The success of the cryptocurrency industry has inspired the Federal Reserve and other central banks to create their own digital currencies using the new technology. Recently, the Federal Reserve Bank of New York and a small group of private financial firms announced a 12-week pilot program to explore the feasibility of a central bank digital currency (CBDC).
Although several other central banks are testing and implementing CBDCs, this is the Fed’s first move. Unfortunately, this is not a step in the right direction.
There is a strong political appetite in the United States for government intervention aimed at reducing economic inequality and increasing financial inclusion. To that end, central bankers and politicians argue that a CBDC will promote financial inclusion, increase payments efficiency, reduce transaction costs, and improve monetary and fiscal policy execution.
The Fed can implement a CBDC in the United States in two ways: wholesale and retail. The Fed’s pilot program represents a version of the wholesale model.
However, the case of a CBDC, retail or wholesale, does not stand up to scrutiny. A wholesale CBDC offers little benefit and opens the door to a dangerous retail CBDC down the line, which risks financial instability and threatens consumer privacy.
A retail CBDC gives citizens direct access to central bank digital currencies, eliminating banks and commercial institutions from the process. Citizens would have a direct bank account with the Federal Reserve and use a digital app to access their funds. Those who do not wish to use digital technology could use a prepaid CBDC card, an option currently available to citizens of the Bahamas.
The retail approach has several dangers. Retail CBDCs risk widespread financial disintermediation by crowding out the lending roles held by traditional banks. Commercial banks will have fewer deposits to lend if citizens transfer a significant portion of their savings into CBDC accounts. Entrepreneurs and businesses will suffer as less capital will be available to finance their businesses.
A sterilized commercial banking system could force the Fed, flush with CBDC deposits, into the business of commercial lending. While currently the “lender of last resort,” the Fed is ill-equipped to serve as a traditional commercial lender. A popular retail CBDC ensures that the Fed, rather than commercial banks, must keep capital flowing to entrepreneurs to avoid stunting economic growth.
On the privacy side, retail CBDCs remove safeguards for consumer privacy by giving governments direct control over citizens’ bank accounts. For example, in China, Communist Party officials are touting their CBDC network, the Digital Currency Electronic Payment System (DECP), as a way to exercise greater financial control over citizens and enforce party discipline.
The significant economic and privacy risks associated with retail CBDCs could explain why more than two-thirds of public comments in response to the Fed’s research paper on CBDCs are negative.
Unlike the retail option, the Fed pilot program represents a version of the wholesale model. A wholesale CBDC would replace the dollars that banks currently hold at the Federal Reserve, although consumers cannot access them directly. The wholesale model changes how banks interact with the Fed, but not how consumers interact with money.
However, by piloting a wholesale model, the Fed is dangling a dangerous option for politicians to seize in the future. Consider the Biden-Harris administration’s recent report on CBDCs, which states that “everyone should be able to use the CBDC system” and that “the CBDC system should expand equitable access to the financial system.” Since a wholesale CBDC is not available to everyone and does nothing to broaden access to the financial system, the retail option is the only way to achieve the administration’s stated goals.
Most money is already digital. A wholesale CBDC does not offer meaningful benefits to consumers, and the Fed should halt its CBDC pilot program and ambitions before political pressure builds up around the dangerous retail option.
As recent inflation illustrates, the Fed has been unable to fulfill its current mission. Rather than expanding into new and unfamiliar areas, it should focus on establishing monetary rules and achieving price stability.
At best, a wholesale CBDC represents a waste of taxpayers’ money on a project that does not serve the Fed’s stated mandate. At worst, it begins a slippery slope towards a retail CBDC and the associated economic and privacy risks.
David Waugh is an editor at the American Institute for Economic Research.