Central banks court crypto controversy

There has been a radical shift in the international payments system: central banks are giving serious consideration to introducing central bank generated digital currencies.

There are two reasons for this: firstly, the prospect of the collapse of the US dollar as an international reserve currency; and secondly the fact that large banks have been making excessive profits out of creating money.

The second of these issues has led to a situation where digital platforms have created a system of digital debits and credits which operates outside the traditional payments system, which is regulated by the central banks.

At the moment the United States is in a parlous economic situation. It has issued and intends to issue $9 trillion in debt since Joe Biden was inaugurated in 2020.

So far, every central bank outside the United States has declined to buy any of the US treasury bonds. All the bonds have been bought by the central bank, the US Federal Reserve. This has been achieved by printing additional money.

Recently, when the US government made a bond issue, the market discounted the dollar value of the three-year bonds, increasing the money the US government would have to pay to redeem its debt. Apart from this, the fact that central banks are not prepared to hold dollar-denominated bonds as part of their assets has weakened confidence in the dollar as a reserve currency. This has been exacerbated by the threat of inflation, which will reduce the value of the US dollar. As a consequence, there has been a flight from dollars and into cryptocurrencies as a hedge against inflation.

There are two types of cryptocurrencies, those that are contemplated by the central banks and those that have been created outside the formal payments system. Importantly, central bank digital currencies (CBDCs) should not be confused with cryptocurrencies, such as Bitcoin, which are digital tokens created by a distributed network or blockchain using cryptographic tools.

While cryptocurrencies are decentralised, CBDCs are centralised; while cryptocurrencies offer anonymity, CBDCs would allow central banks to know exactly who holds what. While cryptocurrencies are generally created using blockchain, CBDCs would likely run on different technological platforms.

The key question is how CBDCs should be regulated. At the moment commercial banks are allowed to create money by raising debt which they lend to their customers. Mostly, these are paper or digital transactions without the movement of real money, but the banks are required to maintain a prudential level of real assets to back up the loans on issue. Without this, depositors would pull out their deposits. The central banks determine this level of asset backing.

However, CBDCs would be issued by the central banks and would have to be supported by the banks themselves. In other words, the buck will stop with the government.

There will therefore be a temptation for governments to issue large amounts of cryptocurrencies to meet their economic policy objectives. This runs the risk of debauching the international payments system, creating a situation where exporters decline to accept payments in what they consider dodgy money. Without the dollar as a reserve currency, the whole trade and investment system in the west could breakdown.

On the other hand, China is issuing its own cryptocurrency and could come to dominate the international trade and payments system, if that becomes the world’s reserve currency.