We propose a generic model of money and liquidity. We provide sufficient conditions under which a swap of private (inside) against public (outside) money leaves the equilibrium allocation and price system unchanged. We apply the results to Central Bank Digital Currency, the “Chicago Plan,” and the Indian de-monetization experiment.
December 2018. PDF. In: Ernest Gnan and Donato Masciandaro, editors, Do We Need Central Bank Digital Currency? Economics, Technology and Institutions, SUERF, The European Money and Finance Forum, Vienna, 2018.
A short version of the CEPR working paper.
Abstract: I offer a macroeconomic perspective on the “Reserves for All” (RFA) proposal to let the general public use electronic central bank money. After distinguishing RFA from cryptocurrencies and relating the proposal to discussions about narrow banking and the abolition of cash I propose an equivalence result according to which a marginal substitution of outside for inside money does not affect macroeconomic outcomes. I identify key conditions on bank and government (central bank) incentives for equivalence and argue that these conditions likely are violated, implying that RFA would change macroeconomic outcomes. I also relate my analysis to common arguments in the discussion about RFA and point to inconsistencies and open questions.
ifo Schnelldienst 16/2018, August 23, 2018. PDF.
VoxEU, August 20, 2018. HTML.
- To a first approximation, inside and outside money are substitutes—the introduction of CBDC does not change the equilibrium allocation.
- Bank incentives and central bank incentives might be affected though.
- CBDC could increase the incentive to extend credit but might undermine the political support for implicit financial assistance to banks.
I offer a macroeconomic perspective on the “Reserves for All” (RFA) proposal to let the general public use electronic central bank money. After distinguishing RFA from cryptocurrencies and relating the proposal to discussions about narrow banking and the abolition of cash I propose an equivalence result according to which a marginal substitution of outside for inside money does not affect macroeconomic outcomes. I identify key conditions on bank and government (central bank) incentives for equivalence and argue that these conditions likely are violated, implying that RFA would change macroeconomic outcomes. I also relate my analysis to common arguments in the discussion about RFA and point to inconsistencies and open questions.
On their blog, Stephen Cecchetti and Kermit Schoenholtz voice doubts regarding the usefulness of universal central bank digital currency (U-CBDC). They argue:
… 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. … 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.
… 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.
… 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.
The problem with this argument is twofold: First, it disregards the possibility of liability substitution: Deposits may be replaced by other forms of bank debt. Second, bank balance sheet length is equated with lending capacity. But empirically, one is far from a perfect predictor of the other. For example, some countries rely much more heavily on bank credit than others, without obvious implications for intermediation and investment.
… 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. … 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 [e.g., India’s program of providing costless, no-frills accounts].
Indeed, none of these arguments makes a convincing case for CBDC (especially since only the first one directly relates to the monetary system). But there are two more convincing arguments. First, it is preposterous to have governments prohibit citizens from using cash—the legal tender—for large transactions, and to force them into using privately issued money instead. Opening the central bank’s balance sheet to the public is a more liberal approach than restricting access to financial institutions.
Second, private money creation puts the central bank at a second mover disadvantage, effectively forcing it to serve as lender of last resort during liquidity crises or even as provider of bailout funds. Since the central bank is obliged to safeguard the payment system it cannot escape this disadvantage; regulatory measures—to the extent that they work and do not cause more harm—may alleviate moral hazard but cannot solve the time consistency problem completely. The more payments are conducted using CBDC the less can the banking sector and its customers dictate monetary policy.
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.
As argued above, threats to capitalism also lurk in other corners.
Central bankers often argue that CBDC would increase the risk of bank runs. On his blog, JP Koning rejects this notion. After all, he retorts, during a confidence crisis bank customers would no longer have to queue to withdraw cash; lender of last resort support would be provided much more quickly; and “large” cash holders would continue to shift funds into treasury bills, not into CBDC.
The general criticism here is that during a crisis, households and businesses will desperately shift their deposits into the ultimate risk-free asset: central bank money. Presumably when deposits were only redeemable in banknotes (as is currently the case) and one had to trudge to an ATM to get them, this afforded people time for sober contemplation, thus rendering runs less damaging. But if small depositors can withdraw money from their accounts while in their pajamas, this makes banks more susceptible to sudden shifts in sentiment, goes the Carney critique.
I don’t buy it. … even in jurisdictions without deposit insurance, I still don’t think that shifts into digital currency in times of stress would exceed shifts into banknotes. A bank will quickly run out of banknotes during a panic as it meets client redemption requests, and will have to make arrangements with the central bank to get more cash. Thanks to the logistics of shipping cash, refilling the ATMs and tellers will take time. In the meantime a highly visible lineup will grow in front of the bank, exacerbating the original panic. Now imagine a world with digital currency. In the event of a panic, customer redemption requests will be instantaneously granted by the bank facing the run. But that same speed also works in favor of the bank, since a request to the central bank for a top-up of digital currency could be filled in just a few seconds. Since all depositors gets what they want when they want, no lineups are created. And so the viral nature of the panic is reduced.
But what about large depositors like corporations and the rich … ? During a crisis, won’t these sophisticated actors be more likely to pull uninsured funds from a bank, which have a small possibility of failure, and put them into risk-free central bank digital currency?
I disagree. In a traditional economy where banknotes circulate, CFOs and the rich don’t generally flee into paper money during a crisis, but into short-term t-bills. Paper money and t-bills are government-issued and thus have the same risk profile, t-bills having the advantage of paying positive interest whereas banknotes are barren. The rush out of deposits into t-bills is a digital one, since it only requires a few clicks of the button to effect. Likewise, in an economy where digital currency circulates, CFOs are unlikely to convert deposits into barren digital currency during stress, but will shift into t-bills. The upshot is that banks are not more susceptible to large deposit shifts thanks to the introduction of digital currency—they always were susceptible to digital bank runs thanks to the presence of short-term government debt.
Of course, depending on the type of CBDC, central banks might also choose to pay negative interest on CBDC in order to depress demand for it.
A BIS report submitted by the Committee on Payments and Market Infrastructures and the Markets Committee discusses potential implications of the introduction of central bank digital currency for payments, monetary policy, and financial stability.
From the executive summary
… CBDC is potentially a new form of digital central bank money that can be distinguished from reserves or settlement balances held by commercial banks at central banks. There are various design choices for a CBDC, including: access (widely vs restricted); degree of anonymity (ranging from complete to none); operational availability (ranging from current opening hours to 24 hours a day and seven days a week); and interest bearing characteristics (yes or no).
… Two main CBDC variants are … a wholesale and a general purpose one. The wholesale variant would limit access to a predefined group of users, while the general purpose one would be widely accessible.
… Traditionally, central banks have … This approach has, in general, served the public and the financial system well, setting a high bar for changing the current monetary and financial structure.
Wholesale CBDCs, combined with the use of distributed ledger technology, may enhance settlement efficiency for transactions involving securities and derivatives. Currently proposed implementations for wholesale payments – designed to comply with existing central bank system requirements relating to capacity, efficiency and robustness – look broadly similar to, and not clearly superior to, existing infrastructures. …
In part because cash is rapidly disappearing in their jurisdiction, some central banks are analysing a CBDC that could be made widely available to the general public and serve as an alternative safe, robust and convenient payment instrument. … analysing whether these goals could also be achieved by other means is advisable, as CBDCs raise important questions and challenges … the benefits of a widely accessible CBDC may be limited if fast (even instant) and efficient private retail payment products are already in place or in development.
… a central bank introducing such a CBDC would have to ensure the fulfilment of anti-money laundering and counter terrorism financing (AML/CFT) requirements, as well as satisfy the public policy requirements of other supervisory and tax regimes. … in some jurisdictions central banks may lack the legal authority to issue a CBDC … compared with the current situation, a non-anonymous CBDC could allow for digital records and traces, which could improve the application of rules aimed at AML/CFT.
Issuance of a CBDC would probably not alter the basic mechanics of monetary policy implementation, including central banks’ use of open market operations. … However, if flows into CBDC were to become large and not associated with offsetting declines in physical banknotes, as could be the case in times of financial stress, challenges could arise (such as a need to broaden the assets that the central bank can hold or take on as collateral).
CBDC could enrich the options offered by the central bank’s monetary policy toolkit, eg by allowing for a strengthening of pass-through of policy rate changes to other interest rates or addressing the zero lower bound (or the even lower, effective bound) on interest rates. … other more conventional tools and policies can to some extent achieve similar outcomes without introducing new risks and challenges (such as implementing negative interest rates on public holdings of a general purpose CBDC). And some of these gains might not arise without discontinuing higher denomination banknotes …
Implications are more pronounced for monetary policy transmission and financial markets, especially if a CBDC was to be designed as, or de facto became, an attractive asset. … could function as a safe asset comparable in nature to short maturity government bills. A general purpose variant could compete with guaranteed bank deposits, with implications for the pricing and composition of banks’ funding.
… A general purpose CBDC could give rise to higher instability of commercial bank deposit funding. Even if designed primarily with payment purposes in mind, in periods of stress a flight towards the central bank may occur on a fast and large scale, challenging commercial banks and the central bank to manage such situations. Introducing a CBDC could result in a wider presence of central banks in financial systems. This, in turn, could mean a greater role for central banks in allocating economic resources … It could move central banks into uncharted territory and could also lead to greater political interference.
For currencies that are widely used in cross-border transactions, all the considerations outlined above would apply with added force, especially during times of generalised flight to safety. …
… Further research …
In the FT, Martin Arnold reports about plans to launch “Saga,” a reserves-backed krypto currency, maybe the closest substitute yet to central bank digital currency.
It is being launched by a Swiss foundation with an advisory board featuring Jacob Frenkel, … Myron Scholes, … and Dan Galai, co-creator of the Vix volatility index. The currency aims to avoid the wild price swings of many cryptocurrencies by tethering itself to reserves deposited in a basket of fiat currencies at commercial banks. Holders of Saga will be able to claim their money back by cashing in the cryptocurrency.
Saga also aims to avoid the anonymity of bitcoin that raises financial crime concerns with regulators and bankers. It will require owners to pass anti-money laundering checks and allow national authorities to check the identity of a Saga holder when required.
Deposits will be made in the IMF’s special drawing right basket of currencies, which is heavily weighted in US dollars.
Reserves for All come into sight.
Update (30 March): From the white paper:
Saga … deploys a reserve anchoring algorithm, serving to stabilise the currency in terms of leading state-issued currencies. As Saga gains trust, its reserve ratio will decrease in favour of an independent establishment of value.
- CBDC is not the same as krypto currencies.
- The case against CBDC is not at all obvious; CBDC has costs and benefits.
- Switzerland should not dismiss CBDC too quickly.
- (The title of the article is misleading, it is not mine. I argued for openness in the discussion rather than for adoption.)
In the FT, Ralph Atkins reports that Romeo Lacher, Chairman of SIX group, supports the idea of Switzerland introducing an ‘E-Franc.’
In the NZZ, Peter Fischer reports that SNB president Thomas Jordan rejects the Vollgeld initiative and stops short of endorsing the ‘reserves for all’ proposal.
… wehrt sich die Nationalbank auch gegen Vorschläge aus akademischen Kreisen, die von der Nationalbank fordern, nicht mehr nur Banken, sondern auch direkt den Schweizer Bürgern elektronisches Zentralbankgeld zur Verfügung zu stellen. Am einfachsten ginge dies, wenn jedermann bei der SNB ein Konto halten könnte. Jordan warnt davor, dass in einem solchen Fall die bewährte Arbeitsteilung zwischen Privatsektor und Zentralbank zur Disposition stünde. Die Fähigkeit der Banken, Kredite zu vergeben und Fristentransformation zu betreiben, würde eingeschränkt. Das Finanzsystem würde als Ganzes nicht sicherer, sondern unter Umständen sogar stärker destabilisiert, wenn es allen Anlegern möglich wäre, nach Belieben plötzlich in Sichtguthaben bei der Zentralbank zu flüchten. Zudem müsste die SNB etwa bei der Überprüfung der Kunden und ihrer Gelder neu Funktionen übernehmen, die sie bei den Banken besser aufgehoben sieht.
Allerdings konzediert auch Jordan, dass sich die technologischen Möglichkeiten im Bereich des digitalen Geldes rasant weiterentwickeln. Das hat das Potenzial, Zahlungssysteme und die Art, wie die Zentralbank ihre Geldpolitik betreiben kann, zu verändern. Jordan hielt in seiner Rede dazu lediglich fest, die SNB verfolge die Entwicklungen aufmerksam. Noch sind Kryptowährungen zu wenig verbreitet, um aus Sicht der Nationalbank ein ernsthaftes Problem darzustellen. Der E-Franken muss warten.
It is correct that ‘reserves for all’ could increase the elasticity of demand for reserves; if unchecked, this could also increase the risk of bank runs. But the central bank would not have to interact with the general public. And the fact that monetary reform would change the banking business is no decisive argument against such a change.
For my columns on the topic, select the ‘reserves for all’ tag.
- The Vollgeld initiative may point to a problem but it does not propose a viable solution.
- Even with Vollgeld, the time consistency friction with its Too-Big-To-Fail implication would persist.
- A more flexible, liberal approach appears more promising.
- It would give the general public a choice between holding deposits and reserves.
- Financial institutions and central banks around the world are pushing in that direction.
On his blog, John Cochrane reports about a Hoover panel including him, Charles Plosser, and John Taylor.
Cochrane focuses on the liability side. He favors a large quantity of (possibly interest bearing) reserves for financial stability reasons. Plosser focuses on the asset side and is worried about credit allocation by the Fed, for political economy reasons. Taylor favors a small balance sheet. Cochrane also talks about reserves for everyone, but issued by the Treasury.
The blockchain technology opens up new possibilities for financial market participants. It allows to get rid of middle men and thus, to save cost, speed up clearing and settlement (possibly lowering capital requirements), protect privacy, avoid operational risks and improve the bargaining position of customers.
Internet based technologies have rendered it cheap to collect information and to network. This lies at the foundation of business models in the “sharing economy.” It also lets fintech companies seize intermediation business from banks and degrade them to utilities, now that the financial crisis has severely damaged banks’ reputation. But both fintech and sharing-economy companies continue to manage information centrally.
The blockchain technology undermines the middle-men business model. It renders cheating in transactions much harder and thereby reduces the value of credibility lent by middle men. The fact that counter parties do not know and trust each other becomes less of an impediment to trade.
The blockchain may lend credibility to a plethora of transactions, including payments denominated in traditional fiat monies like the US dollar or virtual krypto currencies like Bitcoin. An advantage of krypto currencies over traditional currencies concerns the commitment power lent by “smart contracts.” Unlike the money supply of fiat monies that hinges on discretionary decisions by monetary policy makers, the supply of krypto currencies can in principle be insulated against human interference ex post and at the same time conditioned on arbitrary verifiable outcomes (if done properly). This opens the way for resolving commitment problems in monetary economics. (Currently, however, most krypto currencies do not exploit this opportunity; they allow ex post interference by a “monetary policy committee.”) A disadvantage of krypto currencies concerns their limited liquidity and thus, exchange rate variability relative to traditional currencies if only few transactions are conducted using the krypto currency.
Whether blockchain payments are denominated in traditional fiat monies or krypto currencies, they are always of relevance for central banks. Transactions denominated in a krypto currency affect the central bank in similar ways as US dollar transactions, say, affect the monetary authority in a dollarized economy: The central bank looses control over the money supply, and its power to intervene as lender of last resort may be diminished as well. The underlying causes for the crowding out of the legal tender also are familiar from dollarization episodes: Loss of trust in the central bank and the stability of the legal tender, or a desire of the transacting parties to hide their identity if the central bank can monitor payments in the domestic currency but not otherwise.
Blockchain facilitated transactions denominated in domestic currency have the potential to affect central bank operations much more directly. To leverage the efficiency of domestic currency denominated blockchain transactions between financial institutions it is in the interest of banks to have the central bank on board: The domestic currency denominated krypto currency should ideally be base money or a perfect substitute to it, directly exchangeable against central bank reserves. For when perfect substitutability is not guaranteed then the payment associated with the transaction eventually requires clearing through the traditional central bank managed clearing mechanism and as a consequence, the gain in speed and efficiency is relinquished. Of course, building an interface between the blockchain and the central bank’s clearing system could constitute a first step towards completely dismantling the latter and shifting all central bank managed clearing to the former.
Why would central banks want to join forces? If they don’t, they risk being cut out from transactions denominated in domestic currency and to end up monitoring only a fraction of the clearing between market participants. Central banks are under pressure to keep “their” currencies attractive. For the same reason (as well as for others), I propose “Reserves for All”—letting the general public and not only banks access central bank reserves (here, here, here, and here).
In the NZZ, Axel Lehmann offers his views on the prospects of blockchain technologies in banking. Lehmann is Group Chief Operating Officer of UBS Group AG.
- Higher efficiency; lower cost; more robustness and simpler processes; real-time clearing;
- no need for intermediaries; information exchange without risk of interference
- automated “smart contracts;” automated wealth management;
- more control over transactions; better data protection;
- improved possibilities for macro prudential monitoring.
- Speed; scalability; security;
- smart contracts require new contract law;
- interface between traditional payments system and blockchain payment system.
Lehmann favors common standards and he points out that this is what is happening (R3-consortium with UBS, Hyperledger project with Linux foundation).
Related, Martin Arnold reported in the FT in late August that UBS, Deutsche Bank, Santander, BNY Mellon as well as the broker ICAP pursue the project of a “utility settlement coin.” Here is my reading of what this is:
- The aim seems to be to have central banks on board; so USCs might be a form of reserves (base money). The difference to traditional reserves would be that USCs facilitate transactions using distributed ledgers rather than traditional clearing and settlement mechanisms. (This leads to the question of the appropriate interface between the two systems posed by Lehmann.)
But what’s in for central banks? Would this be a test before the whole clearing and settlement system is revamped, based on new blockchain technology? Don’t central banks fear that transactions on distributed ledgers might foster anonymity?
On a new website, Aleksander Berentsen rejects the Swiss Vollgeld initiative. As an alternative, he suggests the Swiss National Bank should offer transaction accounts for everybody, in line with proposals I have made earlier (see here (2016), here (2015), here (2015)).
- Vollgeld seems attractive because it decouples the supply of money from intermediation. By enabling everyone to use legal tender for electronic payments, electronic base money would satisfy a need.
- Vollgeld would prevent bank runs, at least partly; render deposit insurance unnecessary and reduce moral hazard; could help stabilize the credit cycle; and would redistribute seignorage to the central bank.
- But these objectives can be obtained with less intrusive means.
- Moreover, a Vollgeld system would be hard to enforce. Banks and their clients would establish new means of payment to circumvent the regulation. And in times of crisis, the central bank would feel obliged to provide liquidity assistance and bail outs.
- The central problem is not that private money is used for transactions; it rather is that the money’s users rely on the central bank to guarantee the substitutability of private money and base money. In a democracy, the central bank cannot credibly let large parts of the payment system go under.
- A sudden, forceful change of regime does not offer a credible way out of this trap.
- But letting the general public access central bank reserves without abolishing private money from one day to the other may open a path towards a new arrangement where the public learns to distinguish between private and base money and where only the latter is publicly guaranteed.
In a Federal Reserve Bank of New York staff report, Rodney Garratt, Antoine Martin, James McAndrews and Ed Nosal argue in favor of “Segregated Balance Accounts” (SBAs):
SBAs are accounts that a bank or depository institution (DI) could establish at its Federal Reserve Bank using funds borrowed from a lender. … the funds deposited in an SBA would be fully segregated from the other assets of the bank … only the lender of the funds could initiate a transfer out of an SBA; consequently, the borrowing bank could not use the reserves that fund an SBA for any purpose other than paying back the lender. … the loan made by the lender to the bank would be collateralized by the reserve balances in the SBA account.
The authors argue that SBAs could foster competition in money markets and
help strengthen the floor on overnight interest rates that is created by the payment of interest on excess reserves.
The proposal is related to topics I discussed in previous blog posts:
- Narrow banking proposals.
- Reserves for Everyone—Towards a New Monetary Regime.
- Reserves for Everyone—Towards a New Monetary Regime, Vox.
- Notenbankgeld für Alle?, NZZ.
- Sovereign Money in Iceland?
- Reserves for All.
- Allowing the general public to hold reserves at the central bank could help reduce the risk of bank runs and the negative consequences of deposit insurance.
- It would end the need to accept bank deposits as means of payment although they are not legal tender; this need arises due to prohibitions on cash payments, for tax reasons.
- But it could also have negative consequences: Money and credit creation by banks would be undermined, with social costs and benefits.
- Price stability and financial stability could be threatened during the transition period.
- More technical questions would have to be addressed as well: They concern the payment system or the conduct of monetary policy.
- Proposals to go further and to abolish cash are not convincing. One suggested benefit—more leeway for monetary policy makers—is over estimated: Negative rates can also be engineered (effectively) through fiscal policy, and they can fully be implemented with a flexible exchange rate between reserves and cash.
- Another suggested benefit—better monitoring of tax dodgers and criminals—is also overrated; the fixed cost to circumvent the measure would deter minor illegal activity but not major one.
- But abolishing cash would have severe negative consequences for privacy and could negatively affect financial literacy.
- Enforcing an abolishment of cash would be difficult. In a free society, any reform to the monetary system is constrained by the requirement that money must remain attractive for its users.