Digital Currencies and Monetary Policy in the New Era.

• Author: Bagis, Bilal
• Position: ARTICLE

Introduction

The global financial crisis of 2008-2009 (the 2008 crisis, henceforth) was a turning point for the global economy and the financial system. Financial structure, policy approaches, and strategic priorities have all transformed after the crisis. Central banks have adopted new trends and policy-making has since dramatically shifted across the world. Along with the increasing power concentration, responsibilities are also increasing. Monetary policy and central banking instruments have also diversified. The focus within the institutions has shifted toward more regulation, an interventionist stance, power concentration, and market design.

Major world economies (e.g. the U.S., the euro zone, the UK, and Japan) have since increased the balance sheet of their central banks from a little more than $3 trillion in 2007 to almost $30 trillion in 2022 (Graph Unprecedented money supply and quantitative easing (QE) policies after the 2008 crisis and the COVID-19 pandemic of 2020-2021 (the pandemic of 2020, henceforth) have turned into the new normal. These QE policies have also predominantly worked during the past two decades. Yet, national economies need to insure themselvcs against the tail risks of anew currency crisis, new global pandemics, new rounds of negative shocks to the global economy, and most importantly the increasing debt burden or even rising inflation risks too.

A rationale for this expansionary case is that this increased role for central banks could indeed be an outcome of discretionary monetary, endogenous money, and flat LM (money and liquidity) curve assumptions. As in the post-Keynesian endogenous money theory, the quantity of money supply could solelybeendogenouslydetermined. (2) Policymakers may also be thinking outside the box and reconsidering central bank and fiscal authority coordination, as suggested by the modern monetary theory (MMT). (3) Active fiscal policy could be supported by monetary policy. For example, domestic currency-denominated borrowing would enrich policy options such that economies would have no reason to default on their debts. (4)

Zero interest financing that is benefited by the rich world economies with their own reserve currencies would also be shared with their other counterparts. They could also be benefiting from along list of literature ranging from the endogenous money theory to the MMT, the importance of time consistency, and credible commitments to some optimal contracts between central banks, the government, and the public. (5) In line with this view, the U.S. Federal Reserve (Fed) (Blue), the European Central Bank (ECB) (Red), the Bank of England (BoE) (Purple), and the Bank of Japan (BoJ) (Green) have all increased their monetary base post the 2008 crisis and the pandemic of 2020 (Graph 1). The Fed's interventions, in particular, are noteworthy.

This paper focuses on the ways a new instrument, central bank digital currency (CBDC), is expected to improve the modern payment systems, increase the efficacy of monetary policy and ensure financial stability in the new era. (6) Digital currencies are also a necessity as economies go digital. As digitalization becomes the new normal, central banks will inevitably need to issue their own electronic or digital liabilities instead of printing money as they do now.

Keep in mind that technological transformations in finance, payment systems as well international money transfer systems have all initially led to a rise of private ventures of cryptocurrencies, coins, tokens, and earlier electronic or card systems. The block chain technology behind cryptos, unlike poor imitations of physical central bank currencies (cryptocurrencies), however, is likely to remain and change finance forever. The following modern digital wallets, mobile payment applications, cryptocurrencies, and more recently stable coins (that are pegged to the reserve currencies), on the other hand, have all even led national central banks to reconsider the possibility of issuing their own digital central bank currencies. (7)

Having said that, in today's ever-changing world, demand for cryptocurrencies, new digital currency technologies, digital assets and the need for more efficient international payments or international financial transactions is also consistently increasing. Along that line, the digitalization of the renminbi is a recent popular example to meet this increasing demand for a safe digital medium of exchange. (8) These developments have, in the meantime, led to volatility and financial instability concerns in financial markets. (9)

Central Bank Digital Currency

An institutional solution to many modern monetary puzzles is about the instrument change. After the 2008 crisis and the pandemic of 2020, along with financial innovations such as the new cryptocurrencies and stable coins, many central banks have today voiced an interest in the introduction of their owndigitalmoney. (10) A CBDC is, in essence, a new form of electronic currency that is backed and issued by a country's central bank. (11) A digital form of paper money.

Increasing financial stability concerns post the 2008 crisis and the pandemic of 2020, as well as the QE trends, stable coins and cryptocurrencies have all contributed to the advances and acceleration in this new CBDC technology. (12) CBDCs are expected to amplify the influence of the central banks further and reinforce their position and central power in the financial system. Central banks could potentially gain much greater power over the money supply and its control.

A CBDC is also important since a cash-based economy is restricted by many weaknesses such as a zero lower bound (ZLB). In addition to many other benefits, a CBDC would help avoid an effective lower bound (ELB) with a negative interest rate (NIR). (13) Digital currencies would also help make cross-country payments less costly and create more efficient domestic payment systems.

On the other hand, while trade with national currencies is usually deemed as a crucial component of economic and financial independence; digital currencies, in particular some regional and cross-country digital alternatives to the current dominant reserve currencies, would help achieve this flexibility much easier. Such an alternative instrument could also be created through the coordination of central banks, as recently suggested by many regional powers (Iran, Russia, China, etc.). This could also facilitate a modern (regional or global) alternative to John M. Keynes' international clearing union (ICU). (14)

Regulation and legislation are other aspects. The need for more regulation is becoming ever more evident in today's much decentralized financial system. The creation of virtual currencies (such as Bitcoin) and other financial innovations introduce the issue of balance between regulation and innovation to discussions.

China leads in this new financial technology by becoming the first major economy to introduce an official digital currency. However, China's leadership and the country's standard-setting advantages could have further, much longer, and enduring strategic financial and economic implications for the new era, as well. Given the current demand for digital currencies and its advantage as the first country to act, China's digital renminbi project is also a global threat to the dominance of the U.S. dollar (the modern global reserve currency with exorbitant privilege). (15)

Meanwhile, demand and the need for paper and other forms of physical money or currency are also decreasing all over the world. (16) Cash usage is already in decline in many world economies, including Sweden, Finland, China, and South Korea. (17) Digital society (as in e-Estonia) and cashless society (as in Sweden and Finland) trends are commonplace nowadays in many advanced economies. Citizens no longer need to carry paper or metallic currencies in their pockets.

Block chain technology and the post-pandemic digital transformation will certainly speed up this process as a catalyst. Some countries, such as El Salvador and the Central African Republic have already accepted cryptocurrencies as legal tender. In those cases, some form of digital currency has already replaced physical money. The market capitalization of cryptocurrencies also reached $2.6trillion by the end of 2021. (18)

On the other hand, the pandemic of 2020 has also accelerated the digitalization process overall. (19) The globalization process, along with its increasing transaction costs and increasing global competition, has also led to the quest for new means to decrease costs and search for benefits in these new areas such as the digital society and the cashless society. (20)

Digitalization and Electronic Currencies

Digital or electronic currencies do indeed already exist in many forms. For example, not all dollars in circulation are printed today. Modern central banks already print money digitally. They print money digitally and share this electronic money with other financial institutions. Therefore, base money, today, is physical cash and electronic reserves together. In that sense, the world of finance is already familiar with the idea of electronic or digital currencies.

However, only banks and other financial institutions had access to the se old-fashioned electronic currencies. They were allowing individual consumers to use electronic money in exchange for the physical money held in bank accounts. Therefore, consumers had access to this predecessor via credit cards, bank cards, mobile apps, and online payment systems. The transactions were backed by physical money in accounts. With the CBDCs, on the other hand, these digital currencies will be in widespread use. Money itself will be digitally reserved at banks and in central bank accounts.

CBDCs are also proposed to complement the conventional financial system with physical currencies. Therefore, they are expected to complement cash. It is part of the digital...