Are we ready for the political compromises a digital currency may warrant?

It took 300 years for trust in currency to become total and unquestioned, and now digital currency brings with it some new challenges for it

The Supreme Court has finally laid to rest the question of whether the decision to demonetise the entire Indian currency was legal or not. It has said it was.

That takes care of the legality part of it. The economics has already been discussed, and no one has been left in any doubt that it was a terrible decision.

However, its politics has been ignored, which is strange for two reasons. One was the timing of the demonetisation decision, just four months before the 2017 UP assembly election. But this is pure speculation, left to politicians and pundits.

The other reason is that if you study the history of money, you will soon find that it is one of the most intensely political things. Not just its possession, which is political enough. But even its issuance and, by definition, its withdrawal and/or its debasement. These two are just as intensely political, if not more so. What governments create, they can also destroy.

The story of the politics of the different forms money has taken over the ages is fascinating. But this is not the place to recount that. Suffice it to say that transitions from one form to another have always been deeply political, as the cost of issuing money has fallen steeply.

Money started with coins, of course, which were costly to produce. Then over the centuries, it became paper which was much cheaper.

Now comes a new transition, namely digital currency. At the heart of money lies public trust: how to first gain it and then retain it. This is where politics comes in. Central to this was the issuer.

Eventually, the trust aspect was solved by entrusting issuance to the State. But it took around 300 years for the trust to become total and unquestioned.

A paper by Michael D. Bordo and William Roberds explains these transitions lucidly. It raises a critical issue, namely, the sort of political compromises needed when a new medium comes along.

The paper, uploaded last month, is about central bank digital currencies (CBDCs). They say that “a successful monetary transformation must combine microeconomic efficiency with macroeconomic credibility. A paradoxical feature of these transformations is that success in the micro dimension can encourage macro failure. Overcoming this paradox may require politically uncomfortable compromises.”

They say that since CBDCs are now only going to grow, “such compromises will be necessary for the success of CBDCs”. I hope the finance ministry and the RBI will take note.

In a nutshell, as the new currency proves increasingly more efficient at the retail level, issuers have a huge incentive to issue more and more. This causes macroeconomic problems. I would strongly suggest that you read the paper if you are interested in the various issues CBDCs raise.

The bottom line, in the words of Milton Friedman, is “so long as the fiduciary currency has a market value greater than its cost of production -- which under favourable conditions can be compressed close to the cost of paper on which it is printed -- any individual issuer has the incentive to issue additional amounts. A fiduciary currency would thus probably tend through increased issue to degenerate into a commodity standard — there being no stable equilibrium price short of that at which the money value of currency is no greater than that of the paper it contains. And in view of the negligible cost of adding zeros, it is not clear that there is any finite price level for which this is the case.”

We have seen this happen since 1971, when the gold standard was banished by the US. CBDCs will only make the problem worse.