Published: Sept 6, 2019 10:41 a.m. ET 30
Paper bank notes are being upgraded for a digital future around the world
The Federal Reserve has never been more famous than it is today. It drew praise, and ire, for its handling of the financial crisis a decade ago, and the extraordinary measures it took subsequently to stimulate the U.S. economy have made it an important driver of financial markets. Meanwhile, President Trump has made its chairman, Jerome Powell, a household name by frequently criticizing the central bank’s policies in interviews and on Twitter.
And now, a movement has been brewing among economists, financial-services professionals and central bankers to encourage a rethinking of the technology of currency — those paper notes we carry in our wallets — with an eye toward issuing a digital currency. Some argue that could give central banks the tools necessary to break free of chronic disinflation and persistently low or negative interest rates, while giving Americans a risk-free means to transact in a world where digital commerce comprises a growing share of the economy.
“The debate isn’t about whether we need [a digital currency],” Michael Bordo, an economist at Rutgers University and a fellow at the Hoover Institution, a public policy think tank at Stanford University, told MarketWatch. “It’s about how you do it.”
Americans today already use digital currency for most of their purchases. In 2018, they used physical dollars for only 26% of transactions, versus 62% with digital currency, which includes credit cards, debit cards and bank transfers, according to the Fed.
A central bank digital currency could work much like the mostly bank-issued digital money Americans use today, but with some key differences. First, it would be backed by the full faith and credit of the United States government and, therefore, risk-free. The local bank that manages your savings account could fail at any time and the dollars in your account (beyond those insured by the FDIC) would disappear. A Fed “e-dollar” would persist as long as the U.S. government does.
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More important, an e-dollar could pay interest. The idea that cash should pay interest goes back to monetary economist Milton Friedman, who argued in 1969 that the most efficient monetary system would be one in which cash bears interest equal to that of short-term government bonds, to encourage greater use of the dollar.
In good times, earning interest on your e-dollars would simply make everyone a little richer, but in times of crisis it could also be used to institute negative interest rates, essentially a tax on holding cash. Such a policy would likely strike most Americans as governmental overreach but, Bordo argues, the alternative is worse.
Central bank ammunition
The current economic expansion is the longest in U.S. history, but warning signs of a coming recession abound, including slowing economic growth and the recent inversion of the yield curve for U.S. government debt. In response, the Fed reduced interest rates in July and hinted at more cuts to come. But economists worry that the Fed will not have enough ammunition to fight the next downturn, as the central bank has typically had to cut rates by at least 5 percentage points to stimulate the economy following a recession.
The Fed may be forced to restart its program of “quantitative easing,” or the purchase of long-term government debt to push down long-term interest rates, though there is growing concern that this is an ineffective tool. Take a look at Japan, which has been mired in decades-long economic malaise. Interest rates have been stuck near zero for almost 20 years. Despite a massive program of government bond buying that has led to the Bank of Japan owning more than 40% of all Japanese government debt, it has still suffered four recessions over the past 20 years.
The eurozone economy hasn’t fared much better despite imposing negative interest rates on large banks, as it’s suffered two recessions since the financial crisis.
Bordo said the problem with negative rates in Europe and Japan is that, without a central-bank digital currency held by the public at large, those rates can only be imposed on banks, which hurts banks’ ability to lend and does little to encourage the magnitude of spending needed to jolt economies back into normal levels of growth.
He argues that the U.S. economy could soon face the same struggles. “We could be in a situation like Japan,” he said. “The way things are going in the world, where growth is slowing and deflationary pressures persist, we’re probably headed in that direction.”
How would it work?
The Federal Reserve already issues digital dollars, but only banks can use them. They’re called “bank reserves,” and this form of digital currency received a great deal of attention over the past decade for its role in the Fed’s quantitative-easing program, which is simply a process whereby the Fed buys government bonds from banks and gives them newly created digital bank reserves in return. Banks can settle debts among themselves using this digital currency, but it never circulates in the consumer banking system.
One way the Fed could implement the e-dollar is to simply allow any American to open an account at the Federal Reserve, where he could exchange other forms of money, like a check from his employer or a deposit at a private bank, into an e-dollar.
“The only way we can transact with central bank money today is to use reserve notes, but digital payments are now the norm,” said Ousmène Jacques Mandeng, an economist at the London School of Economics who spent much of the past two decades working for financial institutions including Credit Suisse and UBS. “If you wanted to buy something on Amazon, you can’t pay with central bank money. Shouldn’t central banks say that our money can be used in this environment? It’s a very practical issue of public choice.”
Meanwhile, an e-dollar system could be engineered so that payments are nearly instantaneous and costless, Mandeng said. This would be a major upgrade for many Americans, who now pay hefty fees for wire transfers. Newer payment services such as Venmo and Google Wallet, meanwhile, rely on automated clearing house (ACH) exchanges that often take days to process money transfers.
A concern among economists is that personal Fed banking accounts could erode private banks’ profitability and, therefore, reduce the flow of credit they provide to businesses and consumers. Others argue that banks would simply change their business models, and could attract deposits by offering higher interest rates than cash would bear, or by offering discounts on loans and other services for customers who maintain a certain balance.
But given the risk that an e-dollar could significantly harm the banking system, proponents of central bank digital currency say the safest approach would be to allow supervised commercial banks to offer specially designated accounts for it.
While regional Fed banks have produced research that claims significant economic benefits from a central bank digital currency, the Federal Reserve Board of Governors declined to comment for this article. In addition, the board’s public comments have revealed a skepticism on the potential benefits to consumers. In a May 2018 speech, Gov. Lael Brainard said “there is no compelling demonstrated need for Fed-issued digital currency,” because consumers and businesses can use private digital currency already.
Meanwhile, the Fed announced a plan Aug. 5 to develop a service called FedNow that will allow banks and fintech companies to offer real-time money transfers, which will create stiffer competition for the ACH system run by the private bank-owned Clearing House Payments Co., thus undercutting one argument for central bank digital currency.
Fighting monopoly power
For some central banks around the world, neither convenience nor the better implementation of monetary policy is the primary reason they are considering issuing digital currency. The Swedish Riksbank, for instance, is most concerned with the rapid decline in cash usage in its domestic economy, which has been much more pronounced than in the United States. The nominal value of cash in circulation in Sweden has fallen 50% over the past decade, and cash now accounts for only 13% of Swedes’ purchases, according to Hanna Armelius, senior adviser at the Riksbank.
The decline, she said, threatens to create a negative feedback loop — as fewer Swedes prefer cash, more merchants will decline it as payment — and the Riksbank does not want to find itself in a situation in which the public has no access to central bank currency.
“At the Riksbank we would like it if [non-digital] cash continues to be in use, but we have to be prepared that the marginalization of cash will continue,” she said. As private digital money plays a greater role in the economy, “we could end up in a situation where one or two companies become so dominant that they can extract monopoly rents.”
Todd Keister, visiting scholar at the Federal Reserve Bank of Philadelphia, agreed with this concern. “Monopoly power concerns are important,” when thinking about central bank digital currency, he said. “There is a natural monopoly in payment networks. What’s to stop Visa and Mastercard from raising their fees? Enabling an alternative for transacting digitally is really important.”
A wake up call for many central bankers has been Facebook Inc.’s proposed cryptocurrency, Libra. Given Facebook’s scale — it claims nearly 2.5 billion users worldwide — a successful rollout of its own digital currency could give it unprecedented power over the global economy.
Cash usage in the United States is nowhere near as low as in Sweden, but studies suggest that it is declining, from 31% of all transactions in 2016 to 26% in 2018, with cash use most predominant for small transactions. Only 6% of purchases of more than $100 were made with cash last year, according to the Federal Reserve.
There is anecdotal evidence, meanwhile, that businesses are increasingly refusing to accept cash. State and local governments have been combating this trend with legislation forcing stores to do so out of fairness to the roughly 15 million Americans who don’t have access to debit cards or other digital forms of money. Proponents of the e-dollar say it could offer a cheap, safe means for poorer Americans to transact in digital money while also giving businesses the freedom to refuse paper money if they find it too cumbersome.
Alan Blinder, former vice chairman of the Federal Reserve Board of Governors, said in an interview with MarketWatch that maintaining a public role in currency, and constraining the monopoly power of potential issuers of digital money and current players in the payment space, is a reason for the Fed to start taking the issue seriously now.
“In paper currency, the Fed has a legal monopoly — nobody else is allowed to do it,” he said.
“It’s called ‘counterfeiting.’ ” Blinder added that the Fed hasn’t, and won’t, take the same approach to digital currency, but said it could prevent monopoly power in the space by “coming in with its own competition,” and issuing digital currency that would serve as a “public option” in the marketplace of digital money.
The next evolution in monetary policy
This is not the first moment in American history when there was debate over whether public or private institutions should be the primary issuers of currency. The Constitution grants the federal government a monopoly on issuing coined currency and to define the national monetary unit, which Congress named the “dollar” in 1792. But transacting in gold and silver coins is cumbersome and expensive and so paper currency, issued by a variety of state-chartered banks, and the federally chartered Bank of the United States, quickly became the young nation’s primary medium of exchange.
Following the dissolution of the Second Bank of the United States in 1837, a system of “free banking” developed, whereby entrepreneurs were allowed to launch banks with relative ease, as long as they met a certain set of standards set by the states. The system was not ideal for interstate commerce, as businesses had to keep track of the market values of the many notes in circulation, some of which were counterfeit or issued by failed or insolvent banks.
Rutgers’ Bordo said there are parallels between today’s wild West of digital currencies — in which increasingly popular debit and credit cards exist alongside cryptocurrencies such as bitcoin and etherium — and this past era of free banking in America, a period marked by frequent financial crises and bank failures. The U.S. economy suffered due to the high transaction costs inherent in an economy marked by currency competition.
That system fell apart during the Civil War in 1864, when Congress passed legislation that enabled the Treasury Department to issue paper currency, not convertible to gold or silver, that was deemed legal tender for debts public and private. The law was necessary to help finance the Union’s war effort and set in motion a series of statutes that ended state-chartered banks and created a national banking system, wherein nationally chartered banks distributed U.S. dollars backed by gold. U.S. dollars wouldn’t be directly issued by the government until the Federal Reserve System was established in 1914, to create a single institution to manage the money supply and oversee the banking system.
The trend of more gradual control over paper currency by the U.S. Treasury and Federal Reserve increased the efficiency of the U.S. economy and boosted growth, and many economists expect that central bank digital currency would do the same. John Barrdear and Michael Kumhof, research economists at the Bank of England, estimated that the introduction of central bank digital currency could increase the size of a given economy by 3% “due to reductions in real interest rates, in distortionary tax rates, and in monetary transaction costs.”
Supercharging blockchain innovation
Though central bank digital currency as envisioned by most prominent researchers would not be a cryptocurrency, believers in the potential of blockchain technology see central bank digital currency as a technology that could help unleash its potential.
There has been considerable hype around the idea of using blockchain to “tokenize” illiquid assets like real estate, fine art or gemstones, and allow investors around the world to trade slices of these assets with the same ease as they trade stocks and bonds today.
“If you accept tokenization is going to be important, then these ecosystems, like all other financial market infrastructures, will ideally have access to central bank currency for financial settlements,” said London School of Economics’ Mandeng. “Central banks should be technology neutral,” he added. “If [the Fed] allows banks to settle their transactions in central bank money, why shouldn’t individuals who trade in tokenized assets have the same access to this risk-free currency?”
Will the e-dollar see the light of day?
While the Federal Reserve is unlikely to issue e-dollars anytime soon, it will surely be watching experiments with central bank digital currency around the world.
The National Bank of Cambodia is issuing its own blockchain-based digital currency to make its underdeveloped banking and payment system more efficient. The currency will be usable both on private mobile payment applications and commercial bank accounts, giving its underbanked population access to safer and more secure forms of payment. The Bank of Canada, the Bank of England and Norway’s Norges Bank have also been seriously studying the issue. Sweden appears closest to adopting its digital currency, the e-krona, after its parliament set up a formal inquiry into the question.
The Riksbank’s Armelius told MarketWatch that the disappearance of cash and the potential problems associated “has been a political issue for years now,” and estimates that the process of implementing an e-krona “will take years, not decades.”
Meanwhile, Bank of England Gov. Mark Carney proposed in a speech on Aug. 23 at the Fed’s annual Jackson Hole Summit in Wyoming that central bankers around the globe could coordinate to issue a digital “Synthetic Hegemonic Currency,” to replace the dollar as the world’s reserve currency. He suggested that such a tool could eliminate problems that have resulted from the U.S. dollar’s service as the world’s reserve currency, from erratic capital flows in emerging-market economies to the overvaluation of the greenback that suppresses American exports.
As for the e-dollar, former Vice Chairman Blinder argued that the Fed has the power to implement central bank digital currency with the authority already granted it by Congress, but that it likely wouldn’t move without a broader political consensus.
What may bring about this consensus is another question, and Rutgers’ Bordo looks to U.S. history for the answer. He said that big shifts in currency policy have typically occurred “when the politics line up” due to some sort of crisis. The system of free banking was ended only because of the exigencies of the Civil War and the Federal Reserve system was created from the wreckage of the 1907 financial crisis.
As economic storm clouds gather over the United States, and as the Federal Reserve appears to lack the ammunition to save the country from the sort of prolonged malaise that has overtaken other wealthy economies, it’s possible that the next crisis-driven revolution in monetary policy is at hand.
“What makes the politics line up is the next recession,” Bordo said. “When they find that the tools they have aren’t working, then the arguments will start to be listened to.”