Money is a technology coupled with a community

Written by Professor Michael Mainelli, chair of Z/Yen & President of London Chamber of Commerce & Industry - late Lord Mayor of London 2023-2024

Edgy - some cross border CBDC musings

Central Bank Digital Currency (CBDC) are getting edgy. Not in a “buy a leather jacket and join a punk band” way, but in a “this might demolish our economy and we haven’t worked out the kinks” kind of way.

Let’s start simple: my definition of money is “a technology communities use to trade debts across space and time.” That is, it’s a community’s agreed way to freeze favours into tokens. These tokens - cowrie shells, fei stones, gold coins or crypto - only work if the community believes in them. Small communities own things in common and use direct mutual obligations - “Brother John, you missed church again” - while larger ones invent money to swap chickens for shoes. British economist William Jevons captured money’s ideal functions: “medium, measure, standard, store.” In its 16-year lifetime, Bitcoin has been a tiny medium of exchange, a wildly fluctuating unit of measure or standard and an exploding store of value, so far.

Let there be

Fiat money is backed by nothing except government enforcement and your inability to dodge taxes. Its real strength? You can pay your taxes with it. By managing the level of tax debts in the economy, both up and down through borrowing and taxation, governments create tax credits that facilitate trade and exchange.

Four thought experiments on fiat currencies:

1. Don’t believe pounds are tax credits? Call HMRC and tell them you’re not “feeling British” this year. Let me know how that goes from your new offshore penal community.

2. You can use pounds in the Shetlands but not in Calais. That’s 600 miles vs. 90. Why? Because the French demand their own tax IOUs.

3. Kay Ingram said, “Women prefer men who have something tender about them - especially legal tender.” So, is a man who has all the money in the world the most attractive? Clearly not, because if you have all the money in the world, it has no value.

4. Why does government currency in a war zone lose so much value? Because people wonder if the government and its tax system will persist in its present form.

Source: Z/Yen

CBDC ≠ blockchain

CBDC refers to a variety of proposals involving digital currency issued by a central bank, effectively moves towards a wholly digital fiat currency. The purported benefits of CBDCs were set out clearly by the Bank of England in its March 2020 report as supporting resilient payments, avoiding private money creation risks, supporting competition and innovation, meeting future payment needs, improving availability and usability of money, addressing cash use decline and as a building block for better cross-border payments. CBDCs are not cryptocurrencies. They’re government-backed, programmable versions of existing money. Distributed crypto technologies have little relevance to centrally oriented CBDCs. CBDCs don’t need blockchains any more than your microwave needs a database to heat soup.

Magical money trees

In 2016, I gave the House of Lords a variety of ways that CBDCs could get very edgy. Fractional reserve banking - where banks lend out your deposit multiple times - could be on shaky ground. Why would people put money in private banks when they could hold it directly with the Bank of England? Especially when the state wallet might come with emojis and lower risk? When your money is 100% digital and state-secured, why bother with the private sector middleman? Moving the entire ‘operating system’ of the economy onto new technology is a big decision, and I welcome the caution and experimentation central banks are taking. Here’s another ‘single point of failure’ risk. Can we retain an analogue backup?

Do we have enough cookies?

CBDCs provide new tax-collection powers. Complex taxation algorithms can be applied to any CBDC transaction in real time. Watch Question Time, and politicians are invariably asked: “How are you going to pay for that?” Either they say they are going to ‘clamp down on tax avoidance and evasion’ - as if it was that easy - or they invent some new tax measure, with the money ringfenced for their particular policy. American attorney Mike Godwin's law of Nazi analogies is an internet adage that “as an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches 1.” I might coin a parallel law of economic discussions, “as an economic discussion grows longer, the probability of creating a new form of taxation approaches 1.” Once people realise the power of CBDC systems to support various taxation initiatives at low transaction costs, we could expect avalanches of new taxes proposed in late-night debates on the BBC. You could easily have child-noise taxes, alcohol-consumption taxes, foreign-visitor taxes, plastic-bottle taxes and so on.

I gave an example of such a CBDC-based tax, the Nelson’s Column Tax. Given widespread sentiment that London is too overweening, imagine a populist redistribution tax whereby transaction taxes rise in wealthy districts. To bring about levelling up, imagine politicians increasing the taxation rate as you approach Trafalgar Square, from 0.1% in the Scilly Isles or the Shetlands, up to 99.9% beside Nelson’s Column. But too much hypothecation loses the advantage of pooled public funds. Too much hypothecation also removes fungibility and liquidity. Programmable monies are touted as one great benefit but could become an unstoppable Sorcerer’s Apprentice dragging away buckets of liquidity. How do you stop a variety of ill-written contracts locking money away because ticket purchases for a singer covered death or cancellation, not a coma? Or a one-day interest rate surge creating automated lock out and account transfers that are irreversible because they were programmed in. Don’t forget Ethereum’s DAO moment.

Facebook quality privacy from your central bank

CBDCs offer amazing crime-fighting potential for Big Brother. It’s as if the serial numbers that already exist on paper money were being recorded in transactions so you could examine the entire history of the banknote you received in exchange for a newspaper a second ago back to its issuance by the mint. Magical. Also mildly terrifying. Despite the reassurances we will receive, the power is there, and it is hard to put such technological genies back in their bottles. If you don’t have something to hide, why would you object to a CBDC tracking all your purchases and personal transactions? They’re only watching tax evaders, criminals and ‘suspicious activity’. That activity might include gardening equipment if tulip mania makes a comeback. And if your hobby turns unfashionable - say, vintage clothing - you may find yourself on a permanent shame list faster than you can say “Fur Coat Token.”

Quantity has a quality all of its own

The quantity theory of money, MV = PQ, i.e., the total amount of money (M) times the velocity of money (V) equals the average price level (P) times the level of output (Q), has a shaky empirical basis. Quantity and velocity have never been known with any accuracy, and so the models remain largely unproven. All that central bank navel-gazing and monetary prognostication has been so much augury and astrology. CBDCs will provide M and V to a high degree of accuracy.

No small change

I applaud innovation. In Korea in March I met with the Governor of the Bank of Korea and was genuinely impressed with the CBDC experiment on a digital won with 100,000 firms, using a stablecoin technology approach. With the Bank of Korea as the core, there is no need for regulation of the stablecoin as a custodian. The central bank is the only custodian needed. So, with a well-issued CBDC is the stablecoin market, despite the recent frenzies, a waste of time? Personally, I tend to wonder why people don’t look at CBDCs as government electronic money market funds. If the central bank pays interest at all, then the need for investment companies providing money market funds becomes much less and more competitive. To provide interest the central bank may well purchase a variety of short-term, low-risk debt securities like commercial paper, Treasury bills and certificates of deposit. We have a clearer definition of where electronic storage is risk-less or more risk-y. So, no need for stablecoins and less demand for money market funds?

Finally, there is a quadrant diagram of CBDC in financial markets - wholesale versus retail and domestic versus international. To me, retail products are pretty well cared for on both retail electronic money and international transfers. Wholesale financial domestic is also well cared for. The big play has got to be in wholesale international, the cross-border zone for the big guns. That’s the place to watch for CBDC benefits. Though even here thought and action are moving forward swiftly.

Imagine all the money, sharing all the world

Remember journalist Simon Carr’s words when discussing money: “Money turns out to be whatever we agree it to be. It is a collective work of the imagination.” [Independent (12 January 2009)] CBDC may well stand for Central Bank Dynamic Currencies. Monetary history moves in big leaps, punctuated equilibria - Sumerian clay, Chinese paper, medieval tallies, plastic cards, mobile apps. CBDCs may be the next big leap. But leaping can cause bruises.

As we move to the panel, “UK and South Korea - digital financial cooperation and integration”, let's dare to imagine - not just what money is, but what money could be.