Life after Quantitative Easing

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Digital currencies could be a powerful tool for central banks, but there are risks

The last ten years have seen central banks use every weapon in their arsenals, and invent new ones, as they fought the ravages of the financial crisis. Pessimists fear there is nothing left if crisis strikes again. But others believe the issuance of digital currencies could restock their arsenals and give them unprecedented control over economies and markets.

On the eve of the financial crisis central banks seemed to be all powerful. Banks like the Federal Reserve, the European Central Bank and the Bank of England had inflation under control and presided over extended periods of growth, having easily navigated potential banana skins such as the dotcom bubble.

Today, even the most powerful central banks have found their influence on markets is waning as interest rates have trended towards zero or negative. With little room for further cuts, and many economies still too sickly to be subjected to significant rises, they have been left with a dwindling choice of tools with which to steer economies. Debates continue to rage about the effectiveness of quantitative easing (QE), but few want to see these extraordinary measures continue indefinitely.

Unprecedented control

The introduction of central bank-issued digital currencies (CBDC) promises to be a game-changer for central banks. But if and when it happens, it will be a highly complex and disruptive process. Until a major economy actually tries it nobody can be sure to what extent those benefits will materialize, or what unintended consequences there might be.

Issuing digital currencies promises to restock the central bank toolbox with something far more sophisticated than anything they have had before. There is almost no limit to the potential flexibility of digital currencies, which could be programmed in ways that further improve the efficiency of digital quantitative easing. It could give central banks unprecedented control over the economy.

Through their central banks, governments could manipulate digital money to pursue specific social or economic policy objectives, such as discouraging certain behaviours.

This control could be used in a number of ways. Countries like China, that are experiencing capital flight, would be better equipped to manage that problem. But governments, through their central banks, could also manipulate digital money to pursue specific social or economic policy objectives, such as discouraging certain behaviors.

In a more dystopian vision of the future, CBDC’s significant implications for individual liberty could throw up political challenges. That has already been demonstrated by India’s problems implementing the first steps towards currency digitization in the planned abolition of large rupee notes.

Imposing a “carry tax” by programming the currency to devalue over time would encourage spending, increasing the velocity of money and stimulating inflation and growth. It would also be easier for central banks to collect comprehensive information about exactly how money is spent, giving them a much better understanding of their economies and perhaps improving their ability to predict crises.

Tackling too-big-to-fail

Digital currencies might help large economies solve the persistent problem of too-big-to-fail (TBTF) banks by creating a direct link between central banks and large corporates. QE was supposed to allow central banks to pump money into economies to stimulate economic activity, but critics complain that too much of that capital has disappeared into bank balance sheets. By disintermediating the banks and providing money directly to corporates, central banks could use digital currencies for a new and improved version of quantitative easing that did more to stimulate economies.

And of course introducing digital cash that ran in parallel with paper money could be a first step to the eventual abolition of physical cash as we know it. This would give central banks greater monetary policy flexibility, in particular making negative interest rates more effective by removing the option to hold cash without depositing it in banks. It would also make it easier to collect taxes, and fight crime.

Many central banks understand these possibilities: the Bank of England, Bank of Canada and Sweden’s Riksbank have all written about the possibility of issuing digital currencies. It is also possible an emerging markets central bank could be the first to issue CBDC, having less legacy infrastructure that would be made redundant, and a more urgent need for new and efficient systems.

Advantages outweigh costs

In a Bank of England working paper, authors John Barrdear and Michael Kumhof concluded that while more work had to be done to assess the feasibility of issuing digital currencies, the advantages appeared to outweigh the costs.

Canada went a step further by announcing it will actively experiment with digital currencies and distributed ledger technology, in partnership with R3 and Payments Canada. It plans to build a rudimentary wholesale payment system to run experiments in a lab environment, including a simulated settlement asset – digital currency – used as a medium of exchange within the system.

The Bank of Canada is building a rudimentary wholesale payment system to run experiments in a lab environment, including a simulated digital currency as a medium of exchange within the system.

Speaking at a Payments Canada conference in 2016, Carolyn Wilkins, senior deputy governor at the BoC, explained: “Our only goal at this stage is to understand the mechanics, limits and possibilities of this technology.” The best way to understand this technology is to work with it, she added.

Gaining a better understanding of digital currencies will be vital before central banks feel confident to take the next step. As guardians of their domestic economies, central banks must take a skeptical view about changes that could have such profound and far-reaching consequences.

“Whether a CBDC would be feasible and whether it would benefit the economy and the financial sector, over the medium term are big issues, and the answers remain far from clear,” Victoria Cleland, chief cashier at the BoE, said at a P2P Financial Systems conference last year.

Impact on bank deposits

Perhaps of biggest concern is the impact CBDC might have on bank deposits, and therefore on the financial security of the broader public. The BoE’s paper suggested that “upon the introduction of CBDC a substantial portion of retail transaction balances might be expected to switch from bank deposits to CBDC, thereby leaving a larger portion of bank financing dependent on the wholesale market, at higher interest rates.” This would reduce the spread between the interest rates on government bonds and on bank deposits, it said.

As long as a central bank issued digital currency is fully backed by eligible assets such as government securities, a run on bank deposits should be impossible.

Theoretically an economy-wide run on bank deposits via CBDC should be impossible as long as CBDC was only issued by the central bank against eligible assets such as government securities. Deposits could see their value eroded if they were traded against CBDC, but the actual amount of deposits held by the bank would remain constant. This effect could end up being offset by changes in the interest paid on those deposits.

As well as having implications for bank funding, Paola Boel, a senior economist at Riksbank, said the growth of lending in digital currencies could diminish the role of commercial banks. “This may in turn hamper central banks’ ability to control liquidity in the economy and the economic performance through standard monetary policy operations,” she said.

A new kind of institutions too big to fail

Wilkins worries that TBTF banks could be replaced by other TBTF institutions, perhaps in the payments space. Worse still, these institutions might be technologically too big to fail, while remaining small in terms of size or profitability, making it harder to identify them, especially if they operate outside central banks’ regulatory jurisdiction.

Yet it would be bold to predict the imminent demise of the big banks at this point. With many of them already pioneering their own digital currencies, the banks are to some extent already laying the foundations for central banks to follow later, creating the infrastructure that will be necessary before central banks roll out digital versions of their own. This gives them a head start, allowing them to adjust their strategies and internal operations ahead of changes that might otherwise make them obsolete.

Central banks “would definitely be more comfortable following if commercial banks go first,” according to John Dwyer, senior analyst in Celent’s securities and investments practice. “It would help them better understand how it would work, with banks validating the technology and resolving the operational challenges.”

Banks have already started work developing their own digital currencies. Whether it takes five years or fifteen, it is probably only a matter of time before CBDCs become a reality.

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Solomon is a financial journalist for Euromoney Institutional Investor Thought Leadership. With a team of independent journalists, experienced editors and professional marketers, EIITL creates unbiased, original, research driven and thought-provoking content for global business leaders.

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