A staff working paper written for the Bank of England postulates that central bank issued digital currency (CBDC) of 30% of GDP could permanently raise GDP by as much as 3% from lower real interest rates, taxes and monetary transaction costs, according to a recently published paper. The CBDC would be issued against government bonds.
The paper, “The macroeconomics of central bank issued digital currencies” by John Barrdear and Michael Kumhof, examines the macroeconomic impact of a central bank issuing electronic, national-currency-denominated and interest-bearing access to its balance sheet by the issuance of CBDC. The bank used a financial model matching the United States in the pre-crisis period. Bank deposits are created in this model through asset purchases and loans.
Banks have become interested in digital currencies after observing private digital currencies offering access to an alternative unit of account ruled by a set money supply. Bitcoin is the first and largest such system.
Technology Makes It Feasible
A CBDC monetary regime has not existed, the paper noted. One reason is that the technology to make it feasible has not previously been available. Hence, there is little history to shed light on the costs and benefits of such a regime or to determine ways monetary policy can be conducted under such a regime.
The authors, therefore, used a theoretical model to study these issues.
The model postulates an initial CBDC stock equal to 30% of GDP issued against an equivalent amount of government debt. The plan chose 30% since it is similar to the magnitudes of quantitative easing conducted by central banks in the last 10 years.
The CBDC regime delivers several beneficial effects. It delivers a gain in steady-state GDP level of around 3% from lower real interest rates, transaction costs and distortionary tax rates.
A CBDC regime can add to the business cycle’s stabilization by providing policymakers access to a policy instrument that manages the price or the quantity of CBDC. A second policy instrument could help respond to shocks to private money creation.
A concern exists over the proper management of risks associated with transitioning to a new financial regime.
Monetary aspects of private digital currencies are not favored by policymakers, the paper noted, but the payment systems of such schemes have aroused their interest.
It would not be possible technically to deploy a distributed payment system that stays denominated in a traditional currency. This begs the question of whether it would be socially beneficial, which is the question the paper addresses.
A Role For Private Money
The model assumes an economy with a single, government-defined unit of account. The model includes private money in the form of bank deposits maintaining a 1-to-1 exchange rate with government money.
The majority of transaction balances under the model are held as deposits with commercial banks. Commercial banks continue to create the marginal unit of money in the economy.
The use of distributed ledgers is not required to operate a CBDC system, the paper noted, but it is necessary as a practical matter to ensure the resiliency of a system that is important to the economy’s financial stability.
The central bank could set the interest rate paid on CBDC, and it could permit the private sector to determine its quantity by buying and selling CBDC in exchange for defined asset classes. It could also set the quantity of CBDC and permit the private sector to bid the CBDC interest rate up or down until the market clears.
Risks Versus Benefits
An important question in any major monetary reform such as the introduction of a CBDC regime is whether the benefits of the transition justify the risks.
Another concern is the possibility of a run from bank deposits to CBDC.
The model’s calibration is such that minimum capital adequacy requirements, along with voluntary buffers that banks add to avoid the penalty for breaching them, will make deposits secure. It removes a major reason for a run on deposits, and for risk-driven increases in bank funding costs that could affect lending rates.
A CBDC regime would also retain deposit protection for bank deposits, making it unlikely there would be an incentive for a systemic run.
Improved Payment Resiliency
CBDC would also increase payment system resiliency compared to existing payment systems, the paper noted, since users will have an additional alternative in case one system fails, and because the supporting technology would deploy a distributed architecture.
One financial stability risk in attempting to deploy the CBDC regime is mismanaging the transition to an untested monetary and financial environment. For this reason, policymakers have to conduct due diligence before deciding on the transition to a CBDC regime. If due diligence found the transition risks to be manageable, a CBDC regime could be considered a serious option on account of the benefits.
Central banks and private financial institutions are both exploring the emergence of digital currencies and distributed ledgers since the technology may present an opportunity to improve the resiliency, efficiency and accessibility of systems that facilitate financial and monetary transactions. But there are problems with private versions of such currencies, the paper noted.
Private Cryptocurrency Issues
The problems with private cryptocurrencies are not associated with distributed ledgers in general, but with their high costs of transaction verification.
Alternative implementations, like “permissioned” systems, may circumvent these costs by moving away from strictly decentralized designs while retaining many of the benefits. One application of such a system would be the issuance of a CBDC, a national-currency-denominated and interest-bearing access to a central bank’s balance sheet.
The CBDC offers some clear macroeconomic advantages, with few large costs, the paper concluded. The advantages include steady state output gains of almost 3% for an injection of CBDC equal to 30% of GDP, as well as gains in the effectiveness of systematic or discretionary countercyclical monetary policy.
The analysis indicated the only conditions needed to secure the gains are a sufficiently large stock of CBDC issued in a steady state, and an issuance mechanism to ensure the central bank only trades CBDC against government debt instruments.
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Questions To Consider
Important theoretical questions to consider for the future include:
• What are the welfare properties of alternative CBDC policy rules, including interaction with traditional monetary policy rules, macroprudential policy rules, and fiscal policy rules?
• Should CBDC policy rules react to financial variables rather than to inflation?
• What are the pros and cons of introducing CBDC into the economy through spending (on goods/services and/or transfers), lending (directly or through the banking system), or the purchase of financial assets, including not only government bonds but also other financial assets?
• Which of these would best safeguard financial stability?
• How might CBDC issuance interact with the unwinding of quantitative easing?
• What could the impact be of CBDC on global liquidity and exchange rate dynamics?
• How might the CBDC introduction affect the likelihood of a bank run when bank deposits carry default risk, or the dynamics of a run should it occur?