This is why Europe needs a digital euro

The European Central Bank and its counterparts in the UKUSChinaand India explore a new form of state-sponsored money built on similar online ledger technology for cryptocurrencies such as bitcoin and ethereum. So-called central bank digital currencies (CBDCs) envision a future where we all have our own digital wallets and transfer money between them at the touch of a button, without the involvement of big banks, because it all happens on a blockchain

But CBDCs also present an opportunity that has gone unnoticed — to massively reduce the exorbitant levels of public debt that burden many countries. Let’s explain.

The idea behind CBDCs is that individuals and businesses would be given digital wallets by their central bank to make payments, pay taxes, and buy stocks or other securities. While with today’s bank accounts there is always the external possibility that customers will not be able to withdraw funds due to a bank runthat cannot happen with CBDCs as all deposits are 100% backed by reserves.

Current retail banks are required to keep little or no deposits in reserve, although she to have to hold a portion of their capital (i.e. easily sold assets) as protection in the event their loan portfolio gets into trouble. For example, the minimum requirement for Eurozone banks is 15.1%, which means that if they have a capital of €1 billion (£852 million), their loan portfolio cannot exceed €6.6 billion (that is, 6.6 times the deposits).

In an era of CBDCs, we assume that people still have bank accounts, for example to have their money invested by a fund manager or to make a return by having it lent to someone else on behalf of the first person. Our idea is that the 100% reserve protection in central bank portfolios should extend to these retail bank accounts.

That would mean that if a person put 1,000 digital euros in a retail bank account, the bank wouldn’t be able to multiply that deposit by opening more accounts than they could pay on demand. The bank should instead monetize its other services.

Currently, the ECB owns about 25% of the government debt of the EU Member States. Imagine if after the transition to a digital euro it decided to increase this stake to 30% by buying new government bonds issued by member states.

To pay for this, it would create new digital euros – just like what happens today when quantitative easing (QE) is used to support the economy. Crucially, for every unit of central bank money created in this way, the money circulating in the broader economy rises much more: in the eurozone, it approximately triples† This is because QE drives up the value of bonds and other assets, and as a result, retail banks are more willing to lend to people and businesses. This increase in the money supply is why QE can cause inflation.

However, if there were a 100% reserve requirement for retail banks, you would not get this multiplier effect. The money created by the ECB would be that amount and nothing more. Consequently, QE would be much less inflationary than it is now.

The Debt Benefit

So where does the national debt fit in? The high government debt levels in many countries are mainly the result of the global financial crisis of 2007-09, the eurozone crisis of the 2010s and the COVID pandemic. in the euro zone, countries with very high debts as a percentage of GDP include Belgium (100%), France (99%), Spain (96%), Portugal (119%), Italy (133%) and Greece (174%).

One way to deal with high debt is to create a lot of inflation to reduce the value of the debt, but that also makes citizens poorer and can cause unrest in the long run. But by taking advantage of the shift to CBDCs to change the rules surrounding retail banks’ reserves, governments can take a different path.

The opportunity is there during the transition phase, by reversing the process where creating money to buy bonds adds three times as much money to the real economy. By selling bonds in exchange for today’s euros, every euro removed by the central bank results in three disappearing from the economy.

Indeed, this is how digital euros would be introduced into the economy. The ECB would gradually sell government bonds to take the old euros out of circulation, while creating new digital euros to buy back bonds. Since the 100% reserve requirement only applies to the new euros, selling bonds worth €5 million costs €15 million from the economy, but buying bonds for the same amount only adds €5 million to the economy.

However, you would not buy the same amount of bonds as you sold. Because the multiplier doesn’t apply to the bonds being bought, you can triple the number of purchases and the total amount of money in the economy stays the same — in other words, there’s no additional inflation.

For example, the ECB could increase its holdings of EU member states’ sovereign debt from 25% to 75%. Unlike privately owned government bonds, Member States do not have to pay interest to the ECB on such bonds. So EU taxpayers would now only have to pay interest on 25% of their bonds instead of the 75% they now pay interest on.

Interest rates and other questions

An additional reason to do this is the interest. While bond yields have been lean for years, future issuance could see them soar due to inflationary pressures, and central banks are starting to raise short-term interest rates in response. The chart below shows how yields (ie interest rates) on the closely watched 10-year government bonds of Spain, Greece, Italy and Portugal have already risen three to fivefold in recent months.

Mediterranean 10-Year Bond Yields

After several years of huge shocks from the pandemic, the energy crisis and the war emergency, there is a risk that the markets will think that the most indebted countries in Europe cannot cover their debts. This could lead to widespread bond sales and drive interest rates to unmanageable levels. In other words, our approach could even save the eurozone.

Indeed, the ECB could achieve all this without the adoption of a digital euro, simply by imposing a stricter reserve requirement within the current system. But by moving to a CBDC, there is a strong argument that, since it is more secure than bank deposits, retail banks should guarantee that security by following a 100% reserve rule.

Please note, however, that we can only use this medicine once. As a result, EU countries will still have to be disciplined about their budgets.

Instead of completely ending fractional reserve banking this way, there is also a halfway house where you tighten the reserve requirements (say a 50% rule) and enjoy a reduced version of the benefits of our proposed system. Alternatively, after the CBDC transition has ended, the reserve requirement could be gradually relaxed to stimulate the economy depending on GDP growth, inflation, and so on.

What if other central banks don’t follow the same approach? Sure, some coordination would help keep disruption to a minimum, but reserve requirements today differ between countries without significant problems. Also, many countries would likely be tempted to take the same approach. For example, the Bank of England currently owns more than a third of the UK’s public debt and the UK’s public debt as a percentage of GDP currently is at 95%The conversation

This article by Guido Cozziprofessor of macroeconomics, University of St. Gallenand Leonardo Becchettiprofessor of political economy, University of Rome Tor Vergata has been reissued from The conversation under a Creative Commons license. Read the original article