Thank goodness for cryptocurrencies. Their existence provides the opportunity to rethink what, if any, roles we want central banks in the 21st century to have.
If you look at the Fed, you will find it has several roles including:
It issues money;
It sets monetary policy;
It supervises and regulates the nation’s largest banks;
It influences macro-prudential regulations through its role on the Financial Stability Oversight Committee;
It supports the payment system; and
It acts as the Lender of Last Resort.
And if this weren’t enough, many are pushing for it to have a role in financing environmental initiatives.
In the 21st century, does it make sense for the Fed to have all of these roles?
NO!
For example, we saw with the 2008 acute phase of the Great Financial Crisis the Fed was not up to the task of supervising or regulating the nation’s largest banks. Confirmation of this came when chairman Ben Bernanke observed all but 1 or 2 of these banks was insolvent and therefore candidates to be resolved (closed). You would think if the Fed was up to the task of supervising and regulating the nation’s largest banks, the exact opposite would have occurred and Bernanke would have observed only 1 or 2 of these banks was insolvent.
The fact the Fed failed as a supervisor is not surprising. It was never fit for that purpose. Bank supervision grew out of the Fed’s role as a Lender of Last Resort. It was necessary to implement Bagehot’s dictum that during a financial crisis central banks should lend to solvent banks at high rates. Until the dawn of the Information Age, supervision was necessary so the Fed or any other central bank could know which banks were solvent.
Remarkably, in the aftermath of this enormous failure in supervision and regulation, the Fed was rewarded with an expanded role as the leading regulator setting macro-prudential policy. Underlying macro-prudential policy is the idea the financial regulators can look across the financial system, identify areas of increasing risk and then take actions so the realization of the risks doesn’t result in a financial crisis. Nice theory, but with a host of real world implementation problems. For example, is monetary policy considered a source of systemic risk? For everyone who isn’t a financial regulator, the obvious answer is yes. Naturally, the financial regulators ignore it despite the harm current monetary policy is doing by increasing financial instability and undermining both the real economy and society.
Clearly, it is time to rethink the role of central banks. Fortunately, the arrival of cryptocurrencies forces this rethinking and subsequently addressing this issue.
Cryptocurrencies challenge the very notion of what is money. What makes central bank money unique is that it can be used to pay taxes.
Cryptocurrencies also highlight the changing nature of how payments are made with many proponents arguing cryptocurrencies can and will replace the payment system.
Over the last 150 years, we have seen the evolution from payments made using physical currency to payments made using checks to payments made using wire transfers to payments made using credit cards to payments made using applications on a cellphone. Central banks play a role in multiple parts of the payment system. They provide the physical currency. They handle the checks and wire transfers.
Cryptocurrency opens up the opportunity for central banks to increase the number of roles they play in the payment system. In fact, a properly designed central bank digital currency effectively eliminates the need for commercial banks in the payment system.
This is a very important point.
Thanks to the BIS, we have a simple conceptual diagram of how this central bank digital currency would be designed:
The difference between the Indirect Central Bank Digital Currency and the Hybrid Central Bank Digital Currency is the replacement of the commercial banks with firms whose only job is to handle payments.
I ask the readers to pause for a moment and realize just how hard commercial banks are going to fight to keep the payment system hostage.
Why?
Once their failure no longer threatens the payment system, there is no longer a need to prevent the commercial banks from failing.
With the creation of hybrid central bank digital currency, there is also no further need for deposit insurance.
Why?
The money held by the central bank is not at a risk of loss as the central bank can always credit more money to an account.
This radical change to the payment system promises significant improvements in financial stability. So what is the catch?
First, there are privacy concerns. The entity handling our account knows how we spend our money. The reason I prefer the Hybrid model over the Direct model is the ability to erect a barrier similar to what exists today with commercial banks so the government does not have this information.
Second, there are concerns in the name of monetary policy central banks will charge negative rates on our account balances. Since Congress is going to be involved in passing the necessary legislation to make the Hybrid model possible, it should set a 2% minimum interest payment on funds held in a digital currency account. This 2% is not a random number, but is the level of interest rates Bagehot and Keynes determined is necessary so our economy and financial markets function properly.
Three, funds deposited in a central bank digital currency account should be restricted to investment in government or government guaranteed securities only. While there are many who would like central banks to allocate credit, there is no reason to think central banks can do this better than the private market. The private market has another major advantage. It, rather than the taxpayers, absorbs the losses on its investments.
Ok, so what roles does a central bank have after the introduction of the hybrid central bank digital currency?
It issues money; and
It “operates” the payment system.
Readers will immediately notice I have stripped central banks of any role in monetary policy or supervision and regulation.
From the 1980s on, it has frequently been noted monetary policy works with long and variable lags. A compelling case can be made when it comes to monetary policy there is correlation with subsequent economic performance, but it is highly likely there is no causation. If there were causality, it is hard to explain why the global economy is not roaring after over a decade of zero interest rate policies and quantitative easing.
Given this level of uncertainty regarding the efficacy of monetary policy, it is best for elected officials to decide if they even want an entity to administer monetary policy and if they do to create a separate entity whose sole responsibility is monetary policy.
Supervision and regulation of commercial banks should be consolidated in a single entity who is responsible not just for supervision and regulation, but also closing these banks when they are approaching insolvency. This reinforces market discipline on banks to limit their risk taking to what they can afford to lose.
I don’t think commercial banks are going away with the introduction of Hybrid Central Bank Digital Currency. They will continue to provide valuable services like loan origination and servicing. However, removing the payment system and deposit insurance from commercial banks will bring on significant changes in how these banks operate. For example, to attract deposits, they are going to have to pay an interest rate that reflects the risks they are taking.
On the 2% interest minimum, I presume you are talking about 2% real interest. I though it was thought to be three percent. Quite obviously people have money in savings accounts with negative interest rates or are in risk assets that, when adjusted for risk, probably will earn many of them just as low returns when the speculative bubble bursts.
The problem I see is that the Fed got pulled into talking on additional roles because Congress and the Exec branch refuse and refused to use its fiscal policy tools at all. Bernacke decided QE was to prevent a 30’s style collapse but he created a monster in that companies were now focused on earning returns through financial engineering not operations. It created an country addicted to low rates.
By reducing the Fed’s role, I don’t see who is going to be the guardian against inflation because politicians are wont to juice the economy so much that it busts. The core problem is that the Fed has too few tools, all which are clumsy and indirect. I fail to see how without some control over bank lending, we would not just lurch from boom to bust to boom. Bankers are human, and the AI they are going to use is based on human experience, so there is no chance of the price of money creating a equilibrium that would lead to a stable economy. What is worse, given the large amount of wealth and income inequality it’s quite clear the powerful will enact policies that protect their capital, not particularly caring about those who earn income.
Therefore, I think just taking monetary policy and setting to the side, will never occur because it is about power and control. The central banks mess up because they never could guess the magnitude of the impact of their action and they fail to understand the extent of the collateral damage. Extending QE after the first tranche was a huge mistake that has created an enormous bubble. It will burst and the FED will step up to try to save the world, which is of the reason they exist. It would be nice, if they weren’t both the cause and the solution.
All three models assume it is architected, though in fact the market decides. So the banks may think that the indirect model keeps them alive, though protocols such as Compound are an order of magnitude higher in capital efficiency and with an order of magnitude lower running costs. So if you want a loan, you'll get a better rate in crypto than you will from those banks in the indirect model.
I think the analysis is incomplete anyway... Smart contracts can and will replace the banks or payment providers in all of the models above. It appears to assume a CBDC stablecoin... Though stablecoins don't make much sense in the first place.
More likely I think the technological revolution that programmable money provides; namely that the capital is kept in the protocol layer rather than the application layer as at present. Think twitter, facebook etc... Built on the internet and they add the bulk of the value. Dapps built on Ethereum on the other hand provide value to Ethereum.
More broadly though is a simple choice between Catholic style centralisation as pursued by China, or Protestant style decentralisation. The latter has always won and by a considerable margin, hence dreams of centralised control in a CBDC are a pipedream I think. Whilst businesses could and maybe should be forced to use one, no private citizen should allow their finances to be an open book. One could even argue it is the accountancy firms rather than the banks which are corrupt.
All that said the crypto industry isn't doing itself any favours. Either too naive or stupid to play the game, they don't lack resources they merely lack the nouse to use them in a political or wider social way. They act like a cottage industry, and are therefore treated as such.
Don't forget that a CBDC legitimises other crypto currencies. Or would bitcoin not be exchangeable for Britcoin? You can't really stop it. So the way I see it playing out... The banks are currenly trying to stop capital flowing into crypto, unsuccessfully of course. Too late they will realise the only way to attract deposits is to provide yield, and the only place they can get yield is the crypto markets by offering crypto savings accounts. Frankly the next big crash ( soon? ) might spell the beginning of the end anyway. Tax avoidance has already put the lid on the coffin.
And the wondrous politicians will realise they can get more tax from the little people who have access to highly efficient banking and lending than they do currently from the banks.
Well, it's either that or China, social credit and dystopian bastardry. Sorry bit longer than I expected.