16 July 2019

Project Syndicate: Will Facebook’s Libra turn into a cancer?

Facebook's planned cyber currency, Libra, is little more than a glorified currency board – the failed arrangement that in 2001 caused the largest sovereign default the world had ever seen. A major risk is devaluation – and the problems don't stop there.

When it announced its plans to launch a cyber currency, Facebook emphasized that its Libra will benefit “people with less money [who] pay more for financial services,” especially in developing countries. But when one compares Facebook’s current blueprint to those same countries’ experience, Libra starts to look like a hazard.

Consider Argentina, which in April 1991 adopted a novel monetary arrangement: it would peg the value of the Argentine peso to that of the United States dollar, and it would issue pesos only in exchange for dollars. So the peso would now be fully “backed” by reliable American greenbacks, enabling Argentina to end a century of monetary instability.

At first, markets cheered. The system worked – until it didn’t. A decade later, Argentina was forced first to devalue and then float the peso, which lost two-thirds of its value in a matter of months. The political crisis that followed was so deep that Argentina went through four presidents in two weeks. And the default on its $82 billion sovereign debt was the largest the world had seen.

Argentina’s failed policy, known as a currency board, is exactly what Facebook is trying to create with Libra, except that Libra would be pegged to a basket of major currencies, not just to the dollar. Currency boards have been tried at different times and places, and the many lessons we have learned about them apply to Libra.

Because each Libra would be fully backed by hard currencies (with balances held in either bank accounts or government bonds), in theory the Libra should be just as crisis-proof as the Argentine peso once presumably was. This is why Facebook can claim that Libra would be very safe for its users.

Unfortunately, in the real world, as Argentina’s experience shows, currency boards can be dangerous. A major risk is devaluation. The Libra’s value in terms of the currency basket will be decided by a Facebook-led consortium called the Libra Association, and here incentives will be aligned in exactly the wrong way. Imagine that Libra turns out to be a success, and billions of people worldwide swap the equivalent of trillions of US dollars into Libra. Then, allowing the value of Libra to slide by just a tiny fraction of a percentage point would create a tremendous capital gain for Facebook and its partners.

If that sounds too crude (and it is), or likely to run afoul of regulators and the courts, consider an alternative scenario. The basket that backs each Libra is a weighted average of several currencies. Who will decide on the weights? The Libra Association.

Again, the experience of countries like Argentina suggests what might happen. Suppose that, for “technical reasons,” these weights had to be adjusted, and that, “coincidentally,” weights rose on currencies that had been losing value. Then residents of, say, the US would suddenly find that they could buy fewer dollars with their Libras. Their capital loss would be Facebook’s capital gain – and it could be huge.

Perhaps recognizing these risks, the Libra project includes a governance system designed to eliminate them. But such assurances are hard to believe. The classic time inconsistency problem, familiar to economists, emerges: no matter what Facebook says today, the incentives to break its promises once Libra takes off will be enormous.

Full article available on Project Syndicate

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