Much heat, not much light - yet

Media coverage focuses on privately developed cryptocurrencies …

The debate over digital currency has proceeded by leaps and bounds in the last couple of years. Although Bitcoin (BTC) continues to grab the headlines, largely due to its position as the original disruptor, I have long maintained that it is unlikely to be the currency of the future. Indeed I pointed out in 2017 that although there may be a future for digital currencies, BTC may go down as the currency equivalent of the Betamax video system – the first mover which was supplanted by a cheaper, more flexible alternative. Nothing that has happened in the interim has caused me to change my view.

The price of BTC has fluctuated in line with comments by high profile proponents such as Elon Musk, further making it hard to take its claim seriously to be a currency that will one day supplant the fiat money issued by central banks. Earlier this year I noted that a reasonable guess for BTC “fair value” was somewhere below $10,000. Although it has subsequently fallen by 40% from its mid-April highs, it remains well above these levels at just below $40,000.

But the real action in the digital currency space has concerned Dogecoin (DOGE) – currently the sixth largest digital currency by market cap which has increased by a factor of almost 67 since the start of the year versus 33% for BTC, and whose price versus the USD has massively outstripped that of BTC (chart). Ironically, DOGE initially began life as a spoof with the purpose of breaking the stigma surrounding cryptocurrencies. It is designed to be unattractive to investors by keeping a permanently low value due to its mining algorithm which is unlike BTC in that it is not subject to a limit for the number of coins mined. It is also more energy efficient, both in the amount of computing power required to mine each unit and the power consumed in doing so. Although DOGE is accepted as a means of payment by a small number of merchants, it is hard to see it making significant ground as a challenger to BTC let alone conventional forms of money.

… But there are more cons than pros

At the current juncture digital currencies face great difficulty in breaking out of the niche position which they currently occupy largely because they are regarded as extremely volatile vehicles for speculative investment. BoE Governor Andrew Bailey told a parliamentary committee earlier this year, “I'm sceptical about crypto-assets, frankly, because they're dangerous and there's a huge enthusiasm out there.” He went on to say “they have no intrinsic value” and investors should “buy them only if you're prepared to lose all your money.”  

This has not stopped El Salvador from adopting BTC as legal tender, partly to facilitate foreign remittances which are equivalent to 20% of GDP. However, the IMF has pointed out that there are “macroeconomic, financial and legal issues that require very careful analysis.” There certainly are! As this article in Foreign Policy notes, “El Salvador runs on physical cash; 70 percent of the adult population don’t even have a bank account … Only 45 percent of Salvadorans have internet access, and around 10 percent in rural areas.”

… And it may be that central banks will be the saviour of digital currencies

Whilst cryptocurrency proponents continue to extol the virtue of a currency system outside the control of central banks, it is difficult to avoid the conclusion that their breakthrough into the mainstream will be facilitated by central banks themselves. China has already begun experimenting with a digital yuan, having expanded its pilot programme in the spring. Central banks in the UK, US and euro zone are running much more slowly, largely because financial systems are rather more sophisticated and as a result there are huge implications for settlement systems, the nature of the banking  system (issues such as funding costs and balance sheets) and the smooth operation of financial markets – and that is before we consider privacy concerns.  

The BIS recently published a paper which argued that any central bank digital currency (CBDC) should be “minimally invasive.” This is an important issue because a digital currency “represents a claim on an intermediary, [whereas cash] is a direct claim on the central bank” thus changing the fundamental nature of the claims process. As the BIS points out, the Wirecard fraud last year highlights the problems of relying on an intermediary.

Whilst a CBDC would avoid relying on an intermediary it would create other problems. For one thing the conditions required to ensure that a central bank can guarantee the security of a digital asset would be very onerous (quite the opposite of “minimally invasive”). Secondly, as I highlighted last year, the adoption of a CBDC could lead to increased systemic volatility if asset holders opt to seek the safety of central bank-backed assets at the expense of bank deposits at times of financial stress. Faced with these concerns, it is perhaps no surprise that central banks are being forced to proceed relatively slowly.

The race to be first

My view a year ago was that the case for a CBDC was weak from a consumer perspective. However, there are good reasons why central banks in the industrialised world do not want to get left behind in the race with China to develop one. For one thing there are concerns that a digital yuan could undermine the dollar’s role as the global reserve currency. A large proportion of international transactions use the dollar as an intermediate currency which requires access to the SWIFT system. In recent years, the US has increasingly politicised access to SWIFT and efforts to bypass it by using a digital currency such as the yuan would reduce US leverage over the global payments system, particularly since China is the biggest trading partner for a growing number of countries.

In addition, it is clear that there is a demand for digital currencies but they are subject to all sorts of security concerns which would be better managed in the public interest if central banks had a stake. There is also the not-inconsiderable threat that if digital currencies were to increase in popularity, they could threaten the control that central banks are able to exert via traditional monetary policy instruments. As it happens, this is not an argument that rates high on the list of central bank concerns but it cannot be totally discounted.

It is clear, however, that the race to develop a CBDC has gained momentum in recent months and it is not a topic to be dismissed lightly. I remain of the view that Bitcoin will not be the digital currency of the future and agree with the BIS that careful consideration has to be given to the design of a CBDC. But if digital currencies are a fad which is not about to disappear, I am increasingly of the view that society is better off if they are regulated by central banks rather than allowing even less accountable market forces to make our monetary choices for us.

Soddy's Law

The name Frederick Soddy may not mean much to many people. Historians of science might recall that he collaborated with Ernest Rutherford on radioactivity and that he won the Nobel Prize for chemistry in 1921 for his research on radioactive decay. In the world of economics he occupies at best a place on the fringes despite having written four major works on the subject between 1921 and 1936. I recently dipped into his 1934 book The Role of Money (available online here) and although the prose is a little dated and some of the ideas are very much of their time (not to mention flawed), it is nonetheless fascinating to sift through his work to discover that he uncovered a number of macroeconomic ideas long before the celebrated economists of recent years. It is also worthwhile looking again at his work to determine whether it offers any insights on today's policy issues.

A man of astounding economic prescience

Although Soddy was largely dismissed as a crank during his lifetime, many of his policy prescriptions were later adopted into the mainstream. He was, for example, a great critic of the gold standard and argued strongly that exchange rates be allowed to float; he also argued in favour of using the government budget balance as a tool of macroeconomic policy and called for the establishment of independent statistical agencies to compile economic data (particularly to measure the price level). In the event, the idea of using fiscal policy as a policy tool was one of the cornerstones of the post-1945 Keynesian revolution whilst the suspension of dollar convertibility into gold in the early 1970s ushered in the era of floating exchange rates which has prevailed ever since. Moreover the UK established a Central Statistical Office seven years after Soddy first mooted the idea in 1934.

Economics as science

Soddy’s approach was rooted in physics, viewing the economy as a machine which requires inputs to derive outputs. Whilst there is a lot wrong with this way of thinking it was not out of tune with the mainstream views adopted in the post-1945 era, the echoes of which still persist today. But it is appropriate in one sense: A system which relies on such inputs will soon grind to a halt unless there is an infinite supply of them. Accordingly, Soddy’s ideas have been adopted by the modern-day ecological school of economics which views the economy less as a machine and more as a biological system.

The original motivation for his thinking was the recognition that a fractional banking system requires perpetual growth in order that the debt acquired in the process of generating today’s consumption can be repaid. As a scientist, Soddy understood that an economy based on the consumption of finite resources cannot continue to grow indefinitely since this would violate the laws of thermodynamics which prevent machines creating energy out of nothing or recycling it forever – an idea he set out in his 1926 book Wealth, Virtual Wealth, and Debt. 

Soddy recognised the fact that private sector banks create money simply by creating deposits thus inherently increasing the leverage in the system – in his memorable phrase: “Money now is the NOTHING you get for SOMETHING before you can get ANYTHING”. He further recognised that this exacerbated the swings in the credit cycle since banks were prone to call in loans when borrowers were least able to repay whilst they were most willing to grant credit when times were good and therefore when credit was least needed. Accordingly, one of Soddy’s main proposals was that the creation of money be taken out of private hands and should instead be fully backed by government created money.

Father of the Chicago Plan

Although Soddy’s ideas were generally ignored in the UK they did find support in the US. In a review of Soddy’s 1926 work, the great American economist Frank Knight noted that “it is absurd and monstrous for society to pay the commercial banking system “interest” for multiplying several fold the quantity of medium of exchange when a public agency could do it at negligible cost” particularly where there are huge costs associated with the booms and busts of the credit cycle. Influential US economists led by Henry Simons and Irving Fisher went on to formulate the Chicago Plan which advocated wholesale reform of the banking sector, notably the separation of the monetary and credit functions of the banking system, “by requiring 100% backing of deposits by government-issued money, and by ensuring that the financing of new bank credit only took place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks.”

Needless to say the Chicago Plan did not find favour in the 1930s. However in the wake of the 2008 financial crisis the idea of full-reserve (or narrow) banking did come back onto the agenda. Institutions such as the IMF have recently given serious thought to the idea, with an influential working paper in 2012 conducting quantitative analysis which concluded that “the Chicago Plan could significantly reduce business cycle volatility caused by rapid changes in banks’ attitudes towards credit risk, it would eliminate bank runs, and it would lead to an instantaneous and large reduction in the levels of both government and private debt.” The FT’s chief economics commentator, Martin Wolf, who sat on the UK’s Independent Commission on Banking, came to a similar conclusion (although he did not credit Soddy with the original insight).

Rethinking narrow banking

In recent years the debate has taken a step further with the advent of digital currencies. In theory the likes of Bitcoin represent a form of narrow banking given that its supply is fixed. However, to the extent that each Bitcoin unit is divisible into sub-units of 100,000,000 it is possible to imagine a world in which value can be destroyed by division, in which case we are no better off. But the concept of a central bank digital currency (CBDC) may be a different story. The Bank of England’s illustrative model for a Sterling CBDC utilises a two-tier intermediation model, whereby Payment Interface Providers (PIPs) would keep all CBDC reserves at the central bank. These PIPs may be pure payment intermediaries or may be commercial banks processing transactions but the key point is that these CBDC deposits would not be used for lending. Such a policy is not without risks (as I discussed in this post a year ago) and I retain some scepticism that a CBDC does many of the things that are claimed for it. Nonetheless, their introduction may take us a long way closer towards realising Soddy’s idea.

One of the reasons why economists remain sceptical of narrow banking is the conventional view that it will reduce banks’ lending activity which will in turn act as a brake on economic growth[1]. But a lot of modern macro theory increasingly calls this view into question. This paper published in September 2020 by Hugo Rodríguez Mendizábal makes the case that a “fully reserve-backed monetary system does not necessarily have to reduce the amount of liquidity produced by depository institutions.” Space considerations mean that we cannot do justice to the full implications of the case for narrow banking and it is clearly a topic for another time. Suffice to say that it is a very active research area these days.

Last word

For a man who was regarded as a crank operating at the margins of respectable economics, many of Frederick Soddy’s “crazy” ideas have subsequently found a surprising degree of mainstream acceptance. Almost a century after he sowed the seeds, the idea of a full reserve-backed banking system refuses to die and has now become a respectable topic of research. It is perhaps not surprising that many of his ideas have such modern day resonance since many of today’s global economic problems echo those of the 1920s and 1930s. Indeed, as he wrote in 1934: “There is a growing exasperation that an age so splendid and full of the noblest promise of generous life should be in such ill-informed and incompetent hands.”

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[1] Diamond, D. W., and P. H. Dybvig. 1983. ‘Bank Runs, Deposit Insurance, and Liquidity.’ Journal of Political Economy 91(3) pp401-19

Central bank digital currency: More thought needed

The issue of digital currencies has been bubbling away for a few years, even after the initial hype surrounding Bitcoin dissipated in early 2018. I wrote a series of posts in late-2017 pointing out that the Bitcoin rally was unlikely to be sustained. Nonetheless, it has not collapsed into oblivion as I feared possible. Indeed, over the last 15 months the price of Bitcoin relative to the US dollar has traded around the levels which prevailed immediately prior to the peak of the boom in December 2017 (chart). The announcement last year that Facebook was behind a proposal to introduce Libra has given new impetus to the concept of digital currencies, whilst one of the side effects of the current social distancing regime is that many retailers prefer electronic payment rather than handling physical cash.

There are in essence two proposed types of digital currency – one which is operated by the private sector free from central bank interference, whilst the counter proposal is that central banks should engage in this area themselves. Recall that the original idea behind digital currencies was to break away from a money creation process controlled by governments and central banks which were perceived as having debased the value of money by inflating its supply. It is thus ironic that central banks have entered into the debate with increasing urgency in recent years. The cynics argue that this is because the rise of a privately run digital currency would rob central banks of their raison d'être. Central banks argue that the private sector either cannot or will not provide the security that individuals demand of the medium taking the place of physical cash and that it requires some form of oversight to protect the interests of society.

In my view, central banks have not yet made a sufficiently convincing case for the introduction of a digital currency under their control. In a paper issued last month, for example, the Bank of England suggested that a central bank digital currency (CDBC) “could support a more resilient payments landscape. It also has the potential to allow households and businesses to make fast, efficient and reliable payments, and to benefit from an innovative, competitive and inclusive payment system. It could help to meet future payments needs in a digital economy by enabling the private sector to create services that support greater choice for consumers.” All of these are true if the alternative is a privately owned digital currency or a payments system based on blockchain. But in effect we already have a highly developed system of electronic money transfer in the industrialised world based on existing currencies. Payment systems run by the likes of Visa or Mastercard are already highly regulated and the various deposit guarantee schemes in operation across Europe are sufficient to protect most customers against bank default.

A counterargument is that the payments network is a critical piece of the financial architecture where failure could prove catastrophic. The problems faced by Visa a couple of years ago, when the payments system across Europe was knocked out for a number of hours, demonstrated the risks inherent in the system. A CBDC could effectively act as an alternative means of payment in the event of a more prolonged outage. But the introduction of a CBDC would mean a significant amount of disruption to the payments system, which would have to be redesigned. That would entail a lot of effort and cost for a mere backup product.

It also raises a question of where the banking system fits in. In the model proposed by the BoE, banks would be relegated to the role of Payment Interface Providers (PIPs) whose role, amongst other things, is to “provide a user‑friendly interface” to the CBDC platform. But the very existence of banks could be threatened by the introduction of a CBDC. Imagine that customers switch their deposits away from their commercial bank to hold CBDC. Banks could lose low cost stable forms of funding which would threaten their existence, to which they may respond by raising interest rates to counter deposit outflows which in turn would destabilise asset portfolio decisions. In such a case banks would face the potential threat of a huge contraction in their balance sheet, resulting in a fire sale of assets as deposits disappear. As the BIS warned in a more sober paper than that produced by the BoE, the role of banks in providing financial maturity transformation services is “not clear.” Indeed, far from enhancing the stability of the financial system, a CBDC that competes with existing financial institutions could amplify instability if solvency/stability concerns at times of stress prompt a switch away from bank deposits towards the CBDC.

In my view, there are a lot more questions than answers regarding the introduction of CBDC. It is hard to avoid the sense that the debate is at least partly fuelled by the fact that this is a fashionable topic driven by the declining use of physical cash. Moreover, significant technological advances mean that things are now possible which once lay only in the realms of science fiction, and as I noted of blockchain back in 2017 it may be that this particular aspect of the digital currency debate is simply a solution looking for a problem to solve. 

But there is also the possibility that in a world where interest rates are low, and likely to remain so for a long time to come, a CBDC would give central banks more control over the monetary policy transmission mechanism if they can persuade the private sector to give up cash. After all, you cannot impose a negative interest rate on cash because you can simply store it under the mattress, but the interest rate on digital deposits at the central bank could be tweaked at will. It could be that I am missing something but if central banks want us to swap existing financial products for a CBDC it strikes me that they have to make a much stronger case than they have up to now.

Central banks and the digital currency revolution

In previous posts, I have argued that Bitcoin is a bubble which looks destined to burst. But bubble or no, the ideas underpinning digital currencies have piqued the interest of central banks which are aware of their potential. There are many reasons why they are interested in the digital currency revolution. For one thing, if such currencies take off as a medium of exchange, they will erode the traditional central bank monopoly over monetary issuance which in turn would reduce their control over the economy. As a result, there is an incentive for central banks to get involved if for no other reason than to head off the threat posed by private digital currencies.

Another argument in favour of a digital currency is that transactions using blockchain technology are transparent and traceable which would reduce the scope for tax evasion and illegal activity. In addition, it allows a greater degree of policy flexibility when interest rates are at the lower bound. In short, if we separate the unit of account function of money from its other functions by creating a parallel currency, it is possible to set an exchange rate between paper money and electronic money. By allowing paper money to depreciate (i.e. offering fewer units in exchange for the electronic alternative) this reduces the incentive to hold paper. In an environment where electronic currency is the dominant form, central banks have more flexibility to reduce the interest rate on deposits which does not exist in a paper cash economy. In a paper money world, if banks charge negative rates on deposits, individuals need only switch to zero interest bearing cash to avoid the negative charges.

This possibility is not available in an environment where digital currency is the only option: Account holders would have to store it in some other asset outside of central bank control.
In order for such a system to work relies on adapting a blockchain, or electronic digital ledger, which can be controlled centrally rather than relying on the distributed ledger technology currently employed by Bitcoin. As it currently stands, blockchain relies explicitly on a community of mutually distrustful parties to ensure that transactions are recorded correctly. Precisely because nobody trusts anybody else, no single individual or entity controls the digital record. Instead, the settlement technology relies on an encryption system to ensure that all users have access to the ledger simultaneously and each of them can update it. But the form of blockchain used to generate Bitcoin suffers from a number of technical limitations which will preclude the wider use of this particular digital currency.

For one thing, it can only process a relatively small number of transactions. The Bitcoin network can currently only process 7 transactions per second (tps) whereas the credit card Visa has a peak capacity of 56,000 tps and handles 2,000 tps on average. For a currency with aspirations to widespread acceptance this is a huge limitation, and is one of the reasons why I continue to believe that the upside for Bitcoin is limited. The obvious solution to the Bitcoin problem is to raise the size of the data blocks (currently, their size is limited to one megabyte which takes 10 minutes to process). Efforts to get all the Bitcoin miners to agree an increase in the size of the blocks has proved extremely difficult with the result that the blockchain has split once already this year, with one group opting to remain on the current standard and the others going off to form a parallel digital currency with fewer such technical constraints. Ironically, the Bitcoin system was initially designed to run at twice its current speed but it was limited for security reasons.

Indeed, security concerns may well be one of the issues which undermine Bitcoin. In theory, so long as no miner can control more than 50% of the network, they are unable to falsify the chain. But there have been well-publicised instances where Bitcoin exchanges have been hacked so it is clearly not as safe as its proponents believe. Moreover, if one individual or a colluding group of miners is able to gain more than 50% of the total network computing power they will technically be able to force a break in the chain, allowing them to override the rest of the community and take over the chain. Raising the size of the blocks in the chain could inadvertently lead to such an outcome. Miners with access to huge computing power and very low energy costs would be better placed to afford more bandwidth, which may lead to a higher concentration of miners.

So where do central banks come in? One possibility is that they create a centralised digitally encrypted record which would get around the security problems in the current system, Indeed, the system on which Bitcoin is based operates very much like the wild west – if there is a problem you are on your own, as there is no-one to turn to. By acting as the guarantor of the system, central banks eliminate this problem. In such a system, it is envisaged that individuals would hold a digital wallet at the central bank, with their incentive to do so enhanced by the differential rates of return offered on digital and paper money, outlined above.

But what happens to commercial banks in a system where the central bank manages the transactions and creates the digital currency? One possibility might be that banks create their own digital currency which can be exchanged for the central bank unit at a given rate. This would allow banks to create credit in the same way they do now whilst giving central banks the ability to control the overall rate of credit creation by altering the digital currency exchange rate.

Other alternative central bank currency models appear to ignore the commercial banking system altogether, relegating them to the role of transaction processors. In such a world, banks manage a number of lower-level chains which record transactions, and which in turn feed into the main ledger to which only the central bank has the digital key. Essentially, banks would become transaction verifiers rather than account holders. Since the costs of becoming a transaction verifier are far smaller than operating a fully-fledged bank, this might be expected to raise banking competition as new entrants come into the market which will reduce the costs of banking for the wider public.

We are obviously a long way from being able to introduce this kind of system. But it does suggest that the theoretical possibilities of a digital currency system are far greater than the relatively narrow range of outcomes offered by Bitcoin. This is one of the key reasons why we should not dismiss the digital currency story. However, it does not always pay to have first mover advantage. Recall that the mid-1970s Betamax technology, which was many people’s introduction to home video, was quickly supplanted by the technologically inferior VHS system, which in turn gave way to the DVD revolution. Home video was once a big deal, but who remembers Betamax today? We could be saying the same thing about Bitcoin in the years to come.