Central Bank Digital Currencies
Digitizing central banks’ issuance of money risks making money, credit, and banking even more political than it already is.
Central bank digital currencies, or CBDCs, are a remarkably dumb idea. As central bankers scramble to keep up with online trends (never a good thing), it is worth asking if CBDCs be fixed, or at least improved?
First, let’s get to why my opposition to the very concept of CBDCs is so vehement.
It is important to remember that the vast majority of money is already digital, it is little more than a series of entries on a balance sheet. This balance sheet is managed by your bank(s). When you deposit money in the bank, you are essentially exchanging cash for an addition to that ledger sheet. But the majority of payments today never ever involve cash. They are simply moves from one ledger to another, whether that be your employer paying you, taking a loan for a mortgage from a bank, or even the Federal Reserve or another central bank buying / selling bonds in quantitative easing / quantitative tightening (in which case the central bank is moving money it ‘prints’ onto its own balance sheet onto that of the bank by buying bonds in QE or, in QT, sells them and thus takes the money on the banks ledger back onto its own).
Even leaving this somewhat complicated and, for most people, removed-from-daily-relevance understanding of money aside, it is pretty clear that digital transactions are rather frictionless. Buying products online in foreign currency has minimal hassle these days. However, be warned, there are lots of businesses whose profit is driven by charging you a rate below the market price for that currency and making the difference, and “foreign currency fees” remain common for credit and debit cards.
The only thing one needs digital currencies for is to buy other cryptocurrencies. This is how their proponents have chosen to structure the market to enable money laundering / deal with regulator threats. You can now buy Bitcoin exchange-traded funds, which trade like stocks and are purchasable in normal fiat currency rather than supposedly dollar-linked “stablecoins.” Perhaps that will help accelerate the decline of stablecoins such as Tether, recently predicted on this blog (I admit to not having a timeline for the prediction and concede it will be a while yet).
The actual need for CBDCs, therefore seems to be de minimis.
Given that it has taken even the US Federal Reserve, the most powerful central bank the world has ever known, decades to develop the ability to sell its most basic products online / digitally to retail customers, I fail to understand why anyone would have any confidence in the ability to do so for CBDCs without major hiccups and risks.
FT Alphaville has a post out on the European Central Bank’s efforts to explore issuing such a CBDC. It notes that Brussels is telegraphing that it plans to cap the amount of digital euros that can be held by an individual at €3,000. That is a laughably low number - and further speaks to why CBDCs are not just a dumb idea but one that is fundamentally dangerous to financial systems and, in turn, individuals’ wealth.
The reason for the cap is because of fears from central bankers that the very CBDCs their institutions are working on will disincentivize bank deposits. After all, a central bank is not supposed to be able to fail in the same way as a commercial bank. They can print money, and not just in the style of QE described above, but also quite literally. For central banks with strong external demand for the currencies they issue (or securities denominated in that currency), such as the dollar or the euro, they can even do so without immediately triggering major inflation. So while bank runs on central banks can happen, at the very least, in theory, deposits held at them should be able to be repaid in at least their nominal value.
But commercial banks are in charge of lending to grow the economy, whether that be in deciding whether you are eligible for a mortgage, and how large of one and on what interest rate, or in determining which private companies should be lent to. (NB: QT sees central banks intervene in these markets by buying up securities, including corporate bonds or blocks of mortgages, which in the U.S. also receive other government quasi-subsidies from Freddie Mae / Fanny Mac or in terms of being able to deduct interest on tax but the Fed or other central banks cannot originate loans to private companies, other than banks).
“Sure, we could all switch to banking directly with our central bank, but the benefits of competition and specialization amongst banks would be lost.”
CBDCs therefore are the first step in imagining a world where a central bank is not only in charge of maintaining stability in financial markets but also in creating its base conditions in the first place. Sure, we could all switch to banking directly with our central bank, but the benefits of competition and specialization amongst banks would be lost. The central bank would also have to grow tremendously, and of course, easing uncomfortable questions about hiring onto public sector salaries the bankers’ whose oft rightly maligned rapaciousness also drives them to compete.
There is certainly an argument that central banks could disperse the deposits that they get from CBDCs to commercial banks to allow them to continue to compete, but this raises a dilemma. At what point would banks allowed to fail for poor loan making? While perhaps such a system would enable enough diversification in banks so as to ensure that no bank is “too big to fail” as many were in the Global Finance Crisis, and even more have been deemed since, governments have also shown that banks with a specific focus on politically sensitive markets or with politically influential deposit holders and other creditors will not be allowed to fail outright, as was the case with Silicon Valley Bank (SVB) at the beginning of 2023.
Although not a “too big to fail” bank or a “globally significant financial institution,” a more formal designation that largely means the same thing, SVB’s role in keeping payrolls going and supporting the startup industry in the California valley from which it took its name meant that it was rescued and depositors paid out in full, something that other banks ultimately had to help finance. This is already an example of central banks’ interfering in deposits’ distribution, just as they would have to in a world where CBDCs replace cash and deposits. SVB’s crisis did set off a small bank run, and numerous other banks were rescued and depositors made hole, though a few were allowed to fail with more significant issues (in particular those who had shifted to focus on the crypto industry in the preceding years’ bubble). The politics of the banks’ business was ultimately the most important factor.
Given the interests of this blog, it is important to note that my thoughts are in part shaped by the fact that in a CBDC world, this would have particular impacts on the banks that do specialize in foreign loans and trade finance. The latter naturally have more stakeholders in their domestic markets, given the importers and exporters they provide financing for are in the same country as the central bank that would be deciding deposit distribution. Banks with foreign borrowers may be quite near the bottom of the totem pole. In times of crisis, even the closest allies lack the political heft of domestic borrowers. As a result, I think CBDCs are particularly dangerous for international finance and sovereign debt markets - and this is leaving aside how control over such CBDCs may be feared by foreign borrowers, given how easy it would be to program restrictions on to them in line with sanctions or other policy measures.
China’s potential to use its CBDC as a social policy tool has raised lots of eyebrows in the West and the impacts of politics on potential Western CBDCs thus far are much less. I do not think it is an exaggeration to warn that CBDCs would raise other new questions of moral hazard for other forms of lending as well and overall make such markets even more political than before.
Banking is an industry that has always risked runs and collapses because the very nature of their business is to borrow short (depositors are creditors who can demand repayment at any time, and restricting deposits just accelerates bank runs) and lend long (which is how banks earn money through mortgages or sovereign loans or whatever other products they offer, by earning them interest above what they have to pay in interest to depositors or other creditors). Eliminating this risk is impossible, and while regulation is important to minimize it - if it ain’t fixable, don’t break it.