Should Central Banks Offer the Public Digital Currency Accounts?

By Patrick Horan and Nikhil Sridhar

Since the advent of blockchain technology and cryptocurrencies, such as Bitcoin, many people have wondered to what degree these innovations will reshape our financial system and to what degree public policy should be involved in regulating them. Such technologies have also prompted another question: Should central banks issue their own digital currencies?

The question of Central Bank Digital Currency (CBDC) has garnered interest from central banks and the public for the past several years. While no CBDC is currently widely used, about 80% of central banks were studying the issue as of last year, and just recently, the Bank of France successfully completed a CBDC trial using a blockchain platform for interbank settlement, which is just one of many central bank experiments in this space. The Sveriges Riksbank, the world’s oldest central bank, published its report on the initial stages of its CBDC pilot. Perhaps most significantly, earlier this month, China launched its “digital yuan” with the hopes of improving the country’s ability to monitor and more quickly settle payments.

Despite all the commotion surrounding CBDCs, most of the discussion seems limited to policy wonks and central bankers, which leaves most people wondering, what exactly are CBDCs? In a nutshell, they are digital assets that could be used for retail payments, which are everyday payments between consumers and businesses, or wholesale payments, which tend to be between businesses and financial institutions. They also have the potential to offer an additional means for the central bank to implement monetary policy and for financial regulation.

In general, CBDCs can be broken down into two categories. The first category, which has been more widely discussed and is the subject of this essay, refers to central bank accounts. This CBDC is not a circulating currency like paper bank notes or digital coins. Rather, it includes transferable account balances held at the central bank (similar to the balances one would hold in an online checking account). The second category is token-based CBDCs, which encompass digitally issued coins like the digital yuan and will be the subject of a second essay. While we are skeptical of the desirability of CBDCs, we hope to offer the reader a broad overview of the advantages and disadvantages that central bank digital currencies bring to the table through this two-part introduction.

Arguments for CBDC Accounts

Central banks serve as “bankers’ banks” by settling payments between banks and by providing liquidity when necessary. An account-based CBDC would extend a central bank’s services to all citizens. In other words, there would be a “public option” for central bank accounts. Payment transactions would be processed by the central bank, and funds could be debited practically instantaneously from the payer’s CBDC account and credited to the payee’s account.

This proposal is not entirely without precedent: Centuries ago, the Bank of England and the Sveriges Riksbank, the central bank of Sweden, offered accounts to individuals as well as financial institutions until it became impractical to manage accounts for individuals. However, with modern technology, managing individual accounts would not be as difficult today as it was for those central banks at that time.

Many economists have also pointed to the potential for account-based CBDCs to enhance financial inclusion and ensure access to bank services for everyone. In the United States, approximately 14.1 million adults lack a bank account. Although many people within this population simply do not want a bank account, others do not have one because of high fees or the lack of banks nearby. Proponents of CBDCs argue that they would allow anyone to have an account, regardless of ability to pay fees or location; this, in turn, would help policymakers achieve financial inclusion goals that are intended to drive growth and curb inequality.

The COVID-19 economic crisis has given added importance to the argument that CBDCs could revolutionize fiscal and monetary policy. Since last March, the U.S. government has sent three rounds of stimulus checks to most adults via mail or direct deposit. However, in many instances, households experienced delays in receiving their checks. With CBDC accounts, the Fed could simply credit every member of the public with bond-financed money or even newly created money.

According to proponents, another compelling reason for establishing an accounts-based CBDC involves harnessing the capacity of a centralized account system to establish virtually “costless” payments. Several studies have indicated that account-based CBDCs have the potential to significantly increase the speed and security of cross-border transaction settlements, but improving the speed of settlements could also significantly improve domestic economic conditions.

Indeed, a 2016 study by the Bank of England simulated the macroeconomic consequences of account-based CBDCs and found that a CBDC issuance of 30% of GDP in the United States could reduce medium-of-exchange costs such that GDP would increase by up to 3%. These efficiency gains include the reduction in consumer fees incurred by businesses when accepting debit and credit cards and by individuals when accessing cash through debit cards or ATMs.

Economists Michael Bordo and Andrew Levin have pointed to account-based CBDCs as a complement to the existing private payments system. They contend that CBDCs offer necessary competition to prevent private payments networks from becoming overly monopolistic. The competition from CBDCs could spur greater innovation in the private sector and lead to welfare-enhancing outcomes for small businesses and consumers particularly.

Another point made by proponents is that CBDC currency can be used in conjunction with policies to reduce the use of traditional cash and implement negative interest rates. Economist Ken Rogoff has argued that large-denominated paper money poses serious problems for society. First, large-denomination bills enable all sorts of criminal activities, including corruption, tax evasion, the drug trade and terrorism. By abolishing large-denomination bills and encouraging the use of CBDCs, governments can better crack down on these illicit activities.

Second, with interest rates at historic lows, some central banks have eyed negative interest rates as a potential tool to stimulate the economy. However, a central bank cannot as easily stimulate the economy through a negative interest rate policy when there is a large supply of cash, as people can simply store cash in vaults or even under their mattresses. Without cash, however, people would likely hold balances at the central bank or traditional banks, and negative interest rates would be more likely to have a large economic impact.

Finally, proponents say that widely used CBDCs could serve as a substitute for unstable deposits, such as repurchase agreements and money market mutual fund shares, and thus reduce the likelihood of “bank runs” or financial panics.

Economic Arguments Against CBDCs

Despite these potential advantages of CBDCs, there are serious objections. George Mason University economist and Mercatus Senior Fellow Lawrence White has also made the powerful argument that central banks do not have the personnel and expertise to oversee and engage in retail payments. Simply because a central bank handles interbank settlements does not necessarily mean it should (or could) handle retail payments. In the United States, the Federal Reserve, by White’s calculations, would have to hire an additional 400,000 new employees from the private sector to match the customer service of the private sector.

Thus, even if transfers between accounts would be nearly cost-free, setting up the new system would still be quite costly. The private sector is also able to respond to changes in demand and consumer preferences by reacting to the price mechanism and, consequently, can efficiently provide a balance between service and payments. Central banks, not subject to the price mechanism, will likely be unable to do so. Moreover, CBDCs threaten to reduce the funding of private banks as people deposit their money at the central bank instead, likely harming long-run growth.

Another concern is that retail accounts at the central bank could lead to people pulling their money out of traditional banks and putting it in their CBDC accounts whenever there is a panic that traditional banks may not be sound. Thus, CBDCs may make bank runs more likely. Proponents may say that the solution is to have CBDCs replace most or all private bank deposits, but this would then hamper the financial sector’s ability to innovate and experiment.

A less radical solution to this problem would be to require banks to hold onto additional reserves to make them safer, but this would also force them to reduce lending, which in turn reduces economic activity and growth. Another way to control the flow of funds in and out of CBDC accounts is to impose direct restrictions or use variable withdrawal fees to incentivize people to hold money in these accounts, even in times of uncertainty or declining interest rates. But these methods may also be undesirable, as they reduce consumer choice and do not enhance the efficiency of the banking system.

Finally, while the lack of access to banking services is a problem, the solution does not have to be found in CBDCs. An alternative solution would be to make the banking industry more competitive by allowing nonbank financial firms to acquire bank charters. Such a policy change would likely increase competition for consumers who don’t have bank accounts. It would also boost the resiliency of the financial sector by allowing large nonbank firms to participate in financial markets and use their coffers as significant capital cushions during economic contractions. Regulators should continue to explore the use of “Special Purpose National Bank Charters” to help expand the role of financial technology in reaching underserved populations.

Privacy Concerns

CBDCs also raise questions about customers’ privacy: Governments could track all transactions between accounts held at their respective central banks. Although CBDC proponents say that the ability to track transactions is generally beneficial as it allows governments to crack down on illicit activities, they also argue that governments could take steps to preserve anonymity, such as requiring warrants for searches and encrypting accounts.

However, it is unlikely that central banks, as government entities, would offer any more privacy to customers than private banks in the event of pressure from law enforcement agencies seeking customer information. Some might view this privacy issue as a minor concern, but it could be a serious problem, particularly in more authoritarian states where customer information could be exploited for political purposes.

Moreover, it is not a foregone conclusion that such abuses would not necessarily occur in developed countries such as the United States. In 2013, the Department of Justice, with the help of the Federal Deposit Insurance Corp., initiated “Operation Choke Point,” wherein the department investigated certain banks and businesses, including payday lenders and gun retailers, on the grounds that such businesses were considered to be a high risk for fraud. Investigations into Operation Choke Point reveal that FDIC officials pressured banks to end relationships with certain clients, despite these clients never having been accused of wrongdoing.

Account-based CBDCs open interesting avenues of discussion for economists that could revolutionize monetary policy and the role of central banks in payments systems. Despite the potential advantages of CBDCs, however, we are skeptical that the costs are worth the possible benefits. It is not clear that a central bank could outperform a private sector guided by market signals in banking services. If CBDC accounts are to be implemented in the future, one compromise would be to require that they not pay interest rates that are competitive with those of private banks. This requirement would reduce the competitive threat from CBDC accounts while providing an option for those currently without bank accounts.

This article is the first part of a two-part series describing the advantages and disadvantages of central bank digital currencies. Part two focuses on token-based CBDCs.