‘Sovereign money’: a bad idea, part deux
Last week, right after I wrote my previous post on ‘sovereign money’, the BIS published a whole report on this very concept (and more precisely, on the idea of using cryptocurrencies or blockchain-based systems to give anyone the ability to deposit cash/hold assets at the central bank). It is a very good report. Do read the whole thing.
The BIS differentiates between wholesale digital currencies, primarily used for clearing and settlement and available to financial market participants, and ‘general purpose’ ones, which allow the general public to effectively ‘acquire’ digital cash at the central bank rather than hold deposits at a commercial bank or hold central bank physical cash. The BIS acknowledges that this could have some repercussions on the conduct of monetary policy and of its transmission mechanism (as such digital currency would become a potentially widely-held asset and a liability on the central bank’s balance sheet).
The report is pretty detailed about the potential benefits and issues of such digital sovereign money (from minor Know-Your-Customer issues to more critical cross-border deposit flows and siloed high-quality collateral), and essentially agrees with and elaborates on many of Jordan’s – and my – arguments. But crucially (and this is the main focus of this post), it also looks at what could happened should a full-on financial crisis strike. In my previous post, one of my main concerns was commercial banks’ funding depletion due to deposits ‘leaking’ towards that new low risk, very liquid and convenient, central bank legal tender (Tolle, in a BoE blog post, went as far as saying that this could end fractional reserve banking). The BIS takes this reasonning further, pointing at the worsening impacts of such instruments on financial instability risk:
A general purpose CBDC could give rise to higher instability of commercial bank deposit funding. Even if designed primarily with payment purposes in mind, in periods of stress a flight towards the central bank may occur on a fast and large scale, challenging commercial banks and the central bank to manage such situations.
Digital sovereign money would therefore facilitate bank runs, which could occur with “unprecedented speed and scale”, and increase the probability and severity of a crisis. Of course, as history teaches us, in such situation regulators would probably blame ‘inherently unstable’ banks – or capitalism – for not holding enough liquidity and not having a stable-enough deposit base in the first place. Which would be another opportunity to further regulate banks and grant regulators more power. But that’s another story.
Another very interesting point raised by the BIS, and which was also present among my top concerns, is political interference and less effective capital allocation. While the BIS doesn’t elaborate much on political interference in its piece, it does acknoledge the limitations of central planning (and even refers to Hayek’s The Use of Knowledge in Society!):
Introducing a CBDC could result in a wider presence of central banks in financial systems. This, in turn, could mean a greater role for central banks in allocating economic resources, which could entail overall economic losses should such entities be less efficient than the private sector in allocating resources. It could move central banks into uncharted territory and could also lead to greater political interference.
It looks like, for once, many leading central bankers, the central banks’ central bank (i.e. the BIS) and I are on the same line. Champagne?
‘Sovereign money’: a bad idea
Commenter Intajake recently asked what I thought of some BoE research aiming at allowing the general public to hold accounts directly at the central bank. While in this particular case the BoE is considering the use of a crypto-currency/blockchain-type structure to facilitate the implementation of such a system, it’s definitely not a new idea. A number of activists have been advocating a nationalised system of current accounts for decades; more recently, Positive Money has been very vocal in defending ‘transaction accounts’ of ‘risk-free sovereign money’ held by the central bank (see their paper here; which, while not mentioning blockchain, sounds remarkably similar to the BoE “central bank digital currency” initiative).
Coincidentally, Thomas Jordan, Chairman of the Swiss National Bank, also commented on the matter in a speech in January. This follows a campaign for the introduction of sovereign money which led to the organisation of a referendum in the country (next June). Despite this campaign calling for more power to be granted to the SNB, it is interesting to see that Jordan, and the SNB in general, rejects the idea and mostly sees drawbacks to it.
Essentially, Thomas’ rejection of the initiative revolved around six main points:
- Political interference would have negative effects on the lending function of the SNB, which would now be centralised:
With the introduction of sovereign money, the SNB would be landed with a difficult role in lending. The initiative calls for the SNB to guarantee the supply of credit to the economy by financial services providers. In order to carry out this additional mandate, the SNB could provide banks with credit, probably against securitised loans. Depending on the circumstances, the SNB would have to accept credit risks onto its balance sheet and, in return, would have a more direct influence on lending. Such centralisation is not desirable. The smooth functioning of the economy would be hampered by political interference, false incentives and a lack of competition in banking.
- Sovereign money would restrict the supply of credit as the deposit creation function of banks disappears:
Second, sovereign money limits liquidity and maturity transformation as banks would no longer be able to create deposits through lending. Sovereign money thus restricts the supply of liquidity and credit to households and companies. The financing of investment in equipment and housing would likely become more expensive.
- Financial stability would not improve as investors and borrowers will keep making mistakes:
Investors and borrowers will always make misjudgements. A switch to sovereign money would thus not prevent harmful excesses in lending or in the valuation of stocks, bonds or real estate. Also, while the sovereign money initiative targets traditional commercial banks, let us not forget the role played by ‘shadow banks’ in the global financial crisis of 2008/2009.
- Sovereign money requires money supply management, which is in contradiction with SNB’s current inflation targeting mandate.
- Money supply management and inflation targeting both involve ability to reduce the money supply when necessary, usually through open-market operations. However, it is unclear how this process would work in a ‘debt-free’ sovereign money framework.
- The acceptance of the initiative would plunge the Swiss economy into extreme uncertainty.
I believe Jordan makes some very good points, and I’m particularly sympathetic to numbers 1, 2 and 5. The centralisation of the lending function in an institution subject to political power is what worries me most.
As saving deposits represent the largest type of deposits in the US (76%, if my reading of FRED is correct, see below) and possibly in Europe (I can’t find similar data), one could argue that sovereign money current accounts would only impact banks modestly. I believe there is more than meet the eye here.
First, savings have considerably grown as share of total deposits over the past two decades, possibly as a result of QE; in the couple of decades before the crisis they represented a more modest 40 to 60% of total deposits. Second, in the era of near-zero interest rates, a number of savers would probably think that the rewards of keeping their savings at ‘risky’ commercial banks is not worth the risk and instead transfer their savings to the central bank. After all, a large share of saving deposits is actually available on demand and the difference between a 0 and 0.25% remuneration rate is rather minimal. Moreover, saving deposits represent the largest share of non-wholesale funding for the banking system mostly due to the large number of small saving banks in the economy, many of which are specialised in non-productive mortgage lending, and which provide a number of more remunerative long-term time deposit products.
The larger banks, which have larger corporate lending books, rely more on demand deposits/current accounts for funding. Those banks are often the only institutions able to provide financing on a bilateral or syndicated basis to the largest of businesses, which are also the most politicised of companies. A very quick look at the latest financial statements of some of the world largest banks shows: HSBC Bank reported 86% of deposits available on demand, Deutsche Bank 61%, BNP Paribas 78%; JPMorgan reported 39% of total ‘transaction’ accounts and only 4% of time deposits and Wells Fargo 32% and 7% respectively; Mizuho reported 58% of demand deposits.
As those banks’ funding sources start dwindling, banks will have no choice but to turn towards their central bank for funding. As the central bank becomes the main funding provider of the banking system, it also starts having a say in regards to the allocation of credit in the economy, in particular when it involves politicised multinational corporations; lending competition becomes suppressed.
It is quite worrying that sovereign money activists have still not incorporated any element of Public Choice theory – or merely economic history – into their framework and don’t realise the dangers of having the state almost fully in control of the allocation of the money supply.
What the world needs is more competition in banking, not less. Instead of supporting the centralisation of deposit-taking and lending, those activists should instead support the new challenger banks and other fintech startups that are currently emerging. Many of those recently started taking deposits through new current account offerings and such ‘sovereign money’ initiatives would simply kill them off. Be careful what you wish for.