Central Bank Digital Currencies are Coming
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Before you read my thoughts on central bank digital currencies (CBDCs), pull out your wallet and count the cash in it. Add any cash under a mattress or in a bank vault to that amount. That total, be it $12 or a couple of thousand dollars, is the only cash you have.
The bank holding your savings or checking account does not have a pile of cash in a large vault with your name on it. It resides in the ethernet as a series of digital ones and zeroes.
In addition to your non-physical cash, your stocks, bonds, and other assets are almost entirely digitally stored. Whether you write checks or pay bills online, your credit card, mortgage, and car payments occur digitally. Like it or not, we have evolved into a digital-financial system.
Given this reality, it's worth exploring why many fear the rollout of CBDCs.
Banking and fractional reserve magic
There is $17.2 trillion in deposits at commercial banks. In addition, other types of banks, credit unions, brokerage accounts, and financial institutions hold cash deposits. Compare that to the nation's monetary base of $5.5 trillion.
Under our fractional reserve system, the amount of money in the banking system is far less than the amount people and businesses think they have. In Bank Stocks, Do the Rewards Warrant the Risk, I shared the example below to highlight how fractional reserve banking creates money.
Under the fractional reserve banking system, on which America's financial system operates, money is "created" via loans. Here is a simple example:
- You deposit $1,000 into a bank.
- Your neighbor borrows $900 from the same bank to buy a TV from Costco.
- The bank holds the remaining $100 as reserves.
- Costco deposits the $900 into its account at the same bank.
- The bank turns around and lends $810 of Costco's $900 deposit.
- The cycle continues as money multiplies despite the actual cash in the financial system remaining at $1,000.
Whether or not your neighbor pays back the $900, you and Costco have a combined $1,900 in your accounts. In this case, the $900 the bank created via the loan to your neighbor is new money out of thin air.
Given a good percentage of "money" does not exist physically, why are people so trusting of today's financial system but so wary of CBDCs?
Let's explore the pros and cons of a CBDC to get more comfortable with the inevitable change.
I will elaborate on the cons in this article, but appreciating digital currency's advantages is worthwhile:
- Digital transactions are more efficient and often more secure, thus are less costly.
- The Fed can more effectively conduct monetary policy if it chooses. As I will discuss, some may also view this as a con. I am in that camp.
- Transactions and settlements occur instantaneously.
- The need for middleman banks is reduced, further lowering the economic costs of banking.
- Illegal financial activity is easier to trace.
- CBDCs provide financial inclusion for those without a bank or reside where banking services are limited.
In 2020 and 2021, the U.S. government wrote stimulus checks directly to its citizens. Never has the nation witnessed such a quick and impactful stimulus. The government can do the same with CBDCs but even quicker and more impactful. In seconds, the government could credit your CBDC bank account. Further, the government could put a "use by" date on said stimulus. Use it in three weeks, or it vanishes. It might also decree that stimulus deposits can only be used on specific goods or services it wants to help. CBDCs help ensure that stimulus effectively generates economic activity in a timely and directed fashion.
Of course, the likely abuse of such a system, which is inevitable, is a significant flaw. As we have been learning, showering citizens with cash can be very inflationary. Further, it can result in an unfair distribution of funds and a misallocation of where the stimulus is spent.
Unfortunately, the downside of modern monetary theory (MMT) is evident. Whether it's a physical check or CBDC, the government discovered the holy grail of stimulus during the pandemic.
The other monetary policy concern is that the Fed can administer negative rates and not worry about cash fleeing the banking system. Negative rates stimulate economic activity as they disincentivize savings in favor of consumption. Money-like surrogates that offer liquidity, like gold and bitcoin, may be more valuable in such an environment.
Many people fear that with CBDCs, the government can more easily monitor and control your transactions. That should be a big concern. But it can watch all your non-cash transactions today and are likely doing so. Further, the government can access more information than you can imagine between cameras on many street corners and our devices like phones, computers, and many home products.
With a CBDC, the government could theoretically freeze your bank account or even take your money. While also a concern, this already happens at banks. It would just be more efficient.
CBDC will make it a little easier for the government to infringe on our privacy and freeze our spending. But, with technology and the proliferation of the “internet of things,” such privacy and rights have already been lost. The surveillance ship has sailed.
Banking sector difficulties
People do not need to hold CBDCs at a bank. As such, deposits, a cheap source of bank funding, will vanish. As we see with the banking sector today, bank assets must decline as deposits exit the banking system.
If a CBDC results in fewer bank deposits, the supply of bank-originated loans may decrease. In step, interest rates on mortgage, auto, corporate, and all other loans would likely increase. Other entities may replace banks, but it will come at a higher cost to the borrower.
With technology comes fear. The traceability and expanded government powers that accompany CBDC are alarming.
Given the inflation outbreak and the widening gap between wealth classes, giving the Fed expanded monetary policy latitutde is concerning.
But, like it or not, while CBDC provides the government with more access to surveillance and more powerful monetary policy tools, it will attain those abilities anyway.
CBDCs are the next step in financial innovation. Regardless of what we think, the government will do what it deems in its best interests. CBDCs will replace physical currency; it's just a question of when.
Michael Lebowitz is the founding partner of 720 Global and partner with Real Investment Advice. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics. For more information about our upcoming subscription service RIA Pro, please contact us at 301.466.1204 or email [email protected].