Fed’s cryptocurrency pilot opens door for dangerous retail option

The success of the cryptocurrency industry has inspired the Federal Reserve and other central banks to create their own digital currencies using the new technology. Recently, the Federal Reserve Bank of New York and a small group of private financial companies announced a 12-week pilot program to explore the feasibility of a central bank digital currency (CBDC).

Although several other central banks are testing and implementing CBDCs, this is the first move by the Fed. Unfortunately, it is not a move in the right direction.

There is a strong political appetite in the United States for government intervention to reduce economic inequality and increase financial inclusion. To this end, central bankers and politicians claim that a CBDC will promote financial inclusion, increase payment efficiencies, lower transaction costs, and improve the execution of monetary and fiscal policy.

There are two ways the Fed can implement a CBDC in the United States: wholesale and retail. The Fed’s pilot program represents a version of the wholesale model.

However, the case for a CBDC, retail or wholesale, does not hold up to scrutiny. A wholesale CBDC offers few benefits and opens the door for a dangerous retail CBDC down the line, which risks financial instability and threatens consumer privacy.

A retail CBDC gives citizens direct access to central bank digital currencies, removing commercial banks and institutions from the process. Citizens would have a direct bank account with the Federal Reserve and use a digital app to access their funds. Those who do not wish to use digital technology could use a prepaid CBDC card, an option currently available for citizens in the Bahamas.

There are several dangers to the retail approach. Retail CBDCs risk widespread financial disintermediation by crowding out the lending roles held by traditional banks. Commercial banks will have fewer deposits to lend if citizens shift a significant amount of their savings into CBDC accounts. Entrepreneurs and businesses will suffer as less capital is available to fund their ventures.

A sterilized commercial banking system might force the Fed, flush with CBDC deposits, to enter the commercial lending business. While currently the “lender of last resort,” the Fed is ill-equipped to serve as a traditional commercial lender. A popular retail CBDC ensures the Fed, rather than commercial banks, must keep capital flowing to entrepreneurs to avoid stunting economic growth.

On the privacy side, retail CBDCs remove safeguards for consumer privacy by offering governments direct control over citizens’ bank accounts. For example, in China, Communist Party officials tout their CBDC network, the Digital Currency Electronic Payment (DECP) system, as a way to achieve greater financial control over citizens and enforce party discipline.

The significant economic and privacy risks associated with retail CBDCs might explain why over two-thirds of public comments in response to the Fed’s research paper on CBDCs are negative.

In contrast to the retail option, the Fed’s pilot program represents a version of the wholesale model. A wholesale CBDC would replace the dollars banks currently hold at the Federal Reserve, although consumers cannot directly access them. The wholesale model changes how banks interact with the Fed but not how consumers interact with money.

However, by piloting a wholesale model, the Fed is dangling a dangerous option for politicians to seize upon in the future. Consider the recent Biden-Harris administration report on CBDCs, which states that “all should be able to use the CBDC system” and “the CBDC system should expand equitable access to the financial system.” Since a wholesale CBDC is not accessible to all and does nothing to expand access to the financial system, the retail option is the only way to achieve the administration’s stated goals.

Most money is already digital. A wholesale CBDC does not provide meaningful benefits to consumers, and the Fed should stop its pilot program and CBDC ambitions before political pressure builds around the dangerous retail option.

As recent inflation illustrates, the Fed has been unable to fulfill its current mission. Rather than expanding into new and unknown areas, it should focus on establishing monetary rules and achieving price stability.

At best, a wholesale CBDC represents wasting taxpayer funds on a project that doesn’t serve the Fed’s stated mandate. At worst, it begins a slippery slope toward a retail CBDC and the associated economic and privacy risks.

David Waugh is managing editor at the American Institute for Economic Research.