Thoughts on the impact of CBDCs on credit/money creation

Since the release of the ECB's report on the digital euro in November of 2020, I’ve had a lot of thoughts on the impact of CBDCs on credit and money creation. This was further fueled by my work on the design space and options for a Digital Euro, parts of which can be found in EUBOF’s report titled “Central Bank Digital Currencies and a Euro for the Future”. More specifically my contributions are concentrated under Chapters 1 (sections 1.1, 1.2, 1.4) as well as the entirety of chapters 2 and 3.

As I am looking into a PhD in this area specifically, I’ve had the opportunity to connect with researchers and professors especially from Europe but also the rest of the world to discuss my concerns. Following those discussions, I am convinced that the introduction of digital forms of sovereign money, and especially their attractiveness (meaning the demand for them) will have a significant impact on credit/money creation (not only for the reasons that you might think). Central banks especially should take note of this potential effect, to ensure that economies and financial systems remain stable.

What follows are a few spare thoughts on the subject, that one day might constitute part of a PhD research proposal.

Starting from the beginning.

As of now, approximately 90% of central banks globally are actively engaged in some form of CBDC work. Those initiatives range from preliminary research to early or advanced stage pilots, and even fully-fledged CBDC deployments available to the general public. Importantly, and over the years, the premise of CBDCs has evolved past marginal improvements in payment speed and efficiency (this doesn’t mean that the latter does not remain one of the factors).

Digital versions of sovereign money available to the public, are instead increasingly promoted as a means for managing the risks of the digital and economic transformation, fuelled by accelerating technologies and escalating societal and economic events, and this is something that is echoed universally. For Central Banks, those risks predominately manifest in loss of relevance and the dwindling of their monetary sovereignty as consumers opt for convenient, cheap, and inclusive global-scope alternatives developed by foreign or private actors. In this transition, the protection and guarantees of sovereign deployments for the private sector wither, and regulatory ambiguous systems that may undermine the market and economic integrity are fuelled instead.

Besides safeguarding against risks and offering incremental updates in payments, CBDCs also present attractive opportunities for growth and the futureproofing of economies. That is by serving as a platform to incorporate innovations from the private and decentralised space, and by offering new monetary policy tools.

A lot of ink has been spilt on the transformative potential of CBDCs for monetary policy. Naturally, most of the proposed solutions are concerned with conscious design choices and their impact on e.g., the interest rates, the transmission mechanisms of the economy, the velocity of money, novel taxation in the form of demurrage fees, and more.

Yet I argue that besides conscious choices on the monetary characteristics of CBDCs, their “attractiveness” and management scheme alone could have a substantial impact on credit creation and money creation. Of course, their attractiveness does rely to some extent on their monetary characteristics too.

Get to the point already…

As implied above, the attractiveness factor of CBDCs translates to demand, and more specifically demand for CBDCs as a “medium of exchange”, and “store of value”. Of course, as CBDCs are to be denominated in the national currency of the issuing country, they perfectly satisfy the “unit of account” aspect of money. Importantly, different monetary and other characteristics, have a different impact on the attractiveness (demand) of CBDCs either as a store of value or unit of account.

An elementary definition of the attractiveness factor mentioned above would be as follows: It is the collection of specific characteristics that make a CBDC (un)attractive against some other form of money, such as deposits with commercial banks, and hence signal the preference of consumers for one form of money over the other(s). This (un)attractiveness factor could look something like this:

Af = χ+ψ+…+ν

Where χ,ψ,…,ν the specific characteristics of a CBDC that might influence the demand for it, either as a store of value, or unit of account. Those are extensively documented and might include:

• Interest paid
• convenience
• anonymity/pseudonymity
• security
• the management scheme of the CBDC
• Perceived/non-tangible things e.g. how hip it is to transact in said CBDC

This list is of course endless but could be narrowed down by weighing the above factors in several ways. Moreover, the attractiveness factor need not be an entire novel equation. I am convinced that there is some half-arcane equitation out there on demand for money, anonymity, intraday liquidity et al, that can be used as the basis.

So what do you do with this?

Well, I’m glad you asked. The (un)attractiveness factor can be applied to three primary theories of banking, the financial intermediation theory, the fractional reserve theory, and the credit creation theory. Using the attractiveness factor we can tweak their basic assumptions to show a potential effect on credit/money creation. What follows is another elementary example (get used to those):

The fractional reserve theory (which for the record I don't necessarily endorse) makes the following assumption about commercial bank money creation:

Money Multiplier = 1/reserve requirements

The money multiplier shows the maximum amount of commercial bank money that can be created, given a certain amount of central bank money. Ignoring for a second that reserves in many countries are zero, a deposit of 1,000 in a banking system with a reserve requirement of 10% would ultimately account for 10,000 commercial bank money entering the economy.

What happens if we take into account the (un)attractiveness factor? Then the money multiplier changes as follows:

Money Multiplier = 1/reserve requirements+Af

Of course, this is a very basic example and can be extended to other areas, such as demand for deposits, loans, the demand of banks for intraday credit etc.

What do you expect to find?

I don't know. What I know is that there is something to be found. I will leave you with some more elementary assumptions on the impact of the (un)attractiveness of CBDCs on credit creation, in the form of an excerpt from my contribution to EUBOF’s report:

However, the impact of a Federalist CBDC on credit creation may range from severe to marginal depending on the theory of banking that we subscribe to. Over the past couple of centuries, three theories have shaped the way economists perceive money creation, namely (1) the financial intermediation theory of banking, (2) the fractional reserve theory of banking, and (3) the currently prevalent credit creation theory of banking. All have enjoyed the support of top economists:

(1) According to the financial intermediation theory, commercial banks are no different from other non-financial institutions, as in essence, they receive deposits and simply re-allocate them in the form of loans.

(2) Similarly, the fractional reserve theory suggests that individual commercial banks are but financial intermediaries that lend a part of the deposits they receive (say 90%), while keeping a fraction f (i.e., 10%) as ‘reserves’. While in this manner each bank is not creating money, collectively the banking sector does create money through this system. To see how each loan issued by a bank is viewed as a step in a linear sequence of similar steps by other banks. Since each new deposit D may come from a loan issued by another bank that has not yet been repaid, the resulting double-counting is tantamount to an increase in the overall monetary mass by the value of the new loan. Repeating this process indefinitely generates a geometric series of new money whose total value converges to xD, where x = (1/f — 1) and is known as the money multiplier. For f = 10%, x = 9.

(3) Finally, the credit creation theory of banking suggests that commercial banks do not wait for new deposits and do not check their reserve position before issuing new loans. Therefore, they can individually create credit in the form of new deposits that appear in the accounts of the loan recipients. This means that they create money as “fairy dust out of thin air” (Werner, 2014), without even the constraints of the fractional reserve system.

According to theories (1) and (2), an attractive CBDC (digital euro) would inhibit the ability of commercial banks to issue credit. In a scenario of an indirect digital euro that necessitates a 1:1 reserve ratio for digital euro accounts, commercial banks would need to comply with stricter reserve requirements. Consequently, with less available deposits, lending capacity would also be decreased, which could result in increases in the cost of money and interest rates in the wider economy. Conversely, according to theory (3), lending and the cost of money would remain largely unaffected.

I am not entirely sure if my assumptions above are 100% correct — they are likely not. All things considered, I do not believe that CBDCs will not affect credit/money creation even through the credit creation lens.

That is all for now. I will continue looking into this and perhaps find the time to morph it into a research proposal. Take everything I write here with a grain of salt, this is me spilling my guts. I’ve glossed over tones and tones of economic theory just to get a point acrosss.