Welcome to Thoughts on the Market. I am Reza Moghadam, Morgan Stanley's Chief Economic Advisor. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about Europe's plans to introduce a digital central bank currency. It's Thursday, June 10, at 4:00 p.m. in London.
After much consultation and reflection, the European Central Bank is set to soon announce the trial launch of a digital euro - a digital version of cash that will circulate alongside euro notes and coins. I will address three sets of questions today: First, why and why now? Second, what are the risks and what is the ECB going to do about them? And third, what are the policy implications?
Let's start with the why of going digital.
Conceptually, the key driver is the declining role of physical cash as a means of payments, as people switch from using cash to using bank cards and transfers. This is an issue because all banking ultimately rests on people's confidence in the ability to convert bank deposits into real money, i.e. cash. But if cash effectively vanishes, as it largely has for millennials, what will underpin that confidence? What would deposits be convertible into? A central bank digital currency answers that fundamental question about the stability of the financial system.
Okay, but the decline of cash is not news - why react now? One reason is that the pandemic has accelerated the decline of cash. But a more important reason for going digital is the emergence of rival payments technologies, both private stablecoins like Libra or Diem, and public ones like China's digital RMB - notice I didn't mention Bitcoin or other cryptocurrencies whose value appears too volatile to serve as a means of payment. Once stablecoins become widespread, the ability of the ECB to influence interest rates by varying the supply of traditional money would be gravely compromised. The loss of economic sovereignty would be far more serious than, say, Europe's current reliance on American platforms like Visa and MasterCard, which too is a factor in the push for a digital euro.
Now, what about the risks?
The key risk is that a digital euro may do more than just replace physical cash. The public could shift from holding private bank deposits to ECB issued digital euros, thus pushing up bank funding costs.
To limit the hit to banks, the ECB will likely limit the amount that can be held in digital wallets, which are expected to be provided and managed by banks. A cap of around €3,000 per individual is sometimes cited, which seems sensible for large economies, but may create problems for banks in smaller, less affluent ones. The size of the cap is an important detail to be ironed out by the ECB.
Finally, what are the policy implications?
The main one is that once cash disappears, the return on digital euro could in principle be set to any level, including negative. The constraint imposed by zero return on cash would be eliminated, allowing the ECB to lower policy rates to whatever it takes in severe recessions. Governments could also innovate, for example, they can provide stimulus through programable money, which disappears if not spent before a deadline. But such innovations are perhaps years in the future.
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