Money is about to enter a new era of competition

Money is one of humankind’s most remarkable innovations. It allows people to trade goods and services across vast distances. It can also be used to transfer wealth or resources over time. Without money, commerce and trade–all human economic activity–would be severely constrained by time and space.

The privilege of issuing money is synonymous to economic power. It is not surprising that history is full of examples of currency competition between countries. China was the first country to issue paper money. For many centuries, currency issues by private merchants and local governments competed. Indeed, banknotes issued by governmental and private banks coexisted in China as late as the first half of the 20th century.

What finally, decisively ended this competition was the emergence of central banks, which were given the exclusive privilege of issuing legal currency and tasked with maintaining its stability. This shift happened quite early in Sweden; the world’s oldest central bank, the Riksbank, was established there in the 17th century. In China, competition closed with the founding of the People’s Bank of China in 1948, shortly before the formal creation of the People’s Republic of China. Since then, the competition has been mostly international. The relative value of currencies is determined by the reputation and stability the central banks issuing them.

We now stand at the threshold of another era of upheaval. We are at the threshold of another era of change. Digital technologies that will replace cash could completely transform the nature and capabilities. Today, central bank money functions as a unit, a medium for exchange, and a store value. As digital technologies gain popularity, these functions could be separated. That shift could weaken the dominance of central-bank money and set off another wave of currency competition, one that could have lasting consequences for many countries–particularly those with smaller economies.

In ancient societies, money was made from shells, beads, or stones. In China, the seventh century saw the first paper currency. It was in the form certificates of deposit that were issued by reputable merchants who backed the notes’ worth with precious metals or commodities. In the 13th century, Kublai Khan introduced the world’s first unbacked paper currency. Kublai Khan decreed that all citizens of his kingdom must accept the bills as payment for their death.

Kublai’s successors weren’t as disciplined in controlling the printing of paper currency. China and other countries followed his lead and printed money in reckless ways to finance their government spending. This recklessness often leads to inflation surges or even hyperinflation. This in effect results in a sharp fall in the number of goods and services a given amount of money can buy. This principle is still relevant in modern times. It is trust in a central banking institution that ensures widespread acceptance of its notes. However, this trust must be maintained by a disciplined government policy.

Cash seems outdated to many people. As smartphones make it easy to make payments, the ability to physically handle money has become less common. In just a few short years, the way that people in wealthy countries such as the United States and Sweden pay for basic purchases, as well as those in poorer countries like India or Kenya, has changed dramatically. This shift could be a driver of inequality. If cash disappears, one can imagine that it could disenfranchise the elderly and the poor as well as those at technological disadvantage. In reality, however, many countries are near saturation with cell phones. If digital money is used correctly, it could be a powerful tool for financial inclusion for households without access to formal banking systems.

Cash still holds some life. Cash still has some life. During the covid epidemic, cash demand surged in major economies, including the US. This was presumably because people saw it as a safe way to save money. Many states in the US have laws that ensure cash is accepted as payment. This would protect those who are unable or unwilling to pay with other methods. However, consumers, businesses, as well as governments, have welcomed the shift to digital payment methods, especially since they are cheaper and more convenient.

The decline of physical cash, once valued as the most definitive form of money, is but a small feature of the rapidly changing financial landscape, though. The rise of cryptocurrencies has been one of the most significant forces of change. They have challenged long-held beliefs about money and finance.

Bitcoin may not have a significant role in this monetary future.

Bitcoin was created to allow people to transact anonymously (using only digital identities and not real ones) without the involvement of a trusted third party like a central bank or financial institution. This means that anyone can conduct transactions without a bank account or credit card. The algorithm that runs autonomously generates coins and validates transactions. However, the identity of its creator is not known to this day.

The timing of Bitcoin’s introduction in early 2009, when the global financial crisis had decimated trust in governments and banks, could not have been better. Bitcoin’s basic functions were not well-received, even though it gained popularity. Bitcoin’s volatility, which can cause wild price swings, has made it a unreliable payment method. It turns out that the cryptocurrency doesn’t guarantee anonymity. Users’ digital identities can be linked to their real identities with some effort. This is a good thing as Bitcoin transactions that once fuelled the dark web, where illicit and unsavory commerce is conducted, have fallen sharply. Bitcoin and other cryptocurrencies are now speculative financial assets. They have little intrinsic value and high valuations that aren’t backed by investors’ faith.

A new generation of cryptocurrencies is emerging that promises to fix many of Bitcoin’s flaws. Stablecoins are cryptocurrencies that have a stable value because they are backed by US dollars or other fiat currencies. They are rapidly growing. Stablecoins can be described as digital payment systems that are reliable and easily accessible, and will make domestic and international payments faster and cheaper. They are not fully decentralized like Bitcoin, but require that transactions be validated by the issuing entity. This could be a bank or corporation, or even an online entity. Users must trust that the issuing institution will validate legitimate transactions and maintain adequate reserves. Regulators do not currently require independent verification of these actions. Stablecoins, despite their noble goal of providing better payment systems, have raised many concerns.

Despite all these growing pains the cryptocurrency revolution has opened up new frontiers in digital payment technologies and lit a fire under central bankers. Many central banks, long viewed as conservative institutions that are resistant to major changes, are now moving into the digital age. Faced with the declining value of their paper currencies many central banks around world are now looking to issue their money digitally. Japan, China, and Sweden are among the major economies that are exploring central-bank digital currencies (CBDCs), digital versions of their currency notes and coins. Already, the CBDCs have been implemented in Nigeria and the Bahamas. Brazil, India, Russia, and others are currently launching their own experiments. Some countries see CBDCs to be a way to increase access to the formal financial system. Even households without credit cards or bank accounts would have access to a secure and affordable digital payment system. Other countries are also looking at CBDCs to improve the stability and efficiency of digital payment systems. Sweden’s eKrona is being promoted as a backup in case the private-sector payment system fails. This could happen if it is not working well or there are confidence issues.

CBDCs could also help maintain the relevance of central-bank retail money in countries where digital payments are becoming the norm. China is, for instance, pursuing its digital currency at a time when Alipay and WeChat Pay are attempting to dominate the payments landscape.

CBDCs also have many other benefits. They could help bring certain types of economic activity into the tax net (unlike cash transactions which are often not reported to tax authorities), reduce counterfeiting and make it more difficult to use official money for illegal purposes like money laundering, drug trafficking and financing terrorism. They could jeopardize any privacy we have left. After all, digital everything leaves a trace. Transactions using CBDCs will be auditable and traceable as no central bank would allow its money be used for illicit transactions.

What will the world of money look like in five or 10 years’ time? Imagine a world in which many people have digital wallets that contain a mix money from traditional banks, stablecoins managed privately, and possibly one or more CBDCs that move them around depending on global conditions. However, it is not known how stablecoins or CBDCs will interact. Meta, formerly Facebook, had planned to launch its own stablecoin. The US regulators stopped the project because they were concerned about Meta’s goals and the possibility that the stablecoin could finance illegal transactions within and beyond the borders of the US.

The basic case for stablecoins as more efficient and easily accessible forms of digital payment could be undercut by CBDCs. For the moment, stablecoins seem to be holding their own–there were more than 30 in circulation as of March 2022, with a total value of about $185 billion. There is also the possibility that stablecoins could be built on top large-scale commercial ecosystems like Amazon’s. However, their stability is dependent on their being backed with fiat currencies. Their total value is about $185. They would be used primarily for their convenience and cost-savings.

However it plays out, the digital-currency revolution is going to have implications for the international monetary system. Cross-border payments are a complicated task because they involve multiple currencies and institutions that use different technological protocols. They also have varying regulations. This makes international payments slow and expensive, as well as making it difficult to track payments in real-time. These impediments can be reduced by cryptocurrencies which can be freely shared across borders. This will allow for almost instantaneous settlement and payment. CBDCs can be used internationally to ease frictions and gain widespread acceptance.

International payment systems that are more efficient will have a host of advantages. They will make it easier for economic migrants to send money back to their home countries. This is a process that currently costs an average 6% of the transaction amount, according the World Bank. Remittances to low-income countries are more expensive than those going to high-income countries. Many of these countries depend on such inflows for large amounts of their national income.

In principle, financial capital will be able to flow more easily within and across countries to the most productive investment opportunities, raising global economic welfare–at least as measured by GDP and consumption capacity. However, countries will face increased risks from capital flowing across national borders, making it more difficult to manage their exchange rates as well as their economies.

The resulting challenges will be especially thorny for smaller and less developed countries.

The central banks of countries could issue national currencies, especially those that are less convenient or more volatile in value. These currencies, along with other currencies, could be replaced by private stablecoins, and possibly CBDCs issued from the major economies. This would lead to a loss in monetary sovereignty. Less prominent central banks would lose control of the money circulation in their economies. The rise of digital currencies could increase the risk of “dollarization”, a phenomenon where a trusted foreign currency replaces a volatile domestic currency. This has been a problem for many Latin American countries. We have seen people using cryptocurrencies in countries like Turkey and Iran to circumvent capital outflow restrictions when currencies were falling in value. This allows them to move funds out of their country and invest abroad with less risk.

Although there are some changes in the future, the long-held dream of many governments around world to knock the US dollar from its position as the dominant global reserve currency will likely remain the same for the foreseeable future. Stabilcoins that are backed by the dollar are likely to gain greater acceptance than those backed by other currencies, which will indirectly increase its prominence. The digital renminbi is expected to gain popularity as a payment method. A gradual and modest increase of the renminbi’s usage, in conjunction with a rise of stablecoins could decrease the importance of other reserve currencies such as the euro, the British Pound Sterling, the Japanese yen, or the Swiss Franc.

When it comes to money’s function as a medium of exchange, we can anticipate more competition between private currencies and fiat currencies. This should result in payments that are quicker and cheaper, which will benefit consumers and businesses. It should also encourage private and official issuers to maintain the currency’s value.

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But it is worth keeping in mind that technology can have unpredictable consequences. The digitization of currencies may not lead to a proliferation in private and official currencies, but could instead make economic power more concentrated. The digital availability of major currencies like the dollar, euro, and renminbi could make them more accessible worldwide and threaten the currencies of smaller, less powerful countries. Large corporations might also issue digital currencies, taking advantage of their already dominant social media or commercial networks. They could become independent stores of value if they are not quashed by governments. This could lead to even greater monetary instability if countries have multiple issuers, with their domestic currencies fluctuating in price relative to each other.

All that is certain is that the international monetary system is on the threshold of momentous change wrought by the digital revolution. It remains to see if this will ultimately benefit humanity as a whole, or if it will exacerbate existing inequalities.

Eswar Prasad is a professor in the Dyson School at Cornell University, a senior fellow at the Brookings Institution, and author of The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance.