While the world is distracted by crypto and meme stocks (I can be the world sometimes), there is a real revolution building up in parallel that has the immediate ability to completely upend our financial system.
It’s not Bitcoin or Ethereum or any other privately minted cryptocurrency, the true revolution may be building in central bank digital currencies or CBDC’s. At the moment, about 80% of central banks are working on some form of CBDC’s and they have the real potential to change the way government plays a role in our financial system and how we interact with money in our day to day lives.
Why Do It
First it’s important to understand why central banks are working on this at all. It’s of interest to central banks to have a digital currency supported by a digital ledger simply because it makes the implementation of monetary policy more efficient. Right now much of the way monetary policy is conducted is electronic but there are important intermediaries in between the Fed (I will use the Fed in this post as my default central bank since I am in the US) and the public. These intermediaries are banks. The banks hold accounts at the Fed and on a simplified level, the Fed can require more cash or distribute cash from these accounts directly to the banks. What the banks then do with this cash is left up to them but being in the business of lending, they tend to lend it. This action then reverberates throughout the economy.
In the case of money being created (lowering interest rates or QE) the additional lending allows businesses to expand output, consumers to get access to more affordable loans and financial conditions generally ease to help stimulate demand. When the economy is running hot, the Fed can do the opposite to check inflation and nudge the banks to pull back a bit.
One allure of CBDC’s for a central bank though is to free it from having to deal with banks at all. If the Fed all of the sudden has a digital dollar which it can deposit anywhere at an instant, the possibilities of where it can reach almost become limitless. The best way to understand this is through a few examples that get progressively more complex.
Stage 1: Your Account at the Fed
Right now, they way that a CBDC would be distributed is being hotly debated by central bankers and economists. There are multiple options for doing this. The more traditional track is to do something similar to what they do now by just interacting with the commercial banks. Like before, commercial banks’ accounts at the Fed would just see their cash positions go up or down based on what the Fed was looking to do. Yet if the Fed decided to step outside of this structure through CBDC’s and offer accounts directly to the public, there is conceivably nothing stopping them from doing so.
In the latter scenario, every person could have an account at the Fed and when the Fed wanted to stimulate the economy it could distribute cash to everyone instantly rather than deal with the banks. In addition to this, just like banks do, the Fed accounts could offer interest rates at a rate that the Fed sets, potentially offering higher rates than what are usually offered at commercial banks.
A Fed account would be the most secure type of bank account by default. It’s the only institution allowed to create and destroy money so your money placed there has zero risk of being lost due to any bank failure. Contrary to popular belief, the FDIC was created to instill confidence in the banking system, it can’t functionally dole out everyone’s money if we all decided to take it out at once. Yet with CBDC’s the Fed would have direct control over the entire money supply.
The Fed account we all have can facilitate transactions safely and instantly. No more debit and credit card fees for small businesses. The Fed could start to phase out cash by offering higher and higher penalties to convert cash to digital currency until almost all cash is digital. prices of some goods and services would become cheaper as a result of this efficiency.
Fraud and crime in the system could be dramatically reduced. This is because just like every dollar bill has a serial number, every digital dollar could have an identifier that allows it to be tracked. Scamming and fraud could be detected immediately and caught quickly. Even the private crypto has been shown to be able to be tracked down with the FBI recovering the Bitcoin paid to the Colonial Pipeline hackers.
Stage 2: Negative Rates
Currently the Fed target inflation is at 2%. This figure was seemingly picked out of a hat but does have some logic behind it. The logic is that inflation needs to be positive so that the Fed has some wiggle room with rates in order to not have to go below zero.
There are all types of problems that negative interest rates can cause which I won’t get into in this post but we can see them playing out in places like the EU and Japan that currently have negative rates. They essentially penalize the banks and charge their accounts. The banks don’t want to pass these charges onto customers because then they could conceivably just take their money out of the bank and put it under the mattress to not be charged. Banks don’t have that option with the central bank, they are required to keep an account there. So what ends up happening is that negative rates hobble the banks and penalize them. How this exactly affects the economy is still being debated by economists but the results have been bad for banks and mixed for the economies which have tried negative rates.
Yet if everyone had an account at the Fed, the Fed could go negative with everyone once all money is digital. That would mean you would have to spend or invest your money quickly to not be charged. Another proposition is for the Fed to time stamp money so that it slowly loses value over time, incentivizing people to put it to work or lose it.
The advantage of this is that the Fed could target a real price level indefinitely. This means that they wouldn’t need that 2% inflation rate in order to be able to use all their policy tools, rather they could target 0% inflation over the long term. No more depreciation of the dollar over time and people could make spending and savings plans without having to take inflation into account. Hedging for inflation would be eliminated saving insurance and pensions trillions in investments.
Stage 3: Taxes
Yet with all this ability to be able to track out saving and spending like Facebook tracks us now, how long will it be before the fiscal government realizes the power of this tool? Just like the Fed will be able to incentivize our spending and saving behavior, the government could start to try and tinker with our behavior through taxes.
The government already tries to dissuade and incentivize certain behaviors this way, it’s why cigarettes in NYC cost $12 a pack and why long term capital gains are taxed at a lower rate than short term capital gains. But those theoretical Fed accounts can be tracked and even taxed at the individual level. Government could have a field day in the way they tax us to achieve their desires.
For example, imagine that the government wanted to reduce inequality so not only did they tax higher earners at higher rates but started taxing property in their neighborhoods or individual homes regardless of size more than others. Or imagine if they decided they wanted to stimulate demand in the struggling countryside more than in the wealthy cities. One example a researcher gave in Britain was that as you moved closer towards central London your purchases could be taxed at a rate of 99% while in Northern Scotland you could pay little to no tax. The analogous example to this is that your purchase are taxed at 99% in Time’s Square while in Iowa you would pay little to no sales tax.
How Much is Too Much?
Once you start to realize the possibilities of this, it starts to beg the question of how much government involvement do we really want in our lives? Do we really want the Fed and the government dictating what taxes we pay and what interest we receive at the individual level? Would wonky economic theories be forced on our pocket books in the name of the greater good?
CBDC’s make these questions much more pressing and much more personal. Just a few examples are enough to make you wonder about how our lives could be drastically changed by the implementation of CBDC’s and I haven’t even talked about the disintermediation of the banking system that CBDC’s could bring about. The entire financial industry could be put out of business by CBDC’s and the government would end up being the main plumbing system for all financial transactions.
I’ve just scratched the surface of possibilities in this post but the questions raised by CBDC’s go far beyond a speculative Bitcoin investment. The idea of crypto started out rooted in independence from a central government but may have inadvertently supplied the government with the most powerful tool it has ever gained over our daily lives.
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