Schweizer Monat, April 2022, with Markus Brunnermeier. PDF.
We describe challenges the digital money revolution poses for central banks and predict that more and more monetary authorities will introduce CBDCs.
An executive order dated March 9, 2022 outlines what is on the White House’s mind:
The United States has an interest in responsible financial innovation, expanding access to safe and affordable financial services, and reducing the cost of domestic and cross-border funds transfers and payments, including through the continued modernization of public payment systems. We must take strong steps to reduce the risks that digital assets could pose to consumers, investors, and business protections; financial stability and financial system integrity; combating and preventing crime and illicit finance; national security; the ability to exercise human rights; financial inclusion and equity; and climate change and pollution. …
(d) We must reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets. The United States has an interest in ensuring that it remains at the forefront of responsible development and design of digital assets and the technology that underpins new forms of payments and capital flows in the international financial system, particularly in setting standards that promote: democratic values; the rule of law; privacy; the protection of consumers, investors, and businesses; and interoperability with digital platforms, legacy architecture, and international payment systems. The United States derives significant economic and national security benefits from the central role that the United States dollar and United States financial institutions and markets play in the global financial system. Continued United States leadership in the global financial system will sustain United States financial power and promote United States economic interests.
In a speech, the ECB’s Fabio Panetta argues that a digital Euro is necessary because
[i]n the digital age … banknotes could lose their role as a reference value in payments, undermining the integrity of the monetary system. Central banks must therefore consider how to ensure that their money can remain a payments anchor in a digital world.
He argues that
outsourcing the provision of central bank money [to stable coin providers] … would endanger monetary sovereignty [as would the absence of a national digital currency].
Panetta also argues that a digital Euro could
- improve the confidentiality of digital payments and
- increase choice and reduce costs
- avoid interfering with the functioning of the financial system and
- be available within private payment solutions.
Panetta does not discuss
- seignorage and
- time consistency motivations.
Neue Zürcher Zeitung, February 17, 2022. PDF.
- The federal council’s digital finance strategy focuses on regulation.
- There are limits to this strategy when financial markets operate globally and virtually.
- Preserving monetary sovereignty requires an attractive national currency.
- Carrots, not only sticks.
- An attractive currency is not only stable but also usable in digital form.
On the question whether the Fed should seriously consider retail CBDC, the FT sides with the pro camp.
While elsewhere such central bank digital currencies can appear “a solution in search of a problem”, America’s lacklustre retail banking system and the importance of the dollar in cross-border money flows make an obvious case for reform.
Compare the contributions by Darrell Duffie and Chris Waller in the CEPR eBook.
Q: You have been leader of the CEPR Research and Policy Network on FinTech and Digital Currencies since 2021 and explored issues at the heart of monetary theory and payment systems in your research. What do you think is new about digital central bank money and what makes it different from other digital means of payment?
A: Societies have been using digital means of payment for decades. Commercial banks use digital claims against the central bank, “reserves,” to pay each other. Households and firms use digital claims against commercial banks, “deposits,” as well as claims on such deposits, as money. Financial innovations typically improved the convenience for users or helped build additional layers of claims on top of each other, fostering fractional reserve banking and raising money multipliers.
Recently, new digital instruments have appeared on the fringes of the financial system. Some think of them as currencies and others as mere database entries. These instruments exploit the fact that smart ways of managing information, and even smarter approaches to providing incentives in anonymous, decentralized networks can replicate some functions of conventional monies. Monetary theorists are not surprised. They have debated for decades to what extent money is, or is not a substitute for a large societal database. The information technology revolution has made this debate much less theoretical.
Of course, the new entrants such as Bitcoin have not been very successful so far when it comes to actually creating substitute monies. But they have been quite successful in terms of creating new assets, mostly bubbles. Bubbles are also a great mechanism for their creators to extract resources from other people.
What is new about digital central bank money for the general public (central bank digital currency, CBDC) is that households and firms would no longer be restricted to cash when they wanted to pay using a central bank (i.e., government) liability. That is, banks would lose a privilege and households and firms would gain an option. CBDC, which I like to think of as “Reserves for All,” seems natural when you consider the history of central banking. It also seems natural when you consider that many governments strongly discourage the use of cash. Nevertheless, compared with the status quo, “Reserves for All” would amount to a major structural change.
Q: What do you think are the main challenges of issuing a CBDC?
A: From a macroeconomic perspective, introducing “Reserves for All” could have major implications. The balance sheets of central banks would likely expand while commercial banks would likely lose some deposits as a source of funding. Mechanically, they would reduce their asset holdings or attract other sources of funding. The question is, which assets they would shed, and subject to which terms and conditions they would attract new funding. These are important questions because banks play a key role in the transmission of monetary policy to main street.
While many central bankers are concerned about the implications of CBDC for bank assets and funding costs academic research conveys a mixed picture. To assess the consequences of “Reserves for All” it is natural to first ask what it would take to perfectly insulate banks and the real economy from the effects of CBDC issuance. As it turns out, the answer is “not much:” Under fairly general conditions the central bank holds a lot of power and can neutralize the implications of CBDC for macroeconomic outcomes.
Of course, central banks might choose to implement other than the neutral policies. In my view, this is in fact very likely, for reasons related to the political economy of banking and central banking. On the one hand, CBDC would make it even harder for central banks to defend their independence. On the other hand, CBDC would increase the transparency of the monetary system and trigger questions about the fair distribution of seignorage. On top of this, “Reserves for All” might trigger demands for the removal of other “bank privileges:” Interest groups might request LOLR-support, arguing that they are systemically important and just temporarily short of liquidity. Others might want to engage in open market operations with the central bank.
Beyond macroeconomics and political economy, CBDC could substantially change the microeconomics of banking and finance. In the current, two-tiered system there is ample room for complementarities between financing, lending, and payments. The information technology revolution strengthens these complementarities but it also generates new risks or inefficiencies. How the connections between money and information currently change is the subject of ongoing research. I don’t think we have been able to draw robust conclusions yet as to what role CBDC would play in this respect.
Q: Should we, and will we have CBDCs in the near future?
A: Some countries have already decided in favor. Others, like the Riksbank I believe, are still on the sidelines, thinking about the issues, watching, and preparing. Yet others have only recently taken the issue more seriously, mostly because of the Libra/Diem shock in June 2019, which made it clear to everybody that the status quo ceases to be an option.
I think the normative question is still unanswered. Not only does CBDC have many consequences, which we would like to better understand. There are also the unknown consequences that we might want to prepare ourselves for. Moreover, many of the problems that CBDC could potentially address might also allow for different solutions; the fact that CBDC could work does not mean that CBDC is the best option.
In a recent CEPR eBook* several authors share that view, which suggests a case-by-case approach. CBDC might be appropriate for one country but not for another, for instance because cash use has strongly declined in Sweden and this may favor CBDC (as Martin Flodén and Björn Segendorf discuss in their chapter) while the same does not apply in the US or elsewhere.
Regarding the positive question, I think that many more countries will decide to introduce “Reserves for All,” and quite a few of them in the next five years. One reason is that it is politically difficult to wait when others are moving ahead. Another is the fear of “dollarization,” not only in countries with less developed financial markets. The strongest factor, I believe, is the fear that central banks might lose their standing in financial markets. This is connected with the important question, which the Riksbank has been asking early on, whether in the absence of CBDC declining cash circulation could undermine trust in central bank money.
What seems clear to me is that the implications of CBDC go far beyond the remit of central banks. Parliaments and voters therefore should have the final say.
* Dirk Niepelt (2021), editor: “CBDC: Considerations, Projects, Outlook”, CEPR eBook. Changes in the research staff
Finanz und Wirtschaft, December 8, 2021. PDF.
- I draw some conclusions from the CEPR eBook on CBDC, namely:
- Banks will change, whatever happens to CBDC.
- The main risk of retail CBDC is not bank disintermediation.
- CBDC may not be the best option even if it has net benefits.
- It should be for parliaments and voters, not central banks, to decide about the introduction of CBDC.
From the conclusion:
From a macroeconomic perspective, central banks can largely neutralise the consequences of CBDC. What is highly uncertain, however, is whether they would choose to do so – the political risks of ‘Reserves for All’ are first-order. The decision for or against CBDC thus should not only reflect the assessment of economic trade-offs, but also whether societies are confident in their ability to efficiently manage conflicts of interest. If not, and if they fear that the introduction of CBDC could further politicise banking and central banking, then the introduction of CBDC might constitute a risky regime change. It will be interesting to see how different [countries] judge this risk.
CEPR eBook, November 24, 2021. HTML.
VoxEU, November 24, 2021. HTML.
Retail central bank digital currency has morphed from an obscure fascination of technophiles and monetary theorists into a major preoccupation of central bankers. Pilot projects abound and research on the topic has exploded as private sector initiatives such as Libra/Diem have focused policymakers’ minds and taken the status quo option off the table. In this eBook, academics and policymakers review what we know about the economic, legal, and political implications of CBDC, discuss current projects, and look ahead.
The Economist reports on “The race to redefine cross-border finance:”
- SWIFT recently launched SWIFT Go for retail payments.
- FinTech firms often partly bypass SWIFT by aggregating payments first.
- Ripple evades SWIFT, using a cryptocurrency for international transactions.
- Credit card companies build infrastructure independent of SWIFT for retail (push) payments initiated by the sender.
- JPMorgan Chase and a Singaporean bank and Temasek launched Partior for wholesale payments. This network records transfers on a permissioned blockchain.
- CBDCs could enable banks to make overseas payments on a shared ledger.
- SWIFT tries to collaborate with central banks.
- Partior aims to expand, recruiting core settlement banks for both central-bank and commercial-bank digital payments in euro, renminbi and yen.
On VoxEU, Massimo Ferrari, Arnaud Mehl, Fabio Panetta, and Ine Van Robays discuss “The international dimension of central bank digital currencies: Open research questions.” They argue that research has identified three main implications of retail CBDC (with broad access):
- ‘Dollarization’ in other countries.
- Stronger cross-border transmission of shocks, increased exchange rate volatility and altered capital flow dynamics. “Research finds that introducing a CBDC available to non-residents ‘super charges’ uncovered interest rate parity … leads to a stronger rebalancing of global portfolios in response to shocks, and to higher exchange rate volatility.”
- Impact on the international role of currencies.
The authors write that most models to date are unclear about what makes CBDC really different in this context. And they argue that another open question is how intensively central banks should and would cooperate. They write, somewhat optimistically, that “according to the (unwritten) code of central banking, the introduction of a CDBC in one jurisdiction must do no harm. In particular, it must not put the financial system of other jurisdictions at risk.” Let’s see.
Should the SNB follow the Fed and the ECB and rework its strategy? There is a case for rethinking the broad inflation target, the monetary policy concept, and the communication strategy. Equally important is a strategy review outside of the SNB: The SNB cannot and must not decide about the framework within which it operates.
Daher ist eine Strategieüberprüfung inner- und ausserhalb der SNB sinnvoll. Geldpolitisch prüfenswert sind das Inflationszielband, die Zentralität des Zinsinstruments und die Kommunikation. Die Glaubwürdigkeit der SNB verbietet ein Auseinanderklaffen von Theorie und Praxis, aber auch allzu häufiges und detailversessenes Feilen an der Strategie, und sie verlangt Konzentration auf das Wesentliche. Gleichzeitig sollte die SNB ihre Bindung an den – gegebenenfalls sich wandelnden – Willen des Gesetzgebers betonen. Bei Fragen, die nicht allein in ihre Zuständigkeit fallen, muss sie klarstellen, dass sie Partei und nicht Schiedsrichterin ist. Damit die SNB auch in Zukunft zu den grossen Schweizer Erfolgsgeschichten zählt, muss sie von Zeit zu Zeit über die Bücher gehen. Doch alleine kann sie die Verantwortung in Geld- und Währungsfragen nicht tragen.
In his University of St. Gallen MA thesis entitled “CBDC with Collateralized Pass-Through Funding,” Bastian Wetzel assesses how strongly banks would be affected by deposit outflows into retail CBDC:
The results of the study show that 92.7 percent of all sight deposits in the aggregate Swiss banking sector are covered by excess liquidity and eligible assets, whereas sight deposits held in CHF are covered by over 100 percent. Therefore, the collateral constraint seems to be a problem only in the unlikely event where almost all sight deposits converted to CBDC. As expected, refinancing costs decline when disintermediation is low due to negative interest rates on deposits at the SNB. As disintermediation increases, funding costs rise. Thus, if disintermediation is high, the net result from interest operations could decrease by over 4 percent. To compensate for this loss, banks would have to increase their lending rate on their credits outstanding. Yet, if the central bank lends on the same terms as the customer deposits withdrawn, as also proposed by Brunnermeier and Niepelt (2019), instead of the 0.5 percent as assumed in this paper, the impact on funding costs and bank lending could potentially be mitigated. With regard to the emergence of narrow banks, it can be said that the money multiplier is already close to 1. Thus, the concern about full-reserve banking seems to be irrelevant for the time being. The results of the quantification of bank run risk show that while the aggregate banking sector is able to cover the majority of sight deposits, the coverage ratios for individual banking groups is very heterogeneous. While the big banks are covered by more than 100 percent, Cantonal banks are covered by about three quarters and Raiffeisen banks by only half. In addition, compared to big banks, Cantonal banks and especially Raiffeisen banks hold almost no eligible assets. Thus, when considering individual banking groups, a system-wider run could potentially lead to a consolidation in the banking sector. It should be noted that the study conducted is a snapshot at a time when CBDC was not yet implemented.
In the FAZ, Christian Siedenbiedel reports that Deutsche Bank questions whether a digital Euro as envisioned by the ECB (i.e., with tight quantity restrictions) would be successful:
Die Argumentation geht so: Die EZB will den digitalen Euro einführen, um auf den verstärkten Währungswettbewerb zu antworten. … Um sich vor solchem Machtverlust sowohl durch Digitalgeld von anderen Notenbanken („Krypto-Dollars“) als auch durch privates Digitalgeld („Global Stable Coins“) zu schützen, treibe die EZB den Digitaleuro voran. Also aus längerfristigen politischen Motiven. Dabei sei unklar, ob der digitale Euro sich international am Markt durchsetzen könne und ob die Menschen in der Eurozone dafür überhaupt Bedarf hätten. “Das Design des digitalen Euros, soweit bisher bekannt, lässt erwarten, dass die potentiellen Nutzer kaum einen Unterschied zu bestehenden Bezahloptionen erkennen werden”.
Update: From the dbresearch document prepared by Heike Mai:
Lifting the limits on how much each user can hold would change the situation entirely, allowing a massive outflow of bank deposits into the digital euro. As a result, lending decisions and money creation would shift from the decentralised, privately owned banking sector to a central, state-run authority: the ECB. In this case, Europe would face the fundamental question of which type of monetary and financial system it wants. The answer to that would have to come from democratically elected representatives.
The German Banking Industry Committee sees a central role for the digital Euro, however, according to a new paper:
In a policy paper, the German Banking Industry Committee (GBIC) for the first time sets out detailed thoughts on the design of a “digital euro”. In this paper, experts from Germany’s five national banking associations draw up an ecosystem of innovative forms of money that extends far beyond the idea of digitalised central bank money, which is referred to as Central Bank Digital Currency (CBDC). The ECB will probably launch the project for a digital euro in mid-July 2021.
“To be successful, the digital euro must do three things: It must be as easy for consumers to handle as cash. It must be viable in the long term for business enterprises, e.g. for automated machine-to-machine payments. And the digital euro must be well embedded in our delicately balanced, carefully secured and highly regulated European financial system because this system guarantees safe and fair access to financial and banking services for everyone in Europe”, notes Dr Joachim Schmalzl, executive member of the Board of Management of the German Savings Bank Association (DSGV), which is currently the lead coordinator for the German Banking Industry Committee.
In the opinion of the experts from Germany’s five national banking associations, issuing money should remain the responsibility of credit institutions in the proven two-tier banking system [my emphasis], even if the digital euro becomes legal tender like cash. For this reason, the ecosystem of digital money which they propose is made up of three key elements:
- retail CBDC for private use
- wholesale CBDC for commercial and savings banks
- tokenised commercial bank money for use in industry
Retail CBDC issued by the central bank is to be used by private individuals in the euro area in the same way as cash for everyday payments, e.g. to retailers or government agencies. It should be possible to use the digital euro like cash, anonymously and offline. For this purpose, credit institutions will provide consumers in Europe with “CBDC wallets”, i.e. electronic wallets.
Wholesale CBDC issued by the central bank is to be used for the capital markets and interbank transfers. The GBIC’s experts are calling for this special form of the digital euro partly because, by adopting this approach, the ECB would be able to include further digitalisation of central bank accounts in its project. The ultimate aim is to achieve improvements which can benefit consumers, enterprises and also the banking sector.
Tokenised commercial bank money, which will be made available by commercial and savings banks, is to complement the two forms of digital central bank money, in particular to meet corporate demand arising from Industry 4.0 and the Internet of Things. Tokenised commercial bank money could facilitate transactions based on “smart” – i.e. automated – contracts and thus increase process efficiency.
“Increasing process digitalisation and automation will provide completely new opportunities for Europe’s enterprises. The banking sector is ready to provide new solutions for its corporate customers by issuing innovative forms of money. The ECB must define the necessary framework that will enable Europe’s banking sector and real economy to make reasonable use of the new opportunities”, Joachim Schmalzl observed on behalf of the GBIC.
I share the skepticism of DB research. And I can understand that banks prefer to maintain the two-tiered system while pushing for broader and more efficient payment options for their business clients.
In a new working paper the Swiss Bankers Association identifies challenges for banks. Nevertheless it argues that
[a]ny conclusion that the status quo is the least risky option seems premature and shortsighted.
The introduction of digital currencies and design questions regarding payment methods and infrastructure represent strategic business as well as political challenges on which public authorities and business must take a productive position. An informed discussion on the design and implementation of digital currencies is essential. It is time for the general public to consider these issues and drive the opinion-forming process.
Writing about CBDC, John Cochrane makes it clear that he is in favor. He links to my work and writes
Dirk Niepelt has written a lot about CBDC theory, including reserves for all in 2015, a recent Vox-EU summary and papers, here with Markus Brunnermeier a JME paper “CBDC coupled with central bank pass-through funding need not imply a credit crunch nor undermine financial stability,” a follow up including “The model implies annual implicit subsidies to U.S. banks of up to 0.8 percent of GDP during the period 1999-2017.” Here “reserves for all” “does not affect macroeconomic outcomes,”
Swissinfo, December 14, 2020. HTML, podcast.
We talk about CBDC, the Swiss National Bank, whether CBDC would render it easier to implement helicopter drops, and how central bank profits should be distributed.
If people prefer CBDCS, however, the central bank could in effect pass their funds on to banks by lending to them at its policy interest rate. “The issuance of CBDC would simply render the central bank’s implicit lender-of-last-resort guarantee explicit,” wrote Markus Brunnermeier of Princeton University and Dirk Niepelt of Study Centre Gerzensee in a paper in 2019. Explicit and, perhaps, in constant use.
We analyze policy in a two-tiered monetary system. Noncompetitive banks issue deposits while the central bank issues reserves and a retail CBDC. Monies differ with respect to operating costs and liquidity. We map the framework into a baseline business cycle model with “pseudo wedges” and derive optimal policy rules: Spreads satisfy modified Friedman rules and deposits must be taxed or subsidized. We generalize the Brunnermeier and Niepelt (2019) result on the macro irrelevance of CBDC but show that a deposit based payment system requires higher taxes. The model implies annual implicit subsidies to U.S. banks of up to 0.8 percent of GDP during the period 1999-2017.
- BIS: Central banks and BIS publish first central bank digital currency (CBDC) report laying out key requirements (9 October 2020)
- ECB: A Digital Euro (updated regularly)
- Bank of Russia: Bank of Russia announces public discussions on digital ruble (13 October 2020)
Related recent developments:
- Digital Dollar Project: The Digital Dollar Project Publishes Nine Pilot Scenarios to Test Elements of a US CBDC (October 2020)
- Monetative e.V.: Digitales Zentralbankgeld aus Sicht der Zivilgesellschaft (June 2020)
A new report by the Committee on Payments and Market Infrastructures lists 7 types of frictions and 19 focus areas to address these frictions.
On Alphaville, Claire Jones and Izabella Kaminska discuss privacy issues related to CBDC. In the background, Kocherlakota’s “Money is Memory” is lurking.