Mutual Assured Digitisation

Photo by Eric Prouzet on Unsplash

While most commonly associated with the Cold War, the doctrine of Mutual Assured Destruction (rightly termed “MAD”) had one of its earliest recorded references in the form of a letter in 1870 from the English author Wilkie Collins to his German Translator at the time of the Franco-Prussian war: 

“I begin to believe in only one civilising influence – the discovery one of these days, of a destructive agent so terrible that War shall mean annihilation, and men’s fears shall force them to keep the peace.” 

That doctrine found its ultimate manifestation in the nuclear arms race of the Cold War, where huge stockpiles of nuclear armaments were built up on both sides, ostensibly “for show”, albeit a very dangerous show, as demonstrated by this declassified incident about a B-52 bomber breaking up mid-air and accidentally dropping two hydrogen bombs over North Carolina.  

In this day and age, threats of hitting “the red button” feel slightly out of date – perhaps the combined influence of every dystopian, post-nuclear-apocalypse film ever made has truly “civilised” the thought of nuclear war out of conventional tactics. But the need to maintain hegemony has moved expectedly to a different battlefield: a digital one. 

We have written quite a bit on our views on Fiat Currencies, Bitcoin and Decentralised Finance. This time, however, the developments we’re seeing are on the other end of the spectrum: centralised, central bank digital currencies (aka CBDCs) are coming into play. 

Ironically, this is the ultimate manifestation of the “blockchain not bitcoin” mantra that’s been doing the rounds in recent years. A centralised implementation of a ledger that allows absolute control and surveillance over all of money supply is diametrically opposed to the founding principles of digital assets. But where it was embraced from the outset by China, who had already digitised its entire economy via WeChat Pay and AliPay, it was initially spurned by the West.  

Both sides saw the same reasoning: a digitised currency, imbued with the ease, speed and low cost of transaction accorded by the internet, could challenge the US dollar’s status as the world’s reserve currency. One side saw it as an opportunity, the other saw it as a threat to be staved off and outlawed. As it happens, the Huxlian observation that facts do not cease to exist because they are ignored rings true here.  

Ready, set, go. 

Last week, China played its hand, launching the digital renminbi in a pilot in Shenzhen’s Luohu district, including an airdrop of 50,000 digital red packets. And the week before, Iran announced that it was adopting the renminbi as its main reserve currency in place of the USD. 

On the other side of the planet, the EU’s move to trademark “Digital Euro” sparked some excitement on this end of the world, although it is clear that for the incumbents – whether the Euro or the US Dollar – such moves are defensive. The aim of the broader digital euro experiment appears to be to prevent the rise of an alternative digital currency circulating in the Eurozone (including Facebook’s Libra project), supplanting the use of the Euro, as much as it is in response to the inevitable need to digitise and stay relevant. 

And while the US is perhaps fully occupied with its upcoming election, its next move on the digital currency front – certainly after its scathing comments on Bitcoin, Libra and the digital asset space – will be very interesting to watch.  

Everyone is taking sides, and that in itself is a fascinating development, albeit not unexpected. As ever, we don’t claim to have a crystal ball which predicts the next move in this game. However, we will attempt to lay out some potential determinants of the path ahead. 

Initial conditions 

Just as in the case of MAD, the side that secures the weaponry (or technology) in question enjoys multiple advantages: Reputationally, its success in applying the technology in the real world puts it a step above everyone else’s theories; its aims and objectives are made clear as a result of its first actions; most importantly, it is in a position to produce more of said technology having already done so, putting it in a position of strength – a strong advantage over the rest. 

In this case, the Chinese stance is clear: a digital RMB has not only been embraced by the PBoC, it has been launched and its use encouraged. Whatever the ultimate political and governmental aims of such a decision may be, China has – as we’ve long expected – stepped into a new paradigm of monetary management, far apart from everyone else. 

The initial conditions for it to make such a move have been in place for a long time. For one, the people are amenable to the control that the government (through the PBoC – no independent central banks needed) continues to pick up, as part of a social contract that offers them prosperity in return for obedience. Moreover, the “digitisation” of China’s economy has been long in the making: from social credit scores to lending and borrowing on the fully captive digital ecosystems of WeChat Pay and AliPay, which themselves straddle the line between private enterprise and the state, China has been ready to go digital for a number of years now, with the use of cash in the country all but eliminated (tourists and stock photos of RMB notes being the exception).  

All that was needed was a change in name. 

For everyone else, the initial conditions are very different. Traditional monetary systems with a large circulating base of “M0 Cash and coins” still exist. While digital wallets and payment services like Paypal and Square exist, alongside long-established credit/debit card systems like Visa, Mastercard, Amex and (if anyone remembers them) Diners Club, the promise of widespread adoption has yet to be fulfilled. 

The transmission mechanism in a traditional monetary system is completely dependent on commercial banks, themselves for-profit entities, for the distribution of credit. The notion has been that the banks will be the best judges of which borrowers are creditworthy and will allocate capital accordingly. More importantly, the believe in the invisible hand suggested that such privately driven capital allocation would be more efficient than a state-dictated distribution pattern. 

Unfortunately, the willingness of politicians to use not-so-independent monetary policy as a backstop for fiscal expenditure ultimately clashes with private interest to produce the biggest bottleneck in monetary distribution in history: 

In the US itself, the notion that giving more money to banks for them to lend out to the masses was a good idea has – as the data shows – created quite the opposite reaction. While money supply has increased sharply, the velocity of that same money (the number of times it circulates in the economy) has fallen equally sharply. The cash is stuck – because banks don’t want to take the risk of lending to borrowers who may default. 

Or even worse: those in need of credit who can’t open a bank account because, for whatever reason, they’re unable to jump through the hoops of background and credit checks imposed by risk officers who are less than incentivised to rubber stamp new accounts that may go wrong. 

Banks – it turns out – have become a part of the problem in the developed world. 

A change of tone 

The irony of what has panned out is that a potential solution to the monetary transmission problems of the US is to adopt Chinese monetary policy. 

Why not? Just as the bombing of Hiroshima and Nagasaki took whatever compunction out of any government to push for nuclear armament (if we don’t do it everyone else will, so we might as well do it), the same can be said of digitisation – no one wants to be the last one holding out on cash and coins. 

Moreover, does it really make a difference? Physical cash and coins don’t change hands anyway, Visa/Mastercard effective operate digital money transfer systems and a CBDC operates on a centralised ledger (“blockchain”, if you will) maintained by the central bank. In many ways, the pieces are already in place for a digitisation of most developed world currencies, including the USD and EUR. 

Where it would make a difference is with the banks: their proven inability to distribute credit in line with monetary policy aims (at least to retail customers, but why not businesses too?) is a damning sentence against the efficacy of the invisible hand. 

A digital USD run by the Fed, paired up with the government’s entire database of individual identities, could take helicopter money to the next level. We say “could” when we really should say “will” – after all, China’s already done it. 

Not to forget the existing already-digitised supply of USD existing as Stablecoins, reportedly topping US$20bn at the beginning of October 2020, and continuing to grow. US$20bn isn’t a big slice of the total US$18tn of M2 money supply in circulation, but it’s US$20bn worth of proof of concept. 

Where would this leave commercial banks? Everything that’s non-essential and can be dealt with on a purely commercial basis (i.e. doesn’t win votes) can remain within their purview. No surprise – that’s largely the way Chinese banks work, functioning more as a utility than a commercial enterprise. 

The elephant in the room would be the risk of complete and explicit monetisation of fiscal deficits, allowing governments to fund their deficits not just through more central bank issuance, but by the imposition of negative interest rates on cash balances – the one thing that is impossible to enact on cash and coins. 

If not managed properly, the sheer power of a digitised fiat currency operated by a central bank whose independence is increasingly tenuous could wreak unadulterated monetary havoc long after the initial skirmishes (remember North Carolina).  

But the wheels have been set in motion and resistance from here seems largely futile. 

Crossroads 

In our view, the West is finding itself at a slightly unpleasant juncture right now: on one hand, it can flex its political muscle to try and stave off the inevitable, as was done to Facebook’s Libra project (which, by the way, is by no means dead – we think it resurfaces in a different form). 

On the other, it faces the prospect of joining in the Digital arms race with China and the rest of the “emerging” world, where the lack of a well-oiled incumbent system has turned into the catalyst for building something new. The challenge would be to overcome the vested interests of all the incumbents – no easy feat. The unfortunate part is this time, it isn’t joining the race in pole position. 

As far as eventualities go, this is perhaps one more reason why you wouldn’t want to own banks: with their raison d’être severely diminished in a scenario where governments no longer need them to do the heavy lifting of credit distribution, what profitable purpose could they serve? 

In the end, just as during the Cold War the Nash Equilibrium was mass nuclear armament, it’s hard to see how the new equilibrium doesn’t turn out to be mass digitisation. 

Because if you’re not doing it, someone else will.