Central banks are getting closer and closer to issuing digital currencies, but this attempt to fend off the threat of cryptocurrencies raises many questions about the future of the economy.
One consequence of central bank digital currencies, which for the moment is not discussed as much as it should be, is that they could serve as “Trojan horses” for negative interest rates – and these in turn could amount to debt default by stealth.
“I will argue that central bank digital currencies are a technologically advanced representation of central bank money,” the head of the Bank of International Settlements Agustin Carstens said in a recent speech.
“If well designed, they could offer a safe, neutral and final means of settlement for the digital economy.”
The crucial bit of the sentence is “if well designed.” Central bank digital currencies could have all sorts of unintended (or in some cases hidden) consequences.
Still, one cannot stop technological progress. Central bank digital currencies are already well on their way to becoming (digital) reality.
The Bahamas became the first mover when its central bank launched its digital currency, the Sand Dollar, last year in October. One Sand Dollar is equal to one Bahamian dollar, which in turn is pegged to the US dollar.
The central bank works with authorised intermediaries, usually banks, which buy the digital money from it in exchange for ordinary currency. Then, these intermediaries offer digital wallets to their clients.
Individual clients do not necessarily need a bank account to hold a digital currency wallet, but they do need to pass the so-called “know your customer” checks in order to get access to the currency.
The retail users can access their digital currency wallets either via a mobile phone all, or via a pre-paid “classic” card if they do not have a mobile phone.
Financial stability risk
The main advantage of a central bank digital currency is that it cuts costs with handling cash and it offers some sort of banking access to those who do not have bank accounts.
Sweden, one of the countries where cash is used least in the world, has launched a pilot project to see whether and how it could switch to a digital currency, the e-krona.
The holder of e-krona would in effect be the holder of a liability issued by the central bank, thus bypassing commercial banks.
This, according to a Reuters report, has sparked anxiety in the ranks of commercial banks active in Sweden.
One worry is that bank customers would move their money to the central bank with one click, depriving banks of relative secure sources of funds and forcing them to borrow from the wholesale markets.
This would pose a risk to financial stability – something that BIS head also highlighted in his speech.
“An individual’s decision between a central bank digital currency or commercial bank money will depend primarily on the value added by commercial banks in terms of overall service, and their perceived safety,” Carstens said.
“Still, in the extreme, history shows that we cannot rule out runs on commercial banks. This already has happened with wholesale central bank money, as when interbank markets froze during the Great Financial Crisis.”
Negative interest rates
The European Central Bank is, among the G7 countries, the most advanced in terms of a project to launch a digital currency. It plans to take a decision on whether to go ahead with the project sometime in the middle of this year.
The ECB is well aware of the risks to the financial system, which it has discussed in a recent paper it published on the issue.
If demand for digital euros were to increase banks’ funding costs, these could respond either by reducing lending, which would hurt economic activity, or by resorting to riskier investments.
“In crisis situations, when savers have less confidence in the whole banking sector, liquid assets might be shifted very rapidly from commercial bank deposits to the digital euro … This could increase the likelihood and severity of bank runs, weakening financial stability,” according to the ECB paper.
Understandably, neither the BIS paper nor the ECB one goes deep into another potential huge change that central bank digital currencies could bring: the possibility to pass through negative interest rates directly to the population to force shifts in consumer behaviour.
Until now, the so-called “zero-bound” (the fact that interest rates cannot go substantially below zero) has been underpinned by the existence of cash, which remains unaffected by nominal negative interest rates.
But with a digital wallet, this safety cushion disappears. The negative interest rate would eat directly into the currency deposited there, with nominal amounts shrinking by the amount of interest deducted each month.
This could force people to spend their money rather than seeing their pot shrink every month, even if they perhaps do not want/need the things they purchase. Arguably, this would be a good way to stimulate sluggish economies.
But on the other hand, in would also mean that those with a lot of debt would suddenly see themselves at an advantage. Negative interest rates for depositors translate in positive interest rates (or at least zero interest rates) for borrowers.
This poses not only moral hazard – by encouraging the profligate rather than the prudent — but also risks alienating consumers and investors.
There is no doubt that some form of debt forgiveness is needed, with a world already drowning in debt after the financial crisis.
But it would be better, before central banks think of introducing digital currencies, that they offer transparent and fair debt forgiveness measures, rather than risking the credibility of the currencies by using them as a backdoor to default.