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The European Union Is Cashing in on Digital Currency

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11/06/2021

The European Union Is Cashing in on Digital Currency

Europe Tech & Innovation

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The European Union Is Cashing in on Digital Currency

Author

Markus K. Brunnermeier

Professor of Economics at Princeton University

Twenty years after the introduction of the euro, the architecture of money (and our relationship to it) is now at a turning point. With the digitalization of our society, digital money is heading for the central banks, and soon for our current accounts.

On March 23, Institut Montaigne organized a conference on the prospects of the digital euro within the ambitious framework of European monetary sovereignty, with Markus Brunnermeier, professor at Princeton University, Emmanuel Moulin, chief economist at the French Treasury, Natacha Valla, dean of the School of Management and Innovation at Sciences Po and member of the steering committee of Institut Montaigne, and Jakob von Weizsäcker, chief economist at the German Ministry of Finance.

Following the Franco-German Economic and Financial Council, where this topic was widely discussed by ministers Bruno Le Maire and Olaf Scholz, this article traces the stakes of monetary digitalization.

Digitalization has reshaped how we communicate, organize, interact, move and trade. It is now also changing money.

For the end-users, digital money is like physical cash, allowing to instantly transfer value, peer to peer, irrespective of distance. But, fundamentally, digitalization is changing both the architecture of money and the competition between currencies.

The architecture of money

Digitalization naturally favors the expansion of large networks and the structuring of economic activities around "platforms." Payment is thus a key activity: operations and the generation of data depend on it. Hence, payment functionality is crucial for the value and growth of platforms.

Networks, platforms and money are closely linked. Network effects and externalities play an essential role in establishing and maintaining a currency. A currency supported by a digital network may be able to quickly achieve broad domestic and international acceptance.

Most importantly, payment networks have unparalleled access to data. The benefits of a database are derived not only from its size, but also from its diversity: it is far more valuable to know the habits of a million random individuals than to know the habits of a million individuals from the same city. A large payment-based platform that aggregates a wide array of activities is therefore an ideal tool for gathering data.

Payments are at the center of any economic platform, and all other activities would organize themselves around it.

For banks, the changes can bring significant disruptions. Banks are the point of contact for all users of the payment system. In many countries, the dominance of banks’ over financial activities extends even to the provision of insurance and asset management services. The financial system, and the way in which consumers store and exchange value, is organized around banks and credit.

In a platform-based economy, this hierarchy could be overturned. Payments are at the center of any economic platform, and all other activities would organize themselves around it. The consumers’ point of contact would be the entity that owns the platform rather than the bank, and financial services such as payment and insurance would be subordinated to payment services.

Competition between currencies

Economic competition in digital networks, particularly digital currency competition, differs starkly from traditional currency competition. Information can be diffused cheaply and near-instantaneously, and then be automatically converted into whatever form is most convenient for the receiver. Modern technology makes frictionless, intermediated peer-to-peer transactions possible using digital tokens. These characteristics of digital networks weaken the rigidities that impede competition in traditional settings.

In the past, given that trade occurred mostly within geographic regions, it was improbable that a currency would diffuse across borders. Only a few, such as the dollar and the euro, managed to do so. But digital networks are now particularly well-suited to overcoming this issue. Whereas geographic constraints limit the spread of physical currencies, digital currencies are free to circulate within networks beyond borders and service tens, or even hundreds of millions of participants. In the future, the international monetary system could possibly be structured around Digital Currency Areas (DCAs), defined as networks where payments and transactions are made digitally by using a currency that is specific to the network.

The digitalization of money raises new challenges: it opens the way to new forms of currency competition and the monetary system may become more fragmented.

Such DCAs are held together by digital interconnectedness. When participants share the same form of currency, whether or not it is denominated in its own unit of account, strong monetary links develop.

The policy response

For governments and Central Banks, the digitalization of money raises new challenges: it opens the way to new forms of currency competition and the monetary system may become more fragmented. The general public may lose access to public money.

In facing these challenges, Governments and Central Banks are confronted with a dilemma: how should technological progress be supported and encouraged while preserving the ability to pursue their public objectives and conduct monetary policy?

Sovereign governments and Central Banks can certainly prevail if they assert their power and authority. They have the capacity to protect their currencies, they can regulate and, if necessary, prohibit the monetary innovations that they dislike.

They should, however, do more. The general public is entitled to keep access to central bank money as technology changes. It should be offered a digital equivalent to cash, known as Central Bank Digital Currency. Most Central banks in the world are now exploring such CBDCs, and Europe is now taking up a central role, with the project of the digital euro.

A digital euro is an essential component of the policy response to the monetary challenges presented by digitalization. At a time when Europe is looking for new projections into the future, the digital euro offers the possibility to jumpstart and stimulate the modernization of its payment and financial infrastructure.

Copyright: DANIEL ROLAND / AFP

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