Stability and Monetary Policy
August 12 2023
by Tobias Kuhlmann
Thanks to Roman Croessmann and Sandra Kumhofer for their feedback and review.
This article is the third article of a four-part series describing how I think about the future of money and regenerative finance. The second part was about regenerative finance and a stable asset backed by nature. This third part is about stability, monetary policy, and interest rates.
The key concept in this article is that prices of any tradable asset are determined by supply and demand - how much and at what prices people want to buy and sell. Supply and demand can be influenced by introducing interest rates, one of the main mechanisms that are keeping currencies stable.
What Makes a Price?
Let us take a step back to some economic foundations. The borrowing mechanism described in the previous part alone does likely not lead to a stable asset yet - instead, it would probably lead to a volatile debt position as well.
In any kind of market where people want to buy and sell, the value of a good or asset is determined by supply and demand. Imagine an example with five apples in a market and ten people want to buy one. Likely, there will be some that are willing to pay a higher price, pushing the price upwards. If only three people want to buy one of those five apples, the seller will likely decrease its price.
The same underlying economics affect stablecoins. It becomes a question of supply and demand. Suppliers of a stable asset in a Collateral-Debt-Position-type (CDP) design are people who enter CDPs and borrow the stable asset into existence. Demanders are people who want to buy, hold, and use the stable asset.
If there are more people willing to borrow the stable asset into existence than people wanting to use the stable asset, the price will likely decrease. And if there are more people wanting to use the stable asset than people wanting to supply it, the stable asset price will likely increase.
Whether people want to rather supply or demand a stable asset depends on, to a large extent, their expectation of the development of the value of the collateral relative to the stable asset. If someone believes the collateral asset will appreciate in value, entering the CDP is a good idea, because if the collateral does indeed appreciate in value, a profit can be made.
If someone believes the collateral asset will depreciate in value, holding the stable asset instead is a good idea, as it will less likely decline in value.
What is Price Stability?
An economist would probably define the price stability of a good or financial asset as its ability to maintain a relatively steady or predictable value over time. It refers to a situation where the price or value of the asset experiences minimal fluctuations or volatility. But minimal fluctuations compared to what?
Stability is always relative to a reference. In finance, the reference is often the world-dominating fiat currency, currently the US Dollar. By world-dominating, I mean the leading currency that people want their debt to be in, which is usually the currency of the most powerful country and economy. In economics, the reference is often purchasing power measured by consumer price indices.
Another dimension of stability is time. An asset can be stable over the short-term, but not in the long-term. Also the other way around. This is often a trade-off that is hard to navigate and creates one of the largest industries in the world, the investment management industry.
One could argue that fiat currencies, especially the world-dominating US Dollar, provide a good measure for short-term stability relative to purchasing power.
However, in the long run fiat currencies mostly turn out to not be that stable after all due to rising money supply and inflation. For a deeper dive into the long-term dynamics of economies and fiat currencies, I recommend Ray Dalio’s thirty-minute Youtube video on how the economic machine works and principles for dealing with the changing world order.
Longer term, one could argue that a portfolio of productive assets like stocks is likely more stable relative to purchasing power, as for example the SP500 over the last couple of decades. But there does not seem to be a consensus among economists and investment managers on what investment strategies actually provide long-term stability. It partly depends on the rise and fall of fiat currencies and therefore, governments.
How are central banks trying to achieve price stability?
Central banks are the issuer of a currency and one of their main objectives is typically maintaining price stability.
Price stability refers to a state of low and predictable inflation over a sustained period of time. It means keeping the overall level of prices in an economy relatively stable, with minimal fluctuations. Inflation measures the increase in prices and thus the loss in purchasing power of money over time. Most central banks target an inflation level of two percent as a trade-off between price stability and promoting economic growth.
Earlier in this article we learned that prices are determined by supply and demand. So in order to influence prices, a central bank needs to influence supply and demand. Here are some of the key ways a central bank can influence these at the same time:
- Interest Rate Policy: Central banks can increase or decrease interest rates to manage inflation. If inflation is too high, they may raise interest rates to reduce borrowing and spending, which can help cool down the economy and lower price pressures. Conversely, if inflation is too low or the economy is weak, central banks may lower interest rates to stimulate borrowing, spending, and economic growth.
- Open Market Operations: Central banks can conduct open market operations, which involve buying or selling government securities (such as bonds) in the open market. When a central bank purchases securities, it injects money into the economy, increasing the money supply and potentially stimulating spending and inflation. Conversely, when it sells securities, it reduces the money supply and can help dampen inflationary pressures.
- Reserve Requirements: Central banks also have the power to set reserve requirements, which are the minimum amounts of funds that banks must hold in reserve against their deposits. By adjusting these requirements, central banks can influence the amount of money that banks can lend, thereby affecting the overall money supply and inflationary pressures.
Over the short run, this seems to be going rather well. Over the long run, however, economists disagree on whether central banks do a good job or not. A lot of economic health variables are hard to predict and central banks only have an indirect, delayed impact on the very complex economies. This is where crypto can innovate: With all data related to money and the economy stored on the blockchain, economic health variables become more measurable and more directly influenceable, because this new kind of money can become programmable. This leads us to the next section, how stable assets solve the problem of price stability.
What Keeps a Stable Asset Stable?
The same forces that pull on a fiat currency’s stability also apply to stable assets. And the same mechanisms that central banks use for price stability are usually used for stable assets, just differently implemented.
The value of a stable asset will vary over time, based on the imbalance between how many people are willing to supply the stable asset by borrowing it into existence and how many are demanding it to use. One key difference is the supply: It does not come from a central bank, but instead from regular market participants. In the case of CDPs, that is users or investors who want to get utility in the form of a higher expected profit or liquidity from borrowing a stable asset into existence.
Some of the ways a stable asset protocol can influence supply and demand and thus the price stability of the asset are:
Interest Rates: The protocol can add interest rates to the stable asset. The idea here is a value transfer between suppliers and demanders. Depending on the supply-demand imbalance, one side needs to subsidize the other.
If more people demand than supply the stable asset, an interest rate on the stable asset leads to stable asset holders essentially paying stable asset suppliers. More people would likely be willing to enter CDPs, increasing supply, while holding the stable asset would become more expensive, likely decreasing demand and restoring the balance if calibrated well. This regime will mostly be in bear market scenarios where people want to get out of volatile assets.
If more people supply than demand the stable asset, an interest rate on supplying the stable asset, which results in a negative interest rate on holding the stable asset, leads to suppliers essentially paying demanders. More people would likely be willing to hold the stable asset, while fewer people would be willing to supply. When calibrated correctly, this likely pulls the system back into balance. This regime will mostly be in bull markets where people want to get into volatile assets.
An interest rate in stable asset protocols can also be understood as compensation for taking financial risk. If you enter a CDP, you essentially risk losing value and can incur a financial loss. Another perspective is to view interest rates as the cost of stability, which is being paid for by the side that at that moment most wants to use the stable asset protocol. Either the demand or the supply side.
Open Market Operations: In the same way a central bank can sell securities on the open market to buy back currency, a protocol can offer users to redeem their stable assets against an equally worth amount of collateral, often called one-to-one redemption. If a stablecoin is for example pegged to one Euro, and users can always redeem that stablecoin for one Euro worth of collateral, the stable asset has a lower price bound. This can also be understood as automatically decreasing the supply and increasing the demand when necessary. However, for most stable asset protocols the other direction, increasing the stable asset supply, is not possible via open market operations. These protocols can usually not print the stable asset out of thin air like central banks can do with their currency. Stable assets usually need to be backed by something to remain valuable and not run into risk of inflation.
Reserve Requirements: Similar to central banks, a stable asset protocol can set the minimum collateralization ratio of CDPs. This ratio determines how much can be borrowed against a collateral position. This however, is usually a trade-off with financial risk and not directly used as a monetary policy instrument in stable asset protocols.
To dive into these mechanisms with different explanations, I recommend Dankrad Feist’s article on the supply and demand for stablecoins again.
The critical and most complex part of these mechanisms is the implementation of interest rates. This will be the topic of the next and last part of this blog post series. It will be about dynamic interest rates and RAI-type assets and how these concepts can be implemented from an economic perspective.
If you want to keep up to date with these topics, you can follow Mento Labs on Twitter or join the Mento community on Discord.
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