A Crash Course on Digital Cash (Part 2)

Money is a social institution. Greek philosophy is a source of wisdom for many social questions. Yet, in the evolving landscape of digital cash, it's time to steer away from the Aristotelian path.

Let's continue from where we left off in my previous article, where I emphasized the importance of distinguishing between various forms of money, such as central bank money, commercial bank money, and digital cash.

A Crash Course on Digital Cash (Part 1)

It seems that the internet agrees with me, or at least that's what I thought when I came across a question posed by someone: 'Is digital currency real money, like cash?' How does one begin to untangle such a perplexing query?

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It reminds me of 'Mā mā qí mǎ' (妈妈骑马), the opening line of a Chinese tongue twister that every student inevitably encounters. How many times can we express seemingly the same thing but convey different meanings? 'Mā mā qí mǎ' pertains to a mother riding a horse, and this phrase has been used by generations of language instructors to illustrate the significance of the four tones in Chinese. In our discussion of money and cash, it seems that the magic number is three, but is it really?

Let's delve into the current arrangements and orthodox definitions of monetary theory:

1. We have central bank money available to the public in the form of physical cash.

2. It is also accessible through electronic means by commercial banks, but typically not by the public (as central banks began restricting access in the 20th century).

3. Additionally, there is private money, which exists in the form of bank deposits or other means like e-money, stable coins, and essentially everything else.

Central Bank Digital Currencies (CBDCs) would align our monetary system with the Chinese language by introducing a fourth category: cash in electronic form as a liability of a central bank but available to the public. The best definition of what a CBDC is comes from a CPMI report from 2018: 'CBDC is a digital form of central bank money that differs from balances in traditional reserve or settlement accounts.' The only thing we need to settle is: how does it differ? Oh boy.

Central bank money usually defines the unit of account: your salary slip states how many pounds (£) you earned last month, and the invoice from Thames Water specifies the price in pounds (£) per cubic meter. The ability to easily convert the value of a day's work into cubic meters of water—that's the magic of money and its function as a unit of account. This particular function is perhaps the most important one. It is what empowers a central bank to conduct its monetary policy, regardless of whether its liabilities are used as a payment mechanism or a store of value. A crypto-asset like Bitcoin may exhibit high price volatility, but that is inherent to any currency that does not serve as a unit of account in the economy where it's being used.

The term CBDC, as a special form of central bank money, is a relatively recent invention. However, depending on how one defines what a CBDC actually is, the idea goes back a couple of decades to a place called Jackson Hole, Wyoming. It's where James Tobin, best known for the Tobin Tax on certain financial transactions, put forward an idea for 'currency on deposit,' i.e., a non-physical universal form of central bank money with electronic access, during a regular central bank conference in 1987. Some go even further and consider the introduction of real-time gross settlement systems, which began in 1970 with the US Fed adopting such a model, as a de facto CBDC.

European Central Bank: “Wholesale CBDC is generally presented as something new, made possible by the emergence of distributed ledger technology. But wholesale CBDC has existed for decades.”

US Fed: “the term "wholesale CBDC," despite its wide use, is generally a misnomer that leads to confusion since we already have central bank money in digital form that is available to banks for wholesale transactions.”

They seem to illustrate the ‘many-worlds interpretation’ in quantum theory: in one universe, CBDCs are a thing of the future, while in another, central bank liabilities in digital form have existed for a long time. I believe this question can be readily resolved: a digital cash solution required for a digital asset market is different because it must support composability and interact with smart contracts across multiple chains, and unfortunately, this was not yet postulated in 1987 and is not a functionality offered by RTGS systems.

Another point often raised in discussions of digital payment solutions is that money serves three primary functions: as a unit of account, a means of payment, and a store of value. This often leads to debates about the extent to which cryptocurrencies fall short in fulfilling these functional dimensions, which is why some argue that Central Bank Digital Currencies (CBDCs) are necessary for a digital cash solution. However, framing the future of money and its definition solely around these three functions misses the mark. I make this claim fully aware that almost every article written by highly credible industry experts makes this assertion. They have my utmost respect, but in my opinion, such a perspective is fundamentally mistaken here for two reason:

1. Money cannot be considered without contemplating the provision of credit. It stands as the fourth function of money, a concept championed by economist Henry Thornton in the early 19th century, who even argued that credit precedes money. James Tobin's concept of 'currency on deposit' emerged from his aim to disentangle commercial credit from deposit-holding during a banking crisis of that era. The question of how the provision of credit would persist if Central Bank Digital Currencies (CBDCs) were to overshadow bank deposits is frequently raised but remains insufficiently addressed.

2. The crux of the matter lies in the underlying question: Can cryptocurrencies, or projects like the now-defunct Libra/Diem, effectively perform the three functions of money and potentially substitute for a national currency like the pound (£)? Instead, we should be asking a fundamentally different question: How does digital technology transform the function of money?

James Tobin was a student of the Austrian economist and former finance minister and bank president Joseph Schumpeter. He left an indelible mark on economic thought. His work on creative destruction is a personal favourite of mine. He also made contributions to the theory of money. For Schumpeter, money represents a technology of social accounting. To illustrate this concept, let's draw inspiration from one of his examples.

Imagine an extreme socialist society where all economic activity is centrally planned. I come from Eastern Germany, which once had a centrally planned economic system where the government dictated all production and market prices for the next five years. In an extreme model beyond what was in place in Eastern Germany, with a central market-clearing mechanism in place, money becomes unnecessary. The central administration office plans the production of a million pairs of black leather shoes. Through meticulous planning, they identify the one million people most in need of new shoes and provide them with one pair each. What if you don't want black leather shoes and prefer white bridal shoes? Tough luck; you'll have to wait for the next plan! In such an economy, the only necessity is a unit of account to convert working hours into bridal shoes. This, at its most fundamental level, defines money for Schumpeter: a means of recording social activity on an imaginary ledger.

Money is a social institution, and its purpose evolves with the state of available technology. Some of the current three functions (unit of account, means of payment, store of value) could vanish, while entirely new ones may emerge. I've previously discussed how cryptocurrencies are essentially money for computers, not humans. This could be an example of the kind of changed understanding of what money is good for. Aristotle is often credited with being the first writer in history to describe the three functions of money, and Schumpeter left us with a wealth of, often critical, commentary on Aristotle's writings. After nearly 2,500 years, it might be worthwhile to refresh our understanding of the functions of money.

End of Part 2.