Will Facebook's Libra turn into a cancer?

London

WHEN it announced its plans to launch a cyber currency, Facebook emphasised 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 US dollar, and it would issue pesos only in exchange for US 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 five presidents in two weeks. And the default on its US$82 billion sovereign debt was the largest that 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 US dollar. Currency boards have been tried at different times and places, and the many lessons that we have learnt 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 US dollars with their Libras. Their capital loss would be Facebook's capital gain - and it could be huge.

Perhaps recognising 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.

An additional time inconsistency dilemma concerns how the Libra Association is supposed to make profits. The Association will earn interest on its holdings of major currencies, but will not pay interest on Libra. This is, in fact, how central banks, the monopoly issuers of their own currencies, make profits. Economists have a name for this: seigniorage.

Today the potential for seigniorage profits is limited, owing to near-zero interest rates on bank deposits and government bonds issued in major currencies. But what happens the day that world interest rates rise? Will Facebook simply pocket the difference? Or will competition force it and its partners to begin paying interest on Libra? Competition has not kept commercial banks from charging hefty fees on international transactions, and Libra has the potential to be much larger than any commercial bank.

An even bigger danger is that, at some point, the Libra Association could decide to switch from full to fractional backing of Libra with safe liquid assets. The temptation to do this will be difficult to resist, because the reserves backing Libra could earn a much higher return if invested in risky stocks, for example. But then, like commercial banking systems that lack a lender of last resort, the entire Libra edifice would become vulnerable to a speculative run. Of course, by that point the Libra system might have become too big to fail, forcing the US Federal Reserve to act as a lender of last resort. Time inconsistency strikes again!

What about the claim that Libra would be a boon to financial inclusion in emerging and developing countries? Perhaps. But Libra may instead become a source of major headaches for them. Emerging economies have long been combating so-called dollarisation: the tendency of residents to seek insurance by holding US dollar accounts in local banks and denominating contracts (including wage contracts) in US dollars. Because dollarisation keeps central banks from serving as lenders of last resort to domestic banks, it foments financial instability. It also renders monetary policy less effective by, for example, limiting the positive effect of currency depreciation on exports and employment.

Facebook imagines a world in which people everywhere eventually borrow and lend in Libra, and use it for national and international trade. For emerging economies, this would mean being cured of dollarisation only to catch an even worse case of libraisation. If that happens, then Libra will have complicated these countries' monetary and exchange-rate policies and helped trigger a period of slow growth and financial instability.

Facebook is betting that Libra will trigger a Taurus market. But Libra's benefits appear as slippery as a Pisces. The Libra project is dangerous like a Leo, and it will require government regulation to keep it from becoming a Cancer. PROJECT SYNDICATE

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