This blog post accompanies the SDPB Monday Macro segment that aired Tuesday, July 6, 2021. Click here to listen to the segment, which begins at minute 21:25 into the broadcast.)
Central bank digital currency (CBDC) is not cryptocurrency. Indeed, at the moment, CBDC is not anything, really; it doesn’t exist in a practical sense. Conceptually speaking, CBDC is a digital, and thus virtual, monetary liability of the central bank, a generally accepted digital means of payment that is a direct claim on the central bank and available to the non-bank public. In the context of the Federal Reserve System, a CBDC would effectively be a digital Federal Reserve note that circulates outside the banking system—think, a digital twenty-dollar bill that you and I could use to pay for things, for example. That CBDC remains only a conceptualization hasn’t stopped everyone from talking about it incessantly. Just last week, for example, Randal K. Quarles, Vice Chair for Supervision on the Board of Governors of the Federal Reserve System, spoke on the subject to the 113th Annual Utah Bankers Association Convention (Sun Valley, Idaho, June 28, 2021). In the talk, “Parachute Pants and Central Bank Money,” Vice Chair Quarles was cautious, to say the least, reminding listeners that “America’s centuries-long enthusiasm for novelty” has “sometimes led to a mass suspension of our critical thinking and to occasionally impetuous, deluded crazes or fads.”
Perhaps, but with all due respect to Vice Chair Quarles, CBDC is not all that novel; nor is it only popular in the United States. Since 2017, for example, Sweden’s central bank (the Riksbank, est. 1904) has conducted the on-going Riksbank e-krona project, with which the central bank continues to investigate actively its adoption of a CBDC. The current, much-watched e-krona pilot (phase 1), a so-called proof of concept the central bank began in 2020, tests the technical—and, thus, practical—aspects of issuing, clearing, and settling a CBDC. Indeed, in October 2020, several central banks, including the Federal Reserve System, collaborated on “Central Bank Digital Currencies: Foundational Principles and Core Features,” a comprehensive, impartial investigation into the motivations, challenges, and risks of CBDC (Basel, Switzerland, October 9, 2020). The Federal Reserve System promises to release its self-study white paper on the subject sometime soon. Perhaps the allusion to parachute pants was a bit harsh—or not.
I know what you’re thinking: this is nothing new, I hold CBDC in my bank account, my Venmo account, my Zelle account. No you don’t. In every one of those examples, you hold a digital, dollar-denominated claim on an intermediary—your bank, for example. And through a clearing and settling process—the so-called payment system—you (and I) exchange those digital, dollar-denominated claims on intermediaries as generally accepted means of payment. You electronically exchange funds in your checking account for a cup of coffee, for example, And in this way, your checking-account balance is money; but it is not CBDC.
To understand CBDC and appreciate its implications, consider a brief lesson in anatomy—of a central bank. As Schooled readers know well, the defining feature of a central bank is that it issues the economy’s monetary base, including central-bank notes (or, in modern, crypto parlance, tokens) in circulation. In the case of the Federal Reserve, the monetary base consists of Federal Reserve notes (aka, currency) circulating in the hands of the non-bank public, plus bank reserves—think loosely, Federal Reserve notes in the physical or virtual vaults of banks. Thus, the United States monetary base is a liability of the Federal Reserve and an asset to everyone else. A Federal Reserve note is an IOU issued by the Federal Reserve to whomever holds the note. In similar fashion, then, Japan’s (yen-denominated) monetary base is a liability of the Bank of Japan, Sweden’s (krona-denominated) monetary base is a liability of the Riksbank, and so on.
Consider, for example, the simplified Federal Reserve balance sheet that I depict in Figure 1, where the components of the monetary base appear in red font.
Figure 1: Simpified Balance Sheet of the Federal Reserve System, Actual
The monetary base is the primary source of the Federal Reserve’s funds, which is convenient to say the least, because the Federal Reserve simply creates the monetary base by issuing monetary liabilities: namely, currency in circulation and bank reserves. We should all be so lucky. Equity, paid in by member commercial banks, is another source of the Federal Reserve’s funds. The remaining accounts in Figure 1 are entirely relatable (and immaterial to this discussion of CBDC): namely, securities—think, loans to the Treasury (which is distinct from the Federal Reserve)—and so-called discount loans to banks are Federal Reserve assets; these comprise some of the uses of the Federal Reserve’s funds. Incidentally, the monetary base is not the money supply (of a generally accepted means of payment for goods, services, and debts). Rather, in the case of the Federal Reserve, the money supply consists of Federal Reserve notes circulating as currency—the currency portion of the monetary base—and checking-account deposits, either of which we might use to buy a cup of coffee, for example. Thus, the money supply is part sovereign, dis-intermediated liabilities—Federal Reserve notes circulating as currency—and part private, intermediated liabilities—checking-account deposits. (For more on the monetary base and the money supply, see Monday Macro segment, “Fed Up.”),
If the Federal Reserve were to introduce a CBDC, then the central bank’s simplified balance sheet would appear not as Figure 1 but rather as Figure 2, where CBDC appears as a third monetary liability of the central bank.
Figure 2: Simplified Balance Sheet of the Federal Reserve System, CBDC Proposed
All the accounts that appear in Figure 2 (and, for that matter, Figure 1) are aggregations, of course. For example, the account, Securities, is measured as the total value of all types of securities held by the central bank; likewise, the account, Currency in Circulation, is measured as the total value of all denominations of outstanding Federal Reserve notes held by all entities—individuals, corporations, etc.—outside the banking system: for example, the twenty-dollar bill that you currently hold and the ten-dollar bill that I currently hold are included in the total value of the account, Currency in Circulation. In analogous fashion, then, the account, CBDC, would be measured as the total value of all outstanding CBDC held by all entities outside the banking system.
Read that again: the account, CBDC, would be measured as the total value of all outstanding CBDC held by all entities outside the banking system. Put differently, then, a CBDC would effectively afford every entity—think, everyone including you and me—a digital account with the central bank! Sounds crazy, I know; but how else could each of us have a digital means of payment that is a direct claim on the central bank? (Yes, that question is rhetorical.) Your U.S. commercial bank has long held direct digital claims on the Federal Reserve in the form of the bank reserves I identify in Figures 1 and 2. Thus, a CBDC would effectively allow you and me to bank at the Federal Reserve, much as our commercial banks do now.
If you could bank at the Federal Reserve—the lender of last resort—why would you bank at a bank?
The implications of CBDC for commercial banking as we and commercial banks know it are profound and, for commercial banks, existential. (To be sure, the implications of CBDC are vast; here I focus on financial stability and credit allocation only.) Fundamentally, from the perspective of retail savers (like us), digital, sovereign, dis-intermediated liabilities—think, CBDC—and private, intermediated liabilities—think, checkable deposits intermediated by banks—are close though not perfect substitutes; and in a panic, the public may very well prefer CBDC, to which the public could transfer checkable deposits instantly—a bank run at the speed of light, literally. This is to say, the public’s likely preference for CBDC could render checkable and other such bank deposits pro-cyclical—when the economy contracts so too would bank deposits, a major source of funding for commercial banks. We have seen this sort of thing before, way before the money supply was digitized. In Figure 3, I illustrate the U.S. currency-to-deposit ratio, the relationship between currency in circulation—in the hands of the non-bank public—and bank deposits.
In Figure 3, the sudden rise in the currency-to-deposit ratio is evident during the banking crises in the Great Depression. The ratio rose as members of the non-bank public preferred to hold currency—Federal Reserve notes in circulation, a direct liability of the central bank—rather than (then-uninsured) checkable deposits. A similar run on checkable deposits—and uninsured intermediated deposits more generally—could occur in a world with CBDC. And, even in the best of economic circumstances, the non-bank public could choose to keep their liquid savings in CBDC instead of checkable deposits. As the Economist put the matter recently, “If CBDC proved popular, they could suck all deposits out of the banking system” (The Economist, May 8, 2021). If deposits were to leave the banking system en masse, banks could broadly preserve their funding model, but only with heavy central-bank intervention: the non-bank public could lend to the central bank (in the form of CBDC) and the central bank could, in turn, lend to commercial banks (in the form of discount loans); or, banks could find a new, more-costly funding model—a most-disruptive alternative that would effectively eliminate banks as we know them and as they know themselves. (For more on the important functions banks currently perform, see Monday Macro segment, “Extra Credit.”). And although central banks could discourage large holdings of CBDC by, say, imposing caps on CBDC balances or paying negative interest rates on CBDC balances, such tactics would be difficult to implement. This is in part because turning away the public is practically difficult—imagine capping CBDC balances during a banking crisis—and charging the public to store CBDC is technically difficult—imagine charging a negative interest rate on a balance in a digital-wallet that is currently offline but exchangeable peer to peer.
So why CBDC?
No doubt CBDC could advance the payment system, potentially speeding and lowering the cost of clearing and settling monetary exchange. Though at least two other interrelated reasons likely explain the current momentum toward CBDC: the waning popularity of central-bank currency in (physical) circulation and the growing popularity of peer-to-peer, decentralized, distributed-ledger technology, including crypto-assets such as bitcoin and the block-chain technology on which it is based. (For more on crypto assets, see Monday Macro segment, “Tales from the Crypt.”). As for the waning popularity of currency in circulation, consider Figure 4, in which I illustrate currency in circulation as a share of own-country GDP for Sweden, where proof-of-concept work on CBDC is relatively advanced, and the United States.
As a share of GDP, currency in circulation is less than 10 percent in both countries; the recent jumps in the ratios are arithmetic constructions of the falls in GDP in the United States and (to a lesser extent) Sweden in the wake of the pandemic. In Sweden, currency in circulation has generally fallen to absolute lows in recent years, a pattern most economists expect will play out around the world, including the United States, eventually. To put the matter simply, central banks view the extinction, were it to occur, of currency in circulation as a threat to central-bank monetary sovereignty and the effectiveness of central-bank monetary policy. As the Riksbank writes in its e-krona pilot phase-1 report, “When cash has to take a back-seat in favour of the private financial agents’ digital services, this means that the Riksbank’s direct role on the payments market is reduced. The Riksbank may then find it more difficult to fulfill its task of promoting a safe and efficient payment system available to all parts of society.”
This leads to a second explanation for the current momentum toward CBDC: the growing popularity of peer-to-peer, decentralized, distributed-ledger technology—bitcoin, for example. Ostensibly, the extinction of cash affords a role for—and, in some cases around the world, may be precipitated by—alternative, privately issued currencies. Thus, although CBDC need not run on a block-chain platform per se, CBDC is, in part, the sovereign’s response to the threat of cryptocurrencies. And here perhaps lies the greatest of all ironies: a tightly regulated, centralized, sovereign-issued currency to satisfy the preferences of those wishing for an unregulated, decentralized, privately issued, cryptographic monetary social construct—a proposition crazier than parachute pants.