Year: 2016

The technology behind bitcoin, known as ‘blockchain’, has been touted as revolutionary, holding the potential to transform anything from the insurance industry to international aid. However, it is in the hands of central bankers that the technology could reach its true potential.

Central banks around the world are currently devoting their resources to research the concept of a central bank digital currency – a kind of ‘digital cash’. The reason for its potential power: it gets to the heart of the function of a central bank, and, indeed, the very nature of money. “Prospectively, it offers an entirely new way of exchanging and holding assets, including money. It’s an irony, therefore, that some of the economic questions it raises have actually been around for a long time, for as long as economics itself”, said Ben Broadbent, Deputy Governor of the Bank of England, in a speech earlier this year about the possibility of a central bank issued digital currency.

The nature of money
Of course, electronic money is nothing new– in fact, the majority of money in our system exists in electronic form. However, a key difference between electronic money and a possible digital currency is the latter would allow people to transfer money to one another without the need for a commercial bank. People could have a digital wallet, of kind, and move money in a secure way without commercial banks acting as the middleman – much like ordinary cash.

This is a crucial difference, because commercial bank money and currency are different types of capital. World Finance spoke to David Clarke from Positive Money, an organisation campaigning for monetary reform that supports the idea of a central bank issued digital currency. Clarke explained how commercial bank money differs from cash: “The money in your bank account is just an IOU from the bank, created from thin air when the bank issues a loan. It doesn’t correspond with any physical currency or commodity, and it’s technically the property of the bank.” A central bank issued digital currency, on the other hand, would be an extension of cash – a direct claim on the central bank. It would, by definition, be fully protected from default.

Individuals have been excluded from… hold[ing] such a digital currency, but this could change thanks to blockchain technology

Not only is currency a different type of asset, it enters the economy in a different way. While central banks have control over the creation of physical currency, the amount of commercial bank money in the economy is determined by decisions made by the commercial banks. Banks inject fresh money into the economy each time they extend a new line of credit, and thus the quantity of commercial bank money in the economy depends on the willingness of banks to lend. Central banks, however, can only influence money supply indirectly, through monetary policy and regulation.

In a sense, a central bank currency in digital form already exists, as commercial banks can already hold accounts with ‘central bank reserves’. These reserves are the currency deposits that form the basis of a banks’ payments system. When a customer withdraws cash, commercial banks must be able to provide real currency on request, so they need to hold enough in reserve to meet the demand of withdrawals. Similarly, when someone makes a transfer, banks settle payments using reserves.

Individuals, however, have so far been excluded from the ability to hold such a digital currency, but this could change thanks to blockchain technology. If central banks issued a digital currency that was open to all, people could hold their money as digital currency rather than in a commercial bank – with potentially radical implications. For example, if everyone banked with the central bank, “in principle, it would… make for a safer banking system. Backed by liquid assets, rather than risky lending, deposits would become inherently more secure. They wouldn’t be vulnerable to ‘runs’ and we would no longer need to insure them”, said Broadbent.

Set for takeoff
Digital currency could pave the way for ‘helicopter money’ being used as a viable tool by central banks. According to Clarke: “The idea of helicopter money has got a considerable intellectual pedigree – the term was actually popularised by Milton Friedman, who imagined the central bank dropping dollar bills from the sky as a way of boosting spending. But technological innovation has given the idea new relevance.” The concept of helicopter money has most recently been brought into the spotlight after being aired by Ben Bernanke as a possible addition to central bankers’ tool kits.

In economic terms, helicopter money is a tax cut financed by a permanent increase in the money stock – an action that could be administered in order to combat deflation. It would technically be possible without a digital currency, but given a scenario where each person held a digital cash account, the central bank could easily dispense a newly created digital currency to every citizen. Each person’s account would simply be credited with fresh electronic money in a move akin to ‘helicopter drops’ spreading newly printed money.

Helicopter money is, of course, an unconventional monetary policy, and administering it would come with a host of complications (World Finance, however, has argued that it could be useful if administered in a disciplined and moderate form). It has similar economic underpinnings to quantitative easing, but Clarke argues it can avoid one of the key failings attributed to asset purchase programmes: “Compare it to how the government injects money into the economy through quantitative easing ­– one of the main effects of which is to inflate the wealth of those who own pre-existing assets.” It may sound drastic, but there was a time when quantitative easing was entirely off the cards, so helicopter money should certainly not be dismissed along the same lines. Moreover, with the emergence of blockchain technology, the discussion is gaining momentum.

A brand new tool
The nature of the change created by issuing a digital currency would depend on many factors. For example, if digital cash did not acquire interest, it is unlikely that many people would convert their deposits. However, in a scenario in which it did acquire interest, the macroeconomic effects could be huge.

The digital currency revolution could… eliminate commercial bank money altogether; leaving only paper cash and digital currency issued by the central bank

The Bank of England released a working paper earlier this year investigating the idea of introducing an interest-bearing, digital currency. The authors, John Barrdear and Michael Kumhof, note that there is “very little historical or empirical material that could help us to understand the costs and benefits of transitioning to such a regime, or to evaluate the different ways in which monetary policy could be conducted under it”. In short, it has never been done before.

To forecast such a scenario, the pair created a model based on the US economy, envisaging a world in which digital currency makes up 30 percent of the GDP, but ordinary commercial bank money continues to exist. Under such a set-up, the dynamics of the financial sector would see a dramatic change. Ordinary banks would have to compete with the central bank for deposits in order to maintain cash flow; offering relatively higher interest rates as a result. Their modelled scenario comes out with many notable implications, including the economy gaining a three percent boost to GDP. Perhaps most interestingly, the central bank would acquire an entirely new monetary tool.

Because the digital currency would be held directly by households and businesses, changes in interest rates would have a direct effect, meaning when central banks changed rates it would affect the real economy directly. This contrasts to policy rates as they are currently administered, which only work by indirectly influencing the banking system. The new tool would complement the policy rate, as both would exist simultaneously. Control over the digital currency could help central banks respond to deviations from target inflation. For instance, during an economic expansion they could increase the spread between the policy rate and the (lower) digital currency rate in order to hold back inflation.

Going all in
The digital currency revolution could go even further and eliminate commercial bank money altogether; leaving only paper cash and digital currency issued by the central bank. This could occur if there was a full shift in deposits from commercial banks to the central bank and electronic commercial bank money was no longer used to make payments. This would move the system towards what is known as ‘narrow banking’ – a concept that has a long intellectual history, and notably, was favoured by David Ricardo and Adam Smith. The concept gained ground during the Great Depression of the 1930s, when a group of economists at the University of Chicago proposed the ‘Chicago Plan’. The famous plan, supported by Irving Fisher, envisioned an end to the destructive boom and bust cycle. Under the plan, only the central bank would be able to issue new money, reducing the role of banks to pure intermediaries. The idea has experienced a resurgence following the global economic crisis of 2008, with economists exploring it as an opportunity to bring about an end to the financial instability that shook the global economy.

A paper by the International Monetary Fund published in 2012, named The Chicago Plan Revisited, lent further support to the concept, claiming: “The Chicago Plan would indeed represent a highly desirable policy.” The paper further explains how an economy would look under such a plan: “Credit, especially socially useful credit that supports real physical investment activity, would continue to exist. What would cease to exist however is the proliferation of credit created, at the almost exclusive initiative of private institutions, for the sole purpose of creating an adequate money supply that can easily be created debt-free.”

Positive money argues such a scenario – in which central banks have control over money supply – could have far-reaching benefits, and be achieved through the means of a central bank digital currency. That said, Clarke explained they do not advocate implementing digital cash all at once: “We think the starting point is for the Bank of England to introduce a certain amount of digital cash. It could offset this over time by reducing the amount of bank-created money by raising reserve ratios. Under the system we propose, decisions about how much money is created – and when it is created – will be a matter for the monetary policy committee.”

Never say never
The potential implications of a central bank digital currency are certainly radical. However, the concept is quickly gaining momentum, with research taking place in Germany, England and China. In Sweden, the central bank has initiated a debate over the issuance of a digital currency with the stated aim of making a decision within the next two years. Meanwhile, Switzerland is set to hold a referendum regarding a potential ban on commercial banks creating new money after a petition reached 100,000 signatures. Iceland has also issued similar proposals.

Furthermore, private banks themselves have taken an interest in harnessing blockchain technology, which has the potential to undermine the central bank’s role as a trusted third party through which transfers can be made. Moreover, a decline in the use of ordinary cash is rendering the power of central banks to issue cash progressively less relevant. As Clarke said: “It is a radical idea, but we are living through a time where the nature of money and the nature of cash is changing rapidly. In our lifetimes, we will probably see the demise of physical cash as we know it, and central banks will have to respond to that. We have to ask ourselves the question – are we prepared to completely give up control of our money and means of payment to the private sector?”