Debate swirls in monetary policy circles over whether, how, and when to introduce central bank digital currencies. This debate has strong resonance to earlier crossroads in monetary history when major transformations took place. In today’s crossroads, advances in technology—digitalization—have led to the development of new forms of money. These include virtual (crypto) currencies like Bitcoin, stable coins like the Facebook-sponsored Libra/Diem, and central bank digital currencies (CBDC) like the Bahamian Sand Dollar. Today’s innovations resonate with earlier major shifts in monetary history, and here I will examine the case for central bank digital currency through that lens.
My overview of the history of monetary transformations suggests that technological change in money is inevitable and driven by the financial incentives of a market economy. Government has always had a key role in the provision of currency (outside money), which is a public good. It has also regulated inside money provided by the commercial banking system. This held for fiduciary money and will most likely hold for digital money.
Monetary transformations in history have been driven by changing technology, changing tastes, economic growth, and the demands to effectively satisfy the functions of money. Money (and finance) has evolved with human history. Three historical transformations set the stage for the current digital transformation:
- First, in the eighteenth and nineteenth centuries, new financial technology led to the advent of fiduciary money (convertible bank notes) which greatly reduced the resource costs of specie. In addition, the exigencies of rising costs of war finance in the early modern era led to the issue by governments of inconvertible fiat money. CBDC, as a social saving over fiat money, promises to be the next generation in this progression.
- Second, the early record of poorly regulated commercial banks issuing notes, ostensibly convertible into specie, has been used to make the case for government regulation of commercial banking and for a government monopoly of the issue of notes. The record of free banking in the United States displayed considerable instability. The high asymmetric information costs of a multiple currency system created an inefficient payments system. In all these cases, the note issue eventually gravitated towards a central bank/government monopoly. The present-day rise of cryptocurrencies and stable coins suggests that the outcome may also be a process of consolidation toward CBDC.
- Third, central banks in the seventeenth to twentieth centuries evolved to satisfy several important public needs: war finance; an efficient payments system; financial stability; price stability; and macro stability. CBDC could follow in this tradition.
The basic case for CBDC, defined as an asset in electronic form that serves the basic functions of paper currency—with universal access and legal tender—can be traced back to the classical economists’ argument that currency is a public good that would appropriately be provided by the government. CBDC would satisfy the basic functions of money as a unit of account, a medium of exchange, and a store of value.
Several key factors are driving interest today in CBDC:
- First, CBDC would be the twenty-first-century version of Adam Smith’s social saving of fiduciary money by reducing the costs of issuing and operating physical currency (between 0.5 and 1.0 percent of GDP) and by reducing the monopoly rents earned by the commercial banking system.
- Second, digitalization already has greatly reduced the use of cash in several countries, for example, Sweden and Norway. CBDC would provide a payment medium that has all the attributes of physical cash but is less subject to theft and loss.
- Third, CBDC would increase financial inclusion for disadvantaged groups that do not have access to bank accounts.
- Fourth, CBDC may head off the threat to monetary sovereignty from stable coins issued by global digital-services companies like Facebook, which would threaten central banks’ ability to conduct monetary policy.
- Fifth, CBDC would provide a secure, reliable currency, free from the dangers of fraud, hacking, money laundering, and financing terrorism.
Implementation of CBDC raises a number of important questions about its design that have been examined closely by central banks. One issue is the choice of retail versus wholesale CBDC. Significant improvements in the wholesale-payments clearing mechanism suggest that the key issue is retail CBDC. Here the public-good aspect of currency provides a strong rationale for either direct provision or at least close regulation and supervision by government. Accounts at the central bank are eminently feasible, but the private sector has a comparative advantage at financial innovation. Hence, in advanced countries a public-private arrangement may be preferable. Designated institutions could offer CBDC accounts to the public or serve as conduits for the central bank.
CBDCs that are a most secure direct liability of the central bank could lead to disintermediation and runs from the commercial banking system. But research suggests that disintermediation could be offset by central-bank balance sheet policy, by restricting CBDC holdings, or by tiering interest rates on CBDC and non-CBDC accounts. Moreover, central banks have adequate lines of defense to deal with runs.
CBDC would improve monetary policy. Researchers have argued that interest paid on CBDC could improve the transmission mechanism, especially the lending channel. It would also reduce and simplify central bank balance sheets and move us back toward a bills-only policy. Using the interest rate on CBDC as the policy rate could allow central banks to move from the current “floor” system back to a “corridor system.” In this working paper, my co-author Andrew Levin and I argue that allowing the interest rate on CBDC to go negative, along with incentives to reduce cash holding, would eliminate the effective lower bound (ELB) as a constraint on monetary policy. We also argue that interest on CBDC could be used to foster true price stability. Finally, paying interest on a CBDC could be used to improve the lender-of-last-resort function and financial stability.
CBDC would have very important implications for the open economy. It could greatly improve cross-border payments; with digitalization, payments could be almost instant. It would create a social saving similar to the first transatlantic cable in 1866. Some stable coins promise to arrange peer-to-peer payments through their established networks. Were stable-coin providers to dominate these arrangements, they could threaten monetary sovereignty and also be subject to credit risk. This makes the case for CBDC or some regulation. But sovereign CBDCs would need to make arrangements for interoperability with their foreign counterparts.
Also, a system of CBDCs that closely linked together the monetary and payments systems of different countries could lead to an amplification of the spillover effects of domestic monetary policy on other countries. Moreover, CBDCs and stable coins could lead to currency substitution, which could affect the monetary sovereignty of state-owned enterprises, especially those with weak monetary and financial institutions. Effective currency competition could occur because of the ability of stable coins to separate the functions of money. Indeed, stable coins could challenge dollar dominance because of the superiority of their networks.
However, currency competition from private platforms could run into the problems of interoperability and coordination that plagued multiple competing currencies in the nineteenth century. Like them, information asymmetry would make the case for CBDC. A system of interconvertible CBDCs would eliminate the imperfect substitutability of private digital currency.
Four key lessons follow from history on the case for central-bank-provided digital currencies:
- Financial innovation is inevitable, and driven by the financial incentives of a market economy.
- Government has a key role in the provision of money. Outside money is a public good which it is necessary for the central bank to provide. This holds for both fiat money and digital money. The ability to issue it depends on the credibility of the issuer. If that falters, currency competition from other CBDCs or stable coins will erode monetary sovereignty.
- Interest-bearing CBDC could improve the transmission mechanism and transparency of monetary policy. It could greatly simplify central-bank balance sheets. Moreover, CBDC could revolutionize monetary policy if the interest rate on it is used as the policy rate.
- CBDC is a global innovation. It could transform international payments, as the first transatlantic cable did in 1866. It could also exacerbate currency substitution and require international monetary cooperation. CBDC and stable coins could also challenge the international monetary system. The fundamental forces leading to currency domination are unlikely to change, but digitalization could accelerate shifts driven by them, as occurred in the twentieth century when the dollar eclipsed the pound.
Digitalization in money may promise to be the future. Central banks could learn the lessons from history and provide digital currency to effectively fulfill their public mandates.