A New Era of Money by Eswar Prasad
KTFA:
Samson: A new era of money
6th October, 2022 by Eswar Prasad
With electronic bytes replacing the dollar, the euro, and the yuan, some changes — but not others — would be welcome.
Money brought about radical changes in human society, as it opened the way for trade and all commercial activities, even among geographical locations far apart. It allows wealth and resources to move across different regions and times. But throughout most of human history, it has been the subject of greed and robbery.
Today, money is on the brink of a transformation that could reshape banking and financial activities, and perhaps even society.
More importantly, the era of physical currency, or cash, is coming to an end, even in low- and middle-income countries; The era of digital currencies has begun. A new round of competition between official and private currencies in both local and international forums is looming on the horizon. The proliferation of digital technology that is giving this transformation its impetus can encourage the creation of beneficial innovations and expand access to basic financial services. But there is a possibility that technological advances will intensify the concentration of economic power and allow large corporations and governments to interfere more in our financial and private lives.
Traditional financial institutions, especially commercial banks, face challenges with their business models in light of technological developments resulting from the emergence of electronic banks that can reach a greater number of customers and the emergence of electronic platforms via the Internet, such as Prosper Bank, which can deliver Borrowers direct savers.
These new institutions and online platforms increase competition, encourage innovation, and reduce costs. Savers will have access to a wider range of savings, credit and insurance products, while small entrepreneurs will be able to secure their financing needs from sources other than banks, which often have strict loan guarantee and collateral requirements. Domestic and international payments are getting cheaper and faster, benefiting consumers and businesses.
Stability concerns
The emergence of cryptocurrencies such as Bitcoin initially had the potential to revolutionize payments. Cryptocurrencies do not depend in conducting transactions on the funds of central banks or trusted intermediaries such as commercial banks and credit card companies, which limits the inefficiencies and added costs involved in these intermediaries. However, the volatile prices of cryptocurrencies, restrictions on their transaction sizes, and the time taken for transactions made them ineffective as mediums of exchange.
New forms of digital currencies known as stablecoins are gaining more effectiveness as a payment method, although ironically most of them get their stable value from being backed by large amounts of central bank money and government bonds. Blockchain technology is Underpinning these currencies are stimulating far-reaching changes in money and finance that can powerfully affect households, businesses, investors, central banks, and governments. This technology, by providing secure ownership of purely digital objects, encourages the emergence of new digital assets, such as non-fungible tokens (NFTs).
At the same time, central banks are concerned about the repercussions on financial and economic stability if decentralized payment systems (Bitcoin forks) or private stablecoins replace cash and traditional payment systems operated by regulated financial institutions. The infrastructure of a fully private-sector payment system may be efficient and low-cost, but some parts of it may cease to function if confidence is lost during periods of financial turmoil. Without an efficient payment system, any developed economy will end up in a sudden stop.
In response to such concerns, central banks are currently considering issuing digital forms of central bank money for use in retail payments - ie central bank digital currencies (CBDCs). Central banks' motives range from expanding financial inclusion (allowing even those without bank accounts to benefit from a free digital payment system) and raising the efficiency and stability of payment systems by creating a public payment option as a back-end (a role that cash plays at the same time). Present).
But a central bank digital currency has other potential advantages. It will impede illicit activities such as drug deals, money laundering and terrorist financing operations that depend on anonymous cash transactions. It will encourage more economic activities to leave the shadow economy and enter the formal economy, making tax evasion more difficult. Small businesses will benefit from lower transaction costs and avoid the hassles and risks of handling cash.
Dangers of mass clouds
But digital central bank currency also has its drawbacks. Including that they pose risks to the banking system. Commercial banks play a vital role in creating and distributing credit that keeps economies running smoothly. But what would happen if households moved their money from regular bank accounts to digital wallets at central banks, believing they were safer even if they were not paying any interest? If the commercial banks are deprived of deposits, the central bank may find itself in an undesirable position of having to undertake the business of distributing credit, deciding which sectors and companies are eligible for the loans. In addition, having a central bank operate a retail payments system would eliminate private sector innovations aimed at making digital payments cheaper and faster.
Another concern of equal importance is the potential loss of privacy. Even with the safeguards put in place to ensure confidentiality, a central bank will want to keep a verifiable record of transactions to ensure that its digital currency is used only for legitimate purposes.
Hence, central bank digital currency poses the risk of eventually eliminating residual anonymity and privacy features in commercial transactions. However, a carefully designed central bank digital currency, taking advantage of rapidly evolving technical innovations, would mitigate many of those risks. Nevertheless, for all its advantages, the prospect of digital central bank currency eventually replacing cash should not be tolerated.
New technologies would make it more difficult for the central bank to carry out its main tasks - keeping unemployment and inflation low by controlling interest rates. When a central bank such as the US Federal Reserve changes its key interest rate, it affects the interest rates on commercial bank deposits and loans understandably to a reasonable extent. But if the proliferation of digital lending platforms reduces the role of commercial banks in intermediating between savers and borrowers, we do not know whether or how this mechanism for transmitting monetary policy effects can continue to function.
Currency competition
The basic functions of central bank money are on the cusp of imminent change. As recently as a century ago, private currencies competed with each other and with the currencies issued by governments, also known as trust money. The emergence of central banks has shifted the scales forcefully in favor of the legal release currency or trust money, which acts as a unit of account, a medium of exchange, and a store of value. With the emergence of various forms of digital currencies, and the technology that underpins them, it has become possible to separate the functions of money and direct competition with legal release currencies has arisen in some aspects.
Central bank currencies are likely to retain their importance as stores of value, for countries that issue them in digital form, and as mediums of exchange. However, the importance of privately brokered payment systems is likely to increase, intensifying competition between various forms of private money and central bank money regarding their role as mediums of exchange. If we let market forces run on their own, some money issuers and payment technology providers could dominate the scene. Some of these changes may affect the nature of money itself - how it is formed, what it looks like, and its role in the economy.
If we allow market forces to act on their own, it is possible that some money issuers and payment technology providers will dominate the scene.
International money flows
Innovative forms of money and new channels for moving money between and within economies will reshape international capital flows, exchange rates, and the structure of the international monetary system. Some of these changes will have significant benefits, while others will pose new challenges.
International financial transactions will become faster, cheaper, and more transparent. These changes will be a boon for investors seeking to diversify their investment portfolios, companies seeking to mobilize money in global capital markets, and economic migrants who send money back home. Faster and cheaper cross-border payments will boost trade as well, which will particularly benefit emerging market and developing economies that depend on export earnings for a large portion of their GDP.
However, the emergence of new entities to transact with cross-border money flows will facilitate not only international trade but also illicit flows, creating new challenges for regulators and governments. It will increase the difficulties faced by governments in controlling cross-border flows of legitimate investment capital. This poses specific challenges to emerging market economies, which have suffered from periodic economic crises as a result of foreign capital inflows suddenly and in large quantities. These economies will be more exposed to the risks of monetary policy actions by the world's major central banks, which could lead to these capital outflows.
The strength and credibility of digital central bank money is only to the extent of the strength of the institution that issues it and the degree of its credibility.
Neither the emergence of digital central bank currencies nor the reduction of barriers to international financial flows alone will be able to achieve significant progress towards realigning the international monetary system or the balance of power between major currencies. The cost of direct transactions between any emerging market currency pair is decreasing, reducing the need for "intermediate currencies" such as the dollar and the euro.
But the major reserve currencies, especially the dollar, will likely retain their dominance as stores of value because that dominance is based not only on the economic size of the issuing country and the depth of its financial market, but also on the strength of the institutional foundation necessary to maintain investor confidence. Technology cannot be a substitute for an independent central bank and the rule of law.
Similarly, central bank digital currencies will not be able to solve fundamental weaknesses in the central bank's credibility or other problems, such as the government's undisciplined fiscal policies, affecting the value of the national currency. And when the government suffers from a large budget deficit, the hypothesis that the central bank receives directives to issue more money to finance this deficit often leads to higher inflation and a decrease in the purchasing power of the central bank’s money, whether physical or digital. In other words, the strength and credibility of digital central bank money is only as strong and credible as the institution issuing it.
The role of the government
In the coming years, central banks and governments around the world face the challenge of making important decisions about whether to resist new financial technology, passively accept private-sector-led innovation, or be satisfied with the potential efficiency gains that new technology presents.
With the emergence of cryptocurrencies and the prospects for digital central bank currencies, important questions have arisen about the role that government should play in financial markets, that is, whether it is inserting itself into areas that it is best left to the private sector, and whether it can compensate for market failures. Especially the large number of families that do not deal enough with the banking system or do not deal with it at all in developing economies and even in advanced economies such as the United States.
As evidenced by recent cryptocurrency booms and busts, regulation of this sector will be essential to maintaining the integrity of payment systems and financial markets, ensuring adequate protection for investors, and encouraging financial stability. However, given the huge demand for highly efficient payment services at the retail, wholesale and cross-border levels, financial innovations led by the private sector could bring significant benefits to households and businesses. In this regard, the main challenge for central banks and financial regulators is to balance financial innovation with the need to mitigate risks to uninformed investors and to overall financial stability.
New financial technology holds the promise of facilitating access to a variety of financial products and services even for needy families, thereby democratizing finance. However, technological innovations in finance, even innovations that may give way to highly efficient financial intermediation, may have opposing repercussions on income and wealth inequality.
The wealthy could benefit greatly from the benefits of innovations in fintech, which they could use to increase financial returns and diversify risks, and existing financial institutions could adopt these changes for their own benefit. In addition, because the economically marginalized have a limited ability to participate in the digital society and lack financial awareness, some changes may tempt them to enter into investment opportunities that they are not fully aware of and cannot afford. Thus, the implications for income and wealth inequality - which have increased dramatically in many countries and are causing political and social tensions - are hard to understand.
Another major change is the increase in stratification at the national and international levels. Smaller economies and economies with weak institutions may see the end of their central banks and local currencies, increasing the concentration of economic and financial power in the hands of major economies. Meanwhile, big companies, such as Amazon and Meta, could gain greater power by controlling both trade and finance.
Even in a world dominated by decentralized finance activities based on the innovative blockchain technology used in Bitcoin (which is likely to be the true legacy of this technology), governments have important roles to play in the areas of enforcing contract and property rights, protecting investors, and ensuring financial stability. Ultimately, cryptocurrencies and innovative financial products also seem to work most efficiently when they are based on the trust derived from government oversight and control. Governments have a responsibility to ensure that their laws and procedures encourage fair competition, not favoring established institutions with strong positions, nor allowing large players to stifle their smaller competitors.
Centralized or fragmented curriculum?
Financial innovations will create new and hitherto unknown risks, especially if market participants and regulators place too much faith in the technology. Decentralization and its direct result, ie fragmentation, are a double-edged sword. They can increase financial stability by reducing central points of failure and increasing resilience by intensifying the level of redundancy. On the other hand, while fragmented systems can function efficiently in good times, trust in them can become fragile in bad times. If the financial system is dominated by decentralized mechanisms that are not directly backed (eg banks) by a central bank or other government agency, trust can all too easily erode. Thus, decentralization can bring efficiency in good times and quickly destabilize when economies are struggling.
It is also likely that major changes in the societal structure are imminent. Replacing cash with digital payment systems would eliminate any remnants of privacy in commercial transactions. Bitcoin and other cryptocurrencies have been intended to provide anonymity and privacy and de-reliance on governments and major financial institutions for commercial transactions, but they are spurring changes that could end up weakening privacy. Societies will struggle to rein in the power of governments at a time when individual freedoms are at greater risk.
* Eswar Prasad, Professor at Dyson College at Cornell University and a Senior Fellow at the Brookings Institution, is the author of The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance.