Oct 11, 2019

Digging Deeper: What the Heck are Digital Dollars?

What if the US Federal Reserve stops printing currency and minting coins, going to purely digital dollars.  How would this differ from life today, where many of us never actually touch cash? How would this differ from private crypto-currencies?  What role will commercial banks play in this new system? Where does the Federal Reserve Bank stand on this issue? If dollars no longer exist physically, does it change the dollar’s standing globally?

Given that the US has not yet planned for this switch, some of these questions don’t have complete answers.  Michael Bordo, an economist at Rutgers University, and fellow at the Hoover Institution, claims it is not a matter of “if” but “how” the US will move to a purely digital currency.  So let’s take this one question at a time to sort through what we know and what we don’t.

How would a digitized national currency change our everyday transactions?

Today, the Federal Reserve holds funds on behalf of commercial banks called reserves.  The Fed pays interest on these funds.  These funds that move between the Fed and commercial banks are already purely digital,  (no trucks full of currency moving between the Federal Reserve and the banks.) These digital funds can move between banks to settle interbank claims, but can’t be issued to the public.  (No change here.)

In 2018, 62% of commercial transactions occurred digitally, and only 26% were made using cash.  The cash transactions were for smaller purchases, as the number of transactions over $100 using cash was only 6%.  If you currently never touch cash, you are not alone. So how would things change?  

The most basic change in a world of E-dollars would be that funds would no longer need to work their way through a clearing house network (for example, ACH) to move them from your account to wherever you have “sent” them.  With a single public digital currency, this process would take minutes instead of days, much like bitcoin and other crypto-currency transactions now.  The costs of these transactions will drop to almost zero as well. E-dollars would be considered “risk-free” because they would be backed by the US Government, unlike deposits in a bank, which could theoretically fail, and funds not covered by FDIC insurance could be lost. 

How would a public digital currency it be different than the private crypto-currencies that exist today?

Digital currency would have several advantages over crypto-currency. Given that it would be backed by the full faith and credit of the US Government, its value would be relatively stable.  Transactions would clear just as quickly and cheaply. All transactions would be tracked in one (government run) system. You might think this could spell the end of private currencies, but private currencies would still maintain anonymity, which might still be valued by certain factions.

What role will of commercial banks play in this digital dollar world?

That is the $64,000 question!  Theoretically, they could have no role at all, as the Federal Reserve could issue digital currency directly to the public.  The Fed could pay interest (or charge interest with negative interest rates—more on that below) on those accounts. You would have one public currency account with all of your liquid funds.  

If commercial banks were going to stay in existence, they might compete for your funds by offering to pay (more) interest on your deposits.  Alternatively, the Federal Reserve could allow commercial banks to interface with customers on their behalf and hold E-dollars in special customer accounts.  I imagine that the United States will see how this plays out in the countries that are slated to run trials sooner, and in China, where the Peoples Bank of China is looking to launch a digital version of the Yuan by next year. 

Where does the Federal Reserve Bank stand on this issue?  How might monetary policy change?

There is no official stance at this point.  However, in August the Federal Reserve announced a new service called “FedNow” that will allow banks and fintech apps the ability to offer real-time transfers (avoiding the current ACH system with the holding time and costs.)  This would address the key difference/benefit for the consumer without having to dive into the deep end by going 100% digital.

In terms of monetary policy, this is where it gets interesting.  As talk of a potential recession looming on the horizon builds, the fear is that the Fed will have little room to maneuver, given that interest rates are already so low.  In 2008, they had a lot more to work with! This may just be the event that moves the Fed to take action on E-dollars. The MarketWatch article on the subject is a good read, and gives more historical context.  In the article, Bordo explains:

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 Americans as governmental overreach, but, Bordo argued, the alternative is worse.

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 to normal levels of growth.

What might the global impacts be if central banks digitize their currency?  What happens to the “dollar”?

A little historical perspective might be helpful here.  Since the 1920’s, the US dollar has been the dominant global currency.  Foreign countries exchange goods using dollar denominated contracts, which expedites them.  In fact, 40% of world trade is denominated in dollars. Given the level of US dollar deposits in foreign countries, it is often easier to borrow money in dollars in foreign countries.  This makes foreign business vulnerable to currency swings—if the US dollar gets stronger, their loans become more expensive to service and repay. (See also WSJ-subscription)

I found it interesting that Sweden is going to a digital currency sooner because the percentage of cash transactions in that country has dropped to 13%.  A digital currency would give the “unbanked” a free way to pay for things as fewer and fewer establishments accept cash, and prepaid debit cards and other costly ways of moving money around would be undercut.  And they don’t want a private digital currency to have a de facto monopoly as it fills the void. Cambodia, on the other hand, expects that its proposed public digital currency will jump start growth in its country by making its underdeveloped banking system more efficient.

If all countries move to issuing a public digital currency, the need to transact in dollars should go down.  Post World War II, 28% of the world’s exports were provided by the US. Today, that figure has dropped to just below 9%, with developing countries filling the gap.  Perhaps it is inevitable that the dollar drops down a bit in terms of global standing. Facebook's LIBRA is hoping to fill that void as a private, global crypto-currency, but the world’s central bankers are quite leery of this notion.  However, it seems they might support a public version of a global currency, backed by a group of countries (think digital Euro, but beyond Europe?) 

The changes to the global financial landscape are potentially huge.  Mark Carney, Governor of the Bank of England, gave the most talked about speech at the Fed conference in Jackson Hole Wyoming in August.  In it he proposed:

…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 serving that purpose, from erratic capital flows in emerging-market economies to an overvaluation of the greenback that can suppress American exports.

What will a world of digital currency look like?  Time will tell.

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