Bitcoin Economics
Central Bank Digital Currencies (CBDC) are the Polar Opposite of Bitcoin
by Dominik Stroukal — Economic Expert at SatoshiLabs and external contributor to Trezor Blog
Inspired by Bitcoin, but delivering something completely different: Central Bank Digital Currencies. Lately, central banks have felt the urge to make their own digital money, so as to have as much control as possible over the future of digital currency.
The CBDC, as the novelty is known today, has a legacy older than cryptocurrency, but has only become a recognized concept in the wake of Bitcoin. Here and there they are still connected to the now-familiar term “blockchain” and it is not so surprising that, for the public, CBDCs have become understood as a kind of “state-run cryptocurrency”, but nothing could be further from the truth. In fact, CBDCs are, in many ways, the polar opposite of Bitcoin.
Don’t central banks already have digital money?
No, they don’t. Central banks have much less control over money than we often grant them credit for. Most importantly, they have less control than they would like to have. Money is created by commercial banks, and central banks only set the limits and rules by which they try to achieve their goal — generally, a stable increase in prices.
Central banks usually do not even print physical money. Printers do that at the request of commercial banks, while central banks only mediate the process. Most importantly, the central bank doesn’t usually create money, it just exchanges digital money for non-digital money of the same value. Just imagine, if the central bank wanted to give someone some money, how would they do so without throwing it at people from a helicopter? They really have much less control over money than we tend to think.
After the crisis in 2008, Western central banks hit their limit, the so-called zero lower bound. Interest rates cannot be reduced too much below zero, so other ways have been sought to support consumption and thus promote a general increase in prices. The US Fed or the European Central Bank tried quantitative easing, while Trezor’s domestic Czech National Bank, for fear of deflation, introduced an exchange rate commitment and purposefully weakened our currency. Central banks tried everything, but in the midst of it, there was a story that would soon give the central banks a new power: the ability to create their own digital money, the CBDC.
Inspired by Bitcoin
Of course, it was necessary to explain carefully that blockchain is not a magical technology in itself, and when economic motivations in the form of cryptocurrency are removed from the equation, only an interesting but not very effective database remains.
Big companies caught on and started offering blockchain wherever it was possible. To authorities, to companies, to banks, and also to central banks. Let’s not discuss just now whether or not it makes sense. The fact is that central banks have begun to find a way to make their own money — and they were inspired by Bitcoin.
We know this from the very first known use of the term CBDC, in 2016, when the Bank of England acknowledged that the idea of central bank digital money was inspired by Bitcoin.
While this tale of inspiration is remarkable, somehow the resulting product is the exact opposite of what Bitcoin represents.
Of course, when we say the exact opposite, we look not at the form they take but at their properties. That it will be digital, virtual and will use certain principles of cryptography should not surprise us much, because digitalization is already happening today with our current money. But everything that makes Bitcoin revolutionary is discarded.
A CBDC is a centralized system with reversible and censorable transactions, where you must fully trust the central institution to keep its word. Bitcoin is a decentralized trustless system with irreversible and immutable transactions. As a result, CBDCs can also be cheap and fast, while on-chain transactions in Bitcoin are notoriously expensive and slow; it’s a trade-off which we must weigh against the benefits we, the people, gain from each. In terms of individual liberties, CBDCs and Bitcoin weigh heavily on opposite ends of the scales. The former is a means of control, the latter a torch of freedom.
How an official CBDC will work
It will be simple. You open an account with a central bank, where you can send your wage or transfer money. The central bank will buy government bonds against all deposits. So the CBDC will thus be backed by (but not redeemable for) government bonds. Unlike your bank, it will also pay you attractive interest on those deposits to motivate you to transfer money there.
Ok, so we will have two types of money in circulation. We would have “bank money” and a CBDC. We would then use the central bank account as we normally would use our current accounts. It might even be just a little better, because the central bank would add interest to our current account.
But it comes at a price. Why should you, in this system, store money in your bank? Economists discussing the CBDC are fully aware of this and state that bank runs — where people liquidate their bank accounts for cash — pose a great risk. People would simply withdraw their money and send it to a central bank account where it would bear better interest.
Of course, banks would like to prevent this and would have to offer higher interest rates on their accounts, which would lead to lower profits and, for some banks, would necessarily lead to bankruptcy or the mergers with competitors. Or, deposits with the central bank would instead have to pay interest only for a certain amount of deposit, which is a more realistic idea.
Proponents of the CBDC show that this would lead to a one-off problem in the banking sector but, on the other hand, it would be more stable in times of financial crisis. It is almost a perpetual motion machine which lets the government get the best possible sale point for its bonds — a central bank with an infinite money supply. Well, not that the world’s central banks aren’t doing it already, but it’s not as straightforward.
On the assets side, however, it does not have to be just the purchase of government bonds. Central banks around the world are browsing other investments, and some have tested other purchases, such as corporate bonds. They can also lend to banks against household deposits, which they are already doing on a large scale. Or, and this is already a big fantasy, though not unrealistic, the central bank could provide loans directly to people and companies. This is something that central banks largely reject at present. They don’t need it and they don’t want to do it, it is much easier for them to buy bonds so it remains their tried-and-tested preferred method.
The idea of a CBDC can take many forms and the proposed systems vary. The example described above is the most extensive form of implementation, where households and companies also have access to CBDC. In another form, CBDCs may only be available between banks and the central bank, or between the banks themselves. There is also a debate about whether or not they should be exchangeable for bank money on demand. If not, the system would again work slightly differently and have a different impact.
What this means for us mortals
So far, there is nothing to be afraid of (or to cheerfully look forward to, if you like the sound of the proposal). It is still a marginal topic and would probably require a change of the constitution, and all testing is still in its infancy.
Sooner or later, however, the CBDCs will come. They do not pose a danger to Bitcoin: they are not its competitors, they are its exact opposite in terms of intent. But they pose a danger to banks. The centralized banking system will become even more centralized and the central bank will gain new powers and tools. Monetary policy will be one step ahead again — this time, at the expense of banks.
All this looks like a transfer of profits from banks to the central bank, which would not bother the public if they were to receive higher interest rates on deposits in return. However, it is not all going to come for free.
As a result, central banks will inflate their balance sheets by buying assets, which will increase asset prices and run hand in hand with lower yields. Low asset returns and rising asset prices are already pushing more people into speculation, inflating bubbles in financial markets and increasing income inequality as asset prices help the rich while the poorer wait for their wages to grow.
The media will continue to write about CBDCs as a competitor to Bitcoin. This is completely at odds with reality. CBDCs have the potential to compete, but mainly with the banks, or better with the traditional money we use today. That they were inspired by some Bitcoin standards is true, but CBDCs and Bitcoin do not fit into one category. It’s as if Harry Potter was competing with the United States Constitution as the nation’s guiding light, because both texts used the technique called writing on paper. You may find some interesting points of debate there, of course, but the technology at its heart is the least interesting.
Some of us thought, ten years ago, that central banks were running out of breath. I was one of these people; we were wrong. Central banks still have enough ammunition, they can invent new tricks and they can inflate their balance sheets indefinitely. They will do anything necessary in their hunt for inflation and they must, by law, so it is not surprising that they are fighting back. The proposal of a CBDC should mean little for Bitcoin and buying assets to cover deposits, which will in turn benefit people through higher interest rates, sounds much better than boring quantitative easing. In practice, however, the effects are much the same.
