This piece draws on a discussion paper entitled “Monetary reform, central banks and digital currencies,” available at https://www.uvic.ca/socialsciences/economics/assets/docs/discussion/DDP1805.pdf

Much hyperbole surrounds cryptocurrencies—either they herald a new high-tech payments era without interference from the state, or they are a speculative fad which will sooner or later crash and burn.



In support of the first view, the growth and proliferation of these cryptocurrencies is taken as evidence that they meet a market need for a swifter and more secure payments system with the added attraction of anonymity.

Critics however point out that the unstable value of cryptocurrencies (and their multiple valuations) make them more a purely speculative asset than a form of money. Their vulnerability to fraud and hacking make cryptocurrency markets, and markets in cryptocurrency derivatives, highly unstable and open to a speculative crash.

The reality is arguably somewhere in between these two positions, with cryptocurrencies performing some useful functions, and yet being potentially highly unstable in a way which could feed into forces for instability in the rest of the financial system. The situation clearly calls for regulation. This would go against the original libertarian rationale for cryptocurrencies. But, even among promoters of cryptocurrencies, recognition of the role of the state as enabler rather than constrainer is now evident from the efforts to obtain SEC approval for cryptocurrency exchange traded funds (ETFs).

Some central banks have gone further, exploring the possibility that they themselves might issue such currencies. Particular attention has been given to the relative merits of blockchain technology as a way of verifying transactions more speedily and efficiently than at present. Central banks need not use the environmentally-costly private-sector approach of incentivizing multiple “miners” to attempt simultaneously to verify transactions. But it is still an open question whether the technology is as efficient as its supporters allege.

But would it be a good idea for central banks to issue their own digital currencies, with or without blockchain technology? Central banks are already concerned about the loss of seigniorage—the profit from printing money worth more than it costs to make—from the increased use of debit and credit cards over cash. This concern is compounded by the loss of control where payments are made by cryptocurrency, outside the regulatory net.

But what if a controlled supply of central bank digital currency (CBDC) improved financial stability, by taking over the supply of society’s money from commercial banks? For many, the primary cause of the 2008 financial crisis was the unchecked creation of credit by banks, enabled by their confidence that they would be bailed out in the event of unanticipated losses.

There are real concerns that, even with new regulation introduced in the wake of the crisis, the conditions remain for financial institutions to fuel a further crisis (something which cryptocurrency markets may exacerbate). As a result there has been a raft of proposals for (more or less) direct control of the money supply by the state. As a result banks would no longer be able to create credit and the entire private sector financial system would become one of financial intermediation, with no guarantee of central bank liquidity support. Digital currency technology has simply created a new opportunity for state money and a state payments system independent of the banks and their risk of failure.

But this kind of proposal rests on a number of theoretical presuppositions which need to be examined. The first is the primacy being given to the money supply and its control by the central bank. The implication is that the money supply plays a causal role, rather than, as Post-Keynesian theory suggests, arising from the process of credit supply and real (as well as financial) economic activity.

Second it is assumed that a “correct” level of money supply can be identified, with an eye to inflation control. But again Post-Keynesian theory suggests that the demand for money is potentially highly unstable due to the scope for discrete shifts in precautionary demand, such that there is no direct link between money and prices.

Third, and perhaps most telling, it is assumed that the state monopoly on money can be enforced. Yet, as Keynes pointed out in relation to similar proposals in the 1930s, the financial sector is highly innovative and adept at meeting liquidity needs. Now that ability has been extended by the emergence of cryptocurrencies and the products and markets surrounding them. Households and firms would be attracted by higher expected returns from private-sector liquid assets, including cryptocurrencies, only to attempt to surge into the safe state-issued money during a crisis. Further, cryptocurrencies hold the particular attraction of anonymity; it is highly unlikely that this would be a feature of CBDCs.

Fourth, there is a widespread assumption behind plans for eliminating bank credit creation that, without market imperfections (such as state support for banks), the financial sector is inherently stable, enforced by market discipline (possibly supplemented by regulation to reduce market imperfections). But Minskyan analysis of the implications of uncertainty in market pricing and financial structure suggests that the forces for instability are endemic. Periods of apparent stability encourage excessive credit creation, a high degree of leveraging, over-confidence in the pricing of risk and highly-integrated markets in opaque structured products.

These forces for instability extended well beyond retail banking in 2008, and continue to do so. Indeed, government bail-outs extended beyond banks, indicating that the concern was not solely with retail deposits, but with the financial structure as a whole. The strong implication is that, rather than focusing on the doubtful task of trying to replace retail bank deposits as money, without consideration of the rest of the financial system, the sources of instability in the financial system as a whole should be the main focus of attention.

So what is to be done? Just as the problems started with deregulation in the 1970s, breaking down institutional and market segmentation, new regulation is required to reverse that trend. Traditional retail banking performed a useful social function, endogenously meeting credit and liquidity needs. It was only when deregulation allowed retail banks to address non-bank competition that they made credit and liquidity creation serve their own needs for market share.

Where retail banking had been segmented by specific tight regulation, there was a quid pro quo for central banks. To be fully effective in ensuring a stable supply of a safe money asset (bank deposits), the higher regulatory burden on retail banks needed to be accompanied by a lender-of-last-resort guarantee, such that bank deposits were safe money assets.

By the time of the crisis, banks had lost their way as stable providers of credit to small and medium-sized business. During and after the crisis, the most stable institutions tended to be cooperative banks, which had continued to operate as traditional small retail banks, with cautious practices reflecting their social goals and the limit to which they could create credit. Rather than the current situation where these socially-valuable banks are being unduly penalized by stricter capital requirements, much could be done in terms of government support.

Indeed governments could be even more proactive by bringing at least some retail banking fully into the public sector, to address goals other than shareholder value. The problems with the proposals for replacing bank deposits with central bank money stem from separating money creation off from other retail banking functions, notably creating credit for socially-useful purposes, through which money is supplied endogenously.

The idea of state-controlled retail banking is not new. For example, while supporters of social credit in Canada in the 1930s were proposing centrally-controlled state money, the Cooperative Commonwealth Federation (CCF) counterproposal was to continue with the institutional arrangements of traditional retail banking, but bring them under public ownership. They had identified the problems with private sector banking (such as predatory practices) as stemming from the primacy given to the profit motive.

But in the meantime, the monetary authorities now need to double down on drawing as much of the financial sector as possible into the regulatory net. These regulations would allow certain strategies, products, and practices while proscribing others. If the forces for instability are endemic to the financial sector, throwing regulatory sand in the wheels is needed to limit these forces, requiring continual updating to reflect financial innovation. But the process is hampered by the persistence of the theoretical presumptions explored above, which imply that anything that impedes free financial market forces is to be avoided.

If markets cannot be relied upon to promote stability, particularly in a sector of great socio-economic importance, the state has a crucial role to play. Ultimately, state support may be necessary. But, in exchange, the entire financial sector has to accept serious regulatory constraints and the monitoring and supervision required for their enforcement.

The challenges are immense. But this is all the more reason not to be unduly distracted by proposals for central bank digital currencies. It may well be that some form of CBDC eventually becomes workable, and indeed desirable, as a substitute for cash. But we need to look at the financial sector much more broadly if we are to prevent a repeat of 2008.