A farewell to cash

The European Central Bank and the US Federal Reserve have each said that they do not intend to abolish physical cash if and when a central bank digital currency (CBDC) is introduced. Recent policy briefs by the ECB and the Bretton Woods Committee argue against paying interest (positive or negative) on CBDCs. Policymakers should reconsider both stances. There are good reasons not only to support the early introduction of CBDCs, but also to pay interest on them and abolish cash.

The United States is a CBDC laggard. According to the Atlantic Council's CBDC tracker, CBDCs have already been fully launched in 11 currency areas, all of them developing and emerging-market economies, and 100 other countries are exploring the idea. These currency areas have embraced two common arguments in favor of a CBDC: that it can boost financial inclusion and improve the efficiency of payments and settlements.

Of course, CDBCs also have their critics. One argument against them is that commercial banks could be sidelined as households and firms substitute CBDC holdings for commercial bank deposits. This risk grows if a CBDC pays interest (like bank deposits do). Another concern is that the central bank, as the CBDC issuer, might obtain sensitive information about CBDC holders' finances and private spending decisions. And yet another concern is that CBDCs running on a proof-of-work blockchain consensus mechanism would be extraordinarily energy-intensive.

But there is a third argument in favor of CBDCs. If (and only if) a CBDC bears interest and is accompanied by the abolition of physical cash, it will enhance the effectiveness of monetary policy by eliminating the effective lower bound (ELB) on policy interest rates.

The ELB, an artifact of central-bank paper currency with zero nominal interest rates, was a frequent binding constraint on advanced-economy monetary policy from the 2007-09 financial crisis up until policymakers (belatedly) began hiking interest rates in late 2021 and early 2022. Because central banks were unable to set policy rates at significantly negative levels, they had to resort to quantitative easing (QE) – monetizing their balance-sheet expansions through massive purchases of public and private securities.

QE was not only ineffective in boosting below-target inflation rates but also contributed to asset bubbles that continue to threaten financial stability, and made it far too easy for improvident governments to run excessive budget deficits.
Across advanced economies, central banks appear willing to keep policy rates high enough for long enough to restore inflation to the 2% target range by the end of 2024. But low inflation plus a low neutral real interest rate will increase the likelihood of the ELB again becoming a binding constraint in the case of future contractionary and disinflationary shocks.

After all, the Federal Reserve Bank of New York's most recent estimates of r-star – the real interest rate consistent with full employment and stable on-target inflation – are barely above 0.5% for the US. That low level makes eliminating the ELB highly desirable. Should inflation or employment end up materially below target, the Fed would be able to set significantly negative interest rates, if needed.

Moreover, the standard financial-stability argument against interest-bearing CBDCs makes little sense. If private holders of bank deposits decide to switch to a CBDC, and if the resulting disintermediation is considered undesirable, the central bank can make offsetting deposits with the affected financial intermediaries. A fear-driven run out of uninsured bank deposits into CBDCs can be offset and neutralized in the same way.

Similarly, while no CBDC can fully replicate the privacy of physical cash, that might not be so bad. The anonymity of cash makes it a preferred option for criminal and terrorist organizations worldwide. Moreover, the information made available to the central bank (and the government) will depend on the design and implementation of the CBDC.

At one extreme, there could be a completely centralized model, with commercial banks, other financial institutions, and all firms and households holding accounts with the central bank. But there could also be a two-tier system in which banks and other eligible financial institutions maintain wholesale CBDC accounts with the central bank and administer the retail CBDC to the public. A retail CBDC account would effectively be a conventional bank account guaranteed by the central bank. Administrators of retail accounts would pass on to the relevant authorities only the information required to comply with rules to combat money laundering and the financing of terrorism. In the US, this would include compliance with the Bank Secrecy Act.

Or, at the other extreme, there could be a completely decentralized distributed-ledger-based system, like many blockchain-based cryptocurrencies and stablecoins today. Although proof-of-work consensus mechanisms (what Bitcoin uses) are very energy-intensive and don't scale well, proof-of-stake blockchains (like Ethereum's since September 15, 2022) may be able to surmount these obstacles. Either way, a blockchain allows for transaction history to be in the public domain, while individuals' identities can remain private (which is why some cryptocurrencies are also being used by criminal and terrorist organisations).

Finally, paying interest on CBDCs would not adversely affect either financial inclusion or the efficiency of the payments and settlements system.

Policymakers who oppose abolishing physical cash and introducing an interest-bearing CBDC should think again. This is the moment to do both – before the ELB returns.

Disclaimer: This article first appeared on Project Syndicate, and is published by special syndication arrangement.