Like any other major central bank, the Federal Reserve is preoccupied with the economic consequences of the pandemic. Currently, managing unprecedented supply shocks is the first step in its business. But there is another issue that warrants close attention, albeit more quietly. In time, it will break out of the sidelines, gain in importance, and implicate every aspect of central bank policy: What exactly is the future of money?
When thinking about this question, the Fed and its peers are not leading a revolution so much as struggling to catch up. Technology has transformed the monetary system in recent years, and at an accelerating pace. The use of paper money is fading as consumers are gravitating towards more convenient electronic payments, using bank accounts, credit cards and other online systems.
As a result, apart from Bitcoin and other cryptocurrencies, advanced economies are going cashless. Fiat currency was used in about 40 percent of consumer transactions in the United States in 2012. By 2019, the proportion had fallen to about a quarter. In 2020, when the pandemic boosted e-commerce and prompted some brick-and-mortar retailers to turn down cash, the share dropped to 19 percent.
Such a transition will certainly have many advantages, but there are undeniable risks: even if cash is no longer the primary means of settling transactions, it provides a valuable backup. Regulators may do everything they can to ensure that private payment systems are robust, but things can still go wrong — and if that happens, the option to pay with cash offers crucial additional flexibility.
One possible answer to this dilemma is known as the central bank digital currency. Retail Central Banking Currency is electronic money owned by companies and individuals in central bank accounts, operating on a strong, separate network and backed, like fiat currency, with the full faith and credit of the government. They are still vulnerable (for example) to shutdowns of energy and data systems – but without that, they can go very far towards filling the emptied void with physical cash.
In fact, it can be a marked improvement. In their role as a cash reserve, central bank digital currencies can be used for a wide range of transactions, including e-commerce. They can incentivize new payment systems and put competitive pressure on incumbents, thus enhancing efficiency and lowering costs. It may also meet the demand for innovations such as stablecoins – cryptocurrencies that are allegedly backed by other assets – without posing any threats to financial stability.
Finally, central bank digital currencies can serve a purpose that regular money cannot, by creating a new channel for monetary policy. Instead of affecting interest rates indirectly, by acting on the reserves held by banks and other financial institutions, central banks can adjust the interest they pay on the retail balances of central bank digital currency.
Of course, all of these opportunities have potential downsides. The advantages of CBDC as a payments system may be so great initially that the existing systems are out of business, for example, in which case there will be less competition and innovation. Moreover, the greater the perceived benefits of new electronic cash, the less likely businesses and individuals will own paper money and commercial bank deposits. Such “de-intermediary” would have major repercussions for the way banks finance themselves, and could reduce or make commercial bank lending more expensive.
Alternatively, if central banks choose to bolster the supply of credit by expanding their balance sheets and directing alternative financing to commercial banks, they will be drawn deeper into choices they would rather not make — and their claims to do so. Independence, already under pressure, will look increasingly questionable.
None of this will be easy. Once fully engaged, this discussion will likely make the political questions raised by the pandemic seem simple. But there will be no avoiding discussion. One way or another, cashless society is coming. Central banks will have to decide: do they just allow this to happen, or do they seize the opportunity to shape the future of finance?