Mihnea Constantinescu
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What is money? A simple question with many complicated answers. The functional answer is probably the better known one: «Money is what money does». According to this dictum, something qualifies as money when it fulfills (mainly) three functions: a medium of exchange, a unit of accounting and a store of value. Yet it’s apparent that a simple 0/1 test of this dictum will lead us into a maze of conceptual and practical difficulties.
Medium of exchange for all transactions? For some transactions, one may want to use cash (central bank money) but not pay via a bank account (commercial bank money). That may be due to ease and availability – a small payment of a long-forgotten debt while hiking with a friend in a remote area, or it may be due to the need for anonymity – taking a pregnancy test under social constraints. Do these circumstances imply that cash satisfies needs but deposits do not? In a world with no transaction possibility except for commercial deposits, would barter emerge naturally? Or perhaps private alternatives may fulfill this void?
Medium of exchange all the time? The Carrington Event (the 1859 solar storm) interfered with, and in some cases disrupted, telegraph services altogether. Although a counterfactual example, should a similar event occur in our electricity-hungry world, payment by tech-dependent infrastructure would not be possible. Having a low-tech solution, such as cash, can provide a modicum of functionality that may prove essential. The simple examples highlighted above, related only to the medium of exchange function, indicate that a clear-cut categorization is not a straightforward exercise. The same argument applies to the other functions. Money is a tricky idea.
Money can, and many times is, many more things. Money is Memory. Kocherlakota (1998) [1] shows that, money is – functionally equivalent to memory – memory of past transactions among agents in an economy. Under a set of assumptions about private information and the agents’ transactions history, money provides the same service as a transaction ledger – quite like what we call today a blockchain.
Money is Privacy. Kahn, McAndrews and Roberds (2005) [2] highlight the privacy-benefit of money as compared to credit-only settlement. In an economic setting where moral hazard is present, money provides social value and increased efficiency in transactions where agents face imperfect enforcement.
Money splits and unites opinions, with lines drawn along different political rifts (Randall (2012) [3]). Should we be pedantic about what money is? It is useful to understand the scope of the definition as improvements in the functioning of money and its associated markets is a delicate exercise crossing simultaneously political, economic and social boundaries. We want to enhance its flow and further render its value solid without constraining economic actions or introducing distortions through unnecessary limitations. Perhaps a sensible functional rewiring thanks to innovative technologies may also solve some of the existing problems.
Central banking, along with its settlement function, evolved out of the markets’ need for coordinated and predictable payment services and the governments’ needs for management of fiscal income and expenses. From 16th century Venice to 19th century Lombard Street, payment infrastructure and its associated processes grew in importance alongside the rise in payment volume and sophistication. The further the payment leg stepped away from its associated trade leg (in goods, services or financial assets), either by geography or time, the more complex the underlying settlement layer became. Exporting to distant markets, with unfamiliar customs and institutions, forced new methods of risk-sharing in goods and payment delivery.
Today’s Setup
The current two-tiered system consists of central bank money, or more broadly cash and reserves and commercial bank money, or even more broadly bank deposits. This split implies a certain division of responsibilities between commercial banks and central banks as far as clearing and settlement are concerned. McLeay (2014)[4] and the April 2017 Monthly Report of the Bundesbank[5] are excellent resources indicating why this difference is important. The articles highlight the far-reaching implications of the existing money creation process for the stability of the monetary system. An evolutionary outcome forged through more than 200 years of experiments in managing varying elements of financial stability and monetary policy, the current setup offers the general public a payment system with apparently perfectly interchangeable elements: central bank money (cash) and commercial bank money (deposits). But although we, as the final consumer, do not need to worry about this distinction when we pay for our daily coffee, there are some important differences between the two.
When paying with cash, the deal is settled as soon as we hand over the coin or banknote in return for the cup of coffee. The main question at hand is the authenticity of the banknote – a prime concern for the central bank as its issuer. When we pay with a card or a phone (linked to our bank account), the underlying clearing mechanisms is quite different: a phenomenally complex system of electronic messages fires up between the coffee shop’s card terminal and our bank. Depending on who issued the card, who installed the point-of-sale, who is our bank (and the list may still go on), the shop owner will face different costs for the final settlement of the transaction. This tremendous infrastructure is functioning with numerous checks and balances to minimize or eliminate different types of risks: operational, legal and economic. More importantly, the bank needs to hold reserves in the central bank for the settlement of payments. Payment by cash settles debt immediately, payment by bank deposit settles debt conditional on the bank having adequate central bank reserves or enough credibility to raise such liquidity (either from the central bank or from the interbank market).
Buy the coffee while traveling abroad and an extra layer of corresponding banks is required. Now the opening times of the countries’ RTGS systems and the banks’ outstanding FX exposure compound the list of issues. A kaleidoscope of fragmented technologies is now dancing in sync to sustain our increasingly global lives. The lack of standardization in technology, national legal specificities and the need for checks repeated by all payment system participants lead to delays and increased costs. This is abundantly visible in cross-border money transfers.
The Quest for Decentralization
Where does this leave us with respect to central bank digital currencies? Money is means to an end – considering both legs of the transaction will reveal the potential benefits of a blockchain- based central bank currency. The quest for decentralization should be understood in the context of facilitating exchange. Interesting experiments highlighting the relevance of money as an exchange facilitator are the BristolPound and The People’s Bank of Govanhill. The decentralization of economic function, with priorities given to social inclusiveness and ecologically balanced production, is sustained by the decentralization of money issuance. Small businesses unable or unwilling to access credit conduct their activity relying on a locally issued currency. After decades of an incessant quest for efficiency through hypercentralization, these communities are going back to their roots and reinventing money like their 16th century Venetian counterparties. But their contemporary monetary instruments are now powered by mobile apps updating accounts on a blockchain.
Full-speed globalization has led to the concentration of many economic activities in large urban areas, with a preference for global capitals like London, Tokyo and New York. Ideas and people followed. Eventually so does money. Balland et al. (2020) [8] show that for the U.S. (although qualitatively similar dynamics are apparent in other countries as well), high value-added industries – along with the associated well-paid employment they require and the GDP they produce – concentrate in a higher proportion in large cities than in smaller cities. Financial institutions developing their business model around corporate and private customers following the Pareto 80/20 rule – mostly dwellers of large urban areas – further penalize economic hinterlands, settling for less complex economic activity and subsequently less GDP.
With perfect memory and commitment, we might do without money. Geographically limited economies can and do function like this for short periods. Barter would be enough. But as soon as long-distance trade becomes a necessity and as soon as payment is replaced by a promise for later settlement, we get back to the need of interlocked institutions managing risk in payments and exchange. How easily would one exchange a Govanhill Note for a Bristol Pound? What would the rate be and how stable over time would it be? After reinventing money with a local scope, our decentralized communities would need to reinvent the institutions sustaining transactions that are more complex. Their stories are essential reminders of why re-engineering central bank money is a priority. We might have the technology to do away with the two-tier system. If an alternative financial architecture is conceptually better and a new balance of responsibilities are found, they will have profound implications for financial markets and monetary policy. Given today’s over-leveraged economies and strained societies, it might be worth exploring this option.
Today’s Limits Are Our Directions for Improvement
The current system shows its limits for cross-border payments and transfers, particularly in case of contractual nonperformance. Once you order a service over the Internet from a local seller, a lack of delivery may be tackled with more than a bad review. If the seller is from a different jurisdiction and the payment has been settled, a negative review might be the only available tool–especially when a certain subjectivity is present in the evaluation of contractual performance. Just think about that “amazing villa with an ocean view” you booked on your last trip or that “almost new” book ordered online. The expected frictions will prevent a great number of such trades, and tackling such frictions is costly and time-consuming, even for established counterparties not afraid to plunge in cross-border business.
What if an autonomous agent stands in the middle of the trade? One that delivers its service at little cost, performs its duty with the precision of a computer and releases funds only once all parties have agreed that the trade’s initial parameters have been met. The possibility for algorithmic clearing and settlement, empowered by Autonomous Clearing Scripts (quite improperly named “smart contracts”), is something with substantial potential in boosting financial, goods and services trade. We have developed systems for securities settlement whereby delivery is made only against payment. This ensures that neither the security seller nor security buyer face any impediments in exchanging money for ownership rights in a company–an essential element in the development of well-functioning financial markets.
We should be able to have the same functionality for trade – regardless of the size of the deal. And why not set them up so that the completion of the trade leads to payment of VAT directly to the relevant fiscal authorities? What currency could or should the Autonomous Clearing Script process?
Another argument in favor of a central bank digital currency (CBDC) is related to the ever-increasing amount of data needed to conduct the main functions of central banking. Modern central banks have become full- fledged knowledge-production factories. To reach its financial stability and monetary policy objectives, policy making relies today on vast amounts of highly heterogeneous data that are fed in a wide range of statistical models. Timely and accurate data is one of the main dimensions along which central banks (and more generally governments) can experience non-negligible improvements. Not only should we expect sharper policy decisions, but we may hopefully also avoid many crises caused by blind spots in financial markets. Would we have had a 2008 crisis of its magnitude had the regulator been able to observe the actual leverage in the various CMBS tranches? Would it have occurred had the underlying assets been transacted over a public blockchain with valuation instantly available and underlying mortgage payment delays fully transparent? How about repo markets, where a risk-free security may be pledged several times over, rendering the entire system unstable? Further arguments pertaining to the central banking function in a data-driven economy have been developed in Constantinescu (2018) [9] and Constantinescu (2018) [10].
With imperfect commitment, second-best institutional settings to enforce contracts and occasionally context-dependent memory, we are stuck with money. This does not mean we should stop improving how it’s issued, transferred and stored. The benefits of a central bank currency can be uncovered only by looking at the full exchange cycle. Payment systems are only half of the story. It is in the complementarity between payment and exchange that we will find the sources of societal benefit. Improved functioning of government, central banking and financial markets through reduced asymmetric information might also be a nice byproduct.
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[1] Kocherlakota, N. R. (1998), Money is Memory. Journal of Economic Theory Vol. 81, 232-251.
[2] Kahn, C.M, McAndrews, J. and Roberds, W. (2005), Money is Privacy. International Economic Review Vol. 46.
[3] Randall, W.L. (2012), Introduction to an alternative history of money. Levy Economics Institute WP. No. 717.
[4] Michael McLeay, M, Radia, A. and Thomas, R. (2014), Money Creation in the Modern Economy, Bank of England Quarterly Bulletin Q1.
[5] Deutsche Bundesbank (2017), The role of banks, non-banks and the central bank in the money creation process, Monthly Report, April.
[7] https://thepeoplesbankofgovanhill.wordpress.com/about/
[8] Balland, P.-A., Jara-Figueroa, C, Petralia, S.G. Steijn, M.P.A., Ribgy, D.L. and Hidalgo, C.A. (2020), Complex economic activities concentrate in large cities, Nature Human Behavior
[9] https://www.linkedin.com/pulse/blockchains-practice-central-banking-friend-foe-from-constantinescu