Central Bank Digital Currencies (CBDCs) are on their way to becoming the most significant and fundamental shift to the global financial system since Bretton Woods.
CBDCs have the potential to radically transform the global financial system as we know it in nearly any iteration. They can transform finance and, ultimately, the very essence of money. Through CBDCs, fiat money will become genuinely digital and the separation of monetary and fiscal policy will be completed.
The development and implementation of digital government money is not a trend or development that can be traded but rather represents what may be the single most significant change to the way the financial system is constructed and operates, and is a development that everyone should be aware of and educate themselves about.
If Central Bank Digital Currencies are produced and presented in a certain configuration, the very concept of money and currency will be redefined. Everything from how credit is created, to the role of central banks and governments in society, to the mechanisms for transmitting monetary and fiscal policy, to how the banking system operates, to how transactions are processed, to the very nature of money and how it works, has the potential to be redefined and re-engineered entirely.
The issue is that these large changes, in turn, have much more severe consequences. Central Bank Digital Currencies, prompted by temptation, necessity, wealth disparity, and the growth of populism, “could unleash Pandora’s box of unforeseen fiscal and monetary repercussions, overpowering our would-be masters of money.”
What are Digital Currencies Issued by Central Banks?
Central Bank Digital Currencies, in its most advanced form, will enable people, corporations, and virtually everyone else in the private sector to have a digital wallet or bank account directly with their central bank.
This is significant in and of itself, as only commercial banks can account directly with central banks in the form of central bank reserves under our current financial system. The Federal Reserve conducts quantitative easing (QE) in the United States through this channel; they purchase assets from commercial banks in exchange for central bank reserves.
Without getting into detail about how quantitative easing works, actual money creation for the real economy comes through the commercial banking sector. Allowing citizens to maintain a direct CBDC account with the Fed would enable the central bank to stimulate and engage directly with the public, which is now impossible under the current system.
This direct connection to humans is cited as a primary reason for the development of CBDCs. Bypassing the commercial banking system provides policymakers with a completely new toolkit for implementing monetary policy. Central bankers’ stimulatory actions will no longer be limited to commercial banks’ discretion and credit creation for the private sector.
Rather than relying on bank profitability, regulation, and credit demand to influence the actual economy’s money supply, the Fed may directly inject liquidity into individual consumers and businesses. Such a central bank for digital currencies would effectively transform central banks from last resort lenders to last (or first) resort, spenders.
As I will attempt to describe below, there is an enormous amount of responsibility and equally enormous repercussions associated with such a potentially powerful instrument. Almost every central bank in the world has initiated at least preliminary research into developing its own digital government money.
The fact that CBDCs are gaining prominence and entering development stages throughout the world at a time when most developed countries’ traditional (and “emergency”) monetary policy instruments are nearing their usefulness and many countries, most notably the United States, have moved toward fiscal dominance should be viewed in conjunction with the rise of populism.
Policymakers have made it very clear that they aim to preserve asset prices and encourage economic development at whatever cost, given their inability to do so themselves; the logical consequence of these inclinations appears to be CBDCs and their inevitability. Central bankers are in a position to do all possible to avert Japanification due to debt, demographics, and deflation. The next stage in the path of monetary and economic intervention is a digital currency.
CBDCs come in a variety of forms and work in a variety of ways
Without delving too deeply into the technology and infrastructure that might underlie the establishment of Central Bank Digital Currencies, it is critical to understand how the various CBDC variants function and are structured. Several CBDCs are being developed, and as such, I will attempt to describe the most diverse of these proposals, as well as their potential uses and users.
Retail versus wholesale
To begin, CBDCs are classified as retail or wholesale. A CBDC retail establishment would be established for the general public and consumers. This would enable central banks to connect directly with consumers, arming policymakers with the most powerful stimulatory or restrictive tools and data collecting capabilities available. A CBDC retail iteration is the most important shift to today’s monetary system, redefining money itself.
On the other hand, a wholesale CBDC would be established for usage inside the interbank commercial bank market and by other institutional and shadow bank participants. The purpose of a wholesale CBDC would be to improve the efficiency and ease of transactions in these wholesale markets.
However, the advantages of a wholesale CBDC appear to be negligible in comparison to a CBDC retail, where a direct connection with customers provides the stimulatory and intervention mechanisms desired by central banks. Indeed, from the perspective of the United States’ payments infrastructure, “a CBDC appears to be superfluous in wholesale payments” because the existing wholesale payments infrastructure enables efficient wholesale transactions to be handled at “infinite operating costs and no collateral or liquidity demand.”
Indirect versus direct
A direct approach is the most likely version of the CBDC retail mentioned above. A direct approach would provide customers direct access to their central bank, which would then be responsible for the majority, if not all, banking and payment services that are currently the duty of commercial banks.
To earn large incentives from central bankers, a CBDC must operate on a direct model, eliminating the need for middlemen in the money generation process. Simply put, a direct approach would allow individuals to have direct bank accounts with the Fed that include their Central Bank’s digital currency. The central bank would then have complete control over all CBDCs in the private sector that is held in its CBDC account.
The direct iteration of a CBDC has several significant advantages and disadvantages. Commercial banks play a critical role in the world of direct central bank money. Such an environment would fundamentally alter the responsibilities and requirements of central banks and commercial banks.
While it would be costly and significant for central banks, some CBDC permutations may result in the central bank intermediating the commercial banking system in its entirety and assuming complete control over commercial banks’ obligations and responsibilities. From banking to loans, it’s everything there. This is a significant development that I will discuss in further detail later.
In an indirect (or two-tier) CBDC model, clients would deposit their CBDCs directly with a commercial bank, similar to how deposits are now used, with commercial banks continuing to function as middlemen between the central bank and consumers.
Business banks would be forced to deliver CBDC to clients on-demand, based on the reserves that commercial banks hold with central banks. This is comparable to how Central Bank reserves operate now and may not represent a substantial shift in the current financial infrastructure. Indeed, central bankers’ utility of the two-tier approach is largely contingent on the constraints and regulations placed on commercial banks’ ability to use CBDC reserves.
While this model would exempt central banks from the significant operational requirements associated with a direct CBDC, a two-stage model may not necessarily provide meaningful additional incentives to central banks if the goal of a CBDC is to enable central banks to provide direct stimulus without going through the commercial banking sector.
Infrastructure: Comparing distributed ledger technology to present banking technologies
While a CBDC may be founded on existing banking infrastructure or distributed ledger technology, this is unlikely to have a significant impact on how the CBDC works. While most discussions about CBDCs have focused on distributed ledger and blockchain technology, CBDCs can be built using the traditional centralized method for transactions.
Indeed, while true digital currencies (i.e. cryptocurrencies) are synonymous with decentralized distributed ledger technology, a CBDC that relies on a centralized database would remain functionally digital and exhibit characteristics comparable to present monetary systems. On the other hand, if the CBDC were to be used in a direct retail model, distributed ledger technology would be prohibitively expensive and impossible to operate.
CBDCs may be of interest
The viability of a CBDC is one of the most critical concerns that governments must address while developing their digital currency. The creation of a CBDC with an interest rate fundamentally affects the nature of money. While the majority of the world’s currency is composed of bank deposits and financial assets, money’s distinguishing feature today is that physical money is an interest-bearing instrument without an associated interest rate.
Establishing an account-based, direct, and stake-bearing CBDC to replace digital currency would be a political dream; it would unleash the floodgates of liquidity and monetary intervention, as we have seen thus far. For instance, if the central banker’s econometric models indicate that a negative 3% interest rate stimulates the economy, the CBDC’s interest rate support would instantly and selectively permit the implementation of such monetary policy measures.
Such direct incentives are simply not possible now, as long as the commercial banking sector serves as an intermediary between monetary and actual economic policy. Central banks’ ability to attach a CBDC interest rate has significant implications not just for monetary policy functionality, but also for how consumers and people see the money. The next sections discuss these impacts in further detail.
Regardless of the specific technology, infrastructure, or type of CBDC that central banks worldwide eventually introduce, it is critical to recognize that CBDCs are ultimately programmable money, allowing policymakers to control the terms and conditions of that money in ways that are simply not possible today.
Why are CBDCs required?
As I previously stated, central banks are establishing digital currencies for a variety of reasons, the primary one being more power and a broader range of monetary policy instruments available to central bankers and policymakers via CBDCs.
This is perhaps the finest weapon for ever-increasing manipulation and meddling in the economy in a world with CBDCs of interest. As with any incentives available to policymakers, there will be benefits and drawbacks. By actively controlling the CBDC’s interest rates, central bankers can charge varying interest rates on CBDC deposits to diverse persons. This is where a CBDC based on account or identity provides central bankers with a valuable weapon.
By examining previous individual and business spending and saving behavior, policymakers can offer anyone who has historically saved more than they spent a lower interest rate or a negative interest rate in the goal of stimulating consumption and generating economic development. Interest rates and stimulus are likely to be influenced mostly by the political agenda, in conjunction with ESG and populist considerations.
Indeed, to address the developed world’s demographic issue, a CBDC with interest rates might be used to reward younger savings while penalizing wealthy retirees. This effectively becomes a tax on those who are less eager to spend and has a slew of consequences. Indeed, a CBDC based on interest and identity would enable central bankers to tailor results to specific individuals. Additionally, the CBDC cannot implement such targeted monetary policy actions only through interest rate changes.
A direct CBDC enables governments to create legitimate currency. For businesses that have historically struggled to obtain credit during times of crisis as bank lending requirements tighten, the central bank can simply inject additional units of CBDC directly into the company’s CBDC account.
This is a direct incentive in its purest form, one that can be obtained only through the introduction of CBDCs. The impulses supplied by CBDCs are much too pervasive to ignore in an economy whose basic drivers of development such as demographics continue to be unfavorable, fueling the disinflationary trends that have prevailed over the previous four decades.
With the productivity of debt and the speed of money remaining at their lowest levels in over 70 years as a result of increased debt in search of stimulation, central bankers are doing everything possible to reverse that trend. It is naive to assume they will not at least experiment with CBDCs, particularly in more democratic countries such as the USA.
However, a digital government currency gives policymakers additional incentives. Indeed, in extreme cases, individuals’ CBDC holdings may be subject to expiration dates to increase expenditure. CBDCs give policymakers and central banks the ability to deplete their reserves. This is a powerful and terrifying instrument. Direct stimulation enables policymakers and central bankers to make political judgments in ways that traditional monetary and fiscal policies cannot.
What has become clear to me during my study of the Central Bank’s digital currencies is that the negative effects of their acceptance are likely to outweigh the advantages. The implications of the adoption of CBDCs could be wide-ranging and serious, ranging from changes like money to the possibility of unlimited liquidity being directly injected, how a CBDC would affect the banking system, the implications for the dollar’s status as the world’s reserve currency, and privacy concerns and the potential for power abuse.
As I have stated, CBDCs provide policymakers with unprecedented monetary intervention and economic effect capabilities that are much beyond those available now through monetary and fiscal instruments. While today’s “unconventional” monetary policy has undoubtedly impacted asset prices via monetary debasement, CBDCs have the potential to produce truly persistent consumer price inflation.
This will alter the degree of market functioning that a capitalist economy has historically provided, while completely altering price signals for market participants. Certainly, there would be further inefficiencies, and a dearth of economic devastation. While the benefits of a digital government fund look appealing at first glance, these stated benefits are very certainly illusory and much surpassed.
Potential for Inflation
Cryptocurrencies In the truest sense, the central bank enables the generation of limitless money. By removing banking limitations, central banks can opt to grow CBDC deposits at their discretion for any or all individuals, as I have stated. Restriction on this ability to generate real money will inevitably result in inflation.
Lacy stated in a recent podcast with Grant Williams in conversation with the excellent Lacy Hunt about the potential introduction of CBDCs: “If a government digital currency is implemented, it would be a significant infringement on individual liberty to be able to track and manage everyone’s financial records.” A US CBDC would render the Federal Reserve a colossal failure in the money printing business.
The money would lose its value as soon as the money illusion faded and Gresham’s rule triumphed. CBDCs believe that financial transactions produce wealth and money rather than hard work, innovation, and income conservation.
Consequences for the financial sector
Whether CBDCs are introduced in addition to bank deposits or to entirely replace existing fiat currency, and how CBDCs are used by central banks to give direct incentives that circumvent the banking system by default, substantial repercussions for the banking industry are predicted.
CBDCs replacing existing fiat money would have the most severe impact on the commercial banking system in this scenario. If consumers are fully integrated into the CBDC system, the banking industry will lose a significant amount of deposits and liquidity. There are two consequences here: commercial banks’ deposit base would dwindle, and the state sector’s lending function would be transferred to the private sector.
Commercial bank creation is insufficient in the United States, whether due to a lack of demand for new private-sector credit or to commercial banks’ reluctance to lend to the general public. Credit creation in the private sector remains the purest and effective method of money generation in today’s society.
Due to the absence of private sector credit expansion, the commercial banking system is now incapable of assisting economic growth and stimulating the economy through support for the Federal Reserve. Along with the increase in commercial bank lending seen in the table above, this trend can be seen in the commercial bank credit/deposit ratio, which has been falling for over two decades, as has the speed of money.
This is critical since the increase in bank credit and supply are the primary drivers of productive economic expansion today. If commercial banks provide deposits to a CBDC system rather than central banks, central banks and policymakers are responsible for lending and loan creation. As things are currently, central banks lack lending experience and are therefore unqualified to perform these functions.
By adopting a CBDC, however, it becomes completely the duty of central bankers to allocate liquidity, credit, and money productively, which ultimately leads to a centrally planned economy. As desirable as this scenario may seem, officials would make their judgments based on the political agenda. To do this, governments must be more efficient than the private sector in money creation and capital deployment. If CBDCs are formed in combination with the existing commercial banking system, these negative effects for banks and money creation are mitigated, but other concerns remain.
To begin, a CBDC-bearing interest rate would directly compete with bank deposits. This would establish a floor for bank deposit rates based on the rate offered since banks would be forced to provide a higher rate to attract deposits. If banks provided a rate lower than their competitor CBDC, we may see banks withdrawing and depositing money in their CBDC accounts, generating severe liquidity problems for the banking system.
However, for this to occur, the CBDC and current fiat monies must be fungible, which is highly implausible, as I have said. If such were the case, it would be prudent to impose a cap on individuals’ CBDC accounts. CBDCs, on the other hand, are capable of completely upgrading the financial system as we know it. CBDCs have the potential to give governments near-complete control over the monetary system as a whole.
Central Bank The scope and impact of digital currencies are undeniably significant. Individuals must nonetheless comprehend how the money will be reengineered. CBDCs, as we all know, have the potential to revolutionize the financial system and money. From computerized monitoring to unfettered direct stimulation, the arrival of CBDCs appears to be imminent, and the playing field is changing.