The Monetary Turning Point

The monetary system is at a turning point. The hitherto dominant type of money, bank deposit money, has past its zenith, while new types of digital money are on the rise, competing for becoming the next dominant type of money, that is, the prevailing means of payment that determine the functioning of the monetary system. Rising competitors include first of all Central Bank Digital Currency (CBDC), in addition also unbacked cryptocurrencies of lesser prospects. Covered cryptocurrencies, so-called stablecoins, can put additional pressure on bank deposit money, not however on central-bank money. The recomposition of the money supply has repercussions on the role of central banks and monetary policy.

The variety of existing types of money has been evolving, so must the taxonomy of money. To date, the monetary system is described as two-tiered: the basic tier consisting of central-bank base money (cash and so-called reserves), the second tier consisting of bank money in the form of demand deposits, savings and time deposits. Today, this has developed into a three-tier system, the new third tier consisting of money-market fund shares, various types of e-money and stablecoins, most of it built on bank money. Furthermore, unbacked and unwarranted cryptocurrencies such as presently Bitcoin and Ether act as a new type of base money, competing with central-bank money and challenging monetary sovereignty.

The banking sector’s pro-active money creation by way of credit extension dominates the monetary system. Central banks have little choice but to accommodate in hindsight the facts the banks have created in advance. Adding to this, the new third-level money surrogates based on bank money, as well as the now large sector of shadow banks that operates predominantly on bank money, the entire system has become a veritable bank money regime in which central banks act as an auxiliary body of the banking sector.

Since banks under normal conditions need central-bank reserves in the amount of only a small fraction of the bank money they create, the transmission lever of monetary policy has become short and its effectiveness weak.

In recent decades, lending and investment on the basis of both the banks’ monetary credit and shadow banks’ intermediary credit went for the most part into non-GDP finances that do not contribute to fund real-economic output. This resulted in extraordinary asset inflation, bubble building and proneness to crisis. In the bank money regime, financial markets tend to overshoot in positive-feedback loops rather than achieving self-limitation in negative-feedback loops.

Modern money as easily creatable paper money, book money and now also digital money has given rise to an ongoing struggle between central-bank money, partly treasury money, seeking to maintain their sovereign position, and banks as well as other issuers of private money surrogates, trying to dethrone the incumbent and seize the monetary power themselves.

If most of the money denominated in a national currency is circulated by private issuers rather than the national central bank, monetary sovereignty is but an empty shell. Money and finance are determined by those private money issuers to a considerable degree, while they can hardly be held accountable when things go wrong. Instead, central banks have to act as anytime lenders of last resort, and governments guarantee bank deposits on a massive scale.

Bank money has thus acquired para-sovereign status and the monetary prerogatives have largely been ceded to the respective national banking sector. In constitutional terms as well as in the interest of effectual monetary policy, it is about time to put the checks and balances in the monetary system right again.

The modern money supply has experienced several turning points. Broadly speaking, the eighteenth century saw the rise of unregulated paper money, issued by both banks and governments. In the nineteenth century, this was followed by the note monopoly of national central banks in Europe, while in America US Treasury notes were of importance. The twentieth century was marked by the rising tide of bank money, i.e. book money. The twenty-first century is now on its way to becoming the age of digital money, led by Central Bank Digital Currency (CBDC), but likely to be accompanied and challenged by private cryptocurrencies of various types.

Monetary turning points of that kind occur when the dominant money of the time poses problems that cannot be solved within the given framework, and a new type of money emerges that offers some solution or increased efficiency such as lower costs of production, provision and handling, improved ease of use and faster transferability. So far, incumbent monies were less convenient, circulated at lower use frequency and were more expensive to produce and handle than the competing new monies.

Today, the future belongs to digital money, for it is technologically superior to book money. Central Bank Digital Currency (CBDC) and private digital currencies—be they stablecoins or unbacked cryptos—are vying to succeed bank money as the dominant type of money. CBDC is likely to emerge from this as the winner, because CBDC is superior to private cryptos by virtue of being legal tender and safe-stock base money, and also because of the no longer negligible constitutional need to take back monetary control and be able to implement monetary policy effectively.

Bank money, presently still dominant, competes against both CBDC and private digital monies to assert its position. Bank money may well persist for a longer period of time, albeit gradually declining in importance. Central-bank reserves will over time be going down together with bank money, or be replaced with CBDC early on. Solid cash is not a systemically defining factor any more.

To what extent and how soon expectations for CBDC are met depends on the design principles for implementing CBDC. The chapter discusses the Top Ten of CBDC design principles, dealing, for example, with the provision of CBDC according to market demand; the convertibility of CBDC and other types of money; open or restricted access to CBDC and its quantitative availability; whether central-bank support and government guarantees for bank money can be reduced; or the channels by which CBDC is circulated.

Moreover, a number of concerns about CBDC are addressed, for example, whether CBDC increases or decreases the likelihood of a run on bank money; what happens to the functioning of the monetary system when CBDC is increasingly substituted for bank money; or how banks deal with CBDC side by side with bank money, specifically how banks continue to finance their operations.

The rise of CBDC and the gradually diminishing importance of bank money will loosen today’s overly tight bonds between central bank and banks. Options for monetary quantity policy are becoming available again. The effectiveness of central-bank interest-rate policy is being enhanced. The horizon of variables relevant to monetary policy is broadening, e.g. in terms of non-GDP finance and asset inflation. More clearly than before, central banks are becoming national monetary authorities, the monetary power of the state, complementing the executive, legislative and judicial branches. In this function, monetary policy must be independent, comparable to the independence of jurisdiction, i.e. independent from government directives as well as from the immediate requests of banks and financial markets. Monetary, fiscal and private-creditary responsibilities must not be blurred, while responsive cross-domain cooperation remains indispensable. From such a position, a central bank will not only contribute to refinancing the banking sector, but can, within the scope of always limited potentials, also directly contribute to the monetary financing of government expenditure. The creation of CBDC as a monetary asset and as sovereign base money suggests a modified monetary accounting procedure.