What CBDC Is (Not) About: Part V

The high-impact scenario

Photo by Samantha Sophia on Unsplash

Note: This is the fifth post in a series about central bank digital currencies, or CBDC (you can start with Part 1 here). Today, we explore the potential implications of introducing CBDC using the 'high-impact' scenario.

Tl;dr: CBDC could naturally lead to a bottom-up full reserve banking system where money creation is an exclusive privilege of the state. Creeping centralisation would eventually spill over to the real economy as well, accidentally resulting in an economic system with suboptimal allocation of resources according to political agendas.

Towards an organic full reserve system

In the 'high-impact' scenario, CBDC has entirely crowded out private forms of debt money.

Private credit still exists, but ceases to function as money. Banks and other financial institutions continue making loans, but the resulting credit entry in their bookkeeping systems is not considered 'money' anymore – it cannot be used to make purchases in the real economy. Instead, consumers and businesses require deposit-taking and payments-related activities to be conducted exclusively in CBDC.

If this evokes images of narrow banking, you're not far off: the arrangement I just described resembles a full reserve system where all business is conducted in sovereign money alone. [1] The CBDC architecture and design may vary, but the result is functionally the same: all forms of money are 100% backed by public money [2].

Now, the idea of full reserve banking systems is nothing new: in the 1930s, the Chicago plan advocated the nationalisation of money (which failed to materialise), while the central bank of the Soviet Union – the Gosbank – effectively operated the entire financial system for more than half a century (conveniently, it was also the only bank). If you're looking for a more recent example, just go further East: the People's Bank of China already requires the country's major digital payment service providers (i.e. AliPay and WeChat) to fully back all customer deposits with reserves at the central bank.

What would be new here, I believe, is that this development may not necessarily have been prescribed top-down. Rather than being a product of new restrictive legislation and banking regulation, I imagine it to be the result of an organic, natural evolution, driven by changing consumer preferences and market forces, that over time have made private debt money less attractive and less competitive. Consumers and businesses would gradually convert existing deposits into CBDC, and banks would increasingly grant new loans in CBDC, to a point where public money would eventually have completely substituted private debt money in the economy. [3]

Public money, private payments

As the only creator of 'money' in the economy, the central bank has now full control over the money supply. [4] This constitutes not only a major extension of the monetary toolkit, but also an exceptional improvement of its effectiveness: the central bank can now dynamically expand or contract the money pool available to the economy in response to macroeconomic conditions, and directly implement monetary policy on a more targeted basis – measures that may even be automatically enforced in (near) real time. [5]

The role of commercial banks in this environment depends on the implementation of CBDC, but allow me to lay out a scenario that I believe to be the most likely outcome.

Central banks lack the expertise, experience, and resources required to provide customer-facing services. There are ways to overcome limited internal capacities, but central banks have repeatedly shown little desire to get involved in front-end retail activities. Instead, these operations should remain in the domain of the private sector, which has specialised in building long-lasting relationships with customers.

As a result, I believe that a public-private partnership will emerge that leaves money creation exclusively in the hand of the central bank whereas retail payment systems and related 'front-end' activities are exclusively operated by the private sector. In this two-tier model, private institutions do credit assessments, make loans, operate CBDC accounts on behalf of customers, process retail payments, and provide customer support. They remain a crucial interface between the central bank and the economy, but their role has changed – from active money creators to passive CBDC distributors. [6]

Credit crunches and central bank intervention

This has implications beyond the composition of the money supply. [7]

Banks cannot anymore generate the money they subsequently lend out. Instead, loans need to be fully pre-funded from the pool of available public money. This changes the balance sheet structure of the banking sector (reserves, i.e. CBDC, take up a much larger share of total assets) and constrains total lending capacity, potentially resulting in less credit available to the economy.

Banks could start sourcing funds directly from the central bank. However, this would inadvertently turn the central bank into an (indirect) arbiter of credit: banks would only be granted new funds if the central bank deemed the underlying loans to be worth making. Banks would hence be relegated to an unflattering version of 'branch agents', working on behalf of the central bank

You can even take this further. In the case of a severe credit crunch with funding markets freezing up, one could imagine the central bank being forced directly into lending. In an emergency intervention, it would take over not only credit creation, but also allocation. [8] What would begin as a temporary measure could quickly turn into a permanent state of affairs, with the central bank accidentally ending up as an omnipotent central manager of the economy.

It is already difficult to imagine that a single institution with imperfect information and limited resources would have the ability to determine exactly how much money is needed at any point in time (i.e. carefully managing the money supply in a way that the total pool of money always matches the payment and funding needs of all economic agents). It is even harder to imagine that a single institution – with all of its limitations – would have the ability to know exactly how resources can be most efficiently allocated in the economy (i.e. allocate resources in a way that maximises total economic output – which should thus at least equate the total output resulting from a decentralised, market-based allocation process). History provides a number of cautionary tales.

Unelected technocrats suddenly holding total command over the economy would make them susceptible to political interference. The independence of the central bank would be quickly at risk as different parts of government would scramble to appropriate the decision-making process for self-serving purposes. Who could resist the temptation, really? We know human nature, and we know that power tends to corrupt over time, so I think there's no need to further elaborate on this.

Don’t worry – we’re not there yet

In the scenario just described, the public sector reclaims sovereignty over the monetary system through the backdoor: financial institutions lose the privilege of money creation and are relegated to simple intermediaries that manage the consumer-facing 'front-end'. The unprecedented concentration of power in a single institution risks compromising the independence of the central bank, eventually resulting in overall economic losses as central planning increasingly substitutes the market's decentralised allocation process.

Fortunately, we are far away from a situation like this. Central bankers have repeatedly insisted that they have no interest in dis-intermediating the private sector and taking over the monetary system.

However, the world is abound with cautionary examples of the law of unintended consequences. A healthy system of checks and balances is an absolute necessity for regulating the temptation of money creation. One should thus be careful not to inadvertently shift the power balance too much in favour of the public sector – or any side, for that matter.

In the final post of this series, we will briefly explore CBDC's relationship to cash and frame CBDC as a deeply political issue that should be subject to a proper political process that involves society at large.

Footnotes

[1] Narrow banking can be considered one way of implementing a full reserve system. Narrow banks are required to hold 100% of deposits as reserves, which include safe and liquid assets (e.g. government bonds) in addition to public money (i.e. cash, bank reserves – and CBDC). It is a fascinating topic that I might dive into more in future posts.

[2] Two models come to mind:

• In a direct CBDC model, the central bank would be directly offering CBDC to the public, i.e. providing consumers and businesses with a direct claim on central bank liabilities. All transactions would be conducted in CBDC, leaving little room for private instruments.

• In a hybrid CBDC model – which I believe to be the more likely arrangement – banks and other financial institutions would intermediate between the central bank and the economy by issuing liabilities that are fully backed by CBDC. These liabilities – also referred to as synthetic CBDC (sCBDC) – would be widely used by consumers and businesses for retail payments, and be periodically settled by service providers via CBDC.

Legally, the second model may only represent an indirect claim on the central bank. Practically, though, 100% CBDC backing and the use of segregated accounts effectively turn the a priori indirect claim into a synthetic direct claim. In either case, the result is the same – a full reserve banking system.

[3] One potential regulatory consequence – ex post – would be the abolishment of deposit protection schemes, a fundamental building block for upholding the 'illusion of fungibility' between different bank deposits and other money-like instruments. Deposit insurance has little purpose in an environment where deposits are always fully collateralised. This would, of course, further discourage private debt money creation.

[4] I do not cover the implications of a ballooning central bank balance sheet on the asset side here, but suffice to say that finding sufficient eligible collateral to match outstanding liabilities would be a major issue.

[5] In this scenario, bank reserves may eventually be phased out as wholesale settlement is conducted in CBDC.

[6] I think the degree of 'passiveness' here is debatable. It will, as always, depend on the specific implementation and design, so let's reserve this discussion for another time.

[7] Which is now equivalent to M0 – the public base money – of which CBDC likely constitutes the vast majority (cash and bank reserves may eventually both be phased out).

[8] Although one could argue that the situation would not be much different from the intermediated arrangement that creates an artificial perception of separation and independence.