Off The Wire
Chancellor: Central bank coin will crush the banks
Long ago central banks secured a monopoly over the issuance of paper money. Now physical cash in the form of bank notes and coins is in terminal decline. But the monetary authorities don't intend to allow cryptocurrencies to fill the void without a fight. Instead, they're responding with their own version of a so-called "stablecoin". These central bank digital currencies, or CBDCs, could turn out to be the most revolutionary financial innovation since, well, the inception of paper money.
Unlike bitcoin, ethereum and other cryptos, a digital currency issued by the central bank serves all the traditional functions of money. Like paper money, it is legal tender that can be used to settle debts and pay taxes. Whereas cryptos are hugely volatile, difficult to transact in and sometimes risky to store, CBDCs should have the same value as an old bank note, be convenient to use and safe to store. Jay Powell at the Federal Reserve, Christine Lagarde at the European Central Bank and other central bankers emphasise that their digital tokens are a form of "trusted" money, backed by the full credit of the sovereign issuer.
Most central banks around the world are closely examining the potential for digital currencies. Several countries have already embarked on pilot schemes – Sweden is testing an e-krona and China is running trials of a digital yuan. The Boston Fed is working with the Massachusetts Institute of Technology to design a CBDC. The Bahamas' "Sand Dollar", launched last October, claims to be the world's first operational digital currency. The Bank for International Settlements estimates that within three years a quarter of the world's population will be living in countries with digital currencies.
There are many reasons for issuing a CBDC. The digital economy requires a money in its likeness. In Sweden the use of physical cash has become so intermittent that many retailers no longer accept it for payment. Fears that Covid-19 might be transmitted by handling coins and notes accelerated cash's demise.
Since paper money is in effect a free loan from its holders to the state, governments have lost out. Digital currencies should help restore their lost seigniorage. They can also combat the threat to the state's money monopoly provided by cryptos and Libra, Facebook's (FB.O) stalled project for a global currency.
Many questions remain unsettled about how the central banks should design their digital currencies. To wit, should they use a distributed ledger – like bitcoin – or retain a centralised settlements system? Should digital currencies pay interest or not? Should the central bank engage directly with the public or operate only through financial intermediaries? The degree of privacy afforded to users, and whether there should be a size limit on individual holdings, are also being considered.
How central bankers settle these questions will have huge consequences. Say, for instance, that it's decided to remunerate the owners of digital cash. Some economists would welcome the chance to impose negative interest rates on this new electronic money. But a digital currency which pays a competitive rate of interest would siphon away deposits from banks. Commercial banks could be weakened by this new competition just as the internet destroyed the business model of traditional telephone operators and yellow pages. Credit card networks could also be disrupted by a cheaper and more efficient CBDC payments system. Visa (V.N) could turn out to be the next Blockbuster.
A banking revolution brought about by digital currencies would have certain benefits. Commercial banks are leveraged and inherently fragile institutions. The near failure of Royal Bank of Scotland in October 2008 almost brought down the United Kingdom's payments system. If savings were held in a central bank digital currency the financial system might be more resilient. But if banks lost their deposits, they wouldn't be able to advance loans and central banks could be forced into the lending business. No doubt many policymakers would welcome the opportunity to direct savings via a central bank to their pet projects, whether green energy investment or providing a universal basic income. But economic development normally suffers when states take over the allocation of capital.
Money is coined liberty, wrote Fyodor Dostoevsky in "The House of the Dead". Digital money has the potential to enslave a people. Fed Chairman Powell has stated that a traceable currency wouldn't work in the United States. China has no such qualms. The digital yuan is set to become the keystone of President Xi Jinping's surveillance state, complete with its system of social credits and network of face-recognition cameras. The day may not be far off when a jaywalker in Chongqing has a fine automatically deducted from her digital wallet. Tellingly, the Chinese Communist Party already accepts monthly dues paid in digital yuan.
In other ways, China's Red Capitalism is perfectly suited to the advent of digital currencies. Beijing already controls its banking system and largely directs how credit is allocated across the economy. If a large chunk of household savings left the banks for the electronic offering of the People's Bank, the authorities could simply return the money to the state-controlled banks or direct it elsewhere. Nothing of substance would have changed. The digital yuan will also reinforce China's capital controls, making it harder for nationals to sneak money out of the country.
Beijing has greater ambitions, however. China has long railed against the role of the U.S. dollar as the global reserve currency. Washington uses its sway over international payments to impose sanctions on Chinese officials, whether for their treatment of Uighurs or interference in Hong Kong politics. If the digital yuan were used across borders, Beijing would have a way around U.S. sanctions. It's conceivable that China might require its new electronic currency for use in foreign trade and encourage takeup by client countries supported by Xi's Belt and Road Initiative.
The Fed faces the "Innovator's Dilemma". It prefers the status quo, but China's digital yuan threatens America's dominance of the international monetary system. If the dollar is displaced as the global reserve currency, the yield on U.S. Treasuries would inevitably rise, leaving American citizens inevitably less well off. The United States has no choice but to issue its own digital currency, but as the Fed's Powell has repeatedly warned, designing it properly will be key.