By Paul Vigna 

THE NOT-TOO-DISTANT FUTURE -- The National Security Council holds an emergency meeting. North Korea has launched a missile, capable of carrying a nuclear warhead within range of U.S. forces in Guam. At this rate, North Korea could land a nuke on the U.S. mainland in less than a year.

The shocking advance in capability despite heavy trade sanctions is due to a stream of money that the U.S. and its allies cannot monitor -- a cryptocurrency. But it's not one of the risky ones celebrated by overnight millionaires and largely avoided by serious investors, it's a new one, with the stamp of legitimacy: the digital yuan.

The scenario above is fiction, but it isn't fantasy. If China digitizes its currency, as it plans to do, and the North Koreans use it to finance their missile program, it's a flow of money that circumvents U.S. sanctions. That would force the U.S. to grapple with its own now-antiquated currency. If the U.S. follows suit, digitizing the dollar in order to maintain its global economic dominance, it would also find itself in possession of a potentially powerful surveillance tool.

While bitcoin, the first successful cryptocurrency, was created to maintain anonymity in transactions, future digital currencies will be the opposite of anonymous.

And just as every transaction involving a digital yuan would be trackable by China, every digital dollar changing hands would be visible to the U.S., its issuing government. Banks might still manage the flow of money, but they will no longer be the record-keepers they once were.

"The fundamental nature of money is really changing," said Neha Narula, the director of MIT Media Lab's Digital Currency Initiative.

Dr. Narula played the president's "cyber czar" in an enactment of the hypothetical North Korea scenario staged last month at Harvard's Kennedy School. "Digital Currency Wars" also featured former Treasury Secretary Lawrence Summers as well as Ash Carter and Gary Gensler, all of whom have served in presidential administrations. (The presentation can be seen in its entirety here.)

We are moving rapidly into a new monetary era. Countries and companies are looking at digital money as the new standard for their monetary systems and a replacement for actual cash.

Some of the benefits include faster, cheaper payments, a greater ability to root out money launderers, and a more open, inclusive financial system. Digital money is also going to provide new abilities to law enforcement and governments that will almost certainly open up another front in the fight over privacy.

"Privacy is one of the defining problems of our times," said Emin Gün Sirer, chief executive of blockchain-based startup Ava Labs and a professor of computer science at Cornell University, and it will be with money, too. In practice, he said, it's almost impossible to create a form of digital money that doesn't identify its users.

What we think of as "money" is actually an extraordinarily complex network of thousands of commercial banks and central banks. The system works, but is costly and relatively inefficient because everybody is working off their own balance sheets. Digital money would create a system where everybody using a particular currency is working off the same balance sheet.

The idea of bitcoin, unveiled 11 years ago, was to compress the cumbersome functions of the modern financial system to enable money to move anywhere around the world, in minutes, for virtually no cost. If you've ever tried to send even $10 across a border, you can appreciate the allure in this.

But bitcoin was just Act One. Act Two began this summer, when Facebook uncovered its proposed cryptocurrency, libra. This wasn't some loose confederation of cypherpunks and antibankers. Suddenly, one of the world's biggest, most powerful (and most controversial) companies was saying it was going to make money.

A flurry of action followed. The U.S. Congress convened hearings and wrote bills to stop libra from launching. Regulators leaned on some of its original supporters to back out. The Bank of England's Mark Carney suggested an international cryptocurrency should replace the dollar as the world's new reserve currency. The Chinese went further. They took their own efforts into overdrive, and are widely expected to launch a digital version of the yuan in the coming months.

"This is more than just Venmo, more than just PayPal," said Aditi Kumar, executive director of Harvard's Belfer Center for Science and International Affairs, and playwright of "Digital Currency Wars." "This is an entirely new way for countries to operate in the world," she added. "It will make one or two actors all-powerful in the monetary system."

The digital yuan China is planning is in fact a complete inversion of the bitcoin model. All of the data created would be centrally housed and become part of China's surveillance state.

Money has always been a powerful, blunt instrument. It's an imposition not just of will, but of values. After World War II, the dollar became the foundation of the international monetary system. That gave the U.S. government a special tool. The U.S. has used its control over the dollar-based finance system to impose sanctions such as the ones on North Korea.

As the U.S. share of the global economy shrinks and that of countries like China and India expand, countries are actively seeking alternatives to the dollar.

In the fictional North Korea missile crisis, China would be tacitly allowing the financing of Pyongyang's nuclear program to go through, because the government would be able to see where each digital yuan goes. That's an extreme, and entirely hypothetical, scenario, of course, but it's an example of the leverage China would have over every transaction on its system. The only question is how heavy-handed the Chinese would be in using it.

While the Chinese model might be the far end of the spectrum, cryptocurrency has been moving in that direction. While bitcoin was designed to mimic the anonymity of cash in a digital setting, all its transactions are public, and therefore trackable. And Facebook's libra would log transaction data, while recording user identities in a separate database. A central concern in Congress is what Facebook would do with that information.

Say the Federal Reserve digitized the U.S. currency. It could track how every dollar in circulation is spent. That might give it a great advantage in trying to figure out how the economy is growing, and where stimulus efforts would best be directed. But say people in government wanted to lock down some group or activity. They could do that, too. The role of banks would likely change considerably as well, though whether they gain or lose with a digital dollar would depend on how the government issued it.

Whether the U.S. will feel pressure to shift to digital still isn't clear. There are proponents and opponents of cryptocurrencies in Congress. The Fed has examined the idea of creating a digital dollar, but that's all it's done.

At Harvard, Mr. Summers and his fellow stage actors spent some time debating this point. Some felt the U.S. should get in the game, others believed all they needed to do was make improvements to the existing system.

People need to start thinking about this now, Harvard's Ms. Kumar said. China's digital yuan will be a real-world proof of concept. The West will need to respond in some way. "Are we prepared for that?" she said. "Not just technically, but legally? Can we protect privacy in this new world?"

Write to Paul Vigna at paul.vigna@wsj.com

(END) Dow Jones Newswires

December 07, 2019 00:14 ET (05:14 GMT)

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