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 €0.002 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. But the most important innovations – those that improve the payments system and the supply of credit – do not require universal CBDC and its inherent risks. So, why are central banks so intent on preparing? What is the purpose of such contingency planning?
The problem, as we see it, is that central banks fear being left behind in a way that damages the interests of their jurisdiction. Their solution is to create a form of shovel-ready CBDC programmes. But, the resulting framework is unstable. The situation is analogous to the one prior to WWI, when countries prepared to mobilise rapidly for fear that delay meant losing a war. In the early 20th century, in the absence of trust, an obscure event in a far-off land tipped this fragile balance into war. In the current financial circumstances, the bad equilibrium is a world of multiple CBDCs in advanced economies that threaten financial stability domestically and pose a severe threat to monetary control in developing economies.
We see no easy steps to prevent this poor outcome. As in a classic prisoner’s dilemma, there is little way to enforce the cooperative equilibrium in which no one introduces CBDC. First, central banks cannot credibly commit to never issue CBDC. Second, with China already headed down the CBDC road, others now view it as too late to resist – even with full knowledge of the risks, they feel compelled to prepare.
Perhaps the best hope is that central banks will all proceed very slowly and, as Duffie (2021) emphasised, try to ‘get the design right’. In our view, that that means stopping well short of universal, elastically supplied, interest-bearing CBDC.
Editors’ note: An earlier version of this column appeared on www.moneyandbanking.com.
Auer, R and R Boehme (2021), “Central bank digital currency: the quest for minimally invasive technology,” BIS Working Paper No. 948, 8 June.
Bank for International Settlements (2021), Annual Economic Report 2021, Chapter 3, 23 June.
Boar, C and A Wehril (2021), “Ready, steady, go? - Results of the third BIS survey on central bank digital currency,” BIS Papers No 114, 27 January.
Carstens, A (2021), “Digital currencies and the future of the monetary system,” remarks at the Hoover Institution policy seminar, 27 January.
Cecchetti, S and K Schoenholtz (2014), “Narrow Banks Won’t Stop Bank Runs,” www.moneyandbanking.com, 28 April.
Cecchetti, S and K Schoenholtz (2017), “Banking the Unbanked: The Indian Revolution,” www.moneyandbanking.com, 6 November.
Cunliffe, J (2021), “Do we need ‘public’ money?” speech at the OMFIF Digital Money Institute, London, 13 May.
Duffie, D (2021), “Building a Stronger Financial System: Opportunities of a Central Bank Digital Currency,” testimony bore the U.S. Senate Committee on Banking, Housing, and Urban Affairs Subcommittee on Economic Policy, 9 June.
Duffie, D, K Mathieson, and D Pilav (2021), “Central Bank Digital Currency: Principles for Technical Implementation,” mimeo, April.
Fatas, A (2021), “The conflict between CBDC goals and design choices,” VoxEU.org, 3 May.
Quarles, R K (2021), “Parachute Pants and Central Bank Money,” remarks at the 113th Annual Bankers Association Convention, Sun Valley, Idaho, 28 June.
Monnet, E, A Riva and S Ungaro (2021), “Banks runs and central bank digital currency,” VoxEU.org, 1 May.
Shin, H S (2021), “Central bank digital currencies: an opportunity for the monetary system,” Speech on the occasion of the Bank for International Settlements Annual General Meeting, 29 June.
White, L H (2021), “Should the State or the Market Provide Digital Currency?” Cato Journal, Spring/Summer: 237-249.
1 Shin (2021) and the latest BIS Annual Report (2021) provide a thoughtful case arguing that CBDCs “are an idea whose time has come.”.
2 According to a BIS-sponsored survey last year, a majority of central banks already are working on CBDC (Boar and Wehrli 2021).
3 We ignore certain technical issues, such as whether it is account-based or token-based (Carstens 2021).
4 We grant that there may be technical solutions to this problem (Duffie et al. 2021).
5 In a recent speech, Quarles (2021) notes some of the same problems we discuss and concludes that the benefits of CBDC are far from clear.
6 See Fatas (2021) for a further discussion of the need for regulatory changes to accommodate the issuance of CBDC.