Econ 101: Retail Central Bank Digital Currency (CBDC)

The history of money is long and fascinating. Even the currency most frequently used in the United States has a rich history. Money makes possible the specialization and trade upon which our great wealth depends. Through its long history of development and evolution, money has serviced two key functions. It provides the standard unit for pricing traded goods and services so that their values can be meaningfully compared (it’s the unit of account) and it is the common asset in which payments are made (it’s the medium of exchange or payment).

Medium of Payment–Money

When you hire the neighborhood boy to mow your lawn, you probably first agree on a price (the number of dollars) This is the unit of account function of money, which is indispensable for the functioning of markets.  You could agree to trade with the neighborhood boy a nice lunch with lemonade in exchange for his mowing your lawn. But paying him $15 in Federal Reserve Notes has the advantage that he can exchange it for your lunch, or he can buy his lunch at Wendy’s or anything else of his choice.

Obviously, markets can’t really function if each item or service is priced in a different money unit (dollars, Euro, rubles, bitcoin, etc.). The Continental Congress of the United States authorized the issuance of a new currency, the US dollar, on July 6, 1785. Following the ratification of the Constitution of the United States, the new Congress established the United States dollar as the official currency of the United States in the Coinage Act of 1792. The Act also established the United States Mint, which produced and circulated coins with a fix amount of gold or silver (later only gold). “History of the United States dollar”  

As the result of the changing relative price of silver for gold, the bimetal gold/silver standard was replaced with the single metal standard of gold. The dollar was redefined in 1900 as “twenty-five and eight-tenths grains of gold nine-tenths fine,… and all forms of money issued or coined by the United States shall be maintained at a parity of value with this standard.” Fast forwarding through WWI and WWII and the creation of the Bretton Woods Institutions and the failure of the US to adhere to the requirements of the gold standard, the US “closed its gold window” and proceeded with varying degrees of success to manage the supply of its currency so as to preserve its purchasing power.

Over this long history many private actors (banks) created dollars. There are in fact thousands of private producers of dollars (Chase dollars, B of A dollars, etc.) Glossing over the details, it was a one currency system–the US dollar–because each bank’s currency could be redeemed for gold at  fix price or, after the creation of our central bank in 1913, for a deposit at a Federal Reserve Bank. This is obvious when you pay with Federal Reserve Notes, which are direct obligations of our central bank. Originally each note was identified by the Federal Reserve Bank that issued it–there were twelve of them–but even that distinction has been eliminated. Few people even noticed the difference. But most of our dollar money supply (M1: Federal Reserve Notes in circulation plus demand deposits at banks) is privately produced by banks and exists in digital form as accounting records with each of our banks.

Means of Payment

Our money–US dollars (or Euros or bitcoin)–is quite distinct from the various ways in which you can pay it–payment technologies. Cash payments–the transfer of Federal Reserve Notes from me to you–are hand delivered. But most payments are made by digitally transferring an amount of dollars from my bank account to yours. Such digital payments have the obvious advantage of enabling you to pay someone across town, across the country or even across the world (if they accept your currency) plus the safety of keeping your money in the bank pending such payments.  It’s not recommended that you send cash in the mail. The key insight is to understand how my dollar balance in my bank gets to your account at your bank and why your bank is willing to accept it. The quick answer is that your bank will not generally accept a claim on my bank but will record my payment because it receives an increase in its deposits at a Federal Reserve Bank of that amount.

In the old days I wrote a check that authorized my bank (after the check was deposited by you at your bank, which sent it to my bank) to debit my balance with the indicated amount and to transfer that amount from its balance at the Fed to your bank’s account at the Fed. SWIFT performs this payment instruction/authorization function for cross border payments (i.e., those involving two central banks). Today I issue this instruction directly to my bank electronically on the internet or my smart phone. The “dollars” are one currency no matter who creates and issues them because whoever receives them can redeem them for balances at the central bank (or in the old days for gold).

Visa, Master Card and American Express credit cards provide payments on my behalf by lending me the money before I actually make the payment from my bank account to the credit provider at the end of the month. The loan to me involved in such payments, increases the cost of this type of payment.

The execution of the interbank portion of my payments have become increasingly efficient over time but can still take several days because the Federal Reserve Banks do not operate in the evening or on weekends. When our central bank launches FedNow next year it will allow the continuous processing of payments between banks 24/7.

The front end of the payment process, i.e., my initiation of a payment to you, for example, has also benefited from software improvements. Unlike bitcoin, Ethereum, or Ripple, which are currencies, Zelle, Venmo, PayPal, etc. are payment technologies rather than money. They are means for paying US dollars (or other currencies) from me to you. Venmo, for example can be thought of as the payment service part of a bank. It can hold money for you and can transfer it to others (who must also have a Venmo account) but Venmo cannot make loans with your money. Thus, people without bank accounts can use Venmo as if it were a bank account.

The Federal Reserve and other central banks are investigating whether they should also provide the service to the public of paying dollars with so called Central Bank Digital Currency (CBDC). The Federal Reserve defines a CBDC “as a digital liability of the Federal Reserve that is widely available to the general public.” “Money and payments–Fed report”  CBDCs would be a direct claim on the central bank like Federal Reserve notes (cash) but would be held and transferred digitally like your bank deposits. If the Fed goes forward with introducing CBDCs, they would almost certainly be what are called retail CBDCs. Rather than opening accounts at the Fed directly, we would each do so through a bank. We would sign up with and deal with a bank to hold the Fed’s CBDCs. The Fed has no existing capacity to deal directly with each of us in the way that our banks do. The balance of this note will explore how such CBDC would compare with, say, Venmo balances and payments and whether they are worth the trouble.

All digital money is recorded on electronic ledgers, either distributed as with a block chain used by bitcoin, or centrally maintained as with our bank accounts. As block chains are slow and expensive to verify, they would not be used for CBDCs. Just in case you didn’t know, when you walk into your bank and deposit cash, they don’t put it in the value for you. They record the value of the cash you delivered in our account with the bank, and they return the cash to the Fed for a credit to your bank’s Fed account or invest or lend it to someone else (after having converted it into a balance in their Fed account). It is both useful and interesting (to us economists at least) to walk through how my deposit at my bank is transferred to you (your account at your bank).

Taking Venmo as the example of existing digital payment technology, your deposit of dollars to your Venmo account would be digitally transferred from your bank account to your account on Venmo’s ledger. Your bank would transfer the same amount to Venmo’s deposit account with its bank (in the name of PayPal, which owns Venmo) in the usual interbank transfer manner. All (double entry) financial ledgers have a liability side (your deposit with the bank — what the bank owes you) and an asset side (the cash you deposited or the balance in your bank’s fed account for the money you had transferred to it). The ledger shows what the bank owes (liabilities) and the assets it holds with which to pay out what it owes (assets).

All digital money, whether your bank deposit or Venmo or bitcoin, must provide for an on ramp into and off ramp out of the digital system, i.e., for the process of paying cash in to acquire the digital money and of drawing it out as cash. Interestingly, Kenya has had a version of Venmo payments for several decades already. Kenya’s M-Pesa The ownership and use of cell phones (not necessarily smart phones) is very widespread in Kenya, while bank accounts are far more limited. Thus, people paid for phone airtime by the hour by paying cash to street venders selling such service. This became the on ramp for the unbanked to fund their M-Pesa mobile money accounts.

If you have money in your Venmo account (a positive balance), you can issue a payment instruction via your Venmo wallet directly to the friend you are paying. You can also instruct Venmo to take that the money simultaneously from your bank account. You can do all of this on your smart phone while waiting for your drink at a local bar. If your friend doesn’t have a Venmo account, Venmo will instruct her on how to set up one in order to receive your payment. If you give Venmo a day or two to complete the payment, it is free. If you want it delivered immediately (within a few minutes) there is a small fee. When the payment is complete, your balance at Venmo (or your bank) will have been reduced by the amount of the payment and your friend’s balance with Venmo will have been increased by the same amount. She can leave the money there or move it to her bank account (on her cell phone) if she has one. The money will “exist” as an accounting record somewhere. These “dollars” are accepted from wherever they come (from whoever produced them) because they are claims on, or are converted into deposits at, a Federal Reserve Bank.

How would this compare with a payment with central bank digital currency (CBDC)? While the Federal Reserve has not indicated the details of a possible CBDC, it would probably work something like this. I would ask my bank to sell me CBDCs by debiting my checking account by the indicated amount. These would be added to (credited to) my CBDC account at my bank.  My bank would transfer that amount from its general account at its Federal Reserve Bank to a segregated CBDC account at the Fed. My cell phone wallet would record (by accessing my CBDC account at my bank) this amount, and my bank would back it 100% with its CBDC account at the Fed.

Why does this matter? It matters because if my bank fails (goes into bankruptcy), the amount in the bank’s CBDC reserves at the Fed would be excluded from the bankruptcy process. They are exclusively and fully available to back my CBDC holdings. When I pay CBDC to my friend, her bank will receive them without regard for the condition of my bank.

Some of you will recognize this as the equivalent of the so-called Chicago Plan. The Chicago Plan required banks to back all checking account deposits 100% with central bank reserves. Our bank deposits today are largely backed by bank loans and investments plus a small deposit with the central bank. Such CBDC deposits would be totally free of default risk. While all CBDCs would exist on the books of the Federal Reserve, ownership by individuals would be reflected on the books of their respective banks and in their CBDC wallets.

Like the Chicago Plan, CBDCs have the potential to reduce the money multiplier (the ratio of broad money to base money–the Federal Reserve’s monetary liabilities). A shift from demand deposits to CBDC deposits at banks would reduce the funds available to banks for lending by increasing the reserves they must hold at the Fed. This could be easily compensated for by increasing base money (Federal Reserve monetary liabilities). Sudden shifts to the safer CBDCs in reaction to financial shocks, like traditional bank runs, would require central bank intervention. The Fed has also indicated that it would want any digital replacement of its currency notes to provide as much user privacy as possible (like cash) consistent with “affording the transparency necessary to deter criminal activity.”

How would this compare with a Venmo payment. From our perspective (the perspective of the payer and payee) a Venmo or CBDC payment would be executed in the same or very similar way. The difference is that the CBDC balances would be totally risk free (being relatively direct claims on the central bank) while the Venmo balances would be exposed to the risk of the failure of the bank in which Venmo keeps its assets that back our Venmo balances. It is not obvious that this is a big enough difference to make it worth undertaking.

Printing Money

Isn’t that just printing money?  Here is a quick, and hopefully simple, primer on what central banks do.

Central banks print money. They are responsible for issuing a country’s legal tender (banknotes and bank deposits with the central bank) and regulating its value. Most of what we call money is actually privately produced (deposits at commercial banks, credit and debit cards, paypal, etc.) but tied to the money printed by each country’s central bank by the public’s demand that it be redeemable for the central bank’s money. There are a few exceptions to this demand by the market, such as bitcoin (see: the-rise-of-the-bitcoin-virtual-gold-or-cyber-bubble), but they shall ever remain unimportant fads. There is never a question about whether central banks print monetary or not. It is their responsibility to do so. This is as true for a pure gold standard or other fixed exchange rate monetary regimes, as for the variety of fiat money regimes (from monetary targets to inflation targets to flying by the seat of their pants day-to-day).

The important and proper question about a central bank’s behavior is what guides its decisions about when and how much money to print. A secondary question is what does it buy when it issues money (there are no helicopters that drop it from the sky)?

The gold standard: Under a gold standard the central bank buys gold with the money it prints and is legally bound to buy that money back with gold at the same price whenever anyone holding its money wants to redeem it. While this is still printing money, the supply is determined by the preferences of the market (each and every one of us) to hold and use that money. Such central banks have no monetary “policy” in the usual sense. They passively supply whatever amount of money the public demands.

Fiat money: If the central bank issues money with no obligation to redeem it for anything in particular nor at a particular price, its value is determined in the market by its supply and demand. The amount supplied by the central bank relative to the market’s demand for it will determine is value (the price level). Monetary policy consists of the decisions made by central banks that determine the amount of the money they supply and manner in which they supply it.

The public’s demand for money reflects its convenience for making payments, its expected value when exchanged for goods and services, and the opportunity cost of holding it (inventory costs, i.e., the interest rate that could have been earned on holding wealth in other forms). Rapidly changing payment technology (debit/credit cards, Paypal, e-money, etc.) has a profound impact on this demand. There is a vast academic literature on this subject. Unlike any other good or service money’s value derives solely from what it can be exchanged for or more specifically from the economy it brings to exchange/trade.  Fiat currency is always useable and thus “redeemable” for the payment of taxes and other obligations to the government that issued it. These obligations are denominated (valued) in the same units as the currency. These guaranteed uses of fiat money anchor its demand and thus value in the same way that the demand for gold for jewelry and other non-monetary uses anchors its value. Bitcoin has no alternative use and thus has no anchor to its value.

Central banks have learned the value of establishing clear rules for issuing money, such as targeting the rate at which the money supply (by one definition or another) grows, or targeting nominal income, or inflation. These rules guide how much money they “print.” They also influence the public’s demand for money by informing its expectations of the central banks actions. The policy regime adopted—rule—determines the behavior of the money supply and thus its value (or visa versa). The supply of bitcoin also follows a well-defined rule, but its demand is unanchored. The fact that the central bank is printing money is irrelevant by itself.

A secondary consideration is what it is that the central bank buys with the money it prints. Under a gold standard it buys gold. Under a fiat money standard central banks generally buy government securities because these securities are generally of unquestioned safety and in most countries have the deepest and most liquid secondary markets. Central banks also traditionally adhere to a “bills only” policy, i.e., they buy short-term government security, in order not to interfere with the market’s determination of the term structure of interest rates, i.e. the relationship of interest rates on securities with longer maturities relative to those with shorter maturities. In a free market, rates on longer maturities are determined by the expected value of overnight rates over the period in question plus a risk premium for the uncertainty over the behavior of overnight rates.

Whatever the ultimate or intermediate targets of monetary policy, most central banks in recent decades have pursued them by targeting a short-term interest rate, their so-called “operating target.” The Federal Reserve targets the overnight interbank rate, the so-called “federal funds rate,” as its approach to targeting the money supply, nominal income, or inflation. Given all other market factors, a particular fed funds rate target will result from and result in a particular rate of growth in the money supply.

Because most money and related means of payment are privately produced by banks or is ultimately settled through banks, and because banks only keep a small amount of the money produced by their central banks for which bank deposits are redeemable (the so-called “fractional reserve banking system”), central banks have also been given the role of insuring that banks have sufficient liquidity to function smoothly. They are mandated to lend to solvent but illiquid banks when banks need to convert loans into cash to accommodate deposit withdrawals (the so-called “lender of last resort” function).

As more and more central banks successfully adopted the techniques of inflation targeting and most of the rest fixed the exchange rate of their currencies to an inflation targeting currencies such as the U.S. dollar or the Euro, the world entered a long period dubbed “the great moderation.” However, the long period of very low interest rates following the bursting of the “dot com” bubble produced the housing price bubble in many locations in the U.S. and Europe. Its collapse in 2007-8 plunged much of the Western world into the long, Great Contraction.

Monetary Policy Plus (MP+):  In the last few years the Federal Reserve, the European Central Bank (ECB) and other central banks have undertaken many non-traditional actions in an effort to help lift their respective economies out of recession. In the early days of the serious liquidity crunch following the collapse of Lehman Brothers in September 2008, the Fed, ECB, Bank of England and a few other central banks very successfully pumped needed liquidity into their financial systems by expanding the number of counterparties they would lend to, increasing the eligible collateral, and entering into currency swap arrangements to supply dollar liquidity to foreign banks.

However, after unblocking the flow of funds between banks and other financial firms, the Fed’s concern shifted to fighting deflation, then to reviving economic activity. After driving its operating target to almost zero, the Fed continued increasing monetary growth beyond the rate resulting from a zero fed funds target and dubbed it quantitative easing. However, the channels through which monetary policy is traditionally transmitted to the economy (interest rate, credit, asset price, portfolio/wealth effects, exchange rate channels) seemed ineffective. Thus, the Fed began to purchase non-traditional, financial instruments, such as Mortgage Backed Securities (MBSs) and longer-term government securities, in an effort to keep mortgage interest rates low and to encourage the flow of funds into the mortgage market and stimulating investment more generally. These quasi-fiscal policy measures do not square easily with the Fed’s legal mandates of price stability and employment.

With the Fed’s third program of quantitative easing it is now pushing on a string  (QE3: It is attempting to stimulate an economy that lacks a clear policy environment that would encourage more investment rather than one suffering from inadequate liquidity. While market measures of inflation expectations remain very low, long periods of very low interest rates influence the capitalized value of income streams. A given monthly mortgage payment will purchase a more expensive house when interest rates are lower. What people and firms invest in is distorted toward more capital-intensive projects than are economically efficient and justified at normal rates of interest.  Pension funds and other endowments lose income that must be made up somehow (often by moving into riskier investments). Asset price bubbles emerge. On top of these economic risks, the Fed’s need to unwind its huge portfolio of securities (purchased by printing money) when the economy recovers more fully is becoming more and more challenging.

Moreover, the policies of one central bank can affect the exchange rate of its currency if its policies are not coordinated with those of other central banks. This can either improve or worsen the balance of payments between countries (balance of imports and exports). The very wide swings over the last decade in the exchange rate of the US dollar with the Euro, for example, cannot be justified by economic fundamentals and is very disruptive to trade and international capital movements. Recent monetary policy initiatives by the Bank of Japan raise such concerns.

In short, the problem is not that the Fed and other central banks are printing money. The problem is the amount they print and their conceit that they can do more to help the real economy than they really can, thus adding to the market’s uncertainty over the economic, policy, and financial environment in which their decisions to spend and invest must be made. The solution is to reestablish a hard anchor for monetary policy that allows the supply of money to be market determined (as proposed in my: Real SDR Currency Board, paper).

The fantasy of a purely private money that would overcome the weaknesses of government money, remains for the foreseeable future a utopian fantasy: “The Future of Money”. But those of you who enjoy fantasy, might enjoy the following story by Neal Stephenson: “The Great Simoleon Caper”.