A response to the Federal Reserve's paper Money and Payments: The U.S. Dollar in the Age of Digital Transformation

The Federal Reserve published Money and Payments: The U.S. Dollar in the Age of Digital Transformation, and solicits comments about its ideas for a central bank digital currency (CBDC). This is our extended commentary offered in response.

Implications from the Federal Reserve’s Paper

Our first comment is that every monetary change from the Founding of America through present has been to move away from free markets, and to adulterate our currency. An analogy could be made to the Ship of Theseus, with each good plank replaced with an unsound board. A Zombie Ship of Theseus, decaying, but still afloat.

Let’s walk through the Fed’s paper. The very first paragraph on page 1 says, “The Federal Reserve, as the nation’s central bank, works to maintain the public’s confidence by fostering monetary stability, financial stability…”

Monetary stability is defined as 2% debasement per annum, an Orwellian twist. And financial stability in the Fed’s regime is a myth. Interest rates shot the moon between 1947 and 1981, and since then have been falling—with volatility—into the black hole of zero. Meanwhile debt grows exponentially, and the marginal productivity of debt—how much GDP is added for each new dollar of debt—falls decade after decade. It is not only unstable, but unsustainable, heading towards an ultimate heat death of the economic universe.

“CBDC is defined as a digital liability of a central bank that is widely available to the general public.” In other words, it’s like holding a paper dollar bill except it’s digital. Which implies several things:

· The Fed could muscle out the banks from the demand deposits business

· The Fed could buy all the assets, which the banks now finance with demand deposits

· Thus, money and payment services could become more socialized

· The government could declare paper is no longer legal tender, thus forcing everyone into CBDC

· The government could track who spends their CBDC, and what they buy

· This spending data could be used in a social credit score system

· The Fed could refuse payments to or from people who have low scores

· The Fed could lend to businesses and individuals, perhaps based on social credit score

· The Fed could force more credit into the economy

· When bank rates go negative--and they are headed there--the Fed could impose a negative rate on CBDC equal to or greater than the commercial bank rate, to avoid bank runs

If the government could do something, then sooner or later it will do it. In Tolkien’s Lord of the Rings, Boromir could not refuse the temptation to use the One Ring.

Page 3: “Americans have long held money … in bank accounts…” But of course this is not money. It is “….recorded as computer entries on commercial bank ledgers—a … liability … of a commercial bank.”

In other words, the commercial bank owes you. Banks, of course, do not generally trust other banks to hold their own money, but instead hold balances at the Fed.

A CBDC will give everyone the ability to cut out the banks, to obtain “…central bank money, with the safety and liquidity that would entail…” It is safer to be a creditor to the Fed than to any commercial bank.

Next comes a disingenuous claim, “…expand consumer access to the financial system.” Only one thing prevents banks from opening accounts for everyone: regulatory compliance. If the goal is to give everyone access, the solution is simple. Repeal the regulations that make the unbanked unbankable.

Contradictions of an Irredeemable Currency

Page 5: in the very attempt to define its terms, the Fed stumbles across the fundamental contradiction of irredeemable currency. “Central bank money is a liability of the central bank.” This raises some questions.

Is money just a liability? Denominated in what numéraire—unit of account? How is this liability to be paid, and in what form of money? Conflation of money and credit is ubiquitous.

What comes next sharpens this point, “The different types of money carry different amounts of credit and liquidity risk.”

If the word for a “computer entry on commercial bank ledgers” which is “a liability”, and which lacks “safety“, is money—then what is the word for the thing which has no counterparty, does not depend on any ledger, which is not a liability, and does not have credit risk?

On page 7, this contradiction becomes important: “The firms that operate interbank payment services are subject to federal supervision, and systemically important payment firms are subject to heightened supervision and regulation.” And then, “The use of central bank money to settle interbank payments promotes financial stability because it eliminates credit and liquidity risk in systemically important payment systems.”

Got that? The government regulates and supervises banks, and subjects systematically important banks to “heightened supervision and regulation.” But it’s possibly not enough to “promote financial stability” because commercial bank deposits have “credit and liquidity risk.”

This reads like a sales pitch for why the Fed should take over the banking business.

Regulation, Innovation and Efficiency

Next comes a discussion of faster payment clearing, at lower cost. Let’s not overlook the realities on the ground. To the big banks, slow and expensive is a feature, not a bug. Banks like the fees they get to collect, and slow means that they get the free use of your money during the settlement period. What incentive do they have to innovate and cannibalize their government-protected revenue?

To the would-be innovator, it is very expensive to overcome regulation. One not only needs a pile of cash to hire lawyers, but one needs to be a sophisticated consumer of legal services. One could easily spend hundreds of thousands of dollars paying lawyers to generate work product, without obtaining clarity about the legality of a new product.

Hasn’t the Internet settled this issue once and for all? If you want more efficiency, just stop blocking the innovators. Innovation in networking has been rapid, because this area is largely free from regulation. Compare the innovation in the unregulated 2.4GHz radio spectrum (i.e. Wi-Fi) to the regulated radio and TV broadcast spectrum.

Risk, Friction and Economic Concentration

Next, after reiterating that millions of people don’t have access to a bank account, the paper throws in the notion of “more costly financial services”, one of which is payday loans(!) Payday loans are expensive because of the high risk of loss. Nothing can change this, unless the losses are offloaded to the taxpayers. Risk aside, does anyone really want the Fed offering payday loans?!

Next, “Cross-border payments currently face a number of challenges, including slow settlement, high fees, and limited accessibility. The sources of these frictions include the mechanics of currency exchange…” Yes, the incessant churn of currency exchange rates is an artificial and unnecessary friction. The root cause is that each country mandates its own debt-based currency. They are all failing at differing rates, so currency exchange rates fluctuate.

“Reducing these costs could benefit economic growth, enhance global commerce, improve international remittances, and reduce inequality.”

Indeed. There is a time-tested free-market solution to this problem. But nobody wants the gold standard.

On page 12, there is a doozy: “…stablecoins as a means of payment raises a range of concerns related to the potential for … concentration of economic power.”

The Federal Reserve, a government-enforced monopoly, worries that private stablecoin companies will “concentrate economic power.” Whatever the risks may be, of private issuers of stablecoins, concentrating economic power is not one of them.

Technocratic Control and a Valueless/Perverse Dollar

We come next to this ominous assertion, “…nor would a CBDC depend on backing by an underlying asset pool to maintain its value.”

The dollar, as it is constituted today, is backed by underlying assets which are the debts of the Treasury and private borrowers (especially dollars in commercial bank accounts). The value of the dollar comes from the urgent need of every debtor to produce and sell goods, to generate revenues to service its debts. Most people think of the value of a dollar as its purchasing power—what it can buy. Every indebted farmer is desperately producing wheat to dump on the market bid price, to raise the cash to pay his debts. The lower the interest rate falls—it’s been falling since 1981—the more incentive has been offered to borrow more. By now, most farmers (and every other productive enterprise) are in debt up to their eyeballs.

This is a terrible and terribly perverse system.

But there is something even worse than a central bank borrowing dollars into existence. A system where it is outright printed, either by the legislature or by technocrats. In other words, printed according to a politicized process, or printed by an unaccountable bureaucracy. Without backing or restraint, there would be nothing to support the value of the dollar.

Implications for the Dollar from Foreign Digital Currencies

Next, “It is important, however, to consider the implications of a potential future state in which many foreign countries and currency unions may have introduced CBDCs. Some have suggested that, if these new CBDCs were more attractive than existing forms of the U.S. dollar, global use of the dollar could decrease—and a U.S. CBDC might help preserve the international role of the dollar.” The Fed is worried that if foreign countries (e.g. China) issue a CBDC, they could take market share from the US dollar.

They need not worry about that, for many economic reasons about which we have written at length elsewhere.

The Chinese people are forced to hold their wealth in yuan via strict capital controls. Yet they keep trading their yuan for dollars, when they find loopholes. They are risking their lives to dump the yuan. Outside China, people have a choice.

The Temptation to Replace Paper Notes

P16: “The Federal Reserve is committed to ensuring the continued safety and availability of cash and is considering a CBDC as a means to expand safe payment options, not to reduce or replace them.”

So, the Fed would never replace paper notes with CBDC. And Boromir said he would not use the Ring.

This, by the way, was under a heading declaring the intention is to “Extend Public Access to Safe Central Bank Money”. The Fed must walk a fine line between (A) commercial banks are perfectly safe under their supervision and (B) commercial banks are so unsafe that we need CBDCs to provide the public with access to safe money.

“Unintended” Consequences and the Fate of Commercial Banks

P17 raises this little issue, “Banks currently rely (in large part) on deposits to fund their loans. A widely available CBDC would serve as a … substitute for commercial bank money. This substitution effect could reduce the aggregate amount of deposits in the banking system, which could in turn increase bank funding expenses, and reduce credit availability or raise credit costs for households and businesses.”

You mean if the Fed says commercial banks are not safe, while regulating their services to be slower and more expensive, that people would move their balances to the CBDC? What comes next—will the sun rise in the east?

There are consequences that the Fed will later claim were unintended. The Fed would have to provide credit that is now provided by commercial banks.

“Traditional measures … may be insufficient to stave off large outflows of commercial bank deposits into CBDC…”

Especially when commercial bank deposits have negative interest rates (as in Switzerland). People would come to the CBDC in droves. It would practically scream for a negative interest rate on the CBDC (and they will have to declare paper notes not legal tender).

“…potentially address this risk by limiting the total amount of CBDC an end user could hold…”

We define a concept called compensation. It is doing the wrong thing, on purpose, purportedly to fix something else that you cannot or will not properly address. Like letting the air out of three tires, when you have a flat.

Or limiting how much money people may hold, if the Fed’s CBDC is hoovering up bank deposits.

P18 touches on a related problem, “…the introduction of CBDC could affect monetary policy implementation and interest rate control by altering the supply of reserves in the banking system.”

In software development, a complicated bit of new code can interact with existing software in counterintuitive, unpredictable, and nonlinear ways. One of the Fed’s levers to centrally plan the economy is bank reserves. The CBDC will add a way for the public to change bank reserves when they move balances between bank deposits and CBDC.

Unpredictable and nonlinear software systems are difficult or impossible to model. And software is deterministic. But the bank reserves would now depend on the choices of people in the economy. Can the Fed build an accurate model of how CBDC preferences will change bank reserves?

If you believe this to be possible, we have some new software to sell you, which can predict the price of everything!

The Impossibility of Central Planning

Joking aside, central planning is impossible. It is not even possible for Gosplan to know the right level of bank reserves. Much less predict how CBDC will alter bank reserves.

The Fed admits this is complex, stating: “The interactions between CBDC and monetary policy implementation would be more pronounced and more complicated if the CBDC were interest-bearing at levels that are comparable to rates of return on other safe assets.”

If Saruman were here with us, he might ask, “So, Gandalf, if the interest rate on bank deposits is zero, or negative, where then will you go?”

© Monetary Metals 2022