The Fed Publishes A Discussion Paper

The Chinese Central Bank is rolling out a digital yuan into production to coincide with the Winter Olympics, the Fed is producing a discussion paper. 250 million people have downloaded the wallet app for e-CNY, the Chinese Central Bank Digital Currency. less than 250 people at the Boston Fed and the MIT are building a proof of concept application to test out the digital dollar. It is hoped that the digital dollar would be the tortoise, but this year it will be racing the Chinese Tiger, not the hare, and the race appears to be already over. Of course, this is not a footrace with an end, it is definitely a long game. In that sense, the release of this paper is an important and widely anticipated milestone for the Fed and they have released a series of 22 questions for discussion in this paper. Anyone can provide feedback on these questions through a form hosted by the Fed. Although the usual suspects will be the main interlocutors of the Fed through their feedback portal. It will not be a broad based response, just judging from the tone and content of the questions. Reading the paper, it seems like the Fed has answered the questions that they pretend to ask.

A deliberate, methodical and well researched approach is needed to release a new national digital instrument. Federal Reserve policymakers and staff have studied CBDC closely for several years, says the paper. However, gedanken experiments are not enough. Theory definitely has to meet practice.

The Fed’s charter is to conduct the nation’s monetary policy to promote maximum employment and stable prices in the U.S. economy. This charter leads to a broad range of activities and capabilities of the Fed. They range from promoting the stability of the financial system by monitoring and controlling systemic risk to running a payment, clearing and settlement system for commercial banks. The instrument that is a liability of the Fed and widely available to the public is cash. A Central Bank Digital Currency would be the digital equivalent of cash. An instrument shorn of credit and liquidity risks, to be used for instant settlement. Our commercial bank deposits are digital, so are our non-bank holdings, like our paypal balances, but they are not liabilities of the Fed. They appear to be equivalent, due to the removal of credit risk through FDIC Insurance and the promise of par fungibility. A dollar in the bank and a dollar in the pocket are equivalent through the prestidigitation of par. We do not even think about the differences between commercial bank deposits and cash.

Just as cash is distributed through intermediaries, the discussion paper opines that a digital dollar would be distributed through intermediaries as well. Disintermediation of the banks can have unintended consequences on the creation of credit and the generation of money to become capital for productive enterprises. This is conventional wisdom and has been the design principle for e-CNY as well. However, such a move clashes with financial inclusion as people without any bank accounts need access to a digital dollar as well, there should also be conduits for benefit payments without such bank accounts. The stated aims, to have a strict two tier system and financial inclusion are contradictory, it may be resolved by having some form of a Fed digital wallet or card freely distributed to such individuals.

Another major factor preventing a run on the banks would be the feature of a digital dollar of not paying interest; also similar to cash. However even the so called zero-lower-bound of cash and of CBDC could be attractive in the era of negative interest rates. So even zero could be worth something and be attractive compared to a commercial bank deposit that pays an effective negative interest rate.

The other contradiction is privacy versus laws to prevent money-laundering and terrorist financing, which require some form of identity checking. Cash has excellent privacy due to the anonymous nature of transactions. This feature is also a bug, cash and crime are linked. It is easy to evade taxes, to launder money, to make illegal and untraceable donations with cash. One of the ideas is to create a way to have anonymous transactions for smaller amounts, with a limit on the total amount spent in a period. This is in the design for e-CNY. A wallet that can be used to make smaller, peer to peer payments even when there is no internet connectivity or electricity, using smart cards.

The biggest stumbling block for the issuance of a digital dollar may be the stance by the Federal Reserve not to proceed with a CBDC without clear support from the executive branch and from Congress, in the form of a specific authorizing law. The current state of the US Congress does not inspire confidence that such a law will pass.

One of the most interesting parts of the paper is the discussion on monetary policy effects, especially the part about effects of a digital dollar on reserve management in the era of ample-reserves regime. The paper argues that a digital dollar would not affect reserve management through two what if scenarios. For such an analysis, a paper on the ample-reserves regime is referenced. Since the paper on ample-reserves was written before the pandemic, the high water mark of these reserves stood at a peak of $2.8 trillion, or 15 percent of U.S. nominal GDP. This level of reserves were classified as abundant or super-abundant. What superlatives should be used for today’s reserve level which is $4.18 Trillion! supremely-super-abundant? Shows how models and thought experiments fare in the face of reality, a reality not conceivable in 2019. More such realities are awaiting us.

The Appendix A of the paper provide context for all the work happening in the Federal Reserve in the Technical and Economic policy arena. However, details are missing, especially for the technical experimentation work. Appendix B goes into the various types of money in the system and is a good backgrounder for understanding the architecture of the US monetary system.

If it is in your capability and interest, please provide feedback to the Federal Reserve. It is not necessary to answer all 22 questions. This broad engagement is definitely a differentiator of the system in the United States.