Does a sovereign backed digital currency matter?

It’s a question I’ve been brooding about ever since the European central bank announced its digital euro project. But first, let’s take a walk through memory lane and establish some concepts and abstractions to build upon.

Humans at our core are consumers and consumption is central in our economic model. Consumption drives everything. We have needs and wants and we want them fulfilled. Businesses are the organizational unit that builds the goods to satisfy these needs and wants. They produce the goods that customers want. Money is the grease that makes this machine work, it’s the unit of exchange. At steady-state consumers need to have a source of money which is either from some form of employment (trading time for money) or via borrowing (trading collateral for money i.e credit). Consumers can either save, invest, or spend the money that they have. Savings and investment are just steps on the way to spend. The end state is always to spend down the cash and exchange it for goods and services.

What came first, credit or money is a deep philosophical question :). I think that credit came first and it created the concept of money. Colloquially the bank is the organizational unit that is at the core of the credit creation process aka lending. The bank takes collateral from the consumer (a house is a common example) and gives cash in exchange to the consumer against the collateral. The bank has two core decisions it makes before doing this trade. Decision 1: Can the consumer pay this loan back? i.e does he have enough monthly income cash flow to cover the repayments? Decision 2: If the consumer cannot pay me back is the collateral sound enough – so that I can sell it and recoup my principal? In normal economic times, the collateral is sound, the consumer income stream is good – the economic machine keeps turning.

Fast forward to the great financial crisis. We all know the story, the housing bubble popped. What started as a housing crisis, quickly turned into a full-on run on the entire financial system. At its core, every participant in the financial system stopped believing in the quality of the collateral that they had. They could not distinguish between good houses/bad houses, good bonds/bad bonds, and good securities/bad securities. The only thing certain was cash and the liquidations began. In a crisis, a forced liquidation for all participants causes a massive negative feedback loop, and selling begets selling. The financial markets seized up and spilled into the real economy. Credit became scarce and thus companies had to conserve cash. They started cutting their fixed costs of which people are the biggest component. Job losses caused all spending to stop and thus there was a massive contraction in the real economy.

There are two vectors available to get the economy going again. You have to get liquidity into the financial system so that it opens up lending i.e credit to consumer starts flowing again. This is the monetary policy fix. The federal reserve is the master bank in the US banking system and their mandate is to keep the financial system humming, Starting in 2008, the FED embarked on the QE program to add liquidity to the system. At a high level, the fed via QE took out the risk of collateral in the system. Since the Fed has theoretically unlimited capacity (it can create money at will), it went to the banking system and effectively said something to the effect of. I will buy whatever assets you can’t figure out good or bad and give to cash in return. I.e I am the buyer of last resort. You can take these bad loans off your books and give them to me. The theory was that this will cause banks to lend again as they aren’t saddled with bad loans anymore and now have tons of cash in hand. This however did not pan out in practice as banks still had to underwrite the consumers’ ability to pay. The consumer’s ability to repay can only be restored if job growth and wage growth comes back. The fed did what it could, but it was only solving the core problem indirectly – consumers needed income to spend to get the economy going. Pumping money into the financial system cannot fix the core problem of creating income for consumers.

The other vector to get the economy going again is to send cash (liquidity) directly or indirectly to consumers. This is the fiscal policy fix. Consumers can indirectly get cash via government employment programs. The federal government can employ people directly and pay them an income. The public works programs from the great depression are an excellent example of utilizing this tactic. You can also directly just give cash to consumers, Free, gratis – this is also called helicopter money.

By a quirk of the political and regulatory construct in the US, Monetary policy is easier to execute than fiscal policy. The fed is an independent body created by the passage of the Federal reserve act in 1913. Fiscal policy, however, has to be executed by the legislative branch of government i.e politicians ?. In 2008 the fed acted pretty quickly to stabilize the banking system, however, the fiscal side was a completely different story. As recounted in the movie the big short – “I have a feeling, in a few years, people are going to be doing what they always do when the economy tanks. They will be blaming immigrants and poor people -Mark Baum”. It was the rise of the tea party which led to the general reluctance in the legislature to pass anything that resembled fiscal assistance to the end consumer. Giving money to people directly was politically equivalent to bailing out immigrants and poor people. The result of this was economic growth was anemic and it took 11 years ( late 2019) for job growth and income to finally come back to the pre-2008 level.

Then came the pandemic. This wasn’t an economic slowdown. It was an all-out economic full stop. The fed reacted very quickly to put in place an easy monetary policy, just like 2008. However this time there was also appetite on the fiscal side to do something. In the covid-19 crisis, there weren’t any poor people or immigrants to blame, it was a virus ?.. We got a massive fiscal stimulus package via the CARES act. There were direct transfers to consumers, 160M households got $1200 checks from the US treasury. Unemployment benefits were also enhanced, the federal government added an extra $600 per week above the state provided amount. Consumers got cash directly into their pockets.

So what has any of this have to do with the digital euro? That’s for the next post!