Central banks may substitute publicly issued digital currency for the bank-issued digital money that people use every day. How this plays out can profoundly reshape the financial system and make it less stable. This column argues that we don’t need CBDC to solve financial system problems,
While the conflict
is largely quiet and out of public view, we are in the midst of an epic
battle for the soul of the financial system. Central banks are thinking
about whether they should substitute publicly issued digital currency
for the bank-issued digital money that people use every day.1 How this plays out can profoundly reshape the financial system and make it less stable.
The forces driving
government decisions are unusual because there is a widespread fear of
losing an emerging arms race. No one wants to face plunging demand for
their currency or surging outflows from their financial institutions
should another central bank introduce an attractive new means of
exchange. But that pressure to prepare for the financial version of
military mobilisation can lead to a very unstable global system that
thwarts monetary control.
Central bank digital
currency (CBDC) can take many forms. While some may be benign, the most
radical version – one that is universally available, elastically
supplied, and interest bearing – has the potential to trigger
destabilizing financial shifts, weaken the supply of credit, and
undermine privacy.
Our current monetary system and the irresistible drive toward CBDCs
Over the past
century, a variety of forces gave rise to the financial structure we see
around us. First, through a combination of punitive taxes and outright
bans, officials hinder the issuance of private paper money. Second,
governments license private intermediaries (normally commercial banks)
to issue liabilities that are convertible at par into central bank
liabilities. Finally, the central bank runs a wholesale payments system
for banks, while the private sector runs the retail payments system for
the rest of us.
In combination, this means that we are living in a world in which nearly all what people think of as money
is the digital liability of a commercial bank. For example, in the UK,
where the total quantity of M3 is 148% of GDP, demand and time deposits –
digital entries on the ledgers of banks – account for 97% of the total
(or 144% of GDP). For the euro area, 91% of M3 is digital. And, in
China, where broad money exceeds 200% of GDP, 96% of it is digital.
As Bank of England
Deputy Governor Jon Cunliffe (2021) notes in a recent speech, most
people do not know this. They are unaware that when they pay for
groceries, purchase a new phone, or renew a software subscription, they
are using bank-created digital money. Importantly, it is the central
bank that provides the foundation that enables us to rely on this
system. To do so, authorities credibly promise to convert certain bank
liabilities into the means of exchange – the safe, liquid instrument
known as reserves – under as many states of the world as possible.
Experience teaches us that this is something central banks committed to
price stability can do under more states of the world than private
actors. As Cunliffe puts it, we rely on this framework to “tether
private money to the public money issued by the state”.
Where does the
system fall short? We see two principal shortcomings. Some payments are
expensive and slow, and too many people lack full access to the
financial system. Advocates see CBDC as the solution to both problems.
In our view, we do not need CBDC and its attendant risks either to
improve efficiency or to expand access.
Nevertheless,
central banks are plowing ahead, often referring to motives such as
payments efficiency, financial inclusion and monetary policy
implementation.2 We see two other important drivers. First,
there is a desire to supplant cryptocurrencies like Bitcoin and head off
the issuance of private monetary instruments like Libra (now Diem). But
governments know from long experience how to handle such private
currencies when they become salient – impose either punitive taxes or an
outright ban. Second, there is the fear of missing out: central bankers
want to make sure that, if others issue CBDC, they can, too – and
without delay. In our view, this creates instability: in theory, an
unanticipated event could trigger many central banks to mobilise their
digital currencies within a short period, so as not to be left behind.
CBDC: Properties and problems
This brings us to a
few details about CBDC. Before issuing retail digital currency, a
central bank will need to make a series of design decisions. Is it an
anonymous bearer instrument? Will there be quantity restrictions on an
individual’s holdings? Are only residents of the issuing jurisdiction
eligible to hold it? And, like paper currency, will it have a zero
interest rate?3
For paper currency,
we know the answers to these questions. It is an anonymous bearer
instrument. It is supplied elastically to allow the conversion of
certain bank liabilities at par into the medium of exchange without
limit in as many circumstances as possible. Anyone can hold paper
currency. And, it bears zero interest.
The likely characteristics of CBDC are equally clear. To avoid facilitating criminal activity, CBDC cannot
be anonymous. To truly substitute for paper currency, it will have to
be supplied elastically. Individuals will be allowed to hold unlimited
quantities; otherwise, there would be circumstances when bank
liabilities will not be convertible into CBDC at par. Restricting
holdings to residents is a version of capital controls, which are both
impractical and unwise. Finally, we see two reasons that CBDC would have
to bear interest. First, in our view, it is politically unsustainable
for a central bank to pay interest on commercial bank reserve deposits
but not on the deposits of individuals. Second, without it, policymakers
who wish to lower nominal interest rates below the effective lower
bound could not do so.
The issuance of such
‘universal’ CBDC creates four critical problems: disintermediation,
currency substitution, lack of privacy, and the inability to ensure
compliance. On the first, while inertia (combined with interest rate
increases and service improvements) might keep funds in the banking
system for a while, financial strains eventually would prompt uninsured
deposits to flee private banks for the central bank (Monet et al. 2021).
And, for highly trusted central banks that operate in relatively stable
political and financial jurisdictions, these inflows will come from
abroad as well. Given the current high foreign demand for US paper
currency, imagine what would happen if the Fed offered universal,
unlimited accounts – the consequences of this could be catastrophic for
emerging market and developing economies.
The fact that CBDC
is not anonymous leads to the final, related, challenges: privacy and
compliance. On the first, everything we do becomes traceable. While we
are neither libertarians nor advocates of free banking, in this case we
agree with White (2021) – there are enormous risks in allowing
governments to have this level of detailed information about our
activities. As a result, it is difficult to see why democratic countries
would allow such a concentration of power.4
Turning to
compliance, someone will have to do the work to ensure that the users of
CBDC are law abiding. Such know-your-customer and anti-money laundering
efforts are costly. We currently outsource these tasks to commercial
banks. Banks also provide a host of other services. Who will do this,
and who will bear the cost?
One way to manage the privacy and compliance challenges is through the creation of intermediated
CBDC (Auer and Boehme 2021). In this framework, brokers (or banks)
provide individual account services, guarding privacy, monitoring
compliance and aggregating balances into accounts at the central bank
(which would presumably bear interest). However, this approach does not
eliminate the risks of domestic disintermediation or currency
substitution. Funds would still flow into the central bank, just
indirectly through what are narrow banks in all but name (Cecchetti and
Schoenholtz 2014).
Against this
background, it is easy to see why the People’s Bank of China is moving
ahead of other central banks in creating a digital renminbi. Its large
banks are typically state owned, so there is little risk of
disintermediation – even in a financial crisis. With stringent capital
controls in place, there currently are effective limits on inflows into
the currency. There already is little expectation of personal privacy.
Finally, if the government wishes, state-owned banks can easily
subsidize access.
We don’t need CBDC to solve financial system problems
Returning to the
question at hand: Where is the current monetary system falling short?
Our answer is that there is plenty of scope to improve the payments
system and broaden financial access without turning to new digital
currencies, either from central banks or private issuers.5
We already see
public and private sectors moving to provide cheaper, faster, more
reliable, and more accessible retail payments systems that operate both
within and across borders. For example, the euro area has the TIPS
system, with a processing time of 10 seconds at a cost of €0.20 per
transaction. In addition, the UK has Faster Payments, Canada is testing
Real-Time Rail (RTR), and the US Federal Reserve is set to launch FedNow
in 2023. None of these requires CBDC.
As for financial access, the case of India is instructive. Started in 2014, the Pradhan Mantri Jan Dhan Yojana
(PMJDY) provides no-frills bank accounts without charge, using the
country’s universal biometric personal identification to lower costs. To
date, over 420 million people have been brought into the system, with
account balances averaging nearly US $50. Again, India’s success
required subsidies, not the issuance of CBDC (Cecchetti and Schoenholtz
2017).
Putting all of this
together, we conclude that it is imprudent for a central bank to issue
elastically supplied, interest-bearing CBDC with universal access.
Domestically, it could disintermediate private intermediaries, with
inflows of deposits directly into the central bank creating the
temptation for authorities to steer credit directly. Even if the central
bank were to re-circulate the funds to potential lenders through an
auction process, the need for an extensive collateral and haircut system
would vastly expand officials’ influence on credit allocation.
Internationally, there may be a tidal wave of funds fleeing places
perceived as less stable and into those thought to be safe, adding to
inequality and to the influence of the rich recipients. Finally, there
is privacy. While this problem can be addressed, CBDC would surely tempt
authoritarian governments by providing access to everything we do.6
So, why are central banks preparing for CBDC?
This all leads us to
be very concerned. To be clear, we are strong proponents of innovations
that reduce costs and improve welfare....
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