19 October 2021

Vox: Central bank digital currency in an historical perspective

This column argues that technological change in money and finance is inevitable, driven by the financial incentives of a market economy, and identifies four key lessons central banks could learn from history to enable them to provide digital currency to effectively fulfil their public mandates.

Debate swirls in monetary policy circles over whether, how, and when to introduce central bank digital currencies (e.g. Allen et al. 2020, Auer and Bohme 2020, Auer et al. 2020, Agur et al. 2020; see also the Vox debate on “The future of digital money”). This debate has a strong resonance with earlier crossroads in monetary history when major transformations took place. In today’s crossroad, advances in technology – digitalisation – have led to the development of new forms of money. These include virtual (crypto) currencies like bitcoin, stable coins like libra/diem, and central bank digital currencies (CBDC) like the Bahamian sand dollar. Today’s innovations have a resonance with earlier major shifts in monetary history, and in a new paper (Bordo 2021) I examine the case for CBDC through this lens.

My overview of the history of monetary transformations suggests that technological change in money is inevitable, driven by the financial incentives of a market economy. Government has always had a key role in the provision of currency (outside money), which is a public good. It has also regulated inside money provided by the commercial banking system. This held for fiduciary money and will likely hold for digital money.

Monetary transformations in history

Monetary transformations in history have been driven by changing technology, changing tastes, economic growth, and the demands to effectively satisfy the functions of money. Money (and finance) has evolved with human history (Goetzmann 2017). Three historical transformations set the stage for the current digital transformation.

• In the 18th and 19th centuries, new financial technology led to the advent of fiduciary money (convertible bank notes), which greatly reduced the resource costs of specie (Smith 1776). In addition, the exigencies of rising costs of war finance in the early modern era led to the issue by governments of inconvertible fiat money. CBDC as a social saving over fiat money promises to be the next generation in this progression.
• The early record of poorly regulated commercial banks issuing notes, ostensibly convertible into specie, has been used to make the case for government regulation of commercial banking and for a government monopoly of the note issue (Friedman 1960). The record of free banking in the US was one of considerable instability (Gorton 1986). The high asymmetric information costs of a multiple currency system created an inefficient payments system.^1,2 The note issue eventually gravitated towards a central bank/government monopoly. The present day rise of cryptocurrencies and stablecoins suggests that the outcome may also be a process of consolidation towards CBDC.
• Central banks, from the 17th to 20th centuries, evolved to satisfy several important public needs: war finance; an efficient payments system; financial stability; price stability; macro stability. Through a slow and painful learning process, monetary policy has evolved into the present-day flexible inflation targeting based on credibility for low inflation. CBDC could follow in this tradition.

The case for CBDC

The basic case for CBDC – defined as an asset in electronic form which serves the basic functions of paper currency, with universal access and legal tender – can be traced back to the classical economists’ argument that currency is a public good that would appropriately be provided by the government (Friedman and Schwartz 1986). CBDC would satisfy the basic functions of money: a unit of account, a medium of exchange, and a store of value (Bordo and Levin 2017).

The key factors driving interest today in CBDC include the following:

• CBDC would be the 21st century version of Adam Smith’s social saving of fiduciary money by reducing the costs of issuing and operating physical currency (by between 0.5% and 1.0% of GDP according to IMF 2020) and by reducing the monopoly rents earned by the commercial banking system (Barrdear and Kumhoff 2016, Andolfatto 2019). 
• Digitalisation has greatly reduced the use of cash in several countries (e.g. Sweden and Norway). CBDC would provide a payment media which has all the attributes of physical cash but is less subject to theft and loss. 
• CBDC would increase financial inclusion for disadvantaged groups that do not have access to bank accounts. 
• CBDC may head off the threat to monetary sovereignty from stablecoins issued by global digital services companies like Facebook, which would threaten central banks’ ability to conduct monetary policy. 
• CBDC would provide a secure reliable currency, free from the dangers of fraud, hacking, money laundering and financing terrorism.

Implementation of CBDC in the real world

Implementation of CBDC raises a number of important questions about its design which have been examined closely by central banks. One issue is the choice of retail versus wholesale CBDC. Significant improvements in the wholesale payments clearing mechanism suggest that the key issue is retail CBDC. Here, the public good aspect of currency provides a strong rationale for either direct provision or at least close regulation and supervision by government. Accounts at the central bank are eminently feasible, but the private sector has a comparative advantage in financial innovation. Hence, in advanced countries, a two-tiered or public–private arrangement may be preferable. Designated institutions could offer CBDC accounts to the public or serve as conduits for the central bank (Tobin 1987).³

Second, concern among prominent officials (Carstens 2021, Cecchetti 2021) that account-based CBDC which is the most secure direct liability of the central bank would lead to disintermediation and runs from the commercial banking system. Research suggests that disintermediation could be offset by central bank balance sheet policy, by restricting CBDC holdings, or by tiering interest rates on CBDC and non-CBDC accounts (Kiester and Sanchez 2019, Brunnermier and Niepelt 2019, Kumhof and Noone 2018, Bindseil 2020). Moreover, central banks have adequate lines of defence to deal with runs in the form of supervision and regulation, deposit insurance, and lender of last resort.⁴

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