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.

Stresses and strains

Was the government too complacent?

The outbreak of Covid-19 will go undoubtedly down as one of the most traumatic social and economic upheavals of our time. At the time of writing, more than 200,000 people worldwide are recorded as having died and the true figure is undoubtedly higher. More will undoubtedly succumb. But as tragically high as these figures are, it is possible to imagine a far worse pandemic. A typical pandemic would be expected to strike more evenly across the age spectrum than Covid-19 which has predominantly impacted on those aged over 50. You do not have to be a virologist to imagine an even more terrifying disease which is more virulent and infectious than Covid-19. Indeed, the threat of such a pandemic is one of the natural disasters which form a key element in national disaster planning across the world.

Fortunately, such outbreaks are rare but precisely because of that it is so easy to become complacent about the risks which they pose. However, in what now seems like propitious timing, a year before we had even heard of Covid-19, a group of epidemiologists conducted a study to assess the preparedness of global health systems in the event of a global epidemic. They constructed an Epidemic Preparedness Index (EPI) covering 188 countries and based on five key metrics:  overall economic resources; public health communications; infrastructure; public health systems and institutional capacity. According to the authors, “the most prepared countries were concentrated in Europe and North America, while the least prepared countries clustered in Central and West Africa and Southeast Asia.”

All countries have expressed concerns that the outbreak of the disease would overwhelm their health systems, which is why they have imposed a lockdown to spread out the incidence of infections. Health experts are unanimous in their belief that containment and mitigation strategies are the first line of defence to combat a pandemic. Italy was one of the first countries, aside from China, to implement a lockdown on 9 March. At that time it had recorded 7,375 cases and 366 deaths. As of today, it has recorded 197,675 cases and 26,644 fatalities. The UK imposed a lockdown two weeks later than Italy, on 23 March, at which time it had recorded 5,683 cases and 281 fatalities. Almost five weeks later it has recorded 148,377 cases and 20,319 fatalities.

The debate in the UK focuses very heavily on the fact that the government was too late in implementing the lockdown and that it should have learned from the Italian experience. By the time it adopted this strategy, when its figures were similar to those in Italy two weeks previously, it was already too late and the path of the disease was effectively predetermined. There certainly does appear to be a lot of evidence to suggest the British government was reluctant to take such a dramatic measure although others suggest that the scientific advisers were slow to respond.

Either way it appears that the delay in implementing the lockdown played a role in allowing Covid-19 to become more widespread than it need have been although it is easy to be wise after the event. Indeed when Germany implemented a lockdown on 23 March, it had recorded 24,774 cases (more than either the UK or Italy at the same stage) but just 94 fatalities. It is thus likely that future research will concude that some governments were too slow to deploy their first line of defence. But this is not the whole story.

Or is it the lack of spending?

National health systems act as the second line of defence, offering options ranging from testing to intensive care. At this point the degree of funding provided to the health system really starts to come into its own. According to data compiled by the OECD, the UK had fewer medical staff per 1000 of population than many other European nations (see chart below). Although the proportion of doctors is below the OECD average, it is not too far out of line with other EU countries. But the number of nursing staff is somewhat lower. This might partially explain, for example, why the UK has been so slow in rolling out mass testing. To the extent that a shortage of trained medical staff at a time of emergency puts pressure on existing staff as overstretched resources are stretched more thinly, there is some evidence to suggest that funding constraints over the last decade have added to the strains facing the British NHS in recent weeks. Indeed, despite making great play of the fact that a number of temporary hospitals have been opened to add additional capacity to the health system, there have been complaints that there are simply not enough trained staff to provide the requisite services.

I have noted the strains on various parts of the public sector on numerous occasions in recent years and have pointed out the issues facing NHS funding (here, for example). In theory, of course, the NHS was protected from the worst of the austerity but there was still a slowdown in the rate of funding which meant that the supply of health care has not kept pace with demand. In terms of what the service offers, it can be regarded as efficient in an international context. For example, the NHS operates its critical care facilities with an 84% utilisation rate (higher than all other OECD countries bar Ireland, Israel and Canada, see chart below). But this also means that there is limited spare capacity to cope with emergencies. When it comes to the overall capacity of the system, the UK also has fewer intensive care beds per head of population than the OECD average.  

It is hard to avoid the conclusion that the NHS entered the Covid-19 crisis with the bare minimum of resources. For anyone who doubts the strains that the medical profession operate under in normal times, I highly recommend the book by former doctor Adam Kay, This is Going to Hurt, which is a litany of the humorous, bizarre and tragic circumstances routinely encountered by the medical profession. Anecdotal evidence gathered from my own discussions with medical personnel in recent years suggests that the strains intensified during the worst of the government’s austerity programme.

On the basis that demand for health services is infinite, some serious questions will have to be asked once the crisis is over as to what we require of health services in future and how we expect to pay for  them. It is pretty certain that no government will be able to deny funds to the NHS in the near future. Therefore, either spending in non-health related areas will have to be cut or taxes will have to rise. I even suggested a couple of years ago that a hypothecated tax to fund health spending might be something we need to consider. Whatever options we finally choose, the public will accept nothing less than a new deal for the NHS. The era of austerity is over although the question of how to pay for it all will be the subject of future posts.

A crude conundrum

Over the past couple of days we have been treated to the spectacle of negative oil prices with the price of the West Texas Intermediate benchmark closing yesterday at minus $37.63 per barrel. Strictly speaking, it is only the price for delivery in April which has turned negative – the price for delivery in subsequent months remains positive with the May contract ending yesterday at $20.43 (although it slipped to $10 in the course of today). Nonetheless, it raises a number of interesting questions about how market-clearing prices are determined at a time of such huge uncertainty and the outlook for oil markets, in both the near-term and longer-term.

Dealing with the price setting question, in the current situation oil traders are paying prospective buyers to take oil off their hands rather than the other way around. But this is a result of the specific conditions in the oil market. Traders have to settle their forward contracts with physical delivery of crude oil and were desperate to avoid taking delivery of additional oil ahead of today’s settlement date because demand has collapsed to a far greater degree than production. As a result there is insufficient storage space to accommodate the supply glut, which has prompted the collapse in prices in order to restore market balance.

This runs contrary to the way we think of the price-setting process. After all in Economics 101 classes, the supply-demand diagrams always assume that the market-clearing price is positive. But negative prices happen frequently in the electricity market when suppliers sell their output into the national grid. For example if there is a sudden surge in electricity supply generated by renewables which exceeds current demand, the supplier has to supply it to the grid at a negative price. In time, as the generation company is able to adjust supply so the price is forced back up again. This is the key to understanding the current predicament: The burden of adjustment falls fully on prices when supply is unable to adjust (i.e. it becomes totally inelastic), which is precisely what happened in the oil market just ahead of the contract settlement date.

In the wake of the financial crisis, we learned that interest rates could turn negative and now we know that certain commodity prices can also turn negative. But it is not a sustainable situation. If you recall your basic economics, short-term profit maximisation is achieved by setting the selling price at the marginal cost of production. However low production costs may be in places like Saudi Arabia, marginal costs are not negative. In the longer-term, producers will also have to cover their fixed costs. But this raises the question of what is the longer-term equilibrium oil price?

This requires some idea of underlying demand/supply conditions. The International Energy Agency predicts that global oil demand will fall by a record 9.3 million barrels per day in 2020 relative to 2019 (a decline of around 10%). But supply is predicted to fall by only 2.3 mbpd so it is evident that the supply glut which was exacerbated by the Saudi-Russian price war is not about to get any better. The six month contract for WTI, which expires in October, is currently trading at around $25/barrel. Although this may not necessarily be a good predictor of the price six months ahead it is a reasonable proxy for how industry specialists view near-term prospects. For a number of major producers, this is too low to be profitable. According to a 2016 article in the Wall Street Journal, the cost structure of producers such as Brazil, Nigeria, Venezuela and Canada is such that they would struggle to break even if prices remain at these levels (chart below). It would also be bad news for US shale producers whose costs were estimated at $23/barrel. To the extent that shale producers have played a major role in changing the dynamics of global markets in the last decade, a reduction in US output would certainly help to put a floor under prices.

Nonetheless, it seems likely that in the near-term, global oil prices may struggle to exceed $30. That is bad news for those countries which rely on oil as a major source of revenue (it may also be bad news for Newcastle United FC which is reportedly the subject of a takeover by a Saudi-backed consortium). If low prices are sustained in the longer-term, this may act as an obstacle to weaning the world away from fossil fuels since it will be difficult to generate low-cost energy which can compete with oil. However, under normal circumstances prices would be expected to rebound quite quickly as the global economy recovers, which would render this concern redundant. But much will depend on the behaviour of the main producers. OPEC has found it difficult over the years to maintain production discipline and the recent spat between Russia and the Saudis suggests that producers want to maximise their revenues while they still can.

Maybe one day in the future we will look at the collapse in oil prices and regard it as a blip, in much the same way as the price spike of 2008 is now viewed. The savage nature of the economic collapse as the corona shutdown drags on means that many of our preconceived ideas about what is possible are having to be reviewed. However, the recent price collapse may also reflect the shifting tectonic plates of the oil market. This could be the start of a new regime in the world of fossil fuels.

Whistling in the dark or shining a light?

The global picture

As the official bodies begin to put out their growth forecasts for 2020 and 2021 the magnitude of the hit facing the global economy following the Covid-19 shutdown is becoming increasingly clear. The IMF’s latest projections suggest that global GDP will contract this year by 3%, rebounding by 5.8% in 2021. We have not seen anything like it in 90 years since the Great Depression, when world activity is estimated to have fallen by 10% between 1930 and 1932 with three successive annual declines of 3% or more. For the record, it took six years for output to regain its pre-crash highs. The IMF is suggesting that next year we will be able to put all of this behind us and push output back above pre-crash levels. I remain highly sceptical.

The good news, as the IMF points out, is that we do not currently have the degree of protectionism and beggar-thy-neighbour policies of the early-1930s which made the downturn so much worse than it needed to be. But economic nationalism is clearly back in fashion, and Donald Trump’s decision to halt US funding to the World Health Organisation during the greatest public health threat in a century is indicative of the febrile sentiment currently at play (not to mention the fact that it is probably one of the dumbest of petty acts and says a lot about Trump’s way of doing business, but in the interests of politeness to my American friends I will leave it there). Interestingly, the IMF’s forecast makes it clear that whilst output in emerging markets will rebound quickly, the advanced economies will not recoup their output losses in 2021. Indeed, EM economies take a relatively small hit with output projected to fall by only 1% this year and surging by 6.6% next year. My concern with this is that many EMs are export-driven economies, and if the developed world is growing relatively slowly, the demand for EM exports may not recover sufficiently quickly to drive the expected global growth surge.

The big imponderable is how deep will be the scars left by the current shutdown? The cause of the economic collapse is simply that much economic activity is prohibited as lockdowns came into force which has resulted in many people having to remain at home. Such impacts will ripple throughout the economy in as-yet unpredictable ways, and whilst fiscal and monetary policies have been turned up to the max they can only mitigate and not totally offset the economic damage. For example, even though interest rates are at rock bottom levels everywhere, this is no guarantee that people will want to borrow when the worst of the crisis is past. Nor will lenders necessarily be willing to grant credit to those individuals and businesses who are struggling to stay afloat if they are perceived to be a bad credit risk. This puts banks in a difficult position. Whilst they were perceived as the bad guys a decade ago, they want to be seen to be making a positive contribution today. But they also have a duty to their shareholders whose returns have taken a beating, and who will not thank them for any big rise in loan-loss provisions.

So far, all of this has been predicated on the assumption that the Covid-19 crisis can be compressed into the second quarter of 2020. This is far from a certainty. Much will depend on what form of exit strategy is adopted by governments: How long will it take to reopen the economy even if the threat passes relatively quickly if the process is staggered over several stages? Then there is the question of whether the viral threat will indeed pass so suddenly. Scientific evidence suggests that social distancing measures may have to remain in place until 2022 and vigilance maintained until 2024, neither of which are conducive to a sudden pickup in activity. For the record, the IMF did conduct alternative scenarios. In one of the worst case outcomes, the assumption of a longer Covid-19 outbreak in 2020 together with a renewed outbreak in 2021, results in a level of GDP next year which is 8% below the baseline discussed above. This would imply an output loss of more than 5% over two years which starts to look more like a 1930s outcome.

The local picture

Closer to home, the UK Office for Budget Responsibility came out with an illustrative scenario earlier this week which suggested UK GDP could collapse by 13% in 2020, with a 35% contraction in Q2 alone, which is followed by a rebound of 18% in 2021 (chart below). To put that into context, this would be the largest annual contraction in GDP since 1709 when the Great Frost wiped out agricultural output. The projected rebound in 2021 would also be the largest since 1704 (apparently). Even allowing for the fact that the historical data are subject to a huge degree of uncertainty, the OBR figures suggest the most volatile swings in output for over 300 years. Like the IMF (whose predictions for UK growth in 2020 and 2021 are a more modest -6.5% and +4.0% respectively), the OBR figures effectively assume that there will be no economic scarring although I doubt very much that if the OBR’s awful 2020 forecast is realised there will be much of a rebound next year.

Predictably, the IMF and OBR projections were met with the usual scepticism from those who have nothing better to do than criticise the forecasting efforts of others. I am not going to jump on that bandwagon. After all, these forecasts are produced because there is a need to have some basis for planning. What would the sceptics rather we do? Produce nothing and trust to luck by making it up as we go along? Just imagine the howls of rage if governments were not prepared for the worst case outcomes. But it does raise a question as to how such analysis should be treated at a time when predicting the future is little more than guesswork. The OBR made it clear that its analysis was a scenario, not a forecast, yet the media treated it as if it were a forecast. You may ask what is the difference? The answer is that a scenario is a conditional assessment based on a “what-if” approach whereas a forecast is typically viewed as an unconditional, what-will-happen event.

Obviously this is a fine distinction but it is important. The OBR is not suggesting in its analysis that it believes the outcome will necessarily be realised but it is an attempt to highlight the economic risks. Arguably there are better ways to do it. It could, for example, have prepared a range of outcomes along the same lines as the IMF and not chosen to discuss one illustrative case which runs the risk of being treated as an unconditional forecast. As former BoE insider Tony Yates pointed out on Twitter, the criticism levelled at the OBR is “the kind of thing that makes policy bodies nervous about being as transparent as they should be to help us hold them to account.  The BoE was paralysed by this nervousness, and made themselves hard to scrutinise.”

The one thing we know is that all forecasts produced in the current uncertain environment will be wrong in some way. They should be viewed as an attempt to shine some light in the dark, however feeble. In truth, the ordinary voter does not care about GDP growth but when you tell them it is a proxy for the path of employment and incomes, we are then talking about something meaningful for them. As a final thought, when the IMF and OBR are so far apart in their views on the UK, this is an indication that the light cast by the forecast insight is dim indeed.