Monetizing deficits via digital currency

By means of the central bank digital currency, authorities can replace the surge in household debt with income transfers.

Central bank digital currency would enable governments to run sustainable budget deficits via isolating the wealth from the financial system.

A central bank would permanently subsidize households as much as the wealth transfer to the top 1% of the population.

Governments can permanently pile up deficits by isolating the wealth from the financial system.

Wealth and income distribution

Think of an economy in which 1 million people earn $10000 each, totaling $10 billion and 10 people earn $1 billion each, totaling $10 billion. An income distribution change of $5 billion in favor of the rich would reduce consumption for the same amount. It is because someone with an income of $1 billion would not raise consumption due to a further rise. Meanwhile, someone, who spends all of $10000, would reduce consumption as much as the loss.

A consumer has a floor and a ceiling of consumption. A deteriorating distribution of income makes poor poorer and rich richer. As rich get richer, they cannot raise spending over a limit. Hence, they don't spend the additional income that they earn. In the absence of the financial system, aggregate consumption would fall as much as the income transferred from the poor to the rich.

In the US, the share of the top 0.5% in total income has risen from 5% to 18% between 1980 and 2010. The top 1% earns 22% of total income. The graph regarding wealth also signals a deteriorating distribution. Since the 2008 financial crisis, the top 1% of the population have gained wealth from the rest. The bottom 50% of the population have spent from their wealth in 2000s. That is, their income fell short of their needs.

Financial system compensates the fall in consumption by setting debt relationships between the rich and the poor. The top 1% borrows the transferred wealth back to 99% of the population. The bottom 50% hence conserves consumption via raising extra debt. This is the underlying reason behind mounting household debt. Nevertheless, this upward debt trend renders the financial system fragile via three channels.

First, household leverages, the proportion of households' debt to equity, permanently rise. When asset prices and personal incomes plummet in an economic downturn, households default and their collaterals fall short of debt. As a consequence, financial agencies go under, writing off detrimental losses.

Second, high household indebtedness exacerbates financial or economic downturns. When banks squeeze credits to conserve their equities from soaring delinquencies, households are required to cut spending and serve net debt. A fall in expenditure depresses business revenues and trigger layoffs and shutdowns. Slumping personal incomes in turn prompt a second wave of delinquencies and drive banks into further contraction. This process would continue until the collapse of the financial system in the absence of fiscal or monetary intervention.

Third, the wealth generates liquidity risk due to safety concerns. Wealthy people generally prefer safe assets that don't pay high returns. In a financial distress, they run from investment-grade assets, such as commercial asset-backed securities (CABS), and drain liquidity. This behavior results in massive asset purchases of central banks to bar financial markets from collapsing.

Digital central bank currency

Via digital currency, central banks can reverse the deteriorating trend of wealth and income distribution. At the time, a saver cannot open an account at the central bank. As the funds over the government insurance limit of the government ($250,000 for the US) bear the default risk of banks, savers allow investment companies to secure their funds in asset-backed securities on their behalf. If savings over the insurance limit could be deposited at the central bank, risk averse savers would definitely do so. A digital currency issued by a central bank would be as secure as the treasuries of its government. When the wealth is stored at the central bank, it would not involve in debt relationships anymore. The central bank digital currency would thereby reduce the source of anxiety in the financial system via isolating the risk averse wealth from the financial system.

When the risk averse wealth quits the financial system, its transfer from the poor to the rich would not pile debt anymore. Consumption would fall as much as the spending financed by the wealth. Central banks would compensate the loss in spending via typing. Instead of piling up debt, the bottom 50% would maintain their income through monetary subsidies. Thus, the distribution of income would recover without any tax transfer.

Conclusion

In investors' perception, the only risk free assets are treasuries of a few governments. Even though top tranches of securities are sufficiently backed, they are also subject to runs in financial distresses. Nevertheless, supply of risk free treasuries are inadequate to store the surging wealth. Digital central bank currency would solve the safe asset problem and inhibit household debt meanwhile. Being stored at the central bank accounts, the wealth would not involve in debt relations anymore. To maintain spending at the current level, the central bank would type money and transfer it to households.

Central bank digital currency would enable governments to run sustainable budget deficits via isolation of the risk averse wealth. The central bank would permanently subsidize households as much as the wealth transfer to the top 1%. Thus, households would restore their income losses debt-free. Lower indebted households would be less influenced by procyclical financial conditions.