Nominated essay for our essay contest

As part of the Future Markets Consultation, students and young scholars were invited to participate in an essay contest. This essay was nominated in the category of master students. It was written by Marc Beckman, student at the Vienna University of Economics and Business.

A digital euro is on the horizon. Pushed by changing payment preferences and private initiatives such the Facebook-proposed currency Libra, the European Central Bank (ECB) has started to research the prospect of digitalising the euro. It is not alone in doing so. Across the globe, discussions among central bankers and economists on so-called central bank digital currencies (CBDCs) are burgeoning.

This essay aims to look behind this rather technocratic discourse and seeks to identify what would make a digital euro truly unique and promising. I will argue that, if one accepts that there is no justification for excluding citizens from the benefits of digital central bank money, such allows us to democratise central banking, and to democratise finance.

To arrive at that conclusion, I will firstly picture how a widely accessible digital euro could look like and how it relates to current configurations around central bank money. Secondly, I will discuss what problems a digital euro might help tackling. Thirdly, I will sketch how an enlarged access to central bank money can be followed up with changes that foresee a re-organisation of finance more broadly.

What Could a Digital Euro Look Like?

A digital euro is simply the electronic version of €-banknotes. It could be designed in a way that citizens and firms are able to place digital euros in a digital account administered by the ECB – an account that comes with the same functionality that one associates with commercial bank accounts, e.g., paying with debit cards, retrieving cash from ATMs, and making basic transactions on the internet or through a mobile phone application.1 On top of that, the  transfer of digital euros could be made possible in real-time.

No matter its concrete design, the key difference between digital euros and the deposits one currently has in private bank accounts is that only digital euros, not deposits, constitute central bank money. Central bank money – defined here is a liability of the central bank2 – is the safest form of money because it is the only one that is completely backed by the state. In contrast, deposits are not fully backed by the sovereign which means that, if a bank goes bankrupt, one risks losing a part of one’s deposits.3 By introducing a digital euro that is accessible to the general public, the ECB would ensure that citizens have access to central bank money also in a digitalised form. Then, opening a bank account at a commercial bank would not anymore be without alternative as one would alsohave the option of putting money into an account at the central bank.

By offering central bank money to citizens in a digital form, the ECB would correct a fundamental asymmetry that has so far characterised our monetary framework. Indeed, banks already have accounts at the central bank, while citizens have not. As such, private banks have enjoyed an exclusive access to the unparalleled safety  that central bank money affords. Yet, with advances in digital technology that  make widespread access to digital central bank money possible, the structural privileging of banks is not any longer justifiable. Then, by introducing a digital euro, one would enlarge access to central bank money and hence take a step towards democratising central banking.

Yet, many economists are concerned about the implications of giving people equal access to central bank money. The most discussed fear is the risk of disintermediation which would arise if holding money at central bank accounts  becomes so attractive that many people move their money from their private bank account to the central bank account, depleting the private bank of deposits. Central bankers are particularly concerned about the financial instability that this would bring.4 Consequently, they have proposed various measures of how the option of an account at the central bank can be purposively made less attractive. Ideas are to require fees for a central bank account (at least once the amount of stored digital euros exceeds a certain threshold) or to limit the amount of digital euros people can hold in the first place.5 Yet, I argue that these measures would serve to safeguard a dysfunctional status quo that a digital euro would otherwise have the potential to address. In the next section, I will first explain how the current system functions and why it is problematic, and second how a digital euro could help reforming it.

What Problems Could a Digital Euro Help Tackling?

Our monetary system is particular in that it leaves a public good – the creation and trust in money6 – to private management. Currently, the state acts as a franchisor which issues and guarantees money and then entrusts licensed banks, the franchisees, to channel it through the financial system.7 This does not mean that banks distribute a pre-given amount of central bank money to individuals and businesses. Rather, by the act of lending alone, banks generate credit and then rely on the central bank to retrospectively accommodate and monetise the incurred liabilities.8 As such, when a bank gives out a loan to a business, it does not first check if it actually has the money the business is requesting, but simply books the loan as a liability on its balance sheet and then trusts that the central bank will transform that liability into its own liability, i.e., into central bank money.9

The pre-commitment of the central bank to do so every single time a licensed bank incurs a private liability is the reason why our financial system keeps running. And yet, problems arise because licensed banks exploit that institutionalised pre-commitment or because non-licensed banks sneak themselves in the shadow of licensed banks to benefit from that pre-commitment. In other words, the state supports and not sufficiently regulates the credit operations of private banks and shadow banks10 – operations which, however, are problematic in various ways.

Financial and Macroeconomic Instability

Currently, banks give out loans based on where they can make most profit. They expand credit during periods of economic growth, and reduce lending in periods of contraction, thereby exacerbating the booms and busts of economic activity and employment. Furthermore, instead of lending to the real economy, they often gamble on short-term price swings. During a time of stability, their financing becomes increasingly speculative which, when risk perceptions suddenly turn more pessimistic, causes a panic.11 Hence, unrestrained credit-creation power of banks lies at the bottom of our system’s financial instability.12

The activities of shadow banks are prone to the same dynamics of financial instability but are different from the credit operations of banks, partly in that they are less regulated.13 Like licensed banks, shadow banks create credit-money. Yet, the credit money generated by shadow banks (shadow money) is less easily convertible to central bank money than the credit money created by licensed banks (bank money) because only the latter is institutionally supported by the central bank. This makes shadow money risker to hold. At the same time, shadow money, consisting of various types of private debt, is even more volatile and unstable than bank money.14 Hence, it is no surprise that modern financial crises have involved a panic in the shadow banking sector.15 As many licensed banks have also engaged in shadow banking activities, such collapses have compromised their loans to the real economy, causing recessions such as the one following the financial crisis of 2008.

Economic Inequality

With credit creation and allocation being in the hands of licensed banks and shadow banks, their profit-motivation determines who receives credit and to what conditions. It is no surprise then that the wealthy tend to claim more credit at lower interest rates than the poor, simply because wealth functions as a security for the banker. Hence, a better access to credit for the wealthy exacerbates existing economic inequalities. Furthermore, banks’ credit-creating power allows them to expand and increase their profit margin so that shareholders (which already tend to be at the top of the income and wealth distribution) increase their revenues while bank employees land rising salaries and bonuses. As these do not trickle down, economic inequality widens.16

Lack of Freedom & Political Inequality

To a large extent, lack of freedom and political inequality is the corollary of the economic inequality discussed above. Firstly, it seems clear that a lack of money corresponds to a lack of freedom.17 In a metaphorical but also very real sense, poverty closes doors and restricts what one can do. Secondly, it also appears obvious that wealthy individuals and private firms have higher-than-average political power, especially if no proper campaign finance rules or restrictions on funding political parties are in place. Maybe it could even be argued that financial instability causes a lack of freedom. As panics and crises are a deeply engrained feature of the current monetary system, they systemically undermine one’s ability to devise one’s own life plans and hence pose an epistemic limit to freedom.18

Ecological Unsustainability

It is unclear if credit-creation by private (shadow) banks is compatible with a steady-state economy – a condition that many argue must be fulfilled to avoid environmental collapse.19 Yet, it seems certain that insufficiently regulated private credit-creation and allocation poses an impediment to ecological sustainability. Without proper regulation, banks’ profit-seeking lending practices would push for increases in economic output with no regard for planetary boundaries.20 Furthermore, as the infrastructure needed for a low-carbon economy tends to offer returns that are not capturable by individual investors, private actors are prone to under-invest in what would bring large collective benefits and help protecting us from run-away climate change.

A Digital Euro Addressing These Problems

A digital euro can address the identified problems because it challenges what lies beneath them, i.e., the nature of privately managed money. With the introduction of a digital euro, shadow banks would have to alter their business model because many of their previous clients will find acquiring digital euros more attractive than piling into shadow money. For licensed banks, something similar would happen in that citizens and businesses would move their money to an ECB account, causing (at least at first) a liquidity loss and thereby posing a risk to banks’ classic lending model.21 Eventually, the current mode by which banks and shadow banks give out loans or issue short-term debt with only their own profit motive in mind, trusting that the central bank will generously accommodate and monetise their private liabilities, could slowly be abandoned. If a digital euro would start such process, it would dissipate the problems which are associated with that mode of management. From this perspective, the challenge that a digital euro poses to the private management of money is to be viewed positively and hence should not be feared but embraced.

For some, clamping down on the private mode of managing money might sound familiar to the idea of full-reserve banking.22 Viewing the credit-creation power of (shadow) banks as main problem, such wants to eliminate that power by requiring that each loan must be fully backed by funding collected beforehand. Yet, the challenge that a digital euro poses to the private management of money must not necessarily bring an end to private credit-creation. Arguably, if one would eliminate private credit creation without adopting alternative measures to maintain credit levels, this would be deflationary and hence even undesirable. Instead, one could also focus on the other side of the arrangement, namely the generous support that the central bank gives to credit-generating (shadow) banks. Indeed, zooming in on the role of the central bank not only allows us to identify measures how credit levels can be maintained, but also how they can be shifted to address the problems with the private management of money.

What Reshaping of the Financial System Is Possible with a Digital Euro?

One consequence of a widely accessible digital euro is a greatly expanded liability side of the European Central Bank’s balance sheet. But what could the ECB do on its asset side to offset the growth on the liability side? It is precisely here where one can envision new ways for the central bank to modulate the credit supply and facilitate its allocation.

Firstly, the ECB could give more loans to private banks.23 This could (partly) compensate banks for their lost deposits.24 The loans would be handed out in exchange for high-quality collateral and be conditioned on several criteria.25 For example, one criterion could be that banks must only lend to the primary market where real productive activity takes place. Then, only if banks meet this criterion will their privately incurred liabilities be accommodated and monetised by the central bank. This would have the double advantage of preserving the decentralised expertise of private market actors in allocating credit, while at the same time only publicly supporting those bank loans which are given out for productive, not speculative purposes.

Secondly, the ECB could increase its purchase of securities issued by supranational institutions, particularly those of the European Investment Bank (EIB). This would build upon the success of the existing purchases of public sector securities that have contributed to inflation and economic growth rates in line with the ECB mandate.26 Institutions such as the EIB would then have more funding available to invest in public infrastructure projects that spearhead the necessary green transformation. By buying more securities issued by the EIB, the ECB would contribute to the longterm development of the Union’s economic capacity without having to make direct credit-allocation decisions itself.

Thirdly, the ECB could institute a fund which it uses to stabilise systemically important prices.27 It already performs such stabilising function with the price of borrowing and as such, the fund would only extend that function to selected critical consumer prices.28 From the established fund, which would closely mirror the make-up of the financial market, the ECB could buy and sell a broad range of securities to modulate price swings. Thereby, it would contribute to macroeconomic stability and predictable investment horizons.

The consequence of these ideas is that the ECB becomes better able to modulate credit and to facilitate its allocation for public purposes. The hopeful upshot is a financial system that is more stable and responsive to the needs of the people. It is with this in mind that a widely accessible digital euro shows not only potential for democratising central banking, but also for democratising finance.

Bibliography

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  • Beneš, Jaromír, and Michael Kumhof. ‘The Chicago Plan Revisited’, 2012.
  • Bolton, Patrick, Morgan Despres, Luiz Awazu Pereira da Silva, Romain Svartzman, Frederic Samama, and Bank for International Settlements. The Green Swan: Central Banking and Financial Stability in the Age of Climate Change, 2020.
  • Brunnermeier, Markus K., and Dirk Niepelt. ‘On the Equivalence of Private and Public Money’. Journal of Monetary Economics, SPECIAL CONFERENCE ISSUE: “Money Creation and Currency Competition” October 19-20, 2018 Sponsored by the Study Center Gerzensee and Swiss National Bank, 106 (1 October 2019): 27–41.
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  1. The version of a CBDC I describe here corresponds to the design of a digital euro as currently imagined by the ECB (see European Central Bank, Report on a digital euro, (Brussels: European Central Bank, 2020). Using more technical terms, it can be described as a retail CBDC that also works offline.
  2. There is an ongoing debate whether central bank money is seen as a liability, an asset or a (social) equity of
    the nation (see Michael Kumhof et al., ‘Central Bank Money: Liability, Asset, or Equity of the Nation?’, SSRN Electronic Journal, 2020). For simplicity, I stick with the most common  understanding which is to view central bank money as a liability of the central bank (see, e.g., John Kiff et al., ‘A Survey of Research on Retail Central Bank Digital Currency’, IMF Working Papers 20, no. 104 (26 June 2020), which is also the definition that the ECB adopts (see ‘Report on a Digital Euro’, n 1).
  3. The Netherlands, such as many other countries, have set up a scheme by which they guarantee deposits up to a maximum of 1000€ so that citizens will only lose their deposits above that number if bank goes bankrupt. See “Deposit Guarantee Scheme”, De Nederlandsche Bank, accessed 2 January 2021.
  4. It is feared that a digital euro might accelerate bank runs by providing an attractive alternative to bank deposits. See, e.g., Jesús Fernández-Villaverde et al., ‘Central Bank Digital Currency: Central Banking For All?’ (National Bureau of Economic Research, 2020).
  5. See Fabio Panetta, ‘21st Century Cash: Central Banking, Technological Innovation and Digital Currencies’, Do We Need Central Bank Digital Currencies, 2018.
  6. See, e.g., Kenneth J. Arrow, ‘The Organization of Economic Activity: Issues Pertinent to the Choice of Market versus Nonmarket Allocation’, The Analysis and Evaluation of Public Expenditure: The PPB System 1 (1969): 59–73: 2.
  7. The account presented here closely follows Robert C. Hockett and Saule T. Omarova, ‘The Finance Franchise’, Cornell L. Rev. 102 (2016): 1143.
  8. Another way of saying that banks generate credit is to say that banks create bank money, or that banks create deposits. See, e.g., John Maynard Keynes, Treatise on Money: Pure Theory of Money Vol. I (Macmillan, London, 1930): 11; “What Is Money?”, European Central Bank, last modified 26 April 2019.
  9. See, e.g., Richard A. Werner, ‘Can Banks Individually Create Money out of Nothing? — The Theories and the Empirical Evidence’, International Review of Financial Analysis, no. 36 (2014): 1–19.
  10. Shadow banks are financial agents which perform bank-like functions but are not licensed and as closely regulated as banks. Both can be overlapping.
  11. Hyman P. Minsky, ‘The Financial Instability Hypothesis’, The Jerome Levy Economics Institute Working Paper, no. 74 (1992).
  12. Jaromír Beneš and Michael Kumhof, ‘The Chicago Plan Revisited’, 2012.
  13. Whereas banks are subject to prudential regulations which, inter alia, prescribe minimum required levels of liquid assets, shadow banks have, by and large, have escaped similar regulatory scrutiny. Furthermore, the manifestations of shadow banking can evolve, meaning that the few existing regulations that have forced certain financial activities to come out of the shadows might soon become inadequate. See, e.g., Alex Musatov and Michael Perez, ‘Shadow Banking Reemerges, Posing Challenges to Banks and Regulators’, Economic Letter 11, no. 10 (2016): 1–4.
  14. See Adair Turner, ‘Shadow Banking and Financial Instability’, Development, 2008.
  15. See Morgan Ricks, John Crawford, and Lev Menand, ‘FEDACCOUNTS: DIGITAL DOLLARS’ (2020), 46: 13.
  16. See, e.g., Cournède, Boris, and Catherine L. Mann. “Growth and Inequality Effects of Decades of Financial Transformation in OECD Countries.” Comparative Economic Studies 60, no. 1 (2018): 3-14.
  17. See Gerald A. Cohen, ‘Freedom and Money’, Revista Argentina de Teoría Jurídica. Vol. 2, n. 2,(Jun. 2001). ISSN: 1851-6843, 2001.
  18. Johannes Maria Van’t Klooster, ‘How to Make Money: Distributive Justice, Finance, and Monetary Constitutions’ (PhD diss., University of Cambridge, 2018), 143-145.
  19. See, e.g., Joshua Farley et al., ‘Monetary and Fiscal Policies for a Finite Planet’, Sustainability 5, no. 6 (2013): 2802–2826.
  20. If regulation will only be adopted late, a sudden shift in asset allocation will likely financial disruption. See, e.g., Patrick Bolton et al., The Green Swan: Central Banking and Financial Stability in the Age of Climate Change, 2020.
  21. The gravity and speed of the transition into digital euros would of course depend on the remuneration of a digital euro.
  22. See, e.g., Irving Fisher, 100% Money (Adelphi Publication, New York, 1935).
  23. The ECB already mentions this possibility in its report on the digital euro (see European Central Bank, Report on a digital euro, 16). In the USA, such is proposed to do through the Federal Reserve’s discount window loans – the functional equivalent of the ECB’s marginal lending facility (see Saule T. Omarova, ‘The People’s Ledger: How to Democratize Money and Finance the Economy’, SSRN Electronic Journal (2020): 35).
  24. Assuming the ECB would fully compensate banks for their lost deposits, bank funding would only shift in composition but not in quantity, and hence any financial instability concerns due to bank disintermediation would be averted (see, e.g., Markus K. Brunnermeier and Dirk Niepelt, ‘On the Equivalence of Private and Public Money’, Journal of Monetary Economics, 106 (1 October 2019): 27–41). If the ECB would only partly compensate banks, banks would have to look for private capital that, in a one-to-one fashion, finances their lending. Shadow banks would have to do the same. This implies that banks could still engage in other, non-conditionality conforming lending but such would have to be funded exclusively by private deposits, not public money.
  25. The increased demand for high-quality collateral would affect the interest rates for safe assets. It might even be the case that enough high-quality collateral will be available. Then, the central  bank might consider relaxing its safety or liquidity criterion. It could also decide to leave a substantial amount of loans to banks outstanding indefinitely (Ricks, Crawford, and Menand,  FEDACCOUNTS: DIGITAL DOLLARS’: 23).
  26. See European Central Bank, The Macroeconomic Impact of the ECB’s Expanded Asset Purchase Programme (APP). (LU: Publications Office, 2017)
  27. See Robert C. Hockett and Saule T. Omarova, ‘Systemically Significant Prices’, Journal of Financial Regulation 2, no. 1 (1 March 2016): 1–20; Omarova, ‘The People’s Ledger’: 39.
  28. The selection of consumer prices deemed systemically important could be done by the European Commission but is admittedly a very difficult and complex affair. Some intuitive candidates would be food, fuel and other commodity prices that are influential for economic activity (see Robert C Hockett, ‘The Capital Commons: Digital Money and Citizens’ Finance in a Productive Commercial Republic’, n.d., 140: 78).