After much consultation and reflection, the European Central Bank is set to soon announce the trial launch of a digital euro – a digital version of cash that will circulate alongside euro notes and coins. Reza Moghadam, Morgan Stanley’s Chief Economic Advisor, addresses three sets of questions: First, why and why now? Second, what are the risks and what is the ECB going to do about them? And third, what are the policy implications?

Why of going digital?

“The key driver is the declining role of physical cash as a means of payments. But if cash effectively vanishes, what will underpin that confidence? What would deposits be convertible into? A central bank digital currency answers that fundamental question about the stability of the financial system. But the decline of cash is not news – why react now? One reason is that the pandemic has accelerated the decline of cash. But a more important reason for going digital is the emergence of rival payments technologies. Once stablecoins become widespread, the ability of the ECB to influence interest rates by varying the supply of traditional money would be gravely compromised. The loss of economic sovereignty would be far more serious than, say, Europe’s current reliance on American platforms like Visa and MasterCard, which too is a factor in the push for a digital euro.”

What about the risks?

“The key risk is that a digital euro may do more than just replace physical cash. The public could shift from holding private bank deposits to ECB issued digital euros, thus pushing up bank funding costs. To limit the hit to banks, the ECB will likely limit the amount that can be held in digital wallets, which are expected to be provided and managed by banks. A cap of around €3,000 per individual is sometimes cited, which seems sensible for large economies, but may create problems for banks in smaller, less affluent ones. The size of the cap is an important detail to be ironed out by the ECB.”

What are the policy implications?

“The main one is that once cash disappears, the return on digital euro could in principle be set to any level, including negative. The constraint imposed by zero return on cash would be eliminated, allowing the ECB to lower policy rates to whatever it takes in severe recessions. Governments could also innovate, for example, they can provide stimulus through programmable money, which disappears if not spent before a deadline. But such innovations are perhaps years in the future.”