a centralized minority to enact monetary policy. It is ultimately the governance and enforcement of that policy that determines its fate and safety.

As with the US, the power of its enforcement lies with its military-backed trade alliances. It frees the US from the checks and balances other countries and institutions face, as there is no international regulatory authority that can chase down Fed policymakers for misappropriation of funds. And as a result, every decision they make impacts economies throughout the world.

What is a monetary policy and what makes it safe?

At the most basic level, a monetary policy is a set of rules or decisions that determines how a currency is created, destroyed, backed and managed. For example, the Fed creates and destroys money through its balance sheet. And it manages the flow of money by setting interest rates.

Alternative systems, such as Bitcoin, embed its policy in the code. It can only be changed if a majority of network nodes agree to fork it. The code determines how many coins will ever be in existence and sets the conditions needed to issue and transfer coins.

Monetary policy safety is measured at two levels. On the first level, it is measured by the degree to which it protects its currency from losing value and accessibility. People need to be able to use their money without fear of a bank refusing access or a hacker stealing funds. And those same people need to trust that the value will stay consistent over time.

On the second level, it is measured by how the policy is governed. If policy is governed by a single entity, such as the Federal Reserve, versus a decentralized consensus, then there is greater risk of losing its backing to a commodity like gold or another currency.

Alternatively, if the governance mechanism is too rigid, it may not be able to meet the needs of a global economy. Critics of the bitcoin standard argue that once block rewards are gradually lowered, miner fees will not be enough to incentivize a diverse set of validators willing to secure the network of 21 million bitcoin. They argue that the protocol will ultimately need to change if it wants to gain widespread adoption.

The stablecoin solution

Every digital asset that is classified as a crypto currency represents an alternative monetary policy. But very few have ventured to provide greater price stability than the US dollar. Stablecoins are the only class of cryptocurrencies that attempt to provide a stable alternative to the fiat system — with some even offering greater purchasing power protection.

For example, in March of 2021, the Reserve Protocol launched its first stablecoin, the Reserve Dollar (RSV) and the Reserve app to help people in Latin America protect their livelihood from hyperinflation. When the local national currency is inflating 6% per week, inflation of 2% to 8% per year on a dollar stablecoin offers an easier, safer way to preserve purchasing power.

Currently 670,000 registered users access more than 25,000 merchants, transacting more than $300 million monthly with the RSV stablecoin — unlike most volume in crypto, which is speculation, this is all real commerce. The primary uses are payroll, p2p payments, remittances and merchant shopping. The Reserve app is available in Argentina, Venezuela, Panama, Peru and Colombia and will be launching soon in Mexico.

The community behind the Reserve Protocol believes that the need for an inflation and censorship resistant currency goes beyond the countries experiencing hyperinflation. Humanity collectively spends too much time, and often fails, to preserve their spending power over the long term. The world needs alternatives to fiat and centralized money systems, which is why Reserve updated their protocol so that anyone can launch a decentralized asset backed stablecoin. But to really evaluate the potential for any of these new or existing stablecoins to succeed, we need to examine the different types of existing stablecoins.