Full Reserve Banking for Digital Currency & the China Model

Jeremy Allaire: Good morning and welcome to The Money Movement, a show where we explore the issues and ideas driving this brave new world of digital currency and blockchains. I'm really excited about this special edition we're having this morning. We're really privileged to be joined by a really distinguished group of guests; Michael Kumhof from the Bank of England and also previously with the International Monetary Fund. Tommaso Mancini-Griffoli, leading researcher, publisher, and thought leader at the IMF, and David Zhou, who is one of the more preeminent economists in the FinTech world in China, and has published extensively and very thoughtfully about China's new full reserve digital currency, DCEP.

Today, we're really trying to continue some of these global macro themes. I think there are a lot of ideas that we're trying to synthesize here. There are ideas about what's happening in the current global economic crisis, what is this doing to the role of major reserve currencies, what impact could this have on the banking sector, what can we learn from prior crises, the Great Depression, and alternative models for how the financial system might be constructed and then synthesizing that with the here and the now have breakthroughs in technology, digital currency, stable coins, and imagining if we can see the reconstruction, the construction of a new international monetary system and what that might look like.

Kicking this off with our first guests, I'd like to welcome Michael Kumhof who is senior research advisor in the research hub at the Bank of England. Welcome, Michael.

Michael Kumhof: Thanks for having me.

Jeremy: I appreciate you joining very much. I think it'll be great just to start. You've done some very interesting work in this whole topic of full reserve banking, the Chicago Plan, which we've touched on before on this program, and also on digital currency and potential models for central bank digital currency, which I find are interesting and perhaps not coincidental.

I thought it'd be helpful just to kick things off to have you take us back to the 1930s for a moment. Take us back to Irving Fisher's four principles of 100% Money, this idea that we could see fewer and shorter recessions, less public debt, less private debt, no bank runs, a much different inflation situation. You later argued higher output. Maybe to just start, take us back to that set of ideas and we can help the audience understand that.

Michael: Okay. Very briefly, I will tell you about how I got back to that set of ideas myself. It started when I was working at the IMF. Around 2006, I was getting very concerned about what I was reading about what's happening in the US financial sector. I had previously worked with Barclays for five years, and at that point, I started reading a lot about monetary systems and the history of monetary systems.

What I came across as a key reference is a very short booklet by Irving Fisher, 100% Money and the Public Debt, which I then proceeded to model because my full-time job, is basically to devise macroeconomic models that help us to think through macroeconomic mechanisms. Basically, the key notion in that work by Fisher and his contemporaries was that the Great Depression, one of the key problems was a shortage of a medium of exchange. He called it the circulating medium.

The fact that banks create that medium of exchange by making loans, and that is how the majority of the medium of exchange is created, especially today, but even at that time, and the idea that this could create financial instability first in an upturn because banks can make new loans by creating new deposits without having to worry about attracting new deposits from somebody else first. That can lead to lending booms or can make lending booms easier to kick off by the banking system.

Then in a downturn, bank loans started default, banks start to lend less because they are more worried about the risk. Both of that destroys bank deposits and the destruction of bank deposits is the destruction of the medium of exchange precisely at the time when they are needed the most. That was one of the ideas of Fisher. The other idea was that in order to create the money that we use, and this is more true than ever, we need debt because the banks can only create money by somebody going into more debt, getting a loan, so that the proceeds of the loan can be credited to his or her deposit account, meaning that if we want to create enough liquidity, it has a flip side, and that flip side is increasing debt.

The Chicago Plan idea that Fisher laid out so well in that short booklet consists of the separation of the monetary and credit functions of the banking system. In that system, the central bank would be the sole creator of money, and the banks would only be the intermediaries of money. They could no longer create deposits by making loans, but instead would have to attract sufficient deposits of money first before lending them out.

That plan, I should emphasize, was an idea of who were, in essence, the founders of the Chicago School of Economics. They were very fair for industry, but at least in those days, they found that prerequisite for efficient laissez-faire industry was that when it comes to money creation, they should not be that kind of laissez-faire, and they should be handled by a central bank, by the authorities.

I was able then to basically confirm Fisher's conclusions, the ones that you already outlined, better ability to handle financial cycles, financial crisis, less debt, because when you issue money under the Chicago Plan via the central bank, you issue it basically as a token that signifies this is something you can purchase something with, but there is no corresponding debt, so lower debt. The output gains that I came up with had something to do with the fact that this would be an economy where everybody would be far less leveraged than today, including governments. Lower leverage typically implies a lower real interest rate, and a lower real interest rate implies more capital accumulation and more economic growth.

Jeremy: I think that's a fantastic summary. Thank you. I think it's really noteworthy, these ideas for a safer, if you will, and also a more effective financial system emerge following crises. This obviously emerged in the mid-1930s. You're revisiting these ideas shortly after the financial crisis, and I think an ongoing European financial crisis at the time.

I think once again, we're now needing to look at these questions.

Again, we're facing, obviously, an unprecedented amount of monetization of debt globally, but also, we're still in the early days of this economic crisis. I think part of the underlying risk that people may be concerned about is this deeper set of solvency risks at the household level, at the level of the firm, at the level of commercial lending institutions, and ultimately, even sovereigns.

We can look at each individual country in isolation, but we have this very interconnected, global financial system. I saw the European banking authorities actually yesterday publish their view that they think most people, most banks will be okay right now with their stress tests, maybe there's going to be some that don't have quite as strong loan books. Still, it feels like built on rosy assumptions about whether there's cascading waves of economic downturn here, but not so much looking for you to predict the future. I think the interesting question is it feels like these ideas are more relevant and germane again today.

Michael: Yes, I would agree with you. Again, if you look back at Fisher, he was always saying the Great Depression, the main phenomenon was that people were perfectly able to do work, to do real physical work and be productive, but they weren't able to pay each other because they weren't able to get their hands on the medium of exchange, the circulating medium. Now, today, we're in a situation where, first of all, there is a risk that nobody would deny that, that more bank loans will go bad, and that immediately destroys when it's written off it destroys part of the medium of exchange.

There is the risk that banks will lend less because they're nervous and obviously central banks are trying to steer against that but there is that underlying risk, that also destroys the medium of exchange. There's also a third one that I am exploring in a recent paper with Schwann Wang from the University of Oxford, that banks net interest margins are very compressed, because of the low-interest environment that we already have, and that is further reducing banks incentives to lend because they can't make that much money on lending.

Jeremy: Lend when it's not very profitable.

Michael: Yes, exactly. The question then is, how do we deal with this situation and when you realize that the main function of bank lending is to create liquidity by means of which people can pay each other and if you realize that banks have all these headwinds, then you can ask the question, is there any other way in which we can create this liquidity? That's where the whole issue of public money potentially comes into the equation.

Jeremy: It's a good touchpoint on the other theme that we're going to talk about here in the show today, which is these ideas of stable coins, central bank money, digital currencies, and I know, you've touched on some of that in your research at the Bank of England and we have some other guests who are going to speak to that more as well but I think this idea of a full reserve digital money that has the utility value of the internet, which we all now know and understand but this idea that this digital currency must be full reserve, and it must be backed by or the underlying issue is based on something like government securities. We have US dollar coin, which is sort of fundamentally based on short-term US government securities, I think, in the paper you wrote for the Bank of England, you spoke about a model where a central bank digital currency would exclusively be based on essentially sovereign securities issuance.

Michael: Not sovereign securities, is literally central bank reserves. Which is different, because that world has one way, essentially the central bank issues the money that we use, potentially via an intermediary, the Bank of England issued a discussion paper in March where it lays all that out very nicely. Where the central bank could be the issuer but the private sector could provide the customer-facing account, but the account would ultimately represent a liability of the central bank, or an item on the liability side of the central bank.

Jeremy: Right. I think part of part of the notion was that a commercial bank that wanted to possess or an intermediary that wanted to purchase, in a sense, central bank digital currency like this, there are certain eligible assets that would be allowed to do that. You could use fractional reserve, commercial bank, electronic money to do that because it sort of defeats the purpose.

Michael: Yes. In fact, I've written a paper with Claire Noone, who's now at the Reserve Bank of Australia in 2018, where we're talking about this, it has a big bearing on financial stability and the ability of the private sector to potentially run on bank deposits and into CBDC. There are various ways of preventing that and therefore making the financial stability side of this much, much safer than what people might expect. One is by having an interest-paying CBDC where you can make it as attractive or unattractive as you want and the other one is by basically saying, if you want to have this form of central bank money, you need to come to the central bank with an eligible asset and that eligible asset is typically in today's world, a government security.

Jeremy: Right. That makes a lot of sense. Very interesting. I think the convergence of both this digital currency world and ideas of full reserve banking and potential ways to restructure or reconstruct elements to international monetary system are with us. What do you see in the next few years?

Michael: What I see in the next few years? Well, we've talked a lot about the Chicago Plan. We didn't really delineate it very clearly against central bank digital currency a little bit but let me say a few things about that because that's critical going forward. Is that the Chicago Plan is not on the drawing board. That would be a pretty radical reform. Central bank digital currencies are now on the drawing board at a number of central banks and the Chinese are amongst the ones that are furthest ahead it looks like but, for example, in Europe, Sweden has looked into it very closely. Canada is looking into it very closely, et cetera, et cetera.

Central bank digital currency is a world where you have the fractional reserve banking system, and central bank digital currency existing side by side. That's a paper we wrote in 2016 and the intellectual history is interesting. When I wrote the Chicago Plan in 2012, this was like a bolt out of the blue and people thought, what the hell are you talking about, and this is way too extreme and then it's sort of interesting that in just a few years since then, the little cousin of the Chicago Plan, which is what central bank digital currency is, is being debated a lot. You can see that sometimes the debate seemed glacial to me, but I think in historical terms, it's actually pretty quick.

Jeremy: Yes, I would agree. I think many of the underlying motivations for the digital currency movement, if you want to think of it that way, is how do we build a safer financial system? I think that animates a lot of things as well. Michael, this has been a wonderful and fascinating discussion. I really greatly appreciate you joining us on the program and look forward to your continued research and church and work and hope to stay in touch.

Michael: Yes, thanks very much, again, for having me on the show.

Jeremy: Thank you, Michael. I think stepping back here, obviously, there's this fundamental disruption of digital money, of these new forms of medium of exchange. We have these breakthroughs of digital currency itself. We have non-sovereign digital currency, we have stable coins, we have emerging ideas for how governments, or leading central banks could deal with this. There's a lot of questions being raised about what does this mean for central banks and what does this mean in terms of the potential for new types of digital currency banks. Joining us now to discuss all of this is Tommaso Mancini-Griffoli, who is the deputy division chief of the monetary and capital markets department at the International Monetary Fund. Welcome, Tommaso.

Tommaso Mancini-Griffoli: Yes, hi. Thanks very much, Jeremy. Delighted to be here.

Jeremy: Yes, wonderful. You're also a prolific thinker, and writer and researcher on a lot of these topics, I have enjoyed everything that you've done over the years. You've touched on stable coins and global stable coins. You've written extensively about approaches central banks might take to this and then I think this really critical idea that you and others at the fund have put forward for a synthetic or what I like to call a hybrid central bank digital currency model that leads us down this path to the idea of narrow banks. I want to start there. Maybe first just help us understand what is a narrow bank? How does it fit with this idea of full reserve money? How does it fit with this idea of digital currency?

Tommaso: Sure. Thanks, Jeremy. Maybe I should introduce also the concept of synthetic central bank digital currency, so that our listeners can follow more easily. A synthetic central bank digital currency is essentially a private-public partnership, where the private sector issues a liability that is used by you and I to purchase assets for payments but that liability is fully backed with central bank reserves and that liability is issued under license.

License of a central bank would extend and in exchange for the central bank to obviously supervise and regulate the business and the institution. This is different from what people originally called central bank digital currency, which would entail the central bank issuing a liability directly to the public. Either we hold an account of the central bank, or we hold a little digital token on our wallet issued by the central bank and we trade that.

There's a fundamental difference here because the private sector is an important player. When we spoke to central banks about central bank digital currency, they would all say that there are advantages that there are disadvantages as well, but there are advantages, so it's interesting to consider this but, of course, it's very costly, it's very risky to the central bank, and it might deter innovation. This private-public partnership is intended to conserve the competitive advantages of the private sector to interface with clients and innovate and the competitive advantage of the central bank to regulate and provide trust.

Of course, this is similar to a narrow bank, because this is a specialized payment institution that issues liability that are fully backed with central bank reserves. I would like to avoid the term narrow bank because it's so charged. This is not a narrow banking license that the central bank would issue. This is a special synthetic CBDC license that the central bank would issue, and they would have all sorts of limitations in order to avoid problems of financial stability. I guess we'll speak about that later in the program.

Jeremy: It's fascinating and it's something that we have very much gravitated to. I think in the absence of these types of charters and supervision, private sector actors are driving head in the space. You're familiar obviously with the work that we do and others, but it's moving fast. We see these global stable coin arrangements that have reserve models, that have 100% reserve models, that are backed by sovereign securities typically, but it's not yet, hey, there's an account with the Federal Reserve or there's an account with the European Central Bank and it has a set of supervisory relationships.

This idea of public-private partnership, I think, is really, really critical. The private sector in technology has shown incredible capacity for innovation and reach and distribution. If you can marry that to the safety and soundness and the supervisory rigor of leading central banks, you potentially have something quite powerful with that emerging.

Tommaso: Yes, that's precisely the idea, Jeremy, is that we shouldn't stop the innovation, we shouldn't rein in the innovation, but we should make sure that it happens within the confines of a regulated environment. It's great that we have new innovations and payments. We have stable coins that are backed with relatively safe assets, but there's a bunch of different stable coins that are available. It's hard for consumers to know which ones are really fully backed, which ones really offer a claim on the underlying reserves, and how liquid and safe are those reserves. Are they liquid and safe in all states of the world? It might work now, but not during a crisis.

With all these questions that emerge and that pose fundamental risks to users and to the safety of the financial system, the idea is to address those head-on, to provide a regulatory environment, an equal playing field for all the innovators, but to allow them to continue to innovate on the technological front and to allow them to continue to interface with customers since that's what they do well. You described it very well. That's very much our idea.

There are differences, of course, as to how you might design this. There's a debate as to whether the liability would be issued by the central bank or by the private sector. I think that people used to think about central bank digital currency as something that the central bank would run entirely. That idea is outdoor. We've warmed up to the idea of a public-private partnership. The question is how to design that partnership.

Along the value chain, from interacting with customers to undertaking customer due diligence, screening customers essentially to building the interface with which customers trade the tokens to picking the technology, and that's essentially issuing the token, to conserving data, et cetera. All these steps are necessary. The question is, where do you draw the line of what the public sector does and what the private sector does? The fundamental question is about issuance, I think. Is, does the public sector issue and the private sector distribute, or do we also allow the private sector to issue? This is still--

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