As global central bankers study whether they can issue a central bank digital currency (CBDC), the question of whether they should do so has received relatively less attention. At the Federal Reserve, though, a cost-benefit analysis appears to be underway, and the results are not encouraging for CBDC acolytes.
Any CBDC comes with a fundamental, grievous flaw that its proponents generally seek to elide: currency held in a digital wallet is unavailable for lending. It is thus unlike commercial bank money – the digital dollars you hold in your bank account – which can be loaned out, with only a fraction of the deposit held in reserve. (Hence: fractional banking.) CBDC is a digital mattress. Given that the average loan-to-deposit ratio for banks is generally around 1:1, every dollar that migrates from commercial bank deposits to CBDC is one less dollar of lending.
In good times, banks could seek to retain those deposits by paying higher interest rates, but of course, that permanent rise in funding costs would translate into a permanent rise in borrowing costs for businesses and consumers. However, the larger problem is what happens in bad times like 2009 and 2020, when corporations and money managers seek to de-risk as much as possible. Last March, that meant selling trillions of dollars of risk assets and holding them as bank deposits. With a CBDC, that would mean transferring trillions of dollars of bank deposits to CBDC – with the loss of a few months’ interest on that deposit of no consequence (at least in part because rates would be plummeting). Lending would have ceased; lines of credit could not have been funded. As Randal Quarles, Vice Chairman of the Fed, recently summarised, “[A] Federal Reserve CBDC could create considerable challenges for the structure of our banking system, which currently relies on deposits to support the credit needs of households and businesses. An arrangement where the Federal Reserve replaces commercial banks as the dominant provider of money to the general public could constrict the availability of credit, fundamentally alter the economy and expose the public to a host of unanticipated, and undesirable, consequences.”
No one has suggested any solution to this fundamental problem. To stop the potential bleeding, European Central Bank Executive Board Member Fabio Panetta has proposed capping CBDC at €3,000. But with any cap of that size in place, a digital euro would be useless as a commercial payments vehicle: even consumers would need a bank account for larger transactions.
Meanwhile, any potential benefits from a CBDC appear to fade away under analysis:
An answer to the threat of China to the dollar’s hegemony? Fed Chair Jerome Powell dismissed this notion at a recent Federal Open Market Committee press conference: “We’re the world’s reserve currency… because of our rule of law; our democratic institutions, which are the best in the world; our economy; our industrious people; all the things that make the United States the United States… And, of course, we have open capital accounts, which is essential if you’re going to be the reserve currency.”
An antidote to the rise of cryptocurrencies? As Vice Chairman Quarles observed, “Bitcoin and its ilk will… almost certainly remain a risky and speculative investment rather than a revolutionary means of payment, and they are therefore highly unlikely to affect the role of the US dollar or require a response with a CBDC.”
Stablecoins? They are not a risk to the dollar, as they are denominated in dollars and backed by dollar assets. Of course, stablecoins in their current form do pose massive consumer protection problems and potential financial stability risks, as most are in substance opaque prime money market mutual funds. But the solution to that problem is regulation, not a new US currency, and multiple regulators are quite focused on being part of that solution.
A need to modernise the payments system? Vice Chairman Quarles recently noted an ongoing revolution in faster payments, stating, “[The] general public already transacts mostly in digital dollars –by sending and receiving electronic balances in our commercial bank accounts… The Federal Reserve provides a digital dollar to commercial banks, and commercial banks provide digital dollars and other financial services to consumers and businesses. This arrangement serves the nation and the economy well… In summary, the US payment system is very good, and although it is not perfect, work is already underway to significantly improve it.”
Thus, as Governor Christopher Waller recently concluded, “After exploring many possible problems that a CBDC could solve, I am left with the conclusion that a CBDC remains a solution in search of a problem.” And, one might add, a solution with potentially massive costs for the US economy.
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by Greg Baer, President and CEO of the Bank Policy Institute.