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Sept. 21, 2019, 2:29 p.m. EDT

Why the coming recession could force the Federal Reserve to swap greenbacks for digital dollars

Paper bank notes are being upgraded for a digital future around the world

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By Chris Matthews, MarketWatch


Illustration by Glenn Harvey

The Federal Reserve has never been more famous than it is today. It drew praise, and ire, for its handling of the financial crisis a decade ago, and the extraordinary measures it took subsequently to stimulate the U.S. economy have made it an important driver of financial markets. Meanwhile, President Trump has made its chairman, Jerome Powell, a household name by frequently criticizing the central bank’s policies on Twitter and to the press.

A movement, meanwhile, has been brewing among economists, financial-services professionals and central bankers to encourage a rethinking of the technology of currency — those paper notes we carry in our wallets — with an eye toward issuing a digital currency. Some argue that could give central banks the tools necessary to break free of chronic disinflation and persistently low or negative interest rates, while providing Americans a risk-free means to transact in a world where digital commerce constitutes a growing share of the economy.

“The debate isn’t about whether we need [a digital currency],” Michael Bordo, an economist at Rutgers University and a fellow at the Hoover Institution, the public-policy think tank at Stanford University, told MarketWatch. “It’s about how you do it.”

Americans already use digital currency for most of their purchases . In 2018, they used physical dollars for just 26% of transactions, versus 62% with digital currency, which includes credit cards, debit cards and bank transfers, according to the Fed.

A central-bank digital currency could work much like the mostly bank-issued digital money Americans use today, with some key differences. First, it would be backed by the full faith and credit of the United States government and, therefore, risk-free. The local bank that manages your savings account could fail at any time and the dollars in your account (beyond those insured by the FDIC) would disappear. A Fed “e-dollar” would persist as long as the U.S. government does.

More important, an e-dollar could pay interest. The idea that cash should pay interest dates back to monetary economist Milton Friedman, who argued in 1969 that the most efficient monetary system would be one in which cash bears interest equal to that of short-term government bonds, to encourage greater use of the dollar.

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.

Central bank ammunition

The current economic expansion is the longest in U.S. history, but warning signs of a recession abound, including slowing economic growth and the recent inversion of the yield curve for U.S. government debt. In response, the Fed reduced interest rates in July and hinted at more cuts to come. But economists worry that the Fed will not have enough ammunition to fight the next downturn, as the central bank has typically had to cut rates by at least five percentage points to stimulate the economy following a recession.

The Fed may be forced to restart its program of “quantitative easing,” or the purchase of long-term government debt to push down long-term interest rates, though there is growing concern that this is an ineffective tool. Take a look at Japan, which has been mired in a decades-long economic malaise. Interest rates have been stuck near zero for almost 20 years. Despite a massive program of government bond buying that has led to the Bank of Japan’s owning more than 40% of all Japanese government debt, it has still suffered four recessions over the past 20 years.

The eurozone hasn’t fared much better despite imposing negative interest rates on large banks, as it’s suffered two recessions since the financial crisis.

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.

The U.S. economy could soon face the same situation, Bordo said. “We could be in a situation like Japan,” he said. “The way things are going in the world, where growth is slowing and deflationary pressures persist, we’re probably headed in that direction.”

How would it work?

The Federal Reserve already issues digital dollars, but only banks can use them. They’re called “bank reserves,” and this form of digital currency received a great deal of attention over the past decade for its role in the Fed’s quantitative-easing program, with the Fed buying government bonds from banks and giving them newly created digital bank reserves in return. Banks can settle debts among themselves using this digital currency, but it never circulates in the consumer banking system.

One way the Fed could implement the e-dollar is by simply allowing any American to open an account at the Federal Reserve, where other forms of money, like a check from an employer or a deposit at a private bank, could be exchanged in e-dollars.

“The only way we can transact with central-bank money today is to use reserve notes, but digital payments are now the norm,” said Ousmène Jacques Mandeng, an economist at the London School of Economics who spent much of the past two decades working for financial institutions including Credit Suisse and UBS. “If you wanted to buy something on Amazon, you can’t pay with central-bank money. Shouldn’t central banks say that our money can be used in this environment? It’s a very practical issue of public choice.”

Meanwhile, an e-dollar system could be engineered so that payments are nearly instantaneous and costless, Mandeng said. This would be a major upgrade for many Americans, who now pay hefty fees for wire transfers. Newer payment services such as Venmo and Google Wallet, meanwhile, rely on automated clearing house, or ACH, exchanges that often take days to process money transfers.

A concern among economists is that personal Fed banking accounts could erode private banks’ profitability and, therefore, reduce the flow of credit they provide to businesses and consumers. Others argue that banks would simply change their business models, and could attract deposits by offering higher interest rates than cash would bear, or by offering discounts on loans and other services for customers who maintain a certain balance.

But given the risk that an e-dollar could significantly harm the banking system, proponents of a central-bank digital currency say the safest approach would be to allow supervised commercial banks to offer specially designated accounts for it.

While regional Fed banks have produced research that points to significant economic benefits from a central-bank digital currency, the Federal Reserve Board of Governors declined to comment for this story. In addition, the board’s public comments have revealed a skepticism on the potential benefits to consumers. In a May 2018 speech, Fed Gov. Lael Brainard said “there is no compelling demonstrated need for Fed-issued digital currency,” because consumers and businesses can use private digital currency already.

Meanwhile, the Fed announced a plan Aug. 5 to develop a service called FedNow to allow banks and fintech companies to offer real-time money transfers, which will create stiffer competition for the ACH system run by the bank-owned Clearing House Payments Co., thus undercutting one argument for a central-bank digital currency.

Fighting monopoly power

For some central banks around the world, neither convenience nor better implementation of monetary policy is the primary reason for considering the issuance of digital currency. The Swedish Riksbank, for instance, is most concerned with the rapid decline in cash usage in its domestic economy, which has been much more pronounced than in the United States. The nominal value of cash in circulation in Sweden has fallen 50% over the past decade, and cash now accounts for only 13% of Swedes’ purchases, according to Hanna Armelius, senior adviser at the Riksbank.

The decline, she said, threatens to create a negative feedback loop — as fewer Swedes prefer cash, more merchants will decline it as payment — and the Riksbank does not want to find itself in a situation in which the public has no access to the central bank’s currency.

“At the Riksbank we would like it if [nondigital] cash continues to be in use, but we have to be prepared that the marginalization of cash will continue,” she said. As private digital money plays a greater role in the economy, “we could end up in a situation where one or two companies become so dominant that they can extract monopoly rents.”

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