Discover more from Noahpinion
Central Bank Digital Currencies are not very interesting or useful
A lot of people are talking about this idea, but it's unlikely to have a big impact.
“I put radio on the internet!” — Russ Hanneman
People often ask me to weigh in on the idea of a Central Bank Digital Currency (CBDC). A lot of countries are excited about the possibility. China is already experimenting with a digital renminbi, and the Boston Fed has launched its own experiment as well. In the U.S., the idea is often called a “digital dollar”, and Representative Jim Himes has released a white paper endorsing the idea. Meanwhile, there is some fear that a digital yuan could threaten dollar dominance in the global financial system.
I’ve written about a digital dollar and a digital yuan for Bloomberg in the past, and the basic story here is that I don’t think much of the hoopla is justified. What I think happened, more or less, is that the popularization of Bitcoin made a lot of people really excited about the idea that the nature of money could radically change. Bitcoiners were going around saying that fiat is dead and BTC is the future of money and blah blah, and so a lot of legacy institutions felt the need to follow suit and generate some hype about how they were staying in the game. For banks, this meant endorsing Ripple, a cryptocurrency-for-banks that no one really needs. For governments, this meant trotting out the idea of a CBDC.
The thing is, the dollar is already digital. The M2 money supply is currently about 21 trillion dollars, while the amount of paper currency in circulation as of 2020 was just 2 trillion dollars. The vast majority of dollars out there in the world are not little green pieces of paper — they’re just notes on a bank’s ledger, numbers in a bank’s database. Bitcoin didn’t inaugurate an era of internet money; internet money happened long before Bitcoin.
So what would be the point of a CBDC? Well, in fact, some economists have given this some thought. But the first question we need to ask is: Given that dollars are already digital, what would a “digital dollar” actually be? Fortunately, I think I have a pretty good answer to this question.
Why a CBDC is (probably) just a payments app
Remember that money serves as three things: A unit of account, a medium of exchange, and a store of value.
As a unit of account and a store of value, a CBDC “digital dollar” — assuming it was completely interchangeable with other dollars — would be absolutely the same as the dollars that exist today. Any change in the value of a paper dollar or a bank dollar would represent an identical change in the value of a CBDC dollar.
Now, this doesn’t have to be true. The government could conceivably allow the exchange rate between CBDC dollars and other dollars to fluctuate. This would, in effect, mean we had two national currencies instead of one. Cuba already does this. In fact, my PhD advisor Miles Kimball has suggested something like this, in order to generate negative nominal interest rates during recessions.
But other than negative nominal interest rates, I don’t see much point to a dual-currency system. Cuba certainly doesn’t do very well with it. Modi’s experiment with banning cash in India went over like a lead balloon. And it seems like any benefit would be swamped by a reduction in confidence in the U.S. monetary system, since people would start wondering whether one or the other of the dollars would be devalued against the other.
So let’s assume that a digital dollar would be just like any other dollar, except in terms of the way it’s transmitted between parties. In other words, a CBDC would probably be the same unit of account and the same store of value, but a different medium of exchange.
In other words, a CBDC is a payments app.
In fact, so far in China, the digital renminbi, or e-CNY, is just a payments app. And if you read Himes’ proposal, it’s clear he’s also talking about a payments app. He compares a CBDC with Venmo and Zelle, which are existing digital payments apps where you can exchange dollars directly over the internet.
What kind of payments app would it be? To create a proof-of-work blockchain like Bitcoin, or even a proof-of-stake blockchain, for a CBDC would be pretty pointless. Those networks are clunky and slow and expensive to use; their primary appeal is that they don’t require the backing of a government in order to function. But a CBDC is government-backed by definition, so there’s just no point in putting it on a blockchain.
Instead, a CBDC would most likely be an app where you could hold dollars in an online account (technically an account at the Fed) and transfer them via the app. In other words, from the user’s perspective, it would work just like Venmo or PayPal — you’d have an online account, and some dollars in that account, and the ability to send dollars to other people.
But how would it work on the back end? In principle, the Fed might be able to make a disintermediated protocol for securely transferring CBDC money, so that there would be no Fed computer verifying the transaction. (Crypto people relish this sort of disintermediation, because it makes them feel more independent of government control.)
But a CBDC would have absolutely no reason to do this. Intermediation — i.e. having a computer log each transaction — is very cheap, which is why it doesn’t cost you anything to send money via Venmo. It’s not free, but it’s very cheap. And intermediation means that you can get some or all of your money back when things go wrong, such as when your identity gets stolen and someone buys stuff with your credit card. Bitcoin is famously unable to do this. Meanwhile, as we’ll see, being able to observe people’s transactions is one of the (few) potential benefits of a CBDC. So a CBDC would almost certainly be intermediated (as China’s is).
In other words, a digital dollar would basically just be the Fed operating a Venmo/PayPal competitor. The Fed would be competing with these private payments apps, and it would also be slightly competing with banks, since the cash people would hold in their CBDC accounts would not be held at Chase or Wells Fargo or whatever.
Having the Fed compete with private banks and payment apps isn’t a crazy idea — in fact, postal banking is sort of similar — but it’s a very boring idea. Do we really need another payments app? Are Americans burdened by difficult or expensive payments right now? I don’t think so.
So we have to ask: Would CBDCs actually accomplish any purpose whatsoever?
Possible benefits of a CBDC (there aren’t many)
It’s always a good bet that if you can think of a question related to the macroeconomy, a bunch of macroeconomists have already written papers about it. CBDCs are no exception. So let’s see what the research literature has to say about possible benefits (and risks).
Bech & Garratt (2017) talk about a central bank cryptocurrency — the kind of disintermediated, peer-to-peer payments system I dismissed in the previous section. The authors think that a disintermediated CBDC would be good because it would enable greater privacy. But to governments, this is likely more of a bug than a feature. The anonymity of cash is why you always see criminals transporting big suitcases full of dollar bills in the movies, and it’s why we got rid of $1000 bills. By giving people a much bigger anonymous payments system — in effect, billion-dollar bills — an anonymous peer-to-peer CBDC would facilitate crime, money laundering, etc. Meanwhile, most people don’t seem to worry about the fact that their credit card payments and Venmo payments etc. are not anonymous. Sorry, Bech & Garratt, but this isn’t going to fly (least of all in China).
Engert & Fung (2017) go in the exact opposite direction; they cite non-anonymity as a benefit of CBDCs. If CBDCs partially replace cash, it makes it easier for the government to hunt down criminals and money launderers. (Certainly, this is a big part of the appeal for China.) Greater transparency also could potentially make it easier to contest payments.
OK, that’s not nothing, but sophisticated criminals are just going to use cryptocurrency (as they largely already do). Muggers are going to steal cell phones instead of cash (as they largely already do). Etc. etc. This feels like a nothingburger to me, given how transparent and contestable most of our dollar transactions already are.
Meanwhile, Engert & Fung also suggest that a CBDC would increase financial inclusion by helping the unbanked. But since many of the benefits they envision from CBDC require eliminating paper cash, the whole package seems likely to reduce financial inclusion by a lot. Poor people need cash. Remember the disaster of Modi’s demonetization.
Engert & Fung also cite Miles Kimball’s idea of using electronic money to create negative nominal interest rates — i.e., having the cash in your account disappear steadily, prompting you to go out and spend it quickly (thus alleviating a recession). But as Miles has shown, this can already be done perfectly well with the existing system; it does not require a CBDC, it only requires modifying the exchange rate between paper cash and the dollars in electronic bank accounts. So this potential benefit is a nothingburger as well.
Finally, Engert & Fung list financial stability as a benefit of CBDC. Basically, they say that banks are inherently risky, and CBDC would outcompete banks and thus reduce risk in the economy. In other words, they list destroying the private banking system as a feature, rather than a bug, of central bank digital currency. If that sounds a little wacky, it’s because it is. Banks exist for a reason — their riskiness allows them to do a maturity transformation, borrowing short to lend long, thus financing risky but valuable projects. Remember what happened last time banks stopped doing this? We had the biggest recession of our lives. So, no, let’s not get rid of the banking system. (Andolfatto (2019) argues that CBDCs would have little effect on banks, but this is basically a best-case scenario.)
Bordo & Levin (2017) make a number of not-very-convincing arguments for a CBDC. They argue that it can stabilize the value of the dollar (but the Fed can already print as much money as it likes), would create a costless medium of exchange (but not more costless than what we currently use), and would allow the state to phase out paper currency (which as I noted is probably a bad idea).
I think it’s no coincidence that all three of these optimistic papers, basically toying with unrealistic reasons why a CBDC might be necessary, came out in 2017 when the first big Bitcoin boom was going strong. By 2021, economists were starting to get more realistic. Cecchetti & Schoenholtz (2021) argue that CBDCs would not make payments easier or increase financial inclusion. Romero, Wang & Wong (2021) note several of the pitfalls I described above, and advise central banks to be very cautious in rolling out CBDCs.
And David Andolfatto, who has thought more deeply and written more extensively on CBDCs than any other economist I know of, wrote a 2021 paper summing up the debate. Essentially, Andolfatto argues that the U.S. electronic payments system is already very good, and that essentially any goals of CBDC could be accomplished better with small tweaks to the existing system.
In other words, despite the rush of excitement about the future of money that accompanied the Bitcoin boom in 2017, cooler heads are starting to prevail. Having had a few years to mull over the idea, economists have decided that there’s not a lot of obvious upside to the idea of a digital dollar. This is why the idea has been essentially shelved in the United States.
The digital renminbi and dollar dominance
China, however, is a different matter. The country is going full speed ahead with the digital renminbi (or e-CNY), encouraging its people to use the CBDC payment app, and attempting to get other countries like Thailand and UAE to use it as well.
From the Chinese government’s perspective, there are obvious reasons to want a CBDC. It allows easy universal surveillance of all payments by the government. And it makes China’s government less reliant on private finance companies and tech companies, which it has lately been trying to crush with various regulatory crackdowns.
But many people talk about another use for the e-CNY — bringing down the dominance of the U.S. dollar. There are many news stories about this “threat”, and Western governments seem to be taking the idea seriously. So let’s talk a little about that.
The e-CNY will make it a little easier, technologically speaking, to end dollar dominance. Instead of having to establish a relationship with a Chinese bank in order to start spending yuan, you can just download the app from the Chinese government. (Sure, the Chinese government gets to surveil you, but whatever.)
But the e-CNY will not make the politics of dollar overthrow any easier for China. As I wrote in a post earlier this year, China’s government is far too paranoid about losing control over its capital account to allow the yuan to become the global reserve currency:
China has a lot of rules that make it very very hard to sell yuan for foreign currencies. And it’s not just about the current rules — there’s also a general awareness that if capital ever tries to leave China in any significant amount, the government will impose a bunch of new rules in order to stop it. This was vividly demonstrated in 2015-16, when a stock market crash caused a massive capital flight from China, but the government stanched the outflows by tightening up capital controls significantly.
Why does China make it so hard to get money out of China? One big reason is that this is necessary in order for China to control the value of the RMB. When capital flows out of China, it puts downward pressure on the currency, which makes it harder for Chinese companies to afford inputs and for Chinese consumers to afford imports. But when capital flows into China, it raises the value of the yuan, which makes it harder for Chinese exporters to sell goods overseas — since China traditionally has a mercantilist economic policy, this is something it wants to avoid.
So by becoming the international reserve currency, China would give up its control over the value of its currency, exposing it to both unwanted appreciations and unwanted depreciations.
In fact, as I explain in the same post, a little bit of de-dollarization would be a good thing for both the U.S. (since our exports would be cheaper) and the global financial system (which would be less exposed to the risk of a U.S. collapse). But unfortunately, China shows no inclination to open up its capital account and shoulder some of the burden of supporting the global financial system.
In other words, China’s embrace of a CBDC is almost certainly about domestic political control rather than a bid for global financial hegemony. Meaning the U.S. does not need to respond with its own CBDC in order to counter China.
In other words, no matter which way I look at the issue, central bank digital currencies look pretty useless — at least, for free societies with existing electronic payments systems.