There is little doubt that these currencies as they gain ground could pull the carpet under the central banks monopolist chair. Central bankers who are habitual to tell the politicians and businesses about allowing disruptive innovations are going to get a bit on their game as well. More than anything else, it will be interesting whether central banks try and preserve their monopolies or let it go.
Tolle says digitial currencies will create problems for both banks and central banks. One key reason is the payment bit is going to get divorced from the deposits:
Central banks (CBs) have long issued paper currency. The development of Bitcoin and other private digital currencies has provided them with the technological means to issue their own digital currency. But should they?
Addressing this question is part of the Bank’s Research Agenda. In this post I sketch out how a CB digital currency – call it CBcoin – might affect the monetary and banking systems – setting aside other important and complex systemic implications that range from prudential regulation and financial stability to technology, operational and financial conduct.
I argue that taken to its most extreme conclusion, CBcoin issuance could have far-reaching consequences for commercial and central banking – divorcing payments from private bank deposits and even putting an end to banks’ ability to create money. By redefining the architecture of payment systems, CBcoin could thus challenge fractional reserve banking and reshape the conduct of monetary policy.
What happens to banks?
Commercial banks currently have the power to create money. When a bank makes a loan, it simultaneously creates a deposit, adding to broad money. So, by extending credit, banks not only create their own funding (deposits), they also control the level of broad money in the economy (see McLeay et al (2014)). Banks hold a fraction of the loans they extend as CB reserves, so as to back a fraction of their deposit liabilities with CB reserves – a setup known as fractional reserve banking. This fractional backing of deposits means that if all households suddenly wished to convert their deposits into hard currency, banks would not have enough reserves to repay them, so would either need to sell off their loan books in exchange for currency or utilise the CB’s lender-of-last-resort facilities.
If households and firms converted their bank deposits into CBcoin, commercial banks’ deposit-funded model would come under pressure. Broadly speaking, there are two possible delimiting scenarios. In the first, banks would compete with CBcoin by offering higher interest rates on their customer deposits. How much higher would of course be an empirical matter. By raising banks’ funding costs – other things equal – this could dent bank profitability and lead to tighter credit conditions. But banks would continue to issue loans and create broad money. In a recent paper, Barrdear and Kumhof use a DSGE model that accommodates fractional reserve banking to study the macroeconomic consequences of CB digital currency issuance.
Another scenario would see a large-scale shift of customer deposits into CBcoin, forcing banks to sell off their loan books. Bank deposits could still exist but as saving instruments, no longer used to make payments. Banks could still originate loans, provided they lent money actually invested by customers, say, in non-insured investment accounts that couldn’t be used as a medium of exchange. Banks would operate like mutual funds, losing their power to create money and becoming pure intermediaries of loanable funds, as described in economic textbooks.
Under this scenario, the contraction of broad money (bank deposits), and the attendant emergence of ‘private-sector base money’ made of CBcoin would mark the demise of fractional reserve banking (see Sams (2015)). The conversion of bank deposits into CBcoin deposits at the CB would amount to 100% reserve backing for deposits. This could usher in a system similar to theChicago Plan, a set of monetary reforms proposed by Irving Fisher during the Great Depression and recently revisited by Benes and Kumhof (2012). The Plan’s call for the separation of the credit and money-creating functions of private banks would be addressed – with 100% reserve backing, banks could no longer create their own funding – deposits – by lending. Similar “narrow banking” proposals have emerged since the financial crisis, such as that of Kay (2009), Kotlikoff’s Limited-Purpose Banking (2012) or the Vollgeld initiative (2015), recently rejected by the Swiss government.
On central banks?
The conflation of broad and base money, and the separation of credit and money, would allow the CB to control the money supply directly and independently of credit creation, calling for a reassessment of monetary policy along two dimensions. First, the prospect of direct control of the money supply might alter the relative merits of using interest rates or the money supply as the main policy instrument. If so, this newfound CB power could reopen the debate between advocates of rules versus discretion in the conduct of monetary policy. For instance, the signers of the Chicago Plan, in particular Milton Friedman, envisioned a constant money growth rule rather than the discretion over interest rates that has prevailed since CB independence in the 1990s.
Mapping out the implications of CB digital currency issuance is a very complex endeavor. It is helpful as a first pass to sketch out partial scenarios, as I have done in this post for banking and monetary policy, but the devil lies in the detail. Research is ongoing so watch this space!
I am still not clear with the post. Have to think through several of these issues carefully..