Tag: Bitcoin

Should the Federal Reserve Issue a Digital Currency?

The Problem with Bitcoin as Money

Bitcoin has failed in their original purpose of providing a digital currency that could be used in everyday transactions like buying lunch and paying a cellphone bill. As the following figure shows, swings in the value of bitcoin have been too large to make useful as a medium of exchange like dollar bills. During the period shown in the figure—from July 2021 to February 2022—the price of bitcoin has increased by more than $30,000 per bitcoin and then fallen by about the same amount. Bitcoin has become a speculative asset like gold. (We discuss bitcoin in the Apply the Concept, “Are Bitcoins Money?” which appears in Macroeconomics, Chapter 14,  Section 14.2 and in Economics, Chapter 24, Section 24.2. In an earlier blog post found here we discussed how bitcoin has become similar to gold.)

The vertical axis measures the price of bitcoin in dollars per bitcoin.

The Slow U.S. Payments Increases the Appeal of a Digital Currency

Some economists and policymakers argue that there is a need for a digital currency that would do what bitcoin was originally intended to do—serve as a medium of exchange. Digital currencies hold the promise of providing a real-time payments system, which allow payments, such as bank checks, to be made available instantly. The banking systems of other countries, including Japan, China, Mexico, and many European countries, have real-time payment systems in which checks and other payments are cleared and funds made available in a few minutes or less. In contrast, in the United States, it can two days or longer after you deposit a check for the funds to be made available in your account. 

The failure of the United States to adopt a real-time payments system has been costly to many lower-income people who are likely to need paychecks and other payments to be quickly available. In practice, many lower-income people: 1) incur bank overdraft fees, when they write checks in excess of the funds available in their accounts, 2) borrow money at high interest rates from payday lenders, or 3) pay a fee to a check cashing store when they need money more quickly than a bank will clear a check. Aaron Klein of the Brookings Institution estimates that lower-income people in the United States spend $34 billion annually as a result of relying on these sources of funds. (We discuss the U.S. payments system in Money, Banking, and the Financial System, 4th edition, Chapter 2, Section 2.3.)

The Problem with Stablecoins as Money 

Some entrepreneurs have tried to return to the original idea of using cryptocurrencies as a medium of exchange by introducing stablecoins that can be bought and sold for a constant number of dollars—typically one dollar for one stablecoin. The issuers of stablecoins hold in reserve dollars, or very liquid assets like U.S. Treasury bills, to make credible the claim that holders of stablecoins will be able to exchange them one-for-one for dollars. Tether and Circle Internet Financial are the leading issuers of stablecoins. 

So far, stablecoins have been used primarily to buy bitcoin and other cryptocurrencies rather than for day-to-day buying and selling of goods and services in stores or online. Financial regulators, including the U.S. Treasury and the Federal Reserve, are concerned that stablecoins could be a risk to the financial system. These regulators worry that issuers of stablecoins may not, in fact, keep sufficient assets in reserve to redeem them. As a result, stablecoins might be susceptible to runs similar to those that plagued the commercial banking system prior to the establishment of the Federal Deposit Insurance Corporation in the 1930s or that were experienced by some financial firms during the 2008 financial crisis.  In a run, issuers of stablecoins might have to sell financial assets, such as Treasury bills, to be able to redeem the stablecoins they have issued. The result could be a sharp decline in the prices of these assets, which would reduce the financial strength of other firms holding the assets.

In 2019, Facebook (whose corporate name is now Meta Platforms) along with several other firms, including PayPal and credit card firm Visa, began preparations to launch a stablecoin named Libra—the name was later changed to Diem. In May 2021, the firms backing Diem announced that Silvergate Bank, a commercial bank in California, would issue the Diem stablecoin. But according to an article in the Wall Street Journal, the Federal Reserve had “concerns about [the stablecoin’s] effect on financial stability and data privacy and worried [it] could be misused by money launderers and terrorist financiers.” In early 2022, Diem sold its intellectual property to Silvergate, which hoped to still issue the stablecoin at some point.

A Federal Reserve Digital Currency?

If private firms or individual commercial banks have not yet been able to issue a digital currency that can be used in regular buying and selling in stores and online, should central banks do so? In January 2022, the Federal Reserve issued a report discussing the issues involved with a central bank digital currency (CBCD). As we discuss in Macroeconomics, Chapter 14, Section 14.2, most of the money supply of the United States consists of bank deposits. As the Fed’s report points out, because bank deposits are computer entries on banks’ balance sheets, most of the money in the United States today is already digital. As we discuss in Section 14.3, bank deposits are liabilities of commercial banks. In contrast, a CBCD would be a liability of the Fed or other central bank.

The Fed report lists the benefits of a CBCD:

“[I]t could provide households and businesses [with] a convenient, electronic form of central bank money, with the safety and liquidity that would entail; give entrepreneurs a platform on which to create new financial products and services; support faster and cheaper payments (including cross-border payments); and expand consumer access to the financial system.” 

Importantly, the Fed indicates that it won’t begin issuing a CBCD without the backing of the president and Congress:  “The Federal Reserve does not intend to proceed with issuance of a CBDC without clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law.”

The Fed report acknowledges that “a significant number of Americans currently lack access to digital banking and payment services. Additionally, some payments—especially cross-border payments—remain slow and costly.” By issuing a CBDC, the Fed could help to reduce these problems by making digital banking services available to nearly everyone, including lower-income people who currently lack bank checking accounts, and by allowing consumers to have payments instantly available rather than having to wait for a check to clear. 

The report notes that: “A CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk.” Credit risk is the risk that the value of the currency might decline. Because the Fed would be willing to redeem a dollar of CBDC currency for a dollar or paper money, a CBDC has no credit risk. Liquidity risk is the risk that, particularly during a financial crisis, someone holding CBDC might not be able to use it to buy goods and services or financial assets. Fed backing of the CBDC makes it unlikely that someone holding CBDC would have difficulty using it to buy goods and services or financial assets.

But the report also notes several risks that may result from the Fed issuing a CBDC:

  • Banks rely on deposits for the funds they use to make loans to households and firms. If large numbers of households and firms switch from using checking accounts to using CBDC, banks will lose deposits and may have difficulty funding loans. 
  • If the Fed pays interest on the CBDC it issues, households, firms, and investors may switch funds from Treasury bills, money market mutual funds, and other short-term assets to the CBDC, which might potentially disrupt the financial system. Money market mutual funds buy significant amounts of corporate commercial paper. Some corporations rely heavily on the funds they raise from selling commercial paper to fund their short-term credit needs, including paying suppliers and financial inventories. 
  • In a financial panic, many people may withdraw funds from commercial bank deposits and convert the funds into CBDC. These actions might destabilize the banking system. 
  • A related point: A CBDC might result in large swings in bank reserves, particularly during and after a financial panic. As we discuss in Macroeconomics, Chapter 14, Section 14.4 (Economics, Chapter 24, Section 24.4), increasing and decreasing bank reserves is one way in which the Fed carries out monetary policy. So fluctuations in bank reserves may make it more difficult for the Fed to conduct monetary policy, particularly during a financial panic. (This consideration is less important during times like the present when banks hold very large reserves.)
  • Because the Fed has no experience in operating a retail banking operation, it would be likely that if it began issuing a CBDC, it would do so through commercial banks or other financial firms rather than doing so directly. These financial firms would then hold customers CBDC accounts and carry out the actual flow of payments in CBDC among households and firms.

The report notes that the Fed is only beginning to consider the many issues that would be involved in issuing a CBDC and still needs to gather feedback from the general public, financial firms, nonfinancial firms, and investors, as well as from policymakers in Washington. 

Sources:  Peter Rudegeair and Liz Hoffman, “Facebook’s Cryptocurrency Venture to Wind Down, Sell Assets,” Wall Street Journal, January 26, 2022; Liana Baker, Jesse Hamilton, and Olga Kharif, “Mark Zuckerberg’s Stablecoin Ambitions Unravel with Diem Sale Talks,” bloomberg.com, January 25, 2022; Amara Omeokwe, “U.S. Regulators Raise Concern With Stablecoin Digital Currency,” Wall Street Journal, December 17, 2022; Jeanna Smialek, “Fed Opens Debate over a U.S. Central Bank Digital Currency with Long-Awaited Report,”, January 20, 2022;  Board of Governors of the Federal Reserve System, Money and Payments: The U.S. Dollar in the Age of Digital Transformation, January 2022; and Aaron Klein, “The Fastest Way to Address Income Inequality? Implement a Real Time Payments System,” brookings.edu, January 2, 2019.

Is Bitcoin the New Gold?

As we discuss in the chapter, initially, bitcoin was thought of as a way to buy and sell goods and services. Some stores accepted bitcoin and allowed customers to make payment by scanning a bar code with a phone. Some websites offered merchants a way to process purchases made with bitcoins in a manner similar to the way merchants process credit card payments.

In practice, though, swings in the value of bitcoin have been much too large to make it a good substitute for cash, checks, or credit cards in everyday transactions. For instance, at the beginning of 2015, one bitcoin was worth about $300. Over the following five years, the price of bitcoin rose as high at $17,000 before falling to about $8,000 at the beginning of 2020. During 2021, the volatility of bitcoin prices increased, rising as high as $62,000 in April and falling as low as $30,000 in July before rising back above $60,000 in October. (The following chart shows movements in the price of bitcoin from early July to mid-October 2021; the vertical axis shows the price as dollars per bitcoin.)

Some economists have suggested that rather being a medium of exchange, like dollar bills, bitcoin has become a speculative asset, like gold. Bitcoin shares with gold the characteristic that ultimately its total supplied is limited. The supply of Bitcoin can’t increase beyond 21 million, a limit that is expected to be reached in 2030. The gold stock slowly increases as mines produce more gold, although the output of mines is small compared with the existing stock of gold. Some investors and speculators are reassured that, in contrast to the assets in M1 and M2 that can increase as much as the Fed chooses, gold and bitcoin have limits on how much they can increase.

Will Bitcoin Be a Good Hedge Against Inflation? Can It Be Useful in Diversifying a Portfolio?

Some investors and speculators believe that the limited quantities of gold and bitcoin available make them good hedges against inflation—that is, they believe that the prices of gold and bitcoin will reliably increase during periods of inflation.  In fact, though, gold has proven to be a poor hedge against inflation because in the long run the price of gold has not reliably increased faster than the inflation rate. There is no good economic reason to expect that over the long run bitcoin would be a good inflation hedge either.

From a broader perspective than as just an inflation hedge, some economists argue that gold has a role to play in an investor’s portfolio—which is the collection of assets, such as stocks and bonds, that an investor owns. Investors can reduce the financial risk they face through diversification, or spreading their wealth among different assets. For instance, an investor who only holds Apple stock in her portfolio is subject to more risk than an investor with the same dollar amount invested in a portfolio that holds the stocks of multiple firms as well as non-stock investments. An investor obtains the benefits of diversification best by adding assets to her portfolio that are not well correlated with the assets she already owns—that is the prices of the assets she adds to her portfolio don’t typically move in the same direction as the prices of the assets she already owns.

For instance, during a typical recession sales of consumer staples, like baby diapers and laundry detergent, hold up well, while sales of consumers durables, like automobiles, usually decline significantly. So adding shares of stock in Proctor & Gamble to a portfolio that already has many shares of General Motors achieves diversification and reduces financial risk because movements in the price of shares of Proctor & Gamble are likely not to be highly correlated with movements in the price of shares of General Motors.

Studies have shown that during some periods movements in gold prices are not correlated with movements in prices of stocks or bonds. In other words, gold prices may rise during a period when stock prices are declining. As a result, an investor may want to add gold to her portfolio to diversify it. To this point, bitcoin hasn’t been around long enough to draw firm conclusions about whether adding bitcoin to a portfolio provides significant diversification, although some investors believes that it does. 

Finance professionals are divided in their opinions on whether bitcoin is a good substitute for gold in a financial portfolio. In an interview, billionaire investor Ray Dalio, founder of Bridgewater Associates, the world’s hedge fund, noted that while he believes that bitcoin may serve as a hedge against inflation, but if he could only hold gold or bitcoin, “I would choose gold.” His preference for gold is due in part to his belief that the federal government may increase regulation of bitcoin and that regulators might eventually even decide to ban it. A businessinsider.com survey of 10 financial experts found them divided with five preferring gold as an investment and five preferring bitcoin.

Sources: Jade Scipioni, “Bitcoin vs. Gold: Here’s What Billionaire Ray Dalio Thinks,” cnbc.com, August 4, 2021; and Isabelle Lee and Will Daniel, “Bitcoin vs. Gold: 10 Experts Told Us Which Asset They’d Rather Hold for the Next 10 Years, and Why,” businessinsider.com, February 20, 2021.