staci warden is the executive director of the Milken Institute’s Center for Financial Markets and chair of the Rwandan Capital Market Authority (really).
Published April 7, 2017
There has been a lot of noise recently about electronic money, digital (or virtual) currencies and cryptocurrencies. These terms are often used interchangeably, but they are not the same thing. Perhaps the easiest way to make sense of just how they differ is to think about them in terms of the power they confer on — or remove from — central banks.
Electronic money, which has been widely used in the United States for decades, includes everything from familiar “wire transfers” to and from banks to hip, new payment platforms like Venmo. The latter, incidentally, seems to be a big hit with millennials, who, for reasons unfathomable to those of us over 35, think it’s important to share with their friends just who they’ve paid and why.
Electronic money has been gaining market share on cash at a steady pace since the invention of the credit card — PayPal alone moved some $228 billion worldwide in 2014. But this is not the case everywhere. In India, for example, cash is used to pay for most everything, and credit card usage is so low that even Uber has been forced to accept cash payments. At the other end of the spectrum, Sweden has become almost completely cashless, with over 80 percent of all transactions made electronically; many vendors refuse to accept cash at all.
But regardless of the extent to which cashless financial transactions permeate an economy, the option for households to use cash creates a conundrum for central banks in the current era. Why? Because, however it is sliced and diced, monetary policy designed to stimulate economic activity depends on central banks’ ability to lower interest rates, and the option to hold liquid assets as cash makes that hard to do when interest rates are already close to zero.
During the Great Recession, for example, the Fed lowered rates by five percentage points in two years, in order to stimulate bank lending and consumer spending. As a consequence, the Fed’s benchmark interest rate today is only 1 percent. Thus, if the economy were to go back into recession, the Fed would have nowhere to go unless it imposed negative rates on liquid financial assets ranging from checking deposits to Treasury bills. (The Eurozone and Japan, by the way, are already confronting the issue.)
What if there were no cash option for savers — no practical way to hold highly liquid assets outside the financial transaction system?
In that unfamiliar world, households would have to pay to store their savings and/or face negative yields on their investments, and would thus have incentives to convert their liquid assets to currency and stuff it in wall safes and other proverbial mattresses. What if there were no cash option for savers — no practical way to hold highly liquid assets outside the financial transaction system? Enter the brave new world of a digital-currency-based monetary system with no cash base whatsoever.
In such a closed system, central banks would be handed a new lease on life for operating in low-interest-rate environments. For, as Andrew Haldane at the Bank of England and others have pointed out, if savers cannot switch to cash, central banks can impose negative-rate costs more quickly and easily. It’s no coincidence, for example, that the Riksbank in cashless Sweden has been able to impose the most significant negative rates on its banking sector.
Digital currencies would offer additional economic advantages beyond the ability of central banks to break through the zero lower bound on nominal interest rates. First, a digital currency system could significantly reduce the billions of dollars that banks collect from customers and merchants in transaction fees and, likewise, save banks the enormous costs of managing cash. While privacy would perhaps be (further) undermined in such a system, it would also have the advantage of making tax evasion more difficult.
Consider, too, that digital currencies would enable low-transaction-cost micropayments. Because a digital currency is just, well, digits, the idea of a penny as the smallest unit of value becomes a false construct. And as a result, more activities — such as website hits — could be monetized through user fees.
A blockchain-based cryptocurrency such as Bitcoin is also entirely digital, but is fundamentally different in an important way: it would diminish central bank power, not enhance it. A blockchain should be thought of as a community-maintained digital ledger of all the monetary transactions of the community. A blockchain system has a number of interesting (and potentially revolutionary) properties, but one of its critical features is that the money supply of the cryptocurrency is rule-based: it is not subject to central authority of any kind.
In Bitcoin-land, for example, 12.5 bitcoins are created every 10 minutes (and given to the bitcoin “miner” who wins a 10-minute-long computation-intensive contest). Both the pace and the process by which the amount changes (it halves roughly every four years) are based on rules, and all participants in the bitcoin ecosystem have confidence that these rules will not change. Seen from the perspective of monetary management of an economy, the salient feature of a blockchain cryptocurrency is that the central bank loses any control over the money supply dynamics.
It is hard to imagine a scenario in which a central bank would voluntarily relinquish its most fundamental power. But this is, in fact, the feature of the blockchain system that its proponents most highly prize. Bitcoin has proved to be most popular in countries where, or during times when, citizens fear that monetary policy authorities will inflate away the value of their savings (or, even worse, confiscate them). Venezuela is only the most recent example.
It is worth remembering, then, that the efficacy of monetary policy relies on central bank credibility — and further, that such credibility can sometimes only be achieved by “hand tying.” So ironically, if a monetary system is widely perceived as unstable, the most reliable way for a central bank to regain policy authority may be to relinquish it.
In the now-distant past, the go-to alternative was the gold standard, in which the quantity of currency was tied to the amount of a relatively rare, chemically stable metal in circulation A modern variant: the adoption of a stable foreign currency — the dollar, in particular — as one’s own. But sometime down the road a rule-driven digital cryptocurrency might serve the function of stabilizing the money supply outside the reach of government.