How Central Banks Could Create Inflation

How would you like to win the lottery?

50,000 people in China ‘won’ it this week.

To be fair, it wasn’t too much money. Each person got 200 yuan, or around $42.

Still, it’s a nice lunch, or several coffees for the week.

This was all part of an initiative from the Chinese government to celebrate Shenzhen’s 40th anniversary as a special economic zone, where the government distributed 10 million yuan in a giveaway.

But also, as a way to test China’s digital yuan.

China has been looking at developing their own digital currency for years now. And they aren’t the only ones.

The Fed, UK, Japan, and even Australia’s Reserve Bank have been looking at developing their own digital currencies. Research by the Bank of International Settlements (BIS) — also known as the bank of central banks — shows 80% of central banks are studying the tech to make it possible.

We may be closer than we think to central bank digital currencies (CBDC).

In fact, last week, seven central banks along with the BIS released a sort of guide for central banks on how digital currencies should work.

The idea is that a CBDC can be a way to include people outside the financial system. But it will also offer some competition against other initiatives like Facebook’s planned Libra, or Bitcoin [BTC].

But I mean, it’s easy to see other reasons why central banks would be interested in this.

For one, it gives central banks more control.

When you hear digital currency and that it may include blockchain technology, you may be thinking it’ll be something similar to bitcoin. But in fact, it’s nothing like it. Bitcoin is decentralised, while CBDCs would be completely centralised.

The digital yuan is completely controlled by the People’s Bank of China.

Robert Murray from the Foreign Policy Research Institute described it best when he talked about how a digital yuan could restrict freedom and privacy:

‘[T]he digital yuan would enable China to monitor and control spending under its $3.6 trillion stimulus package. A large percentage of China’s consumer and business transactions are already handled digitally, and China, like other governments, is almost certain to conduct surveillance on them. The centrally controlled digital yuan, however, takes this to another level. If the central government distributes multi-billion yuan stimulus payments using the digital yuan, it could essentially tag the funds and dynamically filter or restrict how ministries, cities, and other recipients spend it. Every expenditure of the stimulus package would be tracked and recorded.

Then there’s negative interest rates. As I’ve said before, a CBDC would make it easier to impose negative interest rates.

 

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Central banks are out of ammunition

There is an alternative of course…cash.

If there were negative interest rates people may flock instead to cash. That is, unless there’s a charge.

In a blog post last year the International Monetary Fund explored how to make negative interest rates work alongside cash. The way they solved it was by creating a sort of exchange rate between physical and digital cash. So, for example, if the interest rate is at negative 5%, anyone paying in cash would incur a 5% fee. If you tried to deposit your physical money into your account you would also get 5% less for your cash.

So even if cash manages to survive and coexists with CBDCs, there could be a sort of ‘exchange rate’ between physical cash and digital.

However you spin it, it all means less freedom…for us.

But onto how central banks could create inflation through digital currencies…

Most money is created through loans from commercial banks. For example, let’s say you deposit $1,000 into the bank. Your bank is only required to keep a fraction of that as reserves and then can lend out the rest.

Let’s say that requirement is 10%. So, they can lend out $900.

They have now lent $900 to a business owner. Now there’s $1,900 in the system. $1,000 in your account and $900 with the business owner.

Now, that business owner deposits that $900 in their own bank. Their bank can now lend out $810 from that $900…and so on and so on.

Central banks depend on commercial banks to lend and keep money moving.

But a CBDC could allow central banks to gain some control over how money is lent.

How?

By people holding accounts directly with the central bank instead of commercial banks.

It’s something the Fed Bank of Philadelphia explored this year in ‘Central Bank Digital Currency: Central Banking for All’.

As they said:

The introduction of a CBDC can represent an important innovation in money and banking history. Besides its potential role in eliminating physical cash, a CBDC will allow the central bank to engage in large-scale intermediation by competing with private financial intermediaries for deposits (and, likely, engaging in some form of lending of those deposits). In other words, a CBDC amounts to giving consumers the possibility of holding a bank account with the central bank directly.

I mean, central banks are pretty much out of ammunition. They have lowered interest rates and increased their balance sheets…

CBDCs would give central banks more say on money lending and bypassing the banks, or they could deposit money directly into consumers’ accounts…and this is something that could create inflation.

Best,

Selva Freigedo Signature

Selva Freigedo,
For The Rum Rebellion


Selva Freigedo is a research analyst for The Rum Rebellion.

Born in Argentina, her passion for economic analysis started at a young age. Her father was an economist for the Argentinean governments and the family used to discuss politics and economics at the dinner table.

Argentina is a country with an unusual economic history. Growing up there gave Selva first-hand experience on different economic phenomena such as hyperinflation, devaluation and debt default.

Selva has also lived in Brazil, Spain and the USA.

Back in 2000 she was living in the US as the dot com bubble popped…
And in 2008 she was in Spain as the property market exploded and then collapsed…

She has seen first-hand what happens when bubbles burst.

Selva joined Port Phillip Publishing’s team in 2016, as an analyst. She now writes from her vantage point in Australia, where she settled in 2015.


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