As if central banks' powers and balance sheets haven't grown quite enough since the outbreak of the subprime crisis, we've been hearing more and more calls for them to expand their role in retail payments, by supplying digital money directly to the general public.
Some proposals would have central banks do this by letting ordinary citizens open central bank accounts, while others would have them design and market their own P2P "digital currency." Either sort of central bank digital money would, the plans' supporters claim, be just as convenient as today's dollar-denominated private monies. But central bank digital money would also have the distinct advantage of being just as safe as paper money.
Earlier this week the FT's Martin Sandbu jumped onto the central bank "ecash" bandwagon, in an article prompted by the recent disruption of Visa's European payments network. That disruption, Sandbu wrote, supplied "one of the strongest considerations in favour of introducing official electronic money."[1]
Sandbu's argument is just one of many that have been offered for allowing central banks to supply ecash. But it's representative of the rest in at least one crucial respect: like them, it may seem solid enough at first glance. But upon closer inspection, it turns out to be full of holes.
Central Banks and Computer Glitches
Absent a crisis of confidence, the most likely causes of a private payments system disruption are (1) hacking and (2) a software or hardware breakdown. It appears that a computer hardware failure was to blame for Visa's European troubles, although hacking was suspected at first.
Payments systems operated by central banks are similarly dependent on computer hardware and software, and are for that reason also vulnerable to both hacking and equipment failures. That's the first — and far from trivial — flaw in Sandbu's argument. Within the last two years, for example, hackers have used malware to steal millions from the central banks of Russia and Bangladesh. In the latter case the money came straight out of the Bangladesh Bank's account at the New York Fed. Had it not been for a stroke of good luck, the bank's losses — $101 billion, about a third of which was eventually clawed back — would have been far greater. During the same period hackers also managed to plant a digital "bomb" into the software of the Saudi Arabian Monetary System. Back in 2014, a computer failure at the Bank of England held up thousands of payments, including many by persons trying to close on new homes. So much for the perfect safety of central bank digital money.
If all electronic payments systems are vulnerable to computer-related failures, is there any way to protect oneself against them? In fact there are at least two ways. One is to avoid putting all one's payments eggs in one basket, by keeping multiple credit cards and bank accounts, and by subscribing to PayPal or other independent payment service providers. Of course, keeping funds at a central bank would be another way to diversify, were it allowed. But with so many private-market options out there, it's absurd to suppose that people can't protect themselves from payment system glitches unless central banks themselves enter the electronic cash business.
The other option is to keep some good old paper money on hand. Moreover, that's the only option, apart from resort to barter, that would help in the case of a truly global electronic payment system breakdown, however that might happen. (A cosmic ray shower, perhaps.) But far from being an argument for having central banks enter the electronic payments fray, this far-fetched scenario is a good reason for having them to stick to supplying paper money.
A Flight to E-Cash?
Besides claiming that central bank ecash would protect its holders from the risk of a payments-system breakdown, Sandbu suggests that it would "force a move towards higher reserve requirements for banks," and perhaps even toward full-reserve banking. Allowing central banks to supply digital money to the general public could, in other words, lead spontaneously to the same outcome proponents of the Vollgeld initiative are hoping to achieve in Switzerland by means of next week's referendum. This would happen, Sandbu says, because the public's ready access to such cash would result in "a massive flight from deposits to safer official money." To allow for this contingency, without having to resort to massive last-resort lending, central bankers would have to see to it "that banks hold enough reserves for the purpose up front."
Most people would consider a policy change that's capable of triggering massive bank runs a bad idea. But so far as Sandbu is concerned, increasing the likelihood of such runs is just a convenient way to put paid to fractional-reserve banking, of which he evidently disapproves. Like most critics of fractional-reserve banking, he doesn't say who will supply the credit commercial banks can no longer offer once they convert to a full-reserve basis. Also like them he appears to appreciate neither the synergies between deposit taking and lending that account for their coexistence since the beginnings of banking nor the fact that, if fractional reserve banking systems sometimes appear fragile and unstable even when not threatened by direct competition from central banks, we often have other misguided bank regulations (including under-priced government guarantees) to thank for it.
But would the mere appearance of central bank ecash really provoke "a massive flight from [private bank] deposits"? It's true that, so long as they aren't promising to peg their currencies to some other national currency, central banks can't default: to break a promise, one has to make one in the first place. But given the widespread presence of deposit insurance, and the fact that certain banks are considered Too Big To Fail, most readily-transferable commercial bank deposits (the sort for which ecash is a close substitute) are either explicitly or implicitly insured. Of approximately $12 trillion in U.S. demand deposits, for example, just over $7 trillion are insured, while much of the remainder consists of deposits held at the very largest U.S. banks.
It follows that, if there's to be a massive switch from from commercial bank deposits to central bank ecash, it will have to be inspired, not merely by that alternative's safety, but by its other features, including its convenience and interest return.
Central Banks Make Poor Competitors
Might central bank ecash dominate privately-supplied alternatives along these other dimensions? It might, but only if central banks cheat.
Let's start with interest. Commercial banks' main business consists of attracting deposits and figuring out how to invest them profitably. Competition compels them to seek high risk-adjusted returns (or, if they're Too Big to Fail, to seek high returns regardless of risk), and to share those returns, less their overhead and operating expenses, with their depositors. Central banks, in contrast, are not supposed to be looking out for high returns. Instead, their assets typically consist of relatively safe and low-yielding securities, high-grade commercial paper, foreign exchange, and gold. To the extent that central banks extend credit, they extend it (with occasional, and often controversial, exceptions) to financial firms only, not to earn a profit, but to secure financial stability. It's owing in part to this crucial difference between central and commercial banks that any public substitution of central bank money for commercial bank money is likely to result in a decline in total lending.
Most monetary policy experts would not want to change these limitations on central banks' ability to profit by their investments. Nor do I suppose that Mr. Sandbu is an exception. After all, to the extent that central bank portfolios resemble those of ordinary commercial banks, they cease to be particularly safe institutions; and even if holders of their liabilities are not themselves directly exposed to the risks they take, taxpayers are. Allowing central banks to emulate commercial banks, not only by being able to supply digital money to the general public, but by taking on similar risks, would defeat the purpose of having them serve as suppliers of uniquely safe exchange media. In the limit, so far as transferable deposits are concerned, it would mean having a single, TBTF commercial-qua-central bank instead of today's mix of TBTF and not-TBTF commercial banks. If that sounds like an improvement to you, you're not thinking hard enough.
If they're to avoid excessive risk taking, on the other hand, central banks can only manage to pay competitive returns on their ecash in one of two ways. They can operate so much more efficiently than commercial banks that they are able to more than compensate for their lower-yielding assets, or they can take advantage of their monopoly rents to subsidize their ecash business. The first possibility is far-fetched. The second isn't. But as it amounts to a form of predatory pricing, the effect of which would be to drive central banks' more efficient private rivals out of business, permitting it would be entirely contrary to the public's welfare.[2]
If neither the safety nor the return on central-bank supplied ecash is likely to convince droves of bank depositors to switch to it, central banks might still encourage them by making their ecash easier to transact with than private substitutes. But this, too, is a tall order. Central banks have no experience in retail payments or in otherwise dealing with the general public: even the paper currency they produce is supplied to bankers only, who see to its retail distribution. Central bankers would therefore have to build their retail experience and facilities, whether online or brick-and-mortar, from scratch. In the meantime, they'd be competing head-on with commercial banks and other firms long and aggressively engaged in the business. Here again, the prospects for success seem dim, unless central banks resort to cross-subsidies to fund product-quality improvements, thereby gaining market share at taxpayers' expense.
A Conflict of Interest
In suggesting that central bankers will find it difficult to out-compete commercial bankers unless they cross-subsidize their retail products, I am of course assuming that commercial banks and other private payment service providers will themselves remain as capable as ever of making their own products attractive to the public, by offering relatively attractive returns or otherwise.
Regulations can, however, severely limit the attractiveness of private monies, thereby making potential central-bank supplied ecash appear relatively more attractive. Examples of such regulations include high reserve requirements, other bank portfolio requirements, and usury laws. By making such regulations onerous enough, regulators could slant the digital-money playing field in central banks' favor, thereby overcoming central bankers' inherent disadvantages to usher in Sandbu's ideal of a world in which central bank ecash is king.
But far from making Sandbu's proposed reform appear more promising, the possibility in question supplies another reason for viewing it as a very bad idea. That's because central bankers are among the regulators of private digital money suppliers. For that reason, allowing them to compete with such suppliers creates a conflict of interest, posing the risk that central banks' regulatory actions will be influenced by their desire to preserve or enhance their share of the market for digital money.
Hello, Central Bank E-Cash; Goodbye Payments Innovation
Finally, Sanbu, like many other boosters of central-bank ecash, blithely overlooks the chilling effect his proposed reform could have on future payments innovations. That we have private sector innovators to thank for the very existence of electronic money, starting with Western Union's first telegraphic wire transfer in 1871, is (or ought to be) well known. We have them to thank as well for just about every other payments innovation, from checking accounts and lines of credit to ATMs, debit cards, PayPal, and cryptocurrency. For that matter, paper money itself appears to have been a private innovation, in China first of all, and much later in Europe, where London's goldsmiths were issuing "running cash" notes more than a decade before the Bank of Sweden and Bank of England entered the market, which they later took over with the help of legislation that forced other banks to quit the business. How many of these private-market innovations would have happened had the innovators known that they were competing head-on with central bankers who might replicate their innovations whilst resorting to cross-subsidy financed predatory pricing to beat them at their own game?
There's more than a little irony in proposals like Sandbu's that would reward private sector payments innovators for their successful payments innovations by allowing central banks to employ those very innovations to assume a monopoly of retail payments. But irony is the least of it: the plan runs a very grave risk of putting the kibosh to future, desirable payments innovations. After all, once their monopolies of ecash are established, and assuming that they can resort to cross-subsidies to keep them, central banks will be under no competitive pressure to innovate. So while the prospect of their monopolizing retail payments today, using today's leading-edge digital payments technology, may not seem all that unappealing, the prospect that they might go on employing roughly the same technology a century from now is considerably less so. Yet the possibility can't be lightly set aside.
Paradoxically, appointing more innovation-inclined central bankers won't necessarily help. Innovation is risky; indeed, it's so risky that innovations fail more often than they succeed. When that happens in the private sector, the costs are born by the owners of the innovating firms. But when it happens in government (or quasi-government) agencies, taxpayers end up footing the bill.
All this is of course mere theory. But if you need empirical evidence, consider the U.S. Postal Service's attempts at innovation, including its attempts to pioneer e-mail. Perhaps central banks will somehow avoid the challenges that ultimately scuttled the USPS's efforts. But I wouldn't bet money on it.
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[1] Sandbu has since been joined at the FT by Martin Wolf, who first endorses Switzerland's Vollgeld Initiative, and then suggests that allowing "every citizen to hold an account directly at the central banks" would work just as well. The Economist also endorsed the plan recently, prompting this rejoinder by Scott Sumner.
[2] The interest rate paid by the Fed on bank reserves has itself typically exceeded corresponding rates on short-term Treasury securities, thanks to its holdings of higher-yielding long-term securities, and hence to its having taken on considerable duration risk. Otherwise the Fed would presumably have had to subsidize those interest payments using seigniorage revenue from its currency monopoly.
[Cross-posted from Alt-M.org]