Digital currencies: the ultimate stimulus measure for central banks?

From Macroeconomics to Investments Focus point - December 2018

The President of the American Central Bank loves allegories. You need to advance cautiously in a dark room he declared recently, especially when you are barefoot. A rather intriguing, somewhat worrying statement of Jérôme Powell: so apparently, the Fed would be fumbling in the dark ... it does not have more visibility on growth than us, poor economists scrutinizing signs of economic downturns which could spell turmoil to financial markets? Good Lord ! And what's more, she walks with no shoes on? Beware of the pitfalls ! Actually, the good news of this reduced-sighted approach to US monetary policy is that it should spare us one, possibly two, interest rate increases of the three scheduled for next year.

On topics like the Blockchain, Bitcoin, digital currencies and other crypto-currencies, I also have the impression that we are advancing in the dark and ... the ensuing groping brings some confusion along.

First confusion: that between the Blockchain and the crypto-currencies, with the Bitcoin in the lead. I have stopped counting the meet-ups on crypto-finance where the speaker has to make clear again and again that Blockchain is not Bitcoin. Well, the opposite is actually true: Bitcoin needs the Blockchain to exist, but the latter extends to many other uses, far from crypto-currencies. The certification of CV, deed of land ownership, personal health status are but few examples.

Confusion no 2: digital currencies are often associated with cryptocurrencies. Thus, the head of the IMF, Christine Lagarde, would have recommended - at a recent summit on the Fintech in Singapore - that countries engage fully in the adoption of cryptocurrencies ? Not quite, she talked about digital currencies! A clarification is needed.

Digital or crypto?

A digital currency is a substitute for coins and notes, with the same aim of facilitating transactions, in that exchanges cannot always take place between a hungry tailor and a cold baker. It has no physical existence but can be thought of as a traditional currency. It allows us to buy goods and services, even remotely, that is to say outside national borders. Whenever we buy goods from sites like Amazon, we use digital currency. Under certain conditions that we will see with the example of Sweden below, the digital currency can be thought of as a bank account.

A cryptocurrency is a variety of digital currency. So as with the confusion between Blockchain and Bitcoin, we can say that any cryptocurrency is a form of digital currency, but the converse is not true. Some consider cryptocurrencies to be more reliable than digital currencies because they rely on cryptographic technology that ensures the integrity of the data relevant to a transaction. While in a digital currency, security is provided by a central authority (State or Central Bank), in the case of a cryptocurrency, it is the validation by a decentralized network which ensures security.

To be true, the boss of the International Monetary Fund is rather cautious with regard to cryptocurrencies. If we remember the etymological origin of the word "crypto" (hidden) ... the opposite would have been surprising. Christine Lagarde warns countries against any attempt to fully trade their national currencies for cryptocurrencies: their use for criminal purposes and the lack of control of a central authority make them potential sources of financial instability.

Why are Central Banks interested in digital currencies ?

Several central banks are seriously considering the creation of a digital version of the currency ("Central Bank Digital Currency" or CBDC). These include the Central Bank of Canada, China and Sweden.

I am particularly interested in the case of Sweden. The starting point made by the oldest Central Bank in the world is a cristal clear observation: over the 350 years of its existence, the Riksbank has never seen such a low share of cash in the payments of the residents and tourists in Sweden. While coins and banknotes accounted for 4% of Sweden's GDP 20 years ago, the proportion has fallen to less than 1% today. Some stores in Sweden even today show their refusal to accept cash. Faced with this heavy trend towards a cashless economy, the Riksbank is seriously studying the possibility of introducing an "e-krona". This digital currency would take a dual form: a "value" currency, downloadable via an application on mobile phone and a "account" version which would require the opening of an account at the Central Bank.

The Central Bank makes no bones about the objective it is pursuing with this digital shift: it wants to regain control of the payment system which is now in the hands of private players. This raises the question of whether control by a central authority of the transaction makes it more secure than resorting to Blockchain's inalterable technology. Just like the key issue of who is to manage the total amount of cash available in an economy, and how.

Beyond the need to provide means of payments that avoid the return to barter, the ultimate goal of any monetary creation is that it is in line with economic growth. If the former exceeds the latter, inflation rears.

Digital currency in its "value" form is like a cryptocurrency, except that it is controlled by a central bank. Here, it is the consumer who is king and it is therefore the demand for money for transaction purposes that guides the system. Could it be that one day money creation is excessive? We can not exclude it. How to stop this excessive demand for cash? The Riksbank has no answer yet.

Things are clearer on the "account" version of the digital crown. Yes, it will be necessary to revise the mandate of the Central Bank, for it will have to open as many accounts as there are individuals interested by this currency. Here, the Central Bank finds its usual levers towards adjusting the amount of money available in the system by playing on the price of this currency, namely the interest rate. And this is where things get interesting.

I was recently taken by a statement of a member of the Executive Board of the European Central Bank. For him it is clear, the ECB will not have finished normalizing its balance sheet when the next recession hits the euro zone. A key question then arises: if interest rates are close to their floor at the time of the next crisis, does the ECB take the risk of running out of ammunition when the stimulus is needed?

But what floor are we talking about? The threshold of 0%? Have we not seen the SNB, the ECB, and the Riksbank and a few other central Banks put interest rates in negative territory? Yes but ... without too much abuse. Given the outcry that this policy has caused among banks and their customers, it is difficult to consider having interest rates lower than 1% lastingly.

Unless ... cash has vanished altogether and there are only digital currencies around you? That day, how will you go about withdrawing your cash from your bank account to put it under your mattress or in your trunk in order to escape the negative interest rate tax?

Digital currency may well be a weapon of "massive reconstruction" when it comes to getting a country out of recession. But ... putting interest rates at minus 2% in the Eurozone as suggested by the Taylor rule in 2008, or even minus 10% in countries like Greece as the chart below suggest... is this not a wonderful example of financial repression?

The Taylor rule provides an estimation of where key interest rates should be, depending on deviations of output from full employment and inflation from the objective of the central Bank.

Prof. Michel Girardin Partner

MacroGuide Ltd [email protected]