Debate swirls in monetary policy circles over whether, how, and when to introduce central bank digital currencies (e.g. Allen et al. 2020, Auer and Bohme 2020, Auer et al. 2020, Agur et al. 2020; see also the Vox debate on “The future of digital money”). This debate has a strong resonance with earlier crossroads in monetary history when major transformations took place. In today’s crossroad, advances in technology – digitalisation – have led to the development of new forms of money. These include virtual (crypto) currencies like bitcoin, stable coins like libra/diem, and central bank digital currencies (CBDC) like the Bahamian sand dollar. Today’s innovations have a resonance with earlier major shifts in monetary history, and in a new paper (Bordo 2021) I examine the case for CBDC through this lens.
My overview of the history of monetary transformations suggests that technological change in money is inevitable, driven by the financial incentives of a market economy. Government has always had a key role in the provision of currency (outside money), which is a public good. It has also regulated inside money provided by the commercial banking system. This held for fiduciary money and will likely hold for digital money.
Monetary transformations in history
Monetary transformations in history have been driven by changing technology, changing tastes, economic growth, and the demands to effectively satisfy the functions of money. Money (and finance) has evolved with human history (Goetzmann 2017). Three historical transformations set the stage for the current digital transformation.
- In the 18th and 19th centuries, new financial technology led to the advent of fiduciary money (convertible bank notes), which greatly reduced the resource costs of specie (Smith 1776). In addition, the exigencies of rising costs of war finance in the early modern era led to the issue by governments of inconvertible fiat money. CBDC as a social saving over fiat money promises to be the next generation in this progression.
- The early record of poorly regulated commercial banks issuing notes, ostensibly convertible into specie, has been used to make the case for government regulation of commercial banking and for a government monopoly of the note issue (Friedman 1960). The record of free banking in the US was one of considerable instability (Gorton 1986). The high asymmetric information costs of a multiple currency system created an inefficient payments system.1,2 The note issue eventually gravitated towards a central bank/government monopoly. The present day rise of cryptocurrencies and stablecoins suggests that the outcome may also be a process of consolidation towards CBDC.
- Central banks, from the 17th to 20th centuries, evolved to satisfy several important public needs: war finance; an efficient payments system; financial stability; price stability; macro stability. Through a slow and painful learning process, monetary policy has evolved into the present-day flexible inflation targeting based on credibility for low inflation. CBDC could follow in this tradition.
The case for CBDC
The basic case for CBDC – defined as an asset in electronic form which serves the basic functions of paper currency, with universal access and legal tender – can be traced back to the classical economists’ argument that currency is a public good that would appropriately be provided by the government (Friedman and Schwartz 1986). CBDC would satisfy the basic functions of money: a unit of account, a medium of exchange, and a store of value (Bordo and Levin 2017).
The key factors driving interest today in CBDC include the following:
- CBDC would be the 21st century version of Adam Smith’s social saving of fiduciary money by reducing the costs of issuing and operating physical currency (by between 0.5% and 1.0% of GDP according to IMF 2020) and by reducing the monopoly rents earned by the commercial banking system (Barrdear and Kumhoff 2016, Andolfatto 2019).
- Digitalisation has greatly reduced the use of cash in several countries (e.g. Sweden and Norway). CBDC would provide a payment media which has all the attributes of physical cash but is less subject to theft and loss.
- CBDC would increase financial inclusion for disadvantaged groups that do not have access to bank accounts.
- CBDC may head off the threat to monetary sovereignty from stablecoins issued by global digital services companies like Facebook, which would threaten central banks’ ability to conduct monetary policy.
- CBDC would provide a secure reliable currency, free from the dangers of fraud, hacking, money laundering and financing terrorism.
Implementation of CBDC in the real world
Implementation of CBDC raises a number of important questions about its design which have been examined closely by central banks. One issue is the choice of retail versus wholesale CBDC. Significant improvements in the wholesale payments clearing mechanism suggest that the key issue is retail CBDC. Here, the public good aspect of currency provides a strong rationale for either direct provision or at least close regulation and supervision by government. Accounts at the central bank are eminently feasible, but the private sector has a comparative advantage in financial innovation. Hence, in advanced countries, a two-tiered or public–private arrangement may be preferable. Designated institutions could offer CBDC accounts to the public or serve as conduits for the central bank (Tobin 1987).3
Second, concern among prominent officials (Carstens 2021, Cecchetti 2021) that account-based CBDC which is the most secure direct liability of the central bank would lead to disintermediation and runs from the commercial banking system. Research suggests that disintermediation could be offset by central bank balance sheet policy, by restricting CBDC holdings, or by tiering interest rates on CBDC and non-CBDC accounts (Kiester and Sanchez 2019, Brunnermier and Niepelt 2019, Kumhof and Noone 2018, Bindseil 2020). Moreover, central banks have adequate lines of defence to deal with runs in the form of supervision and regulation, deposit insurance, and lender of last resort.4
CBDC and monetary policy
Researchers have argued that interest paid on CBDC could improve the transmission mechanism, especially the lending channel (Barrdear and Kumhoff 2019, Williamson 2018, IMF 2020, Meaning et al. 2018). It would also reduce and simplify central bank balance sheets and move us back towards a bills-only policy. Using the interest rate on CBDC as the policy rate could allow central banks to move from the current ‘floor system’ back to a ‘corridor system’ (Meaning et al. 2018). In Bordo and Levin (2017), my co-author and I argue that allowing the interest rate on CBDC to go negative, along with incentives to reduce cash holding, would eliminate the effective lower bound as a constraint on monetary policy. We also argue that interest on CBDC could be used to foster true price stability. Finally, paying interest on CBDC could be used to improve the lender-of-last-resort function and financial stability.
CBDC and the open economy
CBDC has very important implications for the open economy. First, it could greatly improve cross-border payments (IMF 2020). With digitalisation, payments could be done almost instantly. It would create a social saving, similar to the first transatlantic cable in 1866 (Garbade and Silber 1978).
Some stablecoins promise to arrange peer-to-peer payments through their established networks. Were stablecoin providers to dominate these arrangements, this could threaten monetary sovereignty and also be a source of credit risk. This makes the case for CBDC or some regulation. But sovereign CBDCs would need to make arrangements for interoperability with their foreign counterparts.
Second, a system of CBDCs that closely links the monetary and payments systems of different countries could lead to an amplification of the spillover effects of domestic monetary policy on other countries.
Third, CBDC and stablecoins could lead to currency substitution — dollar digitalisation — which could impact the monetary sovereignty of state-owned enterprises, especially those with weak monetary and financial institutions. Effective currency competition could occur because of the ability of stablecoins to separate the functions of money (Brunnermier et al. 2019). Indeed, stablecoins could challenge the dollar’s dominance because of the superiority of their networks.
However, currency competition from private platforms could run into the problems of interoperability and coordination that plagued multiple competing currencies in the 19th century. Like them, information asymmetry would make the case for CBDC. A system of interconvertible CBDCs would eliminate the imperfect substitutability of private digital currency (Eichengreen 2019).
Lessons from an historical perspective
Four key lessons follow from history on the case for central bank provided digital currencies:
1 Technological change in money/financial innovation is inevitable, driven by the financial incentives of a market economy.
2 Government has a key role in the provision of money. Outside money is a public good which it is necessary for the central bank to provide. This holds for fiat money and digital money. The ability to issue it depends on the credibility of the issuer. If that falters, currency competition from other CBDCs or stablecoins will erode monetary sovereignty.
3 Interest-bearing CBDC could improve the transmission mechanism and transparency of monetary policy. It could greatly simplify central banks’ balance sheets and help them move back to a simpler framework that existed before the Global Financial Crisis. Moreover, CBDC could revolutionise monetary policy if the interest rate on CBDC is used as the policy rate.
4 CBDC is a global innovation. It could transform international payments like the first transatlantic cable did in 1866. It could also exacerbate currency substitution and require international monetary cooperation. CBDC and stablecoins could also challenge the international monetary system. The fundamental forces leading to currency domination are unlikely to change, but digitalisation could accelerate the shifts driven by them, as occurred in the 20th century when the dollar eclipsed the pound.
Digitalisation in money may promise to be the future. Central banks could learn the lessons from history and provide digital currency to effectively fulfil their public mandates.
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1 The experience of many other countries with free banking and competing currencies was similar.
2 A notable exception was Scotland in the 18th and 19th centuries (White 1984), although Goodhart (1988) attributed this to the banks being an oligopoly, the bank owners subject to unlimited liability, and the presence of the Bank of England as a lender of last resort.
3 Token based CBDC, which are the most cash-like and anonymous but prone to loss or theft, could be used for small transactions.
4 Of importance to central banks, they have devoted considerable resources to security issues including anti- money laundering and anti-terrorist requirements.