Where money comes from and where it is going

Issue 565: 17 January 2024

This article was previously published by The Paypers: Where money comes from and where it is going. Payments:Unpacked is grateful to both Dr. Michael Salmony and The Papers for providing permission to republish this article.

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How is money created and distributed?

We all know that money is now largely digital, so the printing of notes and shipping them around physically in armoured trucks and putting them into ATMs is no longer the dominant distribution system. But - and this may be a surprise to many (even some bankers) - most of the money no longer even comes from the central bank. It is actually created by commercial banks. Although these high street banks cannot create money in the way central banks do - for example, they can't print bank notes - they do create money: every time they issue a loan for EUR 10,000 maybe they only need to have EUR 1000 of real central bank money. The rest is created out of thin air digitally using ones and zeros in their computer. This ‘fractional reserve banking system’ has largely worked well since the 1600s.

However, in the last few years, we have seen money created in entirely new and different ways using crypto and blockchain and DLT. Some people say this comes even more out of thin air and is only based on ‘trust’ in new (sometimes actually not so trustworthy) actors and trust in maths/algorithms (which very few people fully understand but still choose to trust).

But one thing is clear: that the money is no longer being created and distributed by only central banks. It is now being created by several different actors (central banks, commercial banks, and non-banks) and is also being distributed by many actors who often weren’t in the system before. We will not talk about Bitcoin and other new cryptocurrencies here since more than enough has been written about them elsewhere. Here we want to focus on CBDC (central bank digital currency) a new kind of money that is being created by the central banks. One could say the Empire strikes back. It is now the original source of money, the central banks, which are creating a digital version of cash to be used in our economy.

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Motivations

The original impulse for central banks to think about CBDC came on one side from technology (like DLT and tokenisation) and, maybe more significantly, through the Libra shock. Facebook started thinking publicly (and ham-handedly introducing) their own system of money which would be distributed through the Facebook apps around the world between users. This is of course highly threatening to the established banking system, to the role of central banks, to the sovereignty of the money supply, and has raised many legitimate concerns by those who do not want Mr. Zuckerberg controlling their economy. So, the response by the Central banks has rightly been to ban/regulate these kinds of threats but also to think about a state-driven alternative, the creation of a central bank - based digital currency.

This means that they will issue digital money, pass that on to the commercial banks, who then pass it on to the users. This actually sounds like the traditional way in which bank notes were created and distributed - and it is. CBDC is essentially digital cash.

Proponents of CBDC see a number of advantages in this. Indeed 32 different advantages are named in the current global debate:

This is surely a reason for concern: if one is trying to solve 32 different things at once, then one probably isn't going to be solving anything at all.

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Global approaches

The ECB is more focussed and ‘only’ pursues six goals:

(Some of these are doubtful: we already have unprecedented innovation and digitisation in payments; access to public money (cash) is in no immediate danger since the volume of cash in circulation is forever rising*; adding yet another initiative to the already existing thrusts toward a pan-European payment solution is maybe not helpful; etc.)

In any case, other regions have other approaches. Around the world over 100 central banks are seriously investigating this topic. Many are doing largely pointless technology pilots (the technology is not the problem). Some countries have forged ahead and have actually already launched their digital currency. For example, the Bahamas (Sand Dollar), Nigeria (eNaira), and China (eYuan).