The future of digital money lies in striking the right balance

More governments are looking into central bank-backed digital currencies. Getty

Central banks across the world – including those of the Arabian Gulf countries – are considering launching digital currencies. America’s tumultuous monetary history provides many useful lessons for central bankers as the transition away from paper money accelerates. One of the most important is that while unregulated digital currency is unstable, regulated digital money is prone to political capture.

For more than a century, Americans lived without a central bank. During the 1800s, money was issued by thousands of competing financial institutions and more or less anyone was free to throw their monetary hat into the ring, constituting a banking analogue to the Wild West.

Counterintuitively to those who have grown up in the era of strong central banks, this system somehow worked, though it certainly sputtered on more than one occasion. As we debate digital currencies today – centralised digital currencies versus decentralised crypto – we are replaying a very old argument.

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To be more precise, prior to the establishment of the Federal Reserve, the nascent American nation’s federal nature meant that there was no national monetary authority. Anyone could issue currency, and the value associated with those notes stemmed from the trust that people had in the issuing institution.

Critically, competition played a decisive role in the system’s success: every bank was strongly motivated to manage its currency in a disciplined manner or people would switch to a competitor, turning its existing money into worthless pieces of paper.

As a result, the overall price level was very stable, with the creeping inflation that we have become accustomed to in the 21st century being largely absent. However, what the system gained in terms of price stability came at the cost of volatility, as financial crises and bank runs were frequent occurrences.

By the end of the 1907 Bankers’ Panic, many had had enough, and a centralised, overseeing monetary authority was established. Ostensibly, the goal was to protect ordinary citizens from the tumult of a reckless and rudderless financial system. Yet beneath the technocratic veneer lay a more sinister agenda reflecting elites’ insatiable appetite for control, especially those from Wall Street and Capitol Hill.

While the Federal Reserve has since had the occasional wobble, its iron grip on the monetary system – reflected in its monopoly status as an issuer of American paper currency – has remained intact since its establishment in the early 20th century.

Many central banks are frustrated that their carefully fashioned currency monopolies have been challenged by the disruptive upstarts of the crypto world

Many libertarians have lamented this permanent erasure of competition and consider it to be the primary reason for the large, accumulated price inflation experienced during the past 12 decades. After all, in the absence of competitive pressure, even the most disciplined central bank will struggle to resist the urge to print money, thereby inadvertently deflating the value of ordinary people’s savings.

One of the most famous examples of politically motivated monetary mismanagement occurred in the early 1970s when president Richard Nixon pressured Federal Reserve chairman Arthur Burns to keep interest rates artificially low in the lead up to the 1972 presidential election. Such a manoeuvre would never have worked in the free banking era.

Exasperation with the politicisation of monetary decisions – along with a desire to be able to transact with a high degree of privacy – have underwritten the growing attractiveness of cryptocurrencies. Today, many central banks are frustrated that their carefully fashioned currency monopolies have been challenged by the disruptive upstarts of the crypto world.

Central banks across the world – including those of the Arabian Gulf countries – are considering launching digital currencies, such as the UAE's Digital Dirham

The instability caused by crises such as the 2022 collapse of the FTX crypto exchange have provided monetary authorities with the political ammunition needed to promote their own digital currencies. Some of those choosing to take a chance on crypto have experienced catastrophic losses that would be unthinkable when trading regular currencies. Governments inside and outside the region have been keen to bolster this argument with appeals to national security, as crypto has emerged as a favoured instrument for drug cartels and terrorists seeking to avoid detection.

Though centralisation solves salient problems like these, it creates risks that we only discover later. Ordinary people must ask themselves: who controls monetary data? Can accounts be frozen arbitrarily or capriciously? And ultimately, are we building resilience in place of the volatility of cryptocurrencies, or are we engineering dependence and monopoly power that is unlikely to be relinquished?

The 19th-century US taught us that decentralised money can be unstable. The 20th century taught us that centralised money can be politically captured. As we enter the age of digital currency, and citizens and policymakers alike toy with the idea of a central bank digital currency, the real challenge is not choosing sides, but rather avoiding the worst of both worlds. The future of money should be secure, but not obedient. This sentiment is captured by a Dutch proverb: “Trust arrives on foot but leaves on horseback.”