Central banks shouldn't ignore their duty to provide anonymity

Cross section of a banknote with a cotton paper core surrounded by two layers of polymer [Source]

Central bankers are at their most comfortable when engaging in technical debates over the finer points of monetary policy. But over the next few years they may be forced out of their comfort zone into a thorny philosophical debate over anonymity and financial censorship. They are poorly equipped for such a debate.

When central bankers monopolized the issuance of banknotes in the 1800s and early 1900s, little did they know that a hundred years later anonymity would become an important public good. And because banknotes are the only generally-accepted way for law-abiding citizens to make uncensored anonymous payments, central bankers effectively became—by accident rather than design—the sole purveyors of these vital services.*

Banknotes are anonymous because it is very difficult to link banknotes to identities, say by monitoring usage of notes via a note's serial number. As for 'uncensored', this means that banknotes are available for anyone to use—i.e. they are highly resistant to censorship. There are no gateways involved, no need to get permission ahead of time by opening an account or installing some sort of proprietary software or hardware, and no way for the issuer to halt a payment while it is being made.

If you glance through the research papers that central banks typically publish, they're almost all on monetary policy. And why not? A stable medium of exchange is one of the most important services provided by a central bank, so they need to do their homework. But if you try to find research on the topics of anonymity and censorship resistance, good luck. What this tells me is that central bankers know very little about the unique set of services they are providing to the cash-using public, despite being the world's only suppliers. Not only have they blundered into their role of monopoly provider of anonymity and uncensored payments, they are trying their best to pretend the role isn't theirs.

Take for instance the European Central Bank's decision to stop printing the €500 note, which was motivated by the desire to cut down on crime. No doubt a significant chunk of €500 notes are used by criminals, but the ECB seems to have made no effort to quantify the anonymity services lost by the tax-paying non-criminal public. Because the ECB has never officially admitted its role as Europe's sole provider of uncensored payments anonymity, it lacks the sorts of datasets and institutional wisdom that are necessary for formally approaching problems about anonymity and censorship-resistance. So while their decision about the €500 wasn't necessarily wrong, it was surely uninformed.

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Related to all this is Tyler Cowen's recent article criticizing central banks that take an active role in developing their own cryptocurrencies. His critique includes the Fedcoin idea, or a public cryptocurrency available to anyone that is pegged by the central bank to the national unit of account. Cowen says that this "new and potentially risky responsibility" might tax central bankers' resources. The problem with this is that the responsibility of delivering anonymous and censorship resistant cash is an old one. In this context blockchain technology isn't anything special, it's just another technology among many that central bankers might use to upgrade the quality of the public services that they are already providing.

Banknote technology has been constantly improving over the decades. For instance, anti-counterfeiting technology began with serial numbers and elaborate engravings on notes in the 18th and 19th centuries. Even after banknote production was monopolized by governments, improvements continued into the 20th and 21st centuries with security threads, watermarks, holography, raised images, clear windows, latent images, microprinting, and luminescent ink. The substrate on which notes are printed has evolved from cotton and/or linen to polymer, or a hybrid of the two (see image at top). If central bankers had applied Cowen's advice to avoid new technology, banknotes would still be printed on cotton and lack modern anti-counterfeiting devices.

So think of encoding banknotes onto a public blockchain—the Fedcoin idea—as just another change in substrates. In the same way that the anonymity and censorship resistance embedded on a cotton substrate was replicated on a polymer one, why not test out the idea of replicating these features on a blockchain? Along with anonymity and censorship resistance, a public blockchain would capture the decentralization of banknote systems, and thus their robustness in the face of disasters, a feature I wrote about here.**

The advantage to digitally delivering these services rather than physically delivering them on polymer or cotton is that a payment no longer requires face-to-face meetings; it can occur over the internet. This would constitute a dramatic upgrade to the quality and breadth of the anonymity and censorship resistance services that are currently being provided by our central bank monopolists.

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With the emergence of bitcoin and the slowly percolating Fedcoin debate, central bankers are thinking for the first time in ages about designing cash-like systems from scratch. And since these systems may eventually replace the physical stuff, central bankers will have to accept the fact that they are the only providers of anonymity and censorship resistant payments services, and that maybe they should get their act together and think hard about the value of these services to the public. A great start can be found in former Fed policy maker Narayana Kocherlakota's Monetary Mystery Tour, which ends with the exhortation: "Need more economists working on these issues!"

Bringing this back to Cowen's article, I don't agree that central bankers should refuse to test the idea of a central bank-issued cryptocurrency because this represents a new and risky technology. That would be shirking their duty as a monopolist provider of the unique services embedded in paper cash. Central bankers should only say no to Fedcoin because they've done a rigourous cost-benefit calculus that takes into account the social value of anonymity and censorship resistance to the public, and that effort has resulted in a conclusion that the status quo—the provision of these public services on a polymer or cotton substrate—is the best option.

Having blundered into their role as monopoly provider of anonymous payments, here's hoping that the cryptocurrency revolution means that central bank's finally take that role more seriously. If they don't, maybe they should just give up their monopoly.

*Can bitcoin serve as a suitable replacement for cash? Unlike cash, bitcoin can't be used to make anonymous payments. Bitcoin payments are pseudonymous—so they don't quite make it over the line. The other problem is that bitcoin is not pegged to national units of account. Thanks to its terrific volatility, bitcoin has failed emerged as a genuine medium of exchange, so it can't take on the responsibility of providing law-abiding citizens with a generally-accepted anonymous and censorship-resistant medium for making payments.
**I am by no means wedded to blockchains as a way to digitally capture anonymity,censorship resistance, and robustness. There are other ways to go about this that do not involve blockchains.