The Impact of a Central Bank Digital Currency on the Velocity of Money

I was recently asked by Finance Magnates about the potential impact a central bank digital currency (CBDC) might have on an economy. Of course, the context is China's recent announcement that they will be releasing their own DCEP (which stands for "digital currency electronic payment") within the next few months. I wrote about this last week, but I think there are some more general points to be drawn out.

The result of Rachel McIntosh's inquiry led to an article published on Friday titled, "China’s Stablecoin is Likely the Only One the Country Will Allow." The first time she quoted me highlighted this theory that I've been kicking around since people repeatedly started asking me my opinion about China's new CBDC. Of course, I'm not a part of the Chinese government and it would be presumptive of me to pretend that I knew exactly about their motivation to release a CBDC right now. People tend to point to the trade war and the recent Libra announcement as the cause for this release, but I personally don't think that we can take too much from the timing of these announcements. Correlation is not causality and all that. Perhaps the best lens through which to view this situation comes from the financial formulas and tools that academia has rustled up over the past century or so. Let's take a look at my quote and the associated graphic Rachel associated with it.

“Let’s examine this impact from the perspective of the quantity theory of money (MV=PY). China has been relying on huge increases in its money supply (M) to provide inorganic growth in the country in an attempt to stave off a potential debt crisis,” he continued. “And yet, despite printing money at something like an 8+% rate per year since the financial crisis of 2008, price inflation (P) and the GDP (Y) have continued to stagnate.”

In other words, “Growth is declining.” However, “by introducing the DCEP to Chinese consumers, the PBoC may be hoping that they can start to reduce the growth in the money supply (M) by vastly increasing the velocity of money (V) by eliminating almost all barriers to transacting with the DCEP.”

“Currently, even though China is pretty much cashless in the first tier cities, there are still barriers such as you cannot transfer value easily from Alipay to WeChat Pay or from one bank account to another without incurring fees and delay,” Krapels explained. “A DCEP could drastically improve this situation and help to support GDP growth without the debt crisis risks that using the money supply lever imposes on society.”

MV=PY

When finance professors evaluate this formula, they nearly always assume velocity (V) is a constant, usually 1. Although the St. Louis Fed has previously pointed this out, that data has not really been proven and has certainly not begun to affect policy formulation. As usual, the prevailing rule of thumb about something is usually what is accepted, regardless of its quality of truth.

But if we look at where the DCEP will be existing in the money flower presented above, we can easily see that a central bank digital currency, particularly in the most advanced retail fintech society in the world, could have a very substantial impact on the velocity of money. When I say "substantial", keep in mind that the money supply growth (basically the QE component of the quantity theory of money formula) has a massive impact on a nation's GDP (essentially the right side of the formula, P*Y). In China, it does so with a rather small measurement of 8% growth.

No one is really sure what the impact of a CBDC will be on the velocity of money. It's never been implemented before. But I can assure you that that impact is certainly going to be non-zero. The only question is will it have up to a 10% impact, which could mean that the growth in money supply could be reduced to zero. Or will it have an even bigger impact, the consequences of which could be staggering.

It's all about the formulas, baby.

It certainly is going to be interesting to track what the impact of this new digital sovereign currency is going to have on the Chinese economy, especially if it is released by the PBoC before Alibaba Group's famed Singles Day shopping event on November 11. It sounds crazy fast for something like that to happen. But it's China, y'all. Things get built fast over here!