“History is filled with attempts to invent money. People want to make a quick buck, literally.”
Agustín Carstens, General Manager of the BIS, 17 April 2018.
Digital currency is all the rage. Bitcoin has more than one thousand crypto cousins. There is even a token called dentacoin, whose issuers claim it will transform dentistry! In the past, we have been clear in our views. We agree with Agustín Carstens: these are exactly like past attempts of people to issue their own private money. As Carstens said on another occasion, these tokens are “a combination of a bubble, a Ponzi scheme and an environmental disaster.”
Regardless of whether the blockchain will revolutionize dental health, the appearance of cryptocurrencies has driven central banks to think about one particular aspect of their business: paper currency issuance. In Sweden, for example, the value of paper currency in circulation today is only one-half of the nominal amount a decade ago. It now accounts for only about 6 percent of central bank liabilities and less than 2 percent of M2.
In this post, we expand on some aspects of our earlier discussion of central bank digital currency (CBDC). What is it and what would its wider introduction mean for the financial system? Our conclusion is unambiguous: Watch out what you wish for!
We start with two fundamental facts. First, modern central banks already issue a large volume of CBDC. Second, the vast majority of the money that households and businesses use for transactions is in fact digital. The following chart makes these points very clearly. It shows for several economies the fractions in 2002 and 2017 of the monetary base (roughly equal to central bank liabilities) and of M2 (a relatively broad monetary aggregate) that are in digital form.
Digital fraction of the monetary base and M2 (annual average), 2002 and 2017
Notes: For each aggregate, we report the ratio of the amount excluding paper currency—that is, the digital portion—to the total. The euro-area shares are based on country membership at the time. Sources: FRED, European Central Bank, Bank of Japan and Swiss National Bank.
As a consequence of the quantitative easing aimed at combatting the financial crisis and the subsequent episode of sub-target inflation, the digital fraction of the monetary base has grown dramatically over the past 15 years, rising from less than 30 percent to more than 80 percent. The composition has changed the most in Switzerland, where digital central bank liabilities rose from less than 10 percent in 2002 to nearly 90 percent today. (During this period, the Swiss National Bank’s balance sheet rose from roughly 25 percent of Swiss GDP to more than 100 percent!)
In striking contrast to the enormous shifts in central banks’ balance sheets, the digital fraction of M2 has been remarkably stable at around 90 percent in all these economies. In addition, the portion of paper currency (relative to M2) was roughly the same across jurisdictions. Where the data allow us to look back further in time, these M2 fractions don’t change. For example, in the United States, the ratio of non-currency M2 to total M2 since 1960 has fluctuated narrowly between 89 and 93 percent.
Given that the vast majority of transactions money has been digital for a long time, it is unsurprising that payments are almost entirely digital as well, while the small fraction of all payments that are in cash continues to dwindle. In the United States, for example, the value of noncash payments rose from $66.7 trillion in 2003 to $177.8 trillion in 2015. Over the same period, ATM withdrawals—a proxy for cash use—rose from a very modest $520 billion to $704 billion (see here and here). If each dollar bill withdrawn from an ATM is used three times before returning to a bank, cash would still account for only one percent of total payments. Furthermore, since 2003, digital payments have been growing at an annual rate of 8.5 percent, more than three times as fast as cash payments (and more than twice the speed of nominal GDP).
This brings us to our first conclusion: we live in a world of digital money and digital payments, and we have for quite some time. Furthermore, since commercial banks already have CBDC―these are their deposits at the central bank―recent proposals presumably mean that central banks should issue retail digital currency. (For a thorough discussion, see the recent BIS report, the report by Eswar Prasad , the relevant pages in Chapter 1 of the April 2018 IMF Global Financial Stability Report, the Sveriges Riksbank report, and the paper by Barrdear and Kumhoff.)
The prospect of retail CBDC raises a number of interesting questions. Would it be: anonymous, in unlimited supply, have universal access, and pay zero interest? For central bank paper currency, the answer to all of these questions is: yes. For wholesale CBDC―the stuff commercial banks now have and people call reserves―the answer is: no, except that supply is effectively unlimited. For retail CBDC, we strongly suspect that the answer will be that it is not anonymous, is both in unlimited supply and universally available, and pays interest.
It is worth discussing each of these features briefly. To be clear, retail CBDC means allowing nonbanks to have accounts at the central bank. For the same reason that a commercial bank does not allow anonymous accounts, the central bank will not either. (To address problems of money laundering and financial fraud, international standards mandate verification of the identity of all account holders.)
As for unlimited supply, central banks exist to provide an elastic supply of currency, so that is what they do. Typically, the central bank stands ready to exchange currency and reserves at par without limit. Furthermore, the quantity of reserves supplied is at least as much as the banking system demands at the current policy rate target (and currently far more in most advanced economies). This means that if there is a sudden increase in the demand for currency―digital or paper―the central bank accommodates this demand to keep the interest rate from spiking above the target. Moving away from this practice, allowing central bank money to become scarce and therefore trade at a premium, would be an enormous change.
What about universal access? Would the central bank preclude certain people from having accounts and from holding retail CBDC? It would surely be appealing, and may be possible, to keep drug dealers and mobsters from having direct access to CBDC. Beyond that, however, we expect that legitimate users of the currency would be able to open accounts. Presumably, in most countries, anyone with appropriate identification that meets know-your-customer (“KYC”) rules would be able to have an account at the central bank and hold retail CBDC. So, retail CBDC will be U-CBDC—that is, universal central bank digital currency.
Finally, what about interest payments? One argument in favor of issuing U-CBDC is that it relaxes the effective lower bound on nominal interest rates. That is, with U-CBDC central banks can reduce interest rates further below zero than they can when paper currency is in circulation. Assuming that this is the case, then in the same way that reserves pay interest, U-CBDC must pay interest, too. (See Bordo and Levin’s recent discussion of how U-CBDC will influence monetary policy operations.)
So, imagine a world with U-CBDC that is not anonymous, is supplied elastically, and is interest bearing. People will hold U-CBDC through named accounts at the central bank. What happens to the financial system in such a circumstance? What will happen to the central bank and what will happen to commercial banks?
Starting with the latter, since it exists so long as the government remains operating, the central bank is obviously safer than even the safest commercial bank. It immediately follows that demand for accounts at the central bank―demand for U-CBDC―will be high relative to demand for accounts at commercial banks. In fact, in the absence of an interest rate spread, we would expect that large uninsured deposits would shift rapidly out of private commercial banks. Retail deposits will move over time, with the process accelerating as soon as there is even modest stress in the financial system. This is not so much a reversible run on private banks as a permanent exodus.
Now, in an effort to retain their deposit base, commercial banks would surely raise the interest rate they offer to their customers relative to the rate on U-CBDC. But we strongly suspect that the interest rate spread would have to be large for depositors (especially those that are uninsured) to be willing to stick with a private bank. Consequently, even if the commercial banks succeed, we would expect that the introduction of U-CBDC would cause a substantial fraction of deposits to shift to the central bank, with the remainder prone to exit in a period of financial stress.
Moreover, if a large and trusted central bank in a politically stable jurisdiction were to issue U-CBDC, the impact would not stop at its borders. If foreign nationals can hold accounts, something that would be very difficult to stop, then they will likely move funds across borders—especially during periods of economic and financial turmoil in their home countries. For example, if the Federal Reserve were to issue U-CBDC, we expect that this would not only hollow out the U.S. commercial banking system, but also destabilize the financial system in a range of countries.
Finally, what would the central bank become? As its U-CBDC liabilities grow, its assets will need to expand as well. And, since commercial banking will have shrunk, so will the sources of private credit. At this point, the central bank turns into a commercial lender. It will become the state bank. In the allocation of funds, it will substitute increasingly for the discipline of private suppliers and markets, inviting political interference in the allocation of capital, slowing economic growth.
Returning to the beginning, we are compelled to ask what problem it is that U-CBDC is designed to solve. There seem to be three possibilities: the inability of monetary policymakers to set interest rates much below zero; the fact that paper currency is a vehicle for criminality; and the need to broaden financial access. On the first, we currently see little political support for interest rates that go meaningfully below zero. In the United States, negative interest rates likely would add to political challenges for the Federal Reserve, further threatening its independence. As for criminal use of paper currency, as we argued in a recent post, there is a strong case for eliminating anything bigger than the equivalent of a U.S. 20-dollar note, but doing so does not imply a need for U-CBDC.
Finally, there is financial access. Here, we see technology as providing solutions outside of the central bank. India’s program of providing costless, no-frills accounts is a useful model. In less than four years, 315 million previously unbanked Indians have opened accounts, deposited more than INR800 billion (US$12 billion), and received 237 million debit cards. In many countries—even in the emerging world—ownership of a smart phone has become a ticket to mobile payments.
To conclude, we see very little upside for central banks to issue retail digital currency. Instead, we see an enormous risk to the commercial banking system and political challenges for central banks. In the end, we wonder: would capitalism survive the introduction of U-CBDC? It may, but we are not at all sure.