Central bank digital currencies: the asset-side limitation

In January 2014 this blogger (naively) pitched the case for official e-money: digital money issued by a central bank directly to the population.

The logic of the proposal at the time seemed obvious.

Official e-money would…

  1. Allow the central bank to better control the money supply, making everything from negative rates and true (inflationary) helicopter drops to basic income possible.
  2. Encourage transparency and traceability.
  3. Reduce money laundering, tax evasion and all other socially destructive black market activities enabled by cash.
  4. Create a potentially limitless source of safe asset value, at an interest rate that the central bank could control.
  5. Restrict bank deposits (and interest rate-based returns) to the risk inclined, leading to the eventual shuttering of national deposit insurance schemes and the associated moral hazard.

Moreover, since the rate on “official” e-money would never be more than zero, the banking sector (including the shadow banking sector) could continue to compete with the central bank for deposits by offering more attractive interest rates, which reflected the real risk being taken by depositors in the private sector.

Put this way it all seemed so simple.

And yet, there was and remains a flaw in the logic.

We first dubbed this flaw the float management problem. But we now realise it might as well be described as the central-bank balance-sheet issue.

Digital money liabilities ultimately must be offset by corresponding assets if the monetary system is to remain liquid and stable. This is because liquid digital liabilities represent claims on the real economy, which must be accommodated for by stable and replenish-able value somewhere in the system. As it stands, the physical currency liabilities of a central bank are just a small tranche of a much larger liability structure — a framework sees the central bank essentially outsource the bulk of liability (and asset) creation to the private sector for good reason.

Issuing liabilities from a central point is not the challenge. The challenge is centrally managing all the corresponding liquid assets.

It is this constraint, rather than any technological one, which poses the biggest challenge to the mass issuance of digital central bank liabilities.

Thankfully, a message about this constraint is finally being communicated by central banking types.

Take as an example the latest post on the BoE’s Bank Underground blog from James Barker and David Bholat in the Bank’s Advanced Analytics, Research and Statistics Division and Ryland Thomas in the Bank’s Monetary Assessment and Strategy Division.

As they note:

Although there has been a lot of discussion about how central bank digital currency could radically change payment systems – and even the financial sector as a whole – the implication for the assets on central bank balance sheets could be just as critical.

The criticality relates to the fact that the central bank alone would be responsible for determining what assets to buy and it may not be as easy as just buying government bonds:

They may not want to hold more for fear of distorting bond markets, political worries about monetary financing, or simply because there are not enough government bonds in circulation.

The authors suggest what if instead of digital liabilities the central bank issued digital equity? These shares, they say, would be different from conventional shares in a listed company as they wouldn’t give voting rights on the activities of the central bank. An upside, they add, would be the use of equity to purchase private sector assets is that the central bank would be strengthening its capital base at a time when it’s taking more risk.

Except, this doesn’t really solve the discretionary issue of which private assets the cbank should be buying to support the stability of the economy as well as the value of its equity. How can we trust that it manages this job effectively? Should it buy corporation stock, private sector debt, or maybe crypto coins? Or would it be better to buy machinery and industrial equipment directly, so as to service the ongoing consumption needs of society on an ongoing basis? Or something else entirely? At what point would this sort of decision making turn the institution of the central bank into a quasi command economy?

The authors then suggest what if — in a nod to helicopter money — the cbank simply purchased perpetual zero-coupon government bonds issued specifically for the purpose of backing digital liabilities, de facto creating money for the government to either spend or distribute to people directly?

Again, the problem is not so easily solved. This would be tantamount to handing over private sector value to the government unconditionally.

While tax is already a type of unconditional (albeit necessary) transfer from the private sector to the public sector, we as a society at least have a democratic process to keep the weightings of the distributions in check. There are also limitations on how much the government can take unconditionally before disincentivising industry from producing (and replenishing spent value) altogether.

Facilitating the government’s open-ended consumption of resources without a corresponding requirement to maintain an asset of stable value to replenish that consumption, however, would lead only to value erosion through inflation and political instability in the long run.

The authors note the BIS has already argued compellingly against the view that a helicopter free-lunch is sustainable.

In the long run, the problem with centrally-issued digital currencies unfortunately remains the same: it’s an asset management issue and a political economy issue, not a technological one.

Related links:
The time for official e-money is NOW! – FT Alphaville
Float management isn’t easy – FT Alphaville
Cbank digital currencies and the path to Gosbankification – FT Alphaville

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