Cryptocurrencies have captured the interest of investors the world over. They use innovative technology and are game-changing in their methods of account and self-regulation. But what would the macroeconomic impact be if cryptocurrencies were to replace traditional currency?

Security issues and volatility notwithstanding, even an idealised version of cryptocurrencies could cause large-scale damage to the world economy if they were used to replace traditional currency.

The decentralisation that makes them appealing is also the source of their downsides. Most prevalent cryptocurrencies, such as bitcoin and litecoin, are built on a coin generation algorithm that geometrically decreases the rate of production of new coins. Under this model, deflation is nearly inescapable.

Cryptocurrencies and the dangers of deflation

The economic consequences of deflation are dire. A feature of the depths of the most severe recessions, deflation is a self-perpetuating cycle, as consumers notice that prices are dropping and delay consumption accordingly.

Because deflation makes the real value of debts increase, people who have to borrow for education or other expenditures are disadvantaged. Hence, the less well-off suffer the most.

Deflation also discourages new capital investment and entrepreneurship, as the risks of accruing debt are too great. This runs counter to the aim of cryptocurrencies to foster a climate friendly to innovation by preventing market distortion from government intervention.

Some argue that cryptocurrencies will not cause deflation, but an eventual stabilisation of the value of currency. However, this would only be possible if economic growth were zero – conditions that would be satisfied only if the population remained constant, new natural resources were not used, and new technology was not created. This is not a feasible expectation.

Cryptocurrencies would cause a crisis in a recession

Not every cryptocurrency will necessarily induce deflation. Some are built to expand without limit. But even then, there are problems with regulation and lack of monetary policy. In the event of a recession, if cryptocurrencies were the primary form of currency, there would be no monetary policy available to mitigate the damage.

Governments would not be able to set targets for growth and unemployment, or influence their exchange rates to stimulate exports. Recovery from recession would take longer, and it would incur public debt as the only government recourse would be spending more and cutting taxes.

Hence, it is important for wealth managers, which have the ability to influence whether cryptocurrencies are treated as a currency, to do what they can to prevent it. There is a role for cryptocurrencies in the world, and there are definite benefits to the blockchain technology that underpins them, but this role is not as a replacement for fiat currency.

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