Robert Lloyd, CFA
Central Banks, Digital Currencies and the Broad Money Supply
Central banks are considering digital currencies
Many interesting reasons are given; most protect government interests
Central banks realize the broad money supply is controlled by the commercial banks
Markets and banks are not likely to implement or accept these schemes willingly
Central banks throughout the world are considering or actively creating digital currencies. The rise of bitcoin and blockchain technologies has alerted many policy makers to the possibility of a new transnational currency that could replace the global Dollar standard. Naturally, the government or entity that becomes the next reserve currency sponsor will be able to garner many of the benefits the United States has received for decades by possessing the Dollar-based reserve currency of the world.
Government advocates of digital currencies layout their case for creating a digital currency to replace the current system:
1) Technological efficiency – eliminate the cost of bank intermediation in regular payments; get rid of debit and credit card fees.
2) Financial inclusion – provide low cost savings accounts to all; eliminate user fees.
3) Preventing crime – by tracking all cash movement, efforts to avoid taxes and operate in the underground economy will be limited.
4) Safety of the payments system – a unified system controlled by the government would boost confidence is said system.
5) Preservation of seigniorage income – preserving the governments ability to debase the currency
6) Bank competition – free bank accounts will force commercial banks to pay interest to attract deposits.
7) Monetary policy transmission – allow the central bank to directly control the transmission of interest rate policy and quantitative easing upon the banking system.
8) Financial safety – limit the practice of fractional reserve banking to lower risk and the cost of deposit guarantees.
Many of these reasons such as full reserve banking, protecting the payments system, eliminating fees and providing free accounts to the poor have been around for years. It is #7, the inability of central banks to influence the broad money supply along with the popularity of bitcoin that has incentivized the central banks to start looking at digital currencies.
Since the global financial crisis of 2008, the Federal Reserve and the European Central Bank have pursued a policy of low interest rates and quantitative easing to stimulate growth and inflation. These policies were employed extensively by Japan following the collapse of their stock and property bubble in 1990. However, these policies have not produced the promised growth or inflation in any of these territories. Why not? It is simple. Central banks do not lend to the public. They lend to commercial banks who in turn lend to the public economies. If the commercial banks don’t pass through loose monetary policy, there is no inflation, nor is there growth.
Most central banks have lost control of their broad money supply. It is not the situation of the 1970s when we had runaway inflation and expanding money supply. Today, it is stagnation and deflation, with poor access to cheap credit or high implicit interest rates for consumers. Today the US government can borrow 10 year money at < 1%. Compare that to credit card interest rates consumers have experienced over the last 10 years. There is a clear bifurcation between the "haves" and the "have nots."
Naturally, if you are a central bank and the commercial banks you service won’t enact your policies, explore something new.
Commercial banks may have very good reasons for not passing through easy monetary policies to the broad economy. For one, commercial banks are regulated, for-profit entities. This means they must be careful not to lose money while lending and obey all the regulatory constraints placed upon them by law makers, regulators and bank examiners. Additionally, banks have been consolidating dramatically over the last 20 years, reducing competition. Their incentives are long term profit maximization, even at the expense of short term profits.
Modern commercial global banking systems are built around the Dollar standard for better or for worse. A 2014 loan denominated in dollars still has to pay interest and principle in dollars regardless of the borrowing country or currency denomination. Even if the banks agree to re-denominate into a digital currency, there will be winners and losers. The losers will surely litigate or lobby to prevent their interests from being damaged. It is also unclear if the markets will accept a digital currency for commerce. Just take the seigniorage issue, for example. Who wants to own a currency that may be deliberately debased or devalued at a moment’s notice? No one, of course.
Here in the United States, many forget the Federal Reserve system is only quasi-public. When it was created in 1917, Congress demanded the banking system to provide the start-up capital for the new Federal Reserve System. In return, the bank owners would get regular dividend payments as shareholders of the Federal Reserve Bank. In 2019, the banks received $714 million in dividend payments. So, the Federal Reserve is owned in a significant way by the very commercial banks a digital currency would hurt. While not direct, the Federal Reserve member banks hold considerable influence over the regional Federal Reserve banks.
It is unlikely the banking system in the United States will voluntarily switch to a digital currency and has a strong vested interest in keeping the current system status quo. A switch will hurt profits, reduce market power, and lower political clout. For these reasons, a digital currency will be discussed, but likely not implemented in the United States.
Federal Reserve Bank Of Philadelphia, Working Paper WP 20-19, June 2020, Central Bank Digital Currency: Central Banking for All?, Jesus Fernandez-Villaverde, Daniel Sanches, Linda Schilling, and Harald Uhlig.
Robert Lloyd, CFA® is President and Chief Investment Officer of Lloyds Intrepid Wealth Management, and author of the book CENTRAL MARKETS. Since 1994, he has held positions as a trader, analyst, portfolio manager, and wealth manager while working at Invesco, CCM Opportunistic Advisors, and Merrill Lynch. In another life, he served 8 years in the U.S. Navy as a Naval Flight Officer flying in the S-3B Viking. For a complete resumé, visit his profile at LinkedIn.
Rob holds a BBA from the University of Notre Dame and an MBA from the University of Chicago.
Rob is a Chartered Financial Analyst.
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