Gatekeepers of Order
Imagining The Role of Central Banks In A Decentralized, Blockchain Based World
The worst enemy of life, freedom and the common decencies is total anarchy; their second worst enemy is total efficiency. — Aldous Huxley
Over the ages, money has shifted forms but not it’s functions as a store of value and as a medium of exchange. The slowing global economy has accelerated the search for outsize returns resulting in speculative trading in Bitcoin and other cryptocurrencies.
Christine Lagarde, Managing Director of the International Monetary Fund (IMF) in a speech on September 29, 2017 provided further legitimacy to digital currencies by imagining a future where Central Banks have to deal with regulating crypto currencies. In the short to medium term, at least, the possibility of digital currencies coexisting with cards, digital wallets, Apple Pay, Samsung Pay and cash is easy to conceive of. How then will Central Banks change in the face of disruptive experiments such as Bitcoin that fall between complete anarchy and absolute efficiency. This article explores the evolving role of central banks and imagines what the central banks of the future would look like.
A Random Walk Down Memory Lane
The earliest model of central banks that modern central banks follow is the one belonging to ‘The Old Lady of Threadneedle Street’ also known as the Bank of England (BoE). The BoE was established in 1694 to buy government debt and keep the economy afloat during the nine years war with France. It is widely recognized as the precursor of modern central banking. However, the history of central banking predates the BoE with the establishment of the Amsterdam Wisselbank (Bank of Amsterdam) in 1609 and the Swedish Riksbank in 1668.
It is interesting to note that while modern central banks deal in fiat currencies, the banks of the early 18th and 19th century were based on a gold standard. The historic Bretton Woods agreement in 1944 resulted in the creation of a gold exchange standard where the value of a country’s currency was tied to gold. As per Investopedia, a country that uses the gold standard sets a fixed price for gold and buys and sells gold at that price. That fixed price is used to determine the value of the currency. For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be 1/500th of an ounce of gold.
The International Monetary Fund was established, to manage imbalances between countries, in 1945 with 29 members. Today, it has over 189 countries working “to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world."
The Federal Reserve was established in the United States in 1914 to deal with economic shocks to the nation. The Fed was a created because of need for centralization of monetary policy. In 1971, the United States abandoned the gold standard in an event called the Nixon Shock which effectively resulted in the US Dollar becoming a reserve currency. Today, countries do not peg the value to gold but rather dynamically changes as per demand and supply in foreign exchange markets. This is also known as a fiat system where the value of a currency is derived by a government fiat or order.
Governments have increasingly resorted to ‘unlimited printing of currency’ in a practice known as ‘deficit financing’ i.e. borrowing money to finance the difference between government expenditure and government income (mainly through taxes). The Central Bank (for simplicity sake, the bank account of a government) prints additional currency to buy bonds sold by governments ultimately lending money to the government to finance excess expenditure. Deficit financing is designed to increase money supply in an economy to spur demand and growth. The idea is that when firms spend more through wages to meet the increased demand for goods, people will pay more taxes on those wages which will help the government pay off the debt. However, in actuality, deficit financing has continued without restraint.The 2008 financial crisis re-ignited the debate for central banks to go back to the gold exchange standard.
From actual gold to digital gold used in video games such as World of Warcraft, money has changed forms many times. Video game coins had the same conceptual foundation as Bitgold — a crypto currency which was the brain child of Nick Szabo and the precursor to Satoshi Nakamoto’s idea of Bitcoin.
Central Banks today live in a world of notes, coins, cards, digital wallets, mobile payment platforms and crypto currencies. Shadow banking, dark net and other parallel economies run side by side with the white/legitimate economy resulting in a complex set of variables to deal with. Countries such as Singapore, Sweden and Estonia have virtually digitized their currencies while countries such as Germany, India and the US still use cash to a large extent.
The moral of the story: forget replacing fiat currencies, crypto currencies have increased the type and forms of money.
Role of Central Banks
Central Banks, in simple terms, the bank of the government, are the purveyors of monetary policy with the aims of stabilizing the economy and regulating inflation through control over money supply. To that end, they have two main functions: 1. Macroeconomic: Regulating inflation, employment and price stability and 2. Microeconomic: Serving as the ‘lender of the last resort’. In recent times, though, with limited ability to change tax structures (fiscal policy), monetary policy enacted by central banks has become the only instrument of influencing many economies. Thus, Mohamed El-Erian (ex-CEO of PIMCO) calls central banks ‘the only game in town’. The role of central banks is illustrated below:
Central Banks have been very open in communicating their policies publicly which results in market’s forming ‘interest rate expectations’. To understand the role of central a little better, let us look at two examples based on the diagram below:
Example 1: Regulating Inflation Let’s say the central bank wants to reduce inflation or reduce growth, it raises the interest rate at which it lends money to commercial banks. This, in turn, prompts commercial banks to raise interest rates on loans such as mortgages, personal loans and credit cards making it more expensive for the average consumer to buy things with debt. Everything else remaining the same, the demand for goods decreases. With supply being the same, the prices of goods reduces as demand falls resulting in overall inflation coming down. If the central bank wants to increase inflation, it does the exact opposite i.e. it reduces the interest rate.
Example 2: Lending to Commercial Banks: The central bank is also a lender to other banks. If other banks run out of money, they can borrow from the central banks (i.e. from the bank account of the government). However, another way, the central banks regulate inflation through money supply is by increasing the reserves that other commercial banks have to keep with central banks as safety to repay depositors of commercial banks. As central banks, increase reserve requirements lets say from 25% to 30% of deposits, they suck the liquidity (funds available for lending) from the commercial banks and by reducing money supply, they raise interest rates and inflation. Again, to increase inflation, they do exactly the opposite i.e. relax reserve requirements from 30% to 25% of total deposits.
Also, on a daily basis, central banks regulate money supply through ‘money market’ operations. A money market is a market where other banks borrow funds from each other and from the central bank for the short term (less than a week). The instruments used are ‘repurchase agreements) (repos) and reverse repurchase agreements(reverse repos).
Interpol In The World of Blockchains
Most countries are moving towards open API’s with Indian banks already opening up their API’s (i.e. providing access to client data to FinTech players), and Europe following suit with the Payments Service Directive 2 (PSD2) in January of 2018.
Mexico is also considering open API’s and providing a sandbox to FinTech players to play with traditional bank’s API’s. In other words, world financial systems (especially payment) are increasingly getting connected like a giant jigsaw puzzle. The plumbing, behind the flow of money, is getting upgraded with Blockchains for recording and security and open API’s for interaction. In the distant future, one can expect completely connected pipes for flow and recording of money. However, as demonetization in India proved:
Digitization, without destabilization, is a pipe dream.
The current economic structure is flawed but nobody has been able to come up with better and more effective solutions. Technological advancements can improve infrastructure but not the basics underpinnings of currencies and exchange rates. Even if Estonia establishes its own cryptocurrency — the ‘Estcoin’ and most countries follow suit, the underlying economics cannot change without destabilizing the world economy.
In the short to medium term then, a hybrid of cryptocurrencies, digital fiat currencies and physical cash and coins will exist. The world is not yet at a stage where it can simply flip a switch to proceed to a dollarization of cryptocurrencies without dire consequences.
A lot of problems i.e. difficulties in scaling of blockchains because of using a Proof of Work (inefficient) way of ensuring security and forking, anonymity resulting in a shadow economy, regulation of identities etc. need to be resolved.
In the distant future, all currencies would become digital with every individual on the planet requiring a digital identity to participate economically. Blockchains and smart contracts will be used to record and execute transactions. Possibly, quantum computers will power the next internet of everything.
Going back to a gold exchange standard remains a possibility to reduce volatility in the digital currency markets. There will be a federation of central banks which will be a ‘world central bank’ — a kind of interpol of central banks which will receive a tax for ensuring the currency is backed by the government.
A federation will be required because flow of money will be connected around the world. To prevent a run on banks, smart contracts could set limits on the amount of cryptocurrency that can be withdrawn.
Universal Basic Income would be based on retraining milestones or creative/forward thinking performed in an AI enabled world. It could also be paid as rent to the owners/lessors of physical assets.
Although, I admit that it is impossible to foresee one version of the future. As the infographic below shows, the world still hasn’t kicked it’s habit of using cash:
Cash usage in the U.S. is still high relative to EU countries. In 2015, cash usage in the U.S. represented 13.1 percent of its GDP, whereas it represented just 7.1 percent in France and 4.5 percent in Switzerland (source: USNews). The cost of using cash, falls disproportiately, on people outside the financial system or the unbanked population. US News also found that the unbanked pay four times more in fees to access their money than those with bank accounts in the form of a premium to loan sharks or to access payday lending. Countries are adopting digitization at varying speeds as demonstrated by MasterCard’s Digital Evolution Index (DEI):
The above heatmap is a great representation of how digitally evolved various countries are. Sweden and other nordic countries, S.Korea have a high DEI score which indicates extent of digitization. So, unless every country moves up and economic systems evolve in tandem, complete digitization seems centuries away. As of 2013, 85% of all transactions still involved cash.
Thus, while cryptocurrencies are considered to be the future by many, the probability of a scenario where all the global payment systems are in sync, blockchains are scaled globally, smart contracts have replaced existing contracts completely appears very low.
While the world slows down and becomes increasingly complex and volatile, a life of constant learning is inevitable. So, gear up to ride a rollercoaster. The only safety belt is a mentality to retool and adapt to a new world very soon. Rapid change is the only constant and rapid education is the only way to deal with change. I leave you with these somber words by Ron Paul:
“It is no coincidence that the century of total war coincided with the century of central banking”
Revolution and destruction of the existing order, then, could lead to the rebirth of the gatekeepers of economic order. Until then, be prepared for a life between anarchy and absolute efficiency — a brave new world.