[p2p-research] Mervyn King on the (non-)future of central banks

[Martien van Steenbergen]

A plea for a fully digital giral distributed monetary infrastructure.

As promised a copy of the 1999 speech of Mervyn King,  Governor of the  
bank of England on:

The future of central banks

Despite some ups and downs, central banks are ending this century well  
ahead of where they started it. There are more of them, and they have  
greater power and influence. But is this the peak? Will future  
historians look back on central banks as a phenomenon largely of the  
twentieth century? Although central banks have matured, they not yet  
reached old age. There remains much to be done.

The case for price stability, and the role of central bank  
independence in achieving it, needs to be made to a wide audience. We  
must build a constituency for low inflation, without having to resort  
to episodes of high inflation to prove that instability is costly. To  
that end, communication has become more important – central banks have  
moved from mystery and mystique to transparency and openness. The  
language of central banking must evolve to reflect the need to  
maintain broader support for the objective of stability and the  
legitimacy of independent central banks in pursuing it.

Looking further ahead, the future of central banks is not entirely  
secure. Their numbers may decline over the next century. The  
enthusiasm of governments for national currencies has waned as capital  
flows have become liberalised and exchange rates more volatile.  
Following the example of the European Central Bank, more regional  
monetary unions could emerge. Short of this, the creation of currency  
boards, or even complete currency substitution, might also reduce the  
number of independent national monetary authorities.

But much more important is the potential impact of technological  
innovation. At present, central banks are the monopoly supplier of  
base money – cash and bank reserves. Because base money is the  
ultimate medium of exchange and of final settlement, central banks  
have enormous leverage over the value of transactions in the economy,  
even though the size of their balance sheet is very small in relation  
to those of the private sector.

For years, economists have had difficulty in incorporating money into  
rigorous general equilibrium models. To the elegance of the Walrasian  
model of an exchange economy has been bolted on an assumption about  
the technology of making payments such as a “cash in advance”  
constraint. These untidy ways of introducing money into economic  
models are not robust to changes in institutions and technology. Is it  
possible that advances in technology will mean that the arbitrary  
assumptions necessary to introduce money into rigorous theoretical  
models will become redundant, and that the world may come to resemble  
a pure exchange economy?

Electronic transactions in real time hold out that possibility. There  
is no reason, in principle, why final settlements could not be carried  
out by the private sector without the need for clearing through the  
central bank. The practical implementation of such a system would  
require much greater computing power than is at present available. But  
there is no conceptual obstacle to the idea that two individuals  
engaged in a transaction could settle by a transfer of wealth from one  
electronic account to another in real time.

Pre-agreed algorithms would determine which financial assets were sold  
by the purchaser of the good or service according to the value of the  
transaction. And the supplier of that good or service would know that  
incoming funds would be allocated to the appropriate combination of  
assets as prescribed by another pre-agreed algorithm. Eligible assets  
would be any financial assets for which there were market-clearing  
prices in real time. The same system could match demands and supplies  
of financial assets, determine prices and make settlements.

Financial assets and real goods and services would be priced in terms  
of a unit of account. The choice of a unit of account (perhaps a  
commodity standard, which would produce broad stability in the price  
level) would be a matter for public choice and regulation, along the  
lines of existing weights and measures inspectors. Final settlement  
could be made without any recourse to the central bank. As Henckel et  
al. (1999) have noted, the key to a central bank’s ability to  
implement monetary policy is that it “remains, by law or regulation,  
the only entity which is allowed to ‘corner’ the market for settlement  
balances”.

Without such a role in settlements, central banks, in their present  
form, would no longer exist; nor would money. Economies of this kind  
have been discussed by Black (1970), Fama (1980) and Hall (1983). The  
need to limit excessive money creation would be replaced by a concern  
to ensure the integrity of the computer systems used for settlement  
purposes. A regulatory body to monitor such systems would be required.  
Existing regulators, including central banks, would no doubt compete  
for that responsibility. Moreover, in just the same way as the  
Internet is unaware of national boundaries, settlement facilities  
would become international.

The key to any such developments is the ability of computers to  
communicate in real time to permit instantaneous verification of the  
credit worthiness of counterparties, thereby enabling private sector  
real time gross settlement to occur with finality. Any securities for  
which electronic markets exist could be used as part of the settlement  
process. There would be no unique role for base money, and hence the  
central bank monopoly of base money issue would have no value. Central  
banks would lose their ability to implement monetary policy. The  
successors to Bill Gates would have put the successors to Alan  
Greenspan out of business.

As a central banker interested in information technology, should I  
regard this prospect as a dream or a nightmare? Perhaps the answer is  
that central bankers should enjoy life today. I shall place my faith  
in the words of Walter Bagehot who, in Lombard Street (1873), wrote  
that “Nothing would persuade the English people to abolish the Bank of  
England; and if some calamity swept it away, generations must elapse  
before at all the same trust would be placed in any other equivalent.”

Central banks may be at the peak of their power. There may well be  
fewer central banks in the future, and their extinction cannot be  
ruled out. Societies have managed without central banks in the past.  
They may well do so again in the future. The website of my favourite  
football team has the banner “heroes and villains”. For some, central  
bankers are heroes – more powerful and responsible than political  
leaders – and for others they are villains – too fanatical to be  
entrusted with the world economy. For all our sakes, it is important  
that central bankers are seen neither as heroes nor villains. They  
should be modest technicians, striving to improve the way they use the  
tools of their trade, and always eager to learn. Openness of mind and  
fleetness of foot will be the best way to avoid extinction.

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