Since the financial crisis of 2007-08, the role of our monetary order for the emergence of credit and investment cycles has received renewed attention. Based on the work of Knut Wicksell, Ludwig von Mises, and Friedrich von Hayek, an increasing number of financial analysts and economists have identified the creation of money through credit extension by commercial banks under the guidance of central banks as a source of economic instability.1 When a central bank manages interest rates in the credit markets below the ‘natural rate’ (at which money savings and investments are in equilibrium), more money is created through credit extension for new investment while money savings are discouraged. A credit and investment boom ensues, during which investment temporarily exceeds saving. When capacity constraints put a brake on the investment expansion, prices rise, prompting the central bank to induce an increase in credit market rates. Higher interest rates discourage new investment and render some investment undertaken at lower rates economically unviable. As bank loans need to be written off and new investment drops, the boom turns into bust.
Credit and investment boom-bust cycles would of course be avoided if the central bank could stabilise the credit market rate at the level of the natural rate. But as this rate is unobservable, the central bank engages in a process of trial and error to find the correct level for the credit market rate, inducing boom-bust cycles in the process.2 As a consequence, a number of economists and analysts have proposed replacing money creation through bank credit extension with direct money issuance by the central bank or a private entity, or linking money to an existing asset.3
Since the beginning of the euro area crisis in 2010, it has been become clear that the original architecture of European Economic and Monetary Union was unstable. Numerous reforms have been implemented, but political disunity has prevented completion of EMU. Contrary to popular belief, EMU is still only a cash union, because only the banknotes issued by the ECB (and the coins issued by the member states alongside) are of the same credit quality in all the member states of the euro area. Bank deposits, on the other hand, differ according to the quality of the loans with which they were created and – in particular – according to the financial capacity of the states to protect these deposits in the event of bankruptcy of banks. A uniform European deposit insurance scheme (EDIS) is to be created in order to ensure the uniform quality of bank deposit money, but political resistance to the pooling of bank risks has so far prevented this. For the same reason, the creation of a ‘safe asset’ in the form of a government bond without default risk, urgently demanded by financial market participants, has remained elusive.
History has shown again and again that monetary union in the credit money system needs political union as its guarantor. But political union seems more distant today than at the time of the launch of EMU more than two decades ago. Even if we succeed in completing EMU by creating a political union against all odds, we would have established the euro as credit money with all the problems mentioned above.
Against this background, and in view of the challenges and opportunities of digitalisation in the financial sector, I propose to relaunch the euro as digital central bank money. My proposal draws on all three of the above-mentioned ideas for monetary reform: the 100% money concept of the Chicago Plan; the crypto money technique pioneered by Nakamoto; and the asset backing of money suggested by economists of the Austrian school. A more detailed comparison of the various ideas for monetary reform and exposition of how they change the balance sheets of money issuing entities and commercial banks is given in Mayer (2018). I believe that a digital euro offers four important advantages: (1) a safe European common currency without the need to create political union; (2) a monetary order less prone to investment boom-bust cycles; (3) an end to the sovereign-bank doom loop; and (4) the establishment of the euro as a key international currency.
Introducing the secure deposit
The first step towards the euro as digital central bank money would be to create a euro bank deposit which is fully backed with central bank money. The ECB could create the central bank money necessary for covering the deposit by purchasing government bonds (as proposed in the Chicago Plan).4 The ECB has done this since 2015 to increase the money supply. However, the secure deposit would replace existing deposits without increasing the money supply. When owners of existing deposits transfer their money to a secure deposit, the sum of deposits – and hence money supply – remains unchanged. Banks could obtain the reserves needed to back secure deposits by selling government bonds they already hold to the ECB. Or they could buy government bonds in the markets against other assets they hold. Where needed, the ECB could accept other bank credit than government bonds from banks in exchange for reserve money and replace these claims with government bonds when they are redeemed. Thus, a secure deposit and asset as safe as banknotes would be created without any form of state backing needed.5
In a second step, the secure euro deposit could be consolidated on the ECB’s balance sheet and set up as digital central bank money that can be transferred peer-to-peer using distributed ledger (i.e. blockchain) technology. Thus, the euro would become an ‘asset token’, backed solely by government bonds. Embedded in the token could be a ‘smart contract’ stipulating the nature of its backing and rules for the creation of new tokens (see below). The smart contract would be tantamount to a digital watermark identifying the token as a valid euro. Entities tasked with proofing transfers of tokens in the blockchain (i.e. ‘nodes’) would only validate a transfer if the token under review were created according to the rules laid down in the smart contract. A token found in a proof of a transaction not to have been created according to the rules embedded in the smart contract would be treated as counterfeit money. Only the ECB – not the commercial banks as in the credit money system – would be responsible for issuing digital euro tokens. For users accustomed to paper money, the ECB could of course exchange digital euros at parity into bank notes.
A rules-based increase in the money supply
The future increase in the money supply would take the form of additional purchases of government bonds by the ECB. Purchases would have to be decided by the ECB Governing Council independently of political influence and from a long-term perspective. For instance, in the spirit of Milton Friedman’s ‘k-percent rule’, growth of the digital euro money supply could be geared to the expected long-term growth rate of real GDP (the growth potential of the euro area economy).6 Contrary to conventional wisdom and in line with the experience in Japan, I do not see inflation expectations of zero as a problem, but a small rate of depreciation of money could be added to the money growth rule if actual developments proved me wrong. Instead of through bank lending, money supply would be expanded by increasing ECB holdings of government bonds. To avoid money creation for fiscal policy purposes (as proposed by modern monetary theory), governments would be obliged to distribute the money they receive from the bond sales directly to their citizens as a ‘money dividend’. Any government violating this obligation (stipulated in the smart contract embedded in the euro) would engage in distributing counterfeit money, automatically no longer qualify for bond sales to the ECB, and hence not receive new money for distribution to its citizens.
Banks as intermediators
Commercial banks would now have to broker their customers' savings deposits in the form of digital euros to investors, and interest rates would be determined by the demand for funds for investment purposes and the supply of money savings in the credit market. Banks would resemble an investment fund whose assets are protected against first loss by an equity cushion. Savers could choose the bank that suits them according to their preferences for returns and first-loss protection. The central bank would no longer manipulate interest rates to control banks' credit money creation. Commercial banks could of course continue to create private debt money through lending, but there would be no state guarantee for conversion at parity into digital euros. Money would no longer be an instrument for discretionary economic policy. But in view of the new impotence of monetary policy, this would hardly matter.
An end to the sovereign–bank doom loop
Since government debt would be used for backing money with an asset, digitalisation of the euro offers the possibility to reduce the debt of the euro states and end the sovereign-bank doom loop. Recall that the central bank buys government bonds to create the central bank money for the secure deposit, which can be transferred peer-to-peer in the blockchain. Thus, bonds on the central bank’s balance sheet to back the outstanding (digital) central bank money are permanently taken out of the market. At the end of 2018, euro area government debt amounted to €9.9 trillion, or 85% of GDP. Sight deposits amounted to €7.1 trillion. In order to back sight deposits with reserve money, the ECB could acquire €7.1 trillion government bonds against reserve money in total (i.e. some €5 trillion in addition to its existing holdings) and keep these bonds on its balance sheet. Since the stock of bonds is permanently required as cover for the money stock, repayment would be suspended. Moreover, as interest income from the bonds would be returned to governments anyway, coupons could be reset to zero. With a zero coupon and infinite maturity the bonds would cease to count as government debt. Hence, outstanding market debt of euro area governments would fall to €2.8 trillion, or 24.3% of GDP.
Digitalisation could be combined with a ‘New Deal for the euro’: the fiscally conservative countries in the North with lower debt levels would agree to the one-off monetisation of old debt on the balance sheet of the ECB for the creation of the secure deposit. In return, the more highly indebted countries in the South would accept that after the one-off monetisation of their old debts, a renewed monetisation of national debts would be impossible. Thus, the ECB would buy government bonds in amounts to reduce the debt ratio of each EMU country to the same level of 24.3% of GDP (in my example, based on end-2018 data). The more indebted Southern countries would receive a larger amount of debt relief than the fiscally conservative Northern countries with lower debt levels. For instance, to bring the debt ratio for all countries to 24.3% of GDP, the debt ratio of Germany would be reduced by 37.6% of GDP, while the reduction for France and Italy would amount to 74.1% and 100.5% of GDP, respectively. But as all euro member countries would benefit from new room for prudent fiscal policy, the Northern countries could afford to be generous.
With the rules for establishing the digital euro and augmenting the money supply embedded in the smart contract of the asset token, it would be impossible for governments to force the ECB to monetise future debt. Governments in payment difficulties could of course issue their own fiscal money (as has been contemplated by the governments of Greece and Italy at various points in time). But any money issued in breach of the contract and called euro would simply be counterfeit money (like issuing counterfeit central bank notes).
The euro as an international currency
Europeans use American platform companies to communicate and shop on the internet. They use the US dollar for a large part of their international payments. They may in future have to use a cryptocurrency managed predominantly by American platform companies with global reach when they want to pay with digital money; there is hardly a European company suitable to join the association created by Facebook to issue and manage Libra, the envisaged private cryptocurrency capable of attracting a global community of users. Or they may have to use a digital currency issued on behalf of the Chinese government, as China has announced to develop a digital currency which it may well roll out on a global scale. A digital euro would significantly reduce Europe’s dependence on the US dollar as a means for international payments and create a formidable competitor for other global digital currencies likely to emerge in the intermediate future.7 All global users would benefit when several currencies compete for their favour.
Conclusion
I am fully aware that my proposal will be regarded as provocative by many economists and central bankers. Many will argue that there will be no more room for discretionary monetary policy. But have we not exhausted this room already? Others will argue that digitalisation of money will create new financial risks. But is not the existence of the present financial system already at risk? A third (presumably mostly academic) group of economists will argue that I am reviving old-fashioned theories completely out of synch with the present state of macroeconomic theory. But has this theory not failed us in the global financial crisis? And a fourth group (presumably mostly employed by governments and central banks) will argue that my proposal is politically unthinkable. But has the unthinkable not become reality with the speed of thought during the global crisis and the euro crisis? If the past decade has taught economists anything, in my view it is that we should keep an open mind and should not take established wisdom for granted. It is in this spirit that I would welcome a critical discussion of this proposal by fellow economists.
References
Acharya, S (2003) “Safe Banking”, The Journal of American Academic of Business, August.
Carney, M (2019), “The Growing Challenges for Monetary Policy in the current International Monetary and Financial System”, Speech given at the Jackson Hole Symposium, 23 August.
Fisher, I (1935), 100% Money, New Haven.
Huerta de Soto, J (2012), “Money, Bank Credit, and Economic Cycles”, Ludwig von Mises Institute, Auburn, AL.
Mayer, T (2018), Austrian Economics, Money and Finance, Routledge.
Nakamoto, S (2008), “Bitcoin: A Peer-to-Peer Electronic Cash System”.
Endnotes
[1] For a comprehensive exposition of the theory, see Huerta de Soto (2012) and Mayer (2018).
[2] The search for the ‘correct’ rate is described in the Taylor Rule, which explains actual central bank policy relatively well.
[3] An early proposal for direct money issuance by the central bank was the Chicago Plan of 1933, explained in Fisher (1935). A more recent project of direct money issuance by a private entity is Bitcoin, described in Nakamoto (2008). For a proposal to back money fully with gold see, for example, Huerta de Soto (2012).
[4] When the central bank wants to buy a bond, it pays a commercial bank central bank money in its account to create a deposit, with which the commercial bank can buy the bond in the market. When the bond has been bought and delivered to the central bank, the latter has a claim in the form of the bond and a liability in the form of central bank money. The commercial bank has a claim in the form of central bank money and a liability in the form of deposit money. Thus, the latter can now be fully backed with central bank money. The previous bond holder has exchanged his bond against a bank deposit.
[5] Note that this looks similar but is different from the idea of ‘narrow banking’. There, banks are supposed to invest existing deposits in safe and liquid assets. Nothing is said about how these deposits come into existence (e.g. Acharya 2003). Here, we are concerned with the way safe deposits can be created in the first place.
[6] This would differ from the concept of Nakamoto (2008), where the Bitcoin money supply has a ceiling.
[7] Mark Carney, governor of the Bank of England, has recently proposed digital central bank currencies as competitors to the US dollar (Carney 2019).
