Thoughts through the cycle: W2 December ’20

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An ECB Digital Currency – cometh the hour, cometh the owl

  • There is a tendency, perhaps not exclusive to western thought, that often seems to demand a foundation moment. Perhaps due to the Judeo-Christian inheritance and the Genesis story in the Bible, narratives need an event where the thing we have now was once decided for good and all. This of course runs contrary to our knowledge of natural history, where Darwin’s theory of natural selection reveals evolution to be a process which occurs through time. Likewise, the English common law tradition is one based on the collective wisdom of the ages rather than on singular moments of judicial activism. The emergence and then defence of English liberties over time has proved an enduring process, in events as removed from one another as the signing of Magna Carta and the American Declaration of Independence.
  • In political philosophy, the early modern period was one where contract theory was particularly prominent. This was not exclusively a continental trend – Thomas Hobbes ‘Leviathan’ (1651) related how the citizenry could exchange their right to defend themselves as individuals to the sovereign (king) in exchange for protection. Jean-Jacques Rousseau’s ‘The Social Contract’ (1762) probably marked the apogee of contract theory. Although the model he had in mind was the Swiss Alpine community of Neuchâtel, the idea of citizens surrendering to the general will and being ‘forced to be free’ provided much of theoretical basis for the radicalism of the French Revolution, culminating in Robespierre and the guillotine’s reign of terror. All such contract-based thinking requires a foundation moment.
  • The point is that foundation myths can be dangerous, especially if used for political ends. Money too has its own foundation myth. There is a narrative which imagines that in the beginning, the world was very much like an enormous version of ‘Tales from River Cottage’ with myriad lank-haired old-Etonian smallholders bartering sides of bacon for ploughshares. When this so-called ‘coincidence of needs’ became too complicated, money was invented to fill the gap as a means of exchange and then suddenly we had economics. Not only is this anachronistic (the River Cottage TV series, an interpretation of Thoreau’s ‘Walden’ for our time, is about stepping out of society and not into it), but it also ignores clear evidence to the contrary which still exists today. For example, inherent to the idea of credit is the payment of interest in terms of future obligations or contingent liability. The social origins of these sort of future obligations and responsibilities clearly pre-dates money, as is ably explained by the late David Graeber in ‘Debt, The First 5000 Years’ (2011).
  • Why the interest in foundation myths? On the 30th November, ECB President Christine Lagarde published a paper entitled ‘The future of money, innovating while retaining trust.’ There are certain areas of finance where ‘innovation’ is held as a positive development when in fact it means quite the opposite. ‘Innovation’ in the mortgage market for example has only ever meant lending more to those less able to pay it back, with the Northern Rock’s 125% mortgages marking a high point in such creativity. Likewise, when one hears about monetary innovation, one ought instinctively to think in terms how ‘they’ are going to try to create a lot more money without the monetary system itself descending into a Weimar-like disaster.
  • Lagarde’s latest strigine thought piece starts with the money myth, and it is worth quoting at length:

“One reason why money first emerged was to overcome the limitations and inefficiencies of bartering. As economies became more specialised, trade became all the more essential, and a universal medium of exchange was needed to facilitate it. Coins made from (precious) metals fulfilled that purpose for centuries.

But with the development of international trade, coins became increasingly impractical because they are difficult to store and transport in large volumes.

This led to the next phase in the evolution of money through medieval times into the late middle ages and early modern times. Developments included the advent of Templar’s credit notes in France, private giro banking in Italy, bills of exchange and promissory notes, and the first predecessors of paper money.”

  • Not only does she peddle the money-was-invented foundation myth, but there is a clear conflation between money and credit in her argument (a promissory note is a credit instrument which may at times be used as money but only as a means of exchange). Implicit too in this potted history is that banks helped money to develop when in fact they helped credit to develop. The Templars did indeed act like an early supra-national central bank, lending money for Christendom to fight the crusades, but she may not want to contemplate that the order was unceremoniously dumped and its money nicked by an envious Philip the IV of France. Not a great allegory if one works at the only other supra-national central bank in history, the ECB.
  • Aside from these observations, one has to be aware why Lagarde would argue a paper in this way. Her point is monetary innovation is part of this history of money, so the pending innovation – that of a central bank digital currency – is also ok because these things just happen. Her argument progresses to discuss digital currency and the risk posed by crypto-currencies, especially ‘stable-coins’ (cryptos like Facebook’s Libra which are fully backed by dollars). The aim is therefore clear – it is about power and control. The risk of not having a central bank digital currency (CBDC) is that something else would do the job, and the ECB wouldn’t be in control.
  • She also goes on to say that central bank money is unique in terms of being a means of exchange. If one is talking about a certain form of specie as legal tender, then clearly she is correct. However, by focusing on retail money, the point is clearly something different – bank accounts at the central bank. This would revolutionise banking and would likely amount to the nationalisation of credit creation, meaning that the commercial banking system as we know it would likely change from being a credit-creating structure to one which, at best, it would act merely as intermediary between borrower and saver.
  • Based on the logic of universal basic income (UBI) and the recent precedent of cash handouts during the lockdown furloughs, retail accounts at the central bank would be good places into which to dump money for people to spend when politicians felt the need to do so. CBDC is truly the tool of government, hence Lagarde having to reassure the reader about the importance of trust with respect to this radical innovation.
  • The idea of central bank money is a funny thing too. Notes and coins used to be the sum of it. The graph below shows the story of growing excess reserves in the last decade. Before the global financial crisis (GFC), the number was effectively zero. The Eurozone crisis saw the number spike and then fall after then-ECB president Draghi’s famous ‘whatever it takes’ speech. The initiation of quantitative easing (QE) in 2015 started the process of reserves growing and growing, and the Pandemic Emergency Purchase Programme (PEPP) is responsible for the vertiginous rise in 2020.

Source: Bloomberg, 01st December 2020.

  • In terms of the ECB’s balance sheet, these reserves are a liability. The asset held against them is the stock of bonds (sovereign and corporate bonds, mortgage securities etc.) purchased via QE. This ‘central bank money’ isn’t spendable. And it can’t be repaid unless the assets are rolled off the balance sheet (this process is called quantitative tightening or QR, the disastrous policy pursued by the Fed which resulted in the credit market seizing up in Q4 2018 – no other central bank before or since has tried to unwind QE in this way).
  • Commercial banks still lend but they are not obliged to do so, and the post-GFC rules on bank leverage are far stricter in terms of capital requirements so they can’t lend as freely as before. Governments effectively stepped in to fill the gap in the economy left by reduced bank lending and the central banks mopped up the extra government debt through QE, but that money then became ‘stuck’ in the financial system, since QE is not an effort to print money in the real economy but to effect a duration-swap within the financial economy, hence the asset bubbles as investors replaced lower-yielding government bonds with racier alternatives to meet their required rates of return.
  • Thus, creating central bank money in the form of CBDC is something quite different, and would involve effectively transforming it from its current status as a liability into something more like a national good or equity. It could then be lent and spent in the real economy, for whatever purpose was needed – a universal basic income, the green revolution or any other pet project deemed necessary.
  • Why now? This is a global phenomenon, and the digital element is not the main issue at hand. A CBDC in retail hands would be money-printing proper as the money would end up in the real economy, with all the inflationary potential that history reveals to us in terms of the overuse of the printing press stimulating demand beyond the productive capacity of the economy.
  • For the Eurozone, there is clearly a brewing crisis. Opposition to rule-of-law clauses in the new European Recovery Fund by Poland and Hungary risks not only scuppering this (the belated attempt to respond to March’s lockdown), but also risks the whole EU budget programme. The market is clearly assuming that a solution to this impasse is imminent, but the event itself reflects a wider process of fragmentation of which Brexit is only one part.
  • To this end, the IMF is pushing for the EU and ECB to do more on both the fiscal and monetary front, and the IMF’s advocacy of further rate cuts and more QE may well be the green light for Lagarde to go big or go home at the ECB’s final 2020 meeting in mid-December (‘IMF calls for more support to tackle risk of fresh Eurozone slowdown’, Financial Times, 30/11/2020). The problem for the euro is that ‘more is done’, the euro will continue to rise, deflation risk becoming imbedded (if it isn’t already), with the ensuing debt-deflation crisis potentially proving an existential one both to the euro and the Eurozone. As can be seen below, the euro is already pushing up against the $1.20 level where previously the ECB has been able to ‘talk the euro down’. If such open-mouth policies are no longer effective, then there is little to stop the euro rising more, with all the ensuing deflationary implications for the Eurozone.

Source: Bloomberg, 01 December 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • One other benefit of the CBDC would be that it would allow interest rates to go much more negative. Unshackled from the profit-making necessities of the commercial banking sector, a central bank with retail deposits could effectively set rates as low as it wanted, effectively forcing its customers to spend the money or forfeit it through negative rates.
  • This would act as both an extremely powerful demand stimulus within the economy as well as a strongly negative pressure on the currency, the former in the guise of inflation and the latter in the form of depreciation. Amidst a deflationary saga and a currency war, the logic behind the new digital money is obvious. The consequences of such monetary innovation may take some time for people to get their head around, so while trust may not be the first casualty, it will certainly be the last. Lagarde’s little history lesson doesn’t include this bit – it’s called Gresham’s law, and it means eventually, the bad money drives out the good.

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