CBDCs and the Law of Unintended Consequences

Whether you agree with Henry Ford, ‘History is bunk’, or George Santayana, ‘Those who don’t learn from history are doomed to repeat it’, a paper from the Department of Economic History at Uppsala University gives an interesting perspective on the risks of introducing a Central Bank Digital Currency (CBDC).¹ It looks back to when the Riksbank in Sweden decided to replace the then 28 existing unlimited liability commercial banks (ULBs) with central bank notes.

Role of a CBDC

The Bank for International Settlements (BIS), European Central Bank (ECB), Bank of England (BOE) and Riksbank have all made statements about what CBDC is and reasons to implement it. For example, in 2021 the BIS said a CBDC would be to give the public increased access to ‘the safest form of money – a claim on the central bank’.

At the same time, all were quick to make the point that a CBDC would not replace cash, but rather complement it. A CBDC is to provide the public with the possibility to make payments.

Whatever they may say, because any CBDC is a claim on the central bank it means that it is a reserve currency regardless of what objective is stated by the issuer (the central bank). In this paper the focus is on the issue of stability when bank money is replaced with central bank money.

Learning from history

In the past, monetary authorities have tried to seize control over commercial bank- created money by replacing bank-created money with base money. The Riksbank Act of 1897 included the objective of replacing the notes issued by the then 28 existing unlimited liability (commercial) banks (ULBs) with central bank notes.

The Head of the Board of the Riksbank referred to private banknotes in Sweden that lasted from 1831 until 1903 as a case in point, claiming that private money usually collapses. However, empirical historical record shows that these private bank notes did not end due to instability but because of the political decision to end their existence captured in the 1897 Act.

Research areas and findings

1.The economic and political discourse, including the policymakers’ visions on money and monetary systems, which led to the decision to end private banks’ note issuance.

It appears policy makers and central bank representatives did not take into account the difference between central bank issued base money and bank money, just as is seen in many present-day discussions on money and credit. Because of this confusion it was argued that the possibility for the ULBs to issue notes was a source of financial and economic instability.

These views were not based on empirical observations but on a general theoretical discourse concerning the instability of banks, banknote notes and, in particular, private banknotes.

2.How the private banks’ note issuance affected the monetary policy of the monetary authority in practice.

There was a hierarchy of money. The Riksbank’s notes served as base money, being utilized as reserves by the banking system. The ULB notes were bank money largely in the same manner as deposits both then and today. They were issued on the basis of the Riksbank’s issuance of notes and not utilized as reserves by other commercial banks (ULBs or LLBs). Contrary to making the Riksbank’s monetary policy inefficient, as was argued by policymakers and central bank representatives, the ULBs’ note issuance followed suit and amplified the effects of it, hence speeding up the effects of the monetary policy.

The actual change brought by the ending of the ULBs’ note issuance was cosmetic, as the change only made the private banks change from issuing one form of bank money for another by substituting the issuance of deposits for notes.

3.What the authorities, especially the monetary authority, thought would be the consequences of ending the private banks’ note issuance.

The policy employed by the Riksbank at the ending of the private banks’ note issuance was to replace the ULB notes with Riksbank notes. The Riksbank issued the same amount in the same denominations as what had been circulated by the ULBs because it feared a lack of liquidity due to the ending of ULB note issuance.

As a consequence, between the years 1900 and 1903 the Riksbank more than tripled its issuance of banknotes. But as policymakers had not grasped the different roles between the Riksbank notes as base money and the previously circulating ULB notes as bank money, the Riksbank notes ended up as reserves held by the commercial banks instead of circulating as liquidity among the public as the former ULB notes had.

4. The consequences these policies had in practice for the central bank, the banking system, the credit market and the economy in general in terms of increasing or decreasing stability.

First, the Riksbank, tied by the gold standard, initially funded this increase of base money issuance by accepting a decreasing reserve coverage, and then by getting access to foreign funds as capital was imported by the National Debt Office, leading to a deterioration in the Riksbank’s balance sheet and increasing Sweden’s foreign debt.

Second, from 1895 until 1907 the number of commercial banks almost doubled (from 43 to 83), due to an economic boom when demand for credit was high and commercial banks were competing for market shares.

Consequently, the commercial banks did not sterilize this flood of base money by increasing their reserve ratio; instead, the swelling reserves were transmitted into an expansion of commercial bank lending serving to increase the ongoing boom even further. This was amplified as the ending of the ULBs’ note issuance relieved the ULBs from holding gold reserves as legal reserves, shrinking from 9.5 MSEK in 1898 to only 0.25 MSEK in 1903.

The action taken by the Riksbank to mitigate the believed lack of liquidity due to the ending of the ULBs’ banknotes led to a direct, and almost linear, upsurge in the broad money supply and in bank credit, which was not intended nor in line with economic fundamentals but further fed the boom, which was one of the reasons behind the severity of the 1907 crisis.

Conclusions

This paper argues that this does not take into account the fact that there is a hierarchical difference between money issued by the monetary authority and private commercial banks. In particular, the fact that, unlike commercial bank issued money, central bank-issued money is potential bank reserves.

The policy lesson from Sweden’s history is that once issued, a claim on the central bank per definition is ‘potential bank reserves’ and may well come to serve as such, regardless of the intention of the monetary authority.

1 - ‘Replacing bank money with base money: Lessons for CBDCs from the ending of private banknotes in Sweden’. Uppsala Papers in Economic History 2022/03. Anders Ögren. Department of Economic History, Uppsala University.