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Fed Should Consider Establishing Digital Cash

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Fed Should Consider Establishing Digital Cash

March 21, 2018

Although privately-issued digital currencies (such as bitcoin and ethereum) are increasingly popular, they do not fulfill the three primary functions of public money: acting as a unit of account, a medium of exchange, and a store of value. In a new paper presented earlier this month at the Shadow Open Market Committee, Professor Michael Bordo of Rutgers University explains the merits of launching a central bank digital currency (CBDC), drawing on his joint research with Professor Andrew Levin of Dartmouth College.

Bordo suggests that the current cryptocurrency market is similar to that of the 19th-century banking market, where competing commercial banks within one nation would issue banknotes of differing values of gold and silver.

This system was inefficient and acted as an overall hindrance to the payment system. It ultimately led to a "process of standardization and consolidation," where national banks were established, and currency was centralized through those banks.

Now, hundreds of cryptocurrencies exist, with prices ranging from thousands of dollars per unit such as Bitcoin to just $0.00004 in the case of Paccoin. The sheer number of options and the ease of startup for new currencies only complicate the system and further limit the ease of trade between currencies.

The establishment of CBDC-also referred to as "digital cash"--would solve this problem. Bordo outlines three design principles, that would maximize the effectiveness of digital cash in fulfilling the three basic functions of public money and avoiding two significant shortcomings of cryptocurrencies--massive real value fluctuations and inefficient or costly verification.

The first design principle is focused on creating a CBDC that can be used as a medium of exchange. Increasing returns to scale and network externalities are the essential rationales for government-issued currencies, and Bordo argues that the same considerations warrant the introduction of digital cash. He proposes two methods for creating a CBDC, an account-based system, and a token-based system.

Under the account-based system, individuals and businesses could open a digital cash account at the central bank, and each payment transaction would be debited from that account. Alternatively, users of CBDC could have designated accounts at commercial depository institutions, which would hold corresponding amounts of funds in reserve at the central bank. In contrast, a token-based system would have central banks create tokens or value-based digital systems, similar to stored value debit cards.

An account system would allow for increased cybersecurity compared to the token-based system. Due to the accounts being kept individually, any fraudulent activity would be mitigated in size, similar to the current system of credit and debit cards. This would help restrict the scale of cyber-attacks, making it easier to defend the payment system. The three largest crypto exchanges, Mt. Gox, Coincheck, and Parity, have lost over $1.1 billion alone to cyber-attacks. An individual account system would have protected accounts from a large-scale cyber-attack. The account system would also provide an instantaneous and virtually cost-free method of transaction when compared to a slower more costly token system.

The second design principle will help a CBDC achieve a real store of value. Bordo argues that the central bank should pay interest on digital cash at essentially the same risk-free rate as government securities, and that interest rate can serve as the primary monetary policy tool. Moreover, with the introduction of digital cash, the use of paper currency will rapidly diminish. Consequently, the central bank will be able to cut the nominal interest rate below zero in response to "severe adverse shock." This may require extra consideration by a central bank about how to structure fees for transferring funds between digital cash and paper currency (similar to the fee for withdrawing cash from an ATM). Such fees would be negligible for nearly all transactions but would discourage large withdrawals into paper currency in a worst-case scenario. Bordo emphasizes that the fee structure must be transparent and systematic and should not limit the ability of individuals to choose how they make payments or other financial transactions.

Bordo outlines two alternative methods to create a store of value. The first would hold CBDC funds at a constant nominal value. The second would attempt to preserve the real value of CBDC funds by indexing those funds to past changes in price level. However, due to policy constraints, both of these methods could require central banks to rely on additional balance sheet measures such as Quantitative Easing.

The final design principle would allow a CBDC to become a stable unit of account. Bordo argues that adjustments to the interest rate on digital cash would allow monetary policy to focus on achieving true price stability. Rather than aiming at a positive target for inflation, the central bank could concentrate on keeping the value of digital cash stable over time as measured by a general index of consumer prices.

Bordo's argument for price stability would require emphasis to be placed on core measures rather than policy responses to transitory shocks. This would allow the price level to fluctuate in the short term but would ensure that the price level returns to its target over time.

The surging popularity of cryptocurrencies in recent years has shown that low cost, instantaneous transactions could soon become a dominant payment method. However, the decentralization and rapid proliferation of scores of new cryptos could present problems for the payment system. Establishing a centralized digital currency could help avoid the major pitfalls of privately-issued digital currencies.

Several central banks including the Bank of Canada and the Bank of England have already started investigating the possibility of CBDC. The Federal Reserve could also benefit from actively considering the potential merits, pitfalls, and ethical concerns of establishing digital cash.

Jacob Reyes is a contributor to Economics21. Follow him on Twitter @Jacob_DReyes

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