Earlier this month, the People’s Bank of China (PBOC) announced it was expanding the testing of its central bank digital currency (CBDC) to six more economic regions. The Digital Currency Electronic Payment (DCEP) system testing began in 2019 and, so far, some 15 million US dollar equivalent has been introduced into circulation in the form of a “lottery”, in which residents are invited to participate. The e-yuan is accepted as payment by local utilities and a range of other businesses.

While the amount involved so far is tiny, the fact that the programme is now being significantly expanded implies that the total e-yuan in circulation will continue to grow. In time, it is possible that it will become the dominant currency for domestic payments and, in a further step, fully replace the traditional paper yuan.

While China may be leading the way in testing a parallel, purely digital e-currency, the Bank of England announced on 19 April that it is now working with Her Majesty’s Treasury to explore how the UK might embark on a similar programme. In January, the Bank for International Settlements announced that the Bank of England, the Bank of Japan, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank would work together to share their expertise and ideas for how best to introduce e-currencies in their home jurisdictions.

While technological innovation tends to originate in the private sector, when economic officials and central bankers start pushing for it, you can be rather certain that such innovations will be forthcoming, for better or worse. Thus it is important to consider the implications of digital currencies for banking, finance and investing.

CBDCs and cryptocurrencies are NOT the same thing

First, it is important to differentiate between CBDCs and the concept of private e-currencies, including those such as bitcoin, which are built using distributed-ledger blockchain technology. Rather than offer an alternative currency, CBDCs are mostly aimed at making monetary policy more efficient and effective to implement. Economic officials have no interest in replacing their discretion with algorithms or any other form of private-sector solution.

Hence CBDCs, once introduced, are not intended to displace, but to migrate existing monetary systems from paper-based to wholly digital. There will still be legal tender laws requiring their acceptance for payment, and penalties for counterfeiting or other forms of fraud. Money laundering will still be a crime. And central banks will still control monetary policy. Indeed, their control of monetary power will grow.

While central banks set interest rates and conduct open-market operations (e.g. quantitative easing) these actions only have a direct impact on the reserves of the banking system which, for many years now, have been essentially digital. Yes, banks hold some physical cash in reserve, but it is such a tiny portion of their overall balance sheet as to be practically irrelevant.

The broader money supply, including the amount of physical cash in circulation, various types and amounts of bank deposits and credit, fluctuates along with economic activity and liquidity preferences. Thus when the global financial crisis arrived in 2008, central bankers slashed interest rates and created huge amounts of reserves, but this did not prevent a general contraction in credit. Liquidity preferences spiked, including a desire to hold larger amounts of physical cash.

Given that multiple banks failed or had to be rescued, and that interest rates had declined to essentially zero, holding physical cash seemed an entirely reasonable thing to do. But it exposed the limit of central banks’ ability to add further monetary stimulus to their economies.

As one central bank after another began to consider lowering interest rates to outright negative levels, one immediate and obvious complication was that savers would seek to avoid negative rates by withdrawing their cash balances from banks. Such a run on deposits would not only negate the proposed further stimulus, but would have the counterproductive effect of reducing banks’ normally stable depositor base.

CBDCs expand central bank power, for better or worse

CBDCs provide economic officials with a solution to this problem: Once introduced, a purely digital currency cannot be physically withdrawn. No matter if central banks cut interest rates to below zero, even dramatically so, in an effort to get savers to spend more. The e-currency must remain in the banking system. It may circulate more as households and businesses seek to pass the depreciating “hot potato” around, but there is no other option.

CBDCs thus give central bankers the de facto power to “tax” deposits. But they would also give them the ability to easily track and trace every transaction, no matter how tiny, and perhaps embed some sort of sales, VAT or transactions tax depending on the type of transaction involved.

To what extent these new powers would be used or abused is unclear, and a merging of monetary and fiscal policy in this way would no doubt be political, but CBDCs would enable a complete fusion of monetary and fiscal policy, if desired, and would make any form of avoidance or evasion on the part of households or businesses all but impossible outside of direct barter.

The end of financial privacy?

Financial privacy, something that has been eroding for many years, would vanish entirely. That is not to say that there could not be safeguards, but here, too, to what extent or for whatever reason individuals’ transaction histories would be visible to the authorities would need to be decided as a political matter.

This latter point helps to explain why there is much public disagreement amongst economic officials about how best to regulate private digital currencies and prevent their use for money laundering, tax evasion or other illicit economic activities. Whether public or private, purely digital currencies leave the ultimate “paper trail” that can be followed back to inception. Yes, individuals can use cryptography to protect their privacy on a public blockchain, hence why bitcoin is frequently referred to as a “cryptocurrency”.

In a recent article ‘An Analysis of Bitcoin’s Use in Illicit Finance, former acting director of the CIA, Mike Morrell, made precisely this point, saying one expert had called bitcoin a “boon for surveillance,” and that “The broad generalizations about the use of Bitcoin in illicit finance are significantly overstated”.

He should know. The CIA is known to monitor international financial transactions as it seeks to discover the source of all manner of activity, illicit or otherwise, that is considered a threat—real or potential, distant or immediate—to the national security of the United States, and to draw connections between both state and non-state actors whenever possible.

CBDCs as international reserves

The international arena is an interesting one for CBDCs, not only in that they would facilitate the ability of authorities to monitor cross-border transactions, but also because they could potentially disrupt the existing international monetary order. Currently centred around the US dollar, it is worth considering whether another country’s CBDC, once successfully implemented domestically, could displace the dollar and provide the new global reserve.

Given that international reserve balances are already, in effect, digital in nature, the introduction of CBDCs doesn’t fundamentally change the game. Reserves remain within the banking system and are not “spent” in the way domestic physical currencies are. Rather, as they are accumulated, they are sometimes sold to purchase securities of some sort, such as government bonds, or they are exchanged for other currencies, or sometimes gold.

Whether or not the dollar eventually loses its exclusive international reserve status will be down to other factors. It could be that China, Russia, Japan, Germany or the big oil exporters eventually tire of accumulating dollars that seem destined to lose value to inflation over time. But what of the alternatives?

Dollar dominance on the wane, but NOT due to CBDCs

Having written extensively on the topic of global monetary regime change, in my opinion there is currently no national currency alternative to the dollar. All of them have problems of their own. Should the primary candidates migrate to CBDCs in future, with the US opting for whatever reason to be left behind, that doesn’t necessarily imply that the dollar would not remain the dominant reserve.

However, if the dollar’s role continues to decline, as it has gently done so in recent years, there is a more likely candidate to replace it: gold. Gold is the only truly international money, accepted everywhere as a reliable store of value, and one with the strongest possible historical track record providing the de facto global monetary base and, under the classical gold standard, the de jure one. As I argue in my book, The Golden Revolution, Revisited, gold provides the game-theoretic monetary solution to a globalised, multipolar world.

So, while I don’t see CBDCs changing the international monetary regime on their own, it would be a real game-changer indeed if one or more CBDCs were to be linked to gold in some way. That would introduce real, tangible, perhaps irresistible competition for the dollar as the dominant global reserve.

As it stands now, however, it seems a more immediate concern that CBDCs will not only make it easier for central banks to implement negative interest rates, if desired, but that they will acquire a range of new, implied powers. Hence they bring with them broad implications for tax and fiscal policy, financial privacy and the ability for households to preserve their wealth in what has already become a highly challenging economic environment.

Ironically, it might be the technology which inspired CBDCs which offers the ideal escape route.

John Butler
Author, The Golden Revolution