“Soaring Bond Yields Threaten Fed Goal of a Soft Landing” is the headline of a front-page Wall Street Journal story by Nick Timiraos, who writes that, “If the recent climb in borrowing costs—along with the accompanying slump in the stock market and [a 5%] stronger dollar—continues, that could meaningfully slow U.S. and global economies over the next year. The swiftness of the recent rise also increases the risk of financial market breakdowns.” 

The author proposes a list of hypothetical explanations. But all of them are entirely domestic, as if each country’s financial markets were isolated and disconnected from the internet or telephones. The list of explanations or solutions also leaves the Fed powerless to do anything more than stand still.

As Figure 1 indicates (using OECD data), the market for government bonds is global. Changes in the yields of bonds of major countries are generally synchronized as investor arbitrage seeks the best returns, adjusted for exchange rate risk.

Figure 1: 

The black line shows the rise in the UK bond yield from 3.7% in April to about 4.6% in September was just as large as the rise in US yield from 3.5% to 4.4%. That seems inconsistent with the Journal’s purely domestic “likeliest causes” of rising yields being due to “expectations about better U.S. growth and concerns [about] huge federal deficits.” 

Yet synchronized global movements in yields are also inconsistent with an alternative theory that US yields rose because of “reduced demand for Treasuries from foreigners.” 

The article quotes an economist saying, “It’s perplexing. No fundamental explanation is convincing.” But that is simply because all visible efforts at explanation assumed (1) the US is a closed financial system, and (2) the Federal Reserve had nothing to do with the rise of yield on US and competing foreign bonds. 

If limited to those dubious assumptions, then the Fed must now be helpless to alleviate this unexplainable exogenous shock to domestic bond yields. 

But the US has had a lot of experience with inverted yield curves — times when the Fed pushed the federal funds rate above the bond yield. The most stubborn postwar experiment with that “higher for longer” strategy was in 2006–2007, just before the Great Recession. Two earlier experiments (using the discount rate rather than fed funds) were in 1920–21 and 1928–29.

Inverted yield curves can easily be fixed in a week or two. Just keep the federal funds rate lower than the 10-year bond yield and have the FOMC offer sensible “forward guidance” that this policy will continue for the foreseeable future. The Fed probably did flatten the yield curve quickly enough by cutting the funds rate in 2019, but the pandemic lockdowns of March 2020 made that impossible to prove.

Keeping the fed funds rate lower than the US bond yield might not lower worldwide bond yields appreciably (since that also depends on foreign economic conditions and policies). But it would surely ensure a softer landing than we saw in 1970, 1974, 1980, 1981–82, 1991, 2001, or 2007–2009. 

Six months ago, the failures of Silicon Valley Bank and Signature Bank caused a mild panic. Calls for unlimited deposit insurance and placing government officials on bank boards quickly followed despite the fallout being largely contained. Yet, these events have opened the opportunity to further consider the role and the performance of the Federal Deposit Insurance Corporation (FDIC) and federal banking regulators.

To further discuss those considerations, FDIC vice chairman Travis Hill will be coming to Cato this Thursday.

Vice Chairman Hill and I will discuss the state of banking and the economy, recent regulatory actions, and the outlook for banks and bank regulators. We will also dive into some of the recent regulatory actions that the FDIC has proposed since the failure of the two banks last spring.

You can register here to attend the event in person or watch it online.

When we published our Cato Institute Policy Brief (“Argentina Should Dollarize, Pronto,”) on July 27, few outside of Argentina were paying attention to the dollarization debate. This changed on August 13, when Javier Milei, the only pro-dollarization candidate taking part in the primary elections, won a surprise victory, thus unleashing a barrage of commentary about the supposed dangers of dollarizing the Argentine economy. Many commentators, however, appear to rely on theories that do not reflect the actual experience of dollarization in three Latin American countries: Panama, Ecuador, and El Salvador. In this post, we attempt to refute some of the most salient myths about dollarization in Latin America.

1. Dollarization leads to a loss of competitiveness and weak growth.

False: The main advantages of dollarization are a) it ends currency devaluation / depreciation b) it prevents the political class from monetizing the debt and causing high inflation à la Argentina.

Those advantages do not take away from a dollarized country’s ability to be economically competitive and maintain above-average growth. See the case of Panama, which dollarized in 1904. In recent decades, Panama’s economic growth has been among the highest in the region, and its current level of per capita GDP far exceeds those of non-dollarized peers such as Brazil and Colombia.

Source: World Bank

While some argue that Panama’s success is due to the Panama Canal, the proceeds from the Canal’s activity as a percentage of GDP has been less than what other countries in the region obtain by exporting a single commodity. Rather, Panama’s economic strength is based on its open, internationalized banking system, which allows the country to attract foreign capital and guarantees liquidity in the economy.

A country does not become competitive via currency devaluation or depreciation. Were that the case, Argentina today would be extremely competitive, but it is not. Conversely, if an economy became competitive by devaluing its currency in real terms, then Japan would have become significantly less competitive while its currency appreciated by 176 percent versus the U.S. dollar between 1960 and 2004. However, the Japanese economy enjoyed an export boom during said period. On the other hand, the Colombian peso depreciated by 48 percent between 1960 and 2004, yet its exports grew half as fast as those of Japan.

As Manuel Hinds, a former finance minister in El Salvador, explains, Japan succeeded not by devaluing its currency, but rather by “shifting from lower- to higher-value-added production when the currency appreciated in real terms. Germany did the same [in the post-war period]. That is true competitiveness.” Hinds adds that devaluation merely favors the profitability of current, lower-value-added production and deters a shift towards higher-value-added production.

2. Because growth has been slow in Ecuador and El Salvador, dollarization has not succeeded there.

False: Ecuador has not put in place the right supply-side policies to generate Panama-like economic growth, and El Salvador has backtracked in this respect since the 2000s. Dollarization is not a silver bullet. It needs to be accompanied by other pro-growth policies that have been absent in Ecuador and El Salvador, thus their mediocre growth since they dollarized in 2000 and 2001 respectively.

Nonetheless, dollarization has succeeded in both countries because their dollar regimes prevented fiscally profligate, hard left-wing governments from de-dollarizing, re-introducing weak currencies, and monetizing the debt (Rafael Correa in Ecuador and the FMLN in El Salvador).

As a result, both Ecuador and El Salvador have faced fiscal crises in the last few years. However, said problems have not affected the average citizen, who has maintained a sound currency and some of the lowest inflation levels in Latin America.

Also, as citizens of dollarized countries, Ecuadorians and Salvadoreans benefit from far lower interest rates and longer loan periods than under “monetary sovereignty” regimes. Plus, dollarization imposes an intrinsic hard budget constraint on both their governments and parliaments. Hence, those countries’ fiscal situation likely would have been much worse under a national currency.

3. Dollarization failed in Argentina in the 1990s.

False. In the 1990s Argentina had a currency board that exchanged dollars for pesos, a system and that is sometimes confused with dollarization. In fact, equating that exchange-rate system with dollarization is misleading. As Professor Steve Hanke explains, “There are three distinct types of exchange rate regimes: floating, fixed, and pegged—each with different characteristics and different results” (see the table below).

Source: Steve H. Hanke, “A Money Doctor’s Reflections on Currency Reforms and Hard Budget Constraints,” in Public Debt Sustainability: International Perspectives, eds. Barry W. Poulson, John Merrifield, and Steve H. Hanke (Lanham, MD: Lexington Books / Rowman & Littlefield, January 2022), pp. 139–69.

Given the differences between exchange rate regimes, it is incorrect to ascribe the main characteristics of dollarization to a currency peg, which can be changed or done away with. This is not the case with dollarization, whereby a country replaces its currency with the U.S. dollar at a given rate and grants the latter legal tender (de-dollarization is most feasible under a totalitarian regime such as Robert Mugabe’s in Zimbabwe). A peg also leaves a country with monetary policy faculties, a partly domestic source of the monetary base, and, hence, the possibility of a balance of payments crisis. None of these factors are present under dollarization.

An orthodox currency board provides an alternative version of a fixed exchange rate regime. Once in place, it sets the exchange rate but carries out no monetary policy, so that the foreign-based monetary base remains, as Hanke writes, “on autopilot.” Under a currency board—as with dollarization— the balance of payments determines the monetary base as it moves “in a one-to-one correspondence” with any changes in foreign reserves. This prevents monetary policy and exchange rate policy from colliding, thus precluding balance of payment crises (as is the case in floating rate systems).

Had Argentina implemented an orthodox currency board in the 1990s, it would have carried out a fixed exchange rate policy but no monetary policy (such a currency board acts as a straitjacket on the local monetary authorities). Under official dollarization, the dollar would have had legal tender, the peso would have ceased to circulate, and the central bank would have become obsolete in terms of monetary policy. Neither was the case.

As we explain in our policy brief, Argentina’s convertibility system of the 1990s, which fixed the peso to the U.S. dollar, had several characteristics that made it, in Professor Hanke’s terms, an “unorthodox currency board.” Namely, the central bank still controlled the impact of capital inflows and outflows on the money supply (through sterilization and neutralization), it carried out monetary policy, and it acted as a lender of last resort. The convertibility system even came under a dual currency regime, with different official exchange rates for imports and exports. Each of these features made the convertibility system incompatible with both an orthodox currency board system and official dollarization,

Despite its inherent defects, Argentina’s convertibility system did cause the inflation rate to drop from over 2,600 percent in 1989–1990 to less than 1 percent in 1998. Due to its design flaws, however, the Argentine peso began to lose parity with the dollar in 2001, when currency market speculators smelled blood. In January 2002, Argentina carried out a chaotic exit from its fixed exchange rate.

4. The loss of monetary sovereignty leaves a country at a disadvantage due to the inability to counter external shocks with monetary policy.

False. As Hinds writes, Panama, Ecuador, and El Salvador have all “calmly endured the 2008 and COVID-19 crises with much lower interest rates than in the rest of Latin America.”

Besides, dealing with a crisis by devaluing the local currency might bring the mirage of (very) short-term relief, but this is offset by the necessary consequences of devaluation: the loss of purchasing power, higher inflation and interest rates (than in a dollarized scenario), and the strong incentive to maintain low-value-added production.

In extreme circumstances, finance ministers of developing countries—both formally dollarized and non-dollarized— head to Washington looking for the same thing: a loan in U.S. dollars from the IMF, the repayment of which becomes more onerous with a weakening currency. As Hinds explains, the IMF’s power lies in its ability to allow developing countries to access dollars, particularly in times of crises and when the market shuts out funding for particular governments.

Consider, moreover, the effects of devaluation. As Andrei Levchenko and Javier Cravino found in the case of Mexico’s 1994 “Tequila crisis,” “the consumers in the bottom decile of Mexican income distribution experienced cost of living increases about 1.25 times larger than the consumers in the top income decile” during the two following years. Hence, the authors conclude that the distributional effects of large devaluations are “anti-poor”. In Professor Hanke’s words, “when the currency loses value, you import inflation.”

Maintaining a weak national currency might appeal to certain central bankers, who would remain employed and could still act as protagonists in times of crisis, when, according to theory, currency devaluation or depreciation is in the national interest. The very rich are largely unaffected, not least because a large portion of their assets tends to be held already in U.S. dollars or other hard currencies.

For the bulk of the population, however, maintaining purchasing power is of the utmost importance. In fact, as we have seen, a sharp loss in a currency’s value is most detrimental to the poorest segments of the population.

5. Dollarization can lead to very high unemployment levels because of external shocks, while flexible exchange rate regimes can withstand such shocks far better.

False: Panama and Ecuador have proved that dollarized countries in Latin America can maintain low unemployment levels compared to non-dollarized peers, even those with independent central banks such as Brazil and Colombia.

Source: World Bank

A depreciating currency hinders economic growth in the long term, all things being equal. While a weakening currency might reduce the price of labor, thereby stimulating growth and employment in the short term, it raises the cost of capital in the form of higher interest rates. This discourages investment, which is the source of job creation in the long run.

6. The Federal Reserve oversees all monetary policy for dollarized countries.

False. Although dollarization does take away a country’s ability to set its own interest rates and print its own national currency, while dollarized countries’ inflation rates tend to merge with those of the United States, liberalization of the banking system can grant an important degree of independence.

As economist Juan Luis Moreno-Villalaz argued in the Cato Journal in 1999, Panama’s banks, which have been integrated to the global financial system after a series of liberalization measures in the 1970s, allocate their resources inside or outside the country without major restrictions, adjusting their liquidity according to the local demand for credit or money. Hence, changes in the money supply—which arise from the interplay between local factors and the specific conditions of global credit markets—and not the Federal Reserve, determine Panama’s monetary policy. Fed policy affects Panama only to the same extent that it does the rest of the world.

7. Dollarization is a U.S. imperialist policy.

False. No official institution in Washington supports or promotes dollarization. The White House and the U.S. Congress are usually disinterested in the monetary policy of Latin American countries. On the other hand, the large multilateral organizations, namely the World Bank and especially the International Monetary Fund (IMF), tend to oppose dollarization initiatives. For instance, when former Ecuadorean president Jamil Mahuad dollarized in early 2000, he did so against the express wishes of the IMF and the World Bank. Unsurprisingly, current and former IMF economists now oppose Argentina’s potential dollarization.

In part, the IMF’s resistance to dollarization can be explained from a public choice perspective. As part of its mission, the IMF provides member countries with “capacity development, which is technical assistance and training of government officials” in different areas, including “monetary and exchange rate policies.” If a country dollarizes, it no longer carries out such policies. Nor does it employ central bank officials for the IMF to train in terms of monetary and exchange rate policies. This is problematic not only for the IMF. In Latin American countries, economists have strong incentives to work for the local central bank. As Professor Hanke argues, a stint at a Latin American central bank has become the equivalent of holding an advanced university degree. Moreover, central bank economists in Latin America often aspire to an eventual post at the IMF itself. In a dollarized country, no such career path exists for economists. In part, this also explains the opposition to dollarization that is often voiced by local macroeconomists.

Another frequent argument against dollarization is that it is economically harmful due to the loss of seigniorage, the price paid to a currency’s issuer. As we explain in our policy brief, however, the so-called loss involved is small and, ultimately, a minimum price to pay for an end to high inflation. Especially in countries with poor monetary policy, the cost of giving up seigniorage is the equivalent of an insurance premium paid for protection against the higher risks of maintaining a local currency.

Advocates of central bank digital currencies (CBDCs) often claim that CBDCs will help increase financial inclusion, by which they typically mean that CBDCs will help to “bank the unbanked.” To give some typical examples:

Too many Americans don’t have access to easy payments systems and banking accounts, and I think this is something that a digital dollar, a central bank digital currency, could help with. – Janet Yellen (2021)

A well-designed CBDC is uniquely positioned to address barriers to inclusion, including by offering the unbanked alternative pathways to open transactional accounts and participate in the digital economy … – Henry Fingerhut et al. (2022)

CBDC could strengthen the usability, resilience, and efficiency of payment systems and increase financial inclusion. – Bo Li (2023)

However, such claims are weak.

CBDCs and Financial Inclusion in the United States

The Federal Deposit Insurance Corporation (FDIC) regularly conducts a survey of the American people to get a better understanding of how and why many people operate “outside” of the banking system. According to the latest survey, the proportion of American households that do not have access to a bank account (i.e., “unbanked Americans”) was 4.5 percent (Figure 1). While relatively small, that number accounted for roughly 5.9 million households.

Deeper within the survey, the FDIC asked these Americans why they do not have a bank account. “Don’t have enough money to meet minimum balance requirements” was the most cited main reason. “Don’t trust banks,” “Avoiding a bank gives more privacy,” and “Bank account fees are too high” were the second, third, and fourth most cited main reasons, respectively.

Introducing a CBDC would do little to address any of these concerns.

Whether it is because someone lacks the money to meet minimum balance requirements or to cover fees, a CBDC is not really a solution because the payment method itself does nothing to increase someone’s income. Sure, it’s possible that governments might subsidize accounts to eliminate those costs on the front end, but if such subsidies are to occur, they could be done using any consumer payment method. There is nothing inherently unique about a CBDC that is needed to make that happen.

Access to a CBDC (or a “digital dollar”) is not the same as having access to a bank account. Where a bank account opens the door for receiving loans, lines of credit, and other financial services, a CBDC does little more than offer access to digital payments. In fact, a CBDC is much more akin to a prepaid card than a bank account. Although there are advocates that have called for it, governments getting into the business of commercial banking is a much bigger issue than creating a CBDC alone.

Still, what about privacy and trust? For people who currently choose not to have a bank account because they don’t trust banks or prefer to maintain their financial privacy, a CBDC is far from a solution. People might not trust banks, but trust in the government has been at historic lows. Furthermore, unless a CBDC operates without the same anti-money laundering (AML) and know-your-customer (KYC) requirements that the government forces banks to comply with, many unbanked Americans would likely avoid a CBDC.

To make matters worse, CBDC proponents seem to overlook that the private sector has much more expertise and experience in customer-facing activities. In fact, it’s likely largely due to the private sector that the number of unbanked households has fallen from 8.2 percent to just 4.5 percent over the last ten years (Figure 1). The proliferation of mobile banking, basic bank accounts, and the like have made banking more accessible than ever before.

Still Much to Do

If policymakers want to promote financial inclusion, there are more direct options on the table.

Rather than expand the government with the creation of a CBDC and everything that entails, policymakers should focus on removing legislative barriers to competition. Opening the door to new entrants could make it so that the number of unbanked households continues to decrease and the quality of financial services available at the lower end of the spectrum continues to increase.

There is no shortage of options for policymakers looking for legislative barriers to remove in order to improve financial inclusion. To start, the Bank Secrecy Act is what legally requires banks to collect and report the personal information of customers to the government. Altogether it cost financial institutions an estimated $45.9 billion in 2022—those are costs that are passed on to consumers.

Elsewhere, the Durbin Amendment (Section 1075 of the 2010 Dodd-Frank Act) established price controls that made it more difficult for banks to offer low-cost accounts. Even from the perspective of merchants, one study found that the Durbin Amendment “had limited and unequal impact on reducing merchants’ costs… and it has produced unintended consequences for some merchants in terms of raising costs.”

These examples are only the tip of the iceberg, but the point is simple. Rather than launching another new government intervention that is unlikely to address the problems faced by the unbanked, removing legislative barriers to a more competitive financial sector has the power to open doors for those outside the financial system. It’s time to drop the illusion of CBDC inclusion and focus on reforms that can create substantive change today.

Bank of America is at the center of an ongoing January 6 investigation. Yet not because it (or its leadership) was directly involved in the riot. Rather, there has been an ongoing investigation into whether Bank of America supplied the Federal Bureau of Investigation (FBI) with financial records of people in the DC area for January 5–7, 2021.

Brian Knight, director of innovation and governance at the Mercatus Center, has created an ongoing series to break down the facts as new updates come forward. The first installment of the series can be found here, but I want to highlight just a few of the key pieces that Knight has identified over the last few months.

In the first installment, Knight explores whether handing over this information was legal. He explains that the Right to Financial Privacy Act is meant to protect citizens from the government, but it provides immunity for private institutions sharing financial information with the government under certain circumstances (see 12 U.S.C. Section 3403(c)). Depending on how much information was shared, this provision could mean the process was legal.

In another installment, Knight walks through why Bank of America may have been so proactive in its effort to share its records with the FBI. There are many factors to consider, but let’s focus on two. First, financial institutions have long been required under the law to act as de facto law enforcement investigators. Therefore, it’s possible that sharing this information was seen as being a proactive measure under those requirements. Second, financial institutions must be mindful of the risk of regulatory retaliation. Knight points to a study by Nicholas Parrillo, a professor at Yale Law School, to explain:

[B]ecause banks are basically incapable of perfectly following the multitudinous and complex rules that govern banking, they rely on having a positive relationship with their regulators to prevent those regulators from going too hard on them when the inevitable mistake occurs.

So between the immunity provision for sharing information, banks being deputized as de facto law enforcement investigators, and the threat of regulatory retaliation, it’s easy to see why Bank of America may have handed this information over.

Yet, in the most recent installment, Knight shares the news that Representative Thomas Massie (R‑KY) announced he has evidence that it was the FBI that told Bank of America what records to give them. If true, this detail changes what legal questions need to be asked. And, as Knight explains, the Right to Financial Privacy Act might not be much help here either.

The Right to Financial Privacy Act has around 20 different exceptions to its protections and a few of them could easily apply in this situation. For example, there’s an exception when government authorities “only” request the name, address, account number, and account type of a customer or a group of customers. There’s also an exception for government authorities authorized to conduct investigations related to terrorism (e.g., the FBI). Likewise, there is another exception if government authorities determine there is a risk that delaying access would lead to people getting hurt, property being damaged, or people fleeing prosecution.

The story is still unfolding and it’s still unclear what exactly happened, so be sure to follow Knight’s series. However, one thing does seem clear: the Right to Financial Privacy Act does not live up to its name. This example is, unfortunately, another case in a long history of the Right to Financial Privacy Act failing to protect people’s privacy. As Congress continues to investigate what happened, it should also look to reforming the Act.

An interesting issue with central bank digital currencies (CBDCs) is their status as a direct liability of the central bank. This distinction rarely gets the attention of the broader public, but it’s an important distinction because it could lead to a complete destabilization of the financial system as we know it. For example, a CBDC would likely worsen bank runs, lead people to leave the banking system, and increase the cost of loans. Broadly speaking, this direct liability feature is one of the main reasons that a CBDC represents a radical departure from the existing financial system.

What Is a Liability?

For those that might not be familiar, the term “liability” is used in finance to describe something that person A owes to person B. In contrast, an “asset” is something that person A owns outright. From here, we can see that something—such as a loan or a deposit—can simultaneously be a liability for one person and an asset for another person. The difference between what is owned (assets) and what is owed (liabilities) is referred to as “equity.” Generally, equity is the residual value that belongs to the owners of the bank.

If we step back to accounting 101, we can model the relationship between assets, liabilities, and equities in a simplified balance sheet for a bank (see Figure 1). There might be different items in each category, but, ultimately, assets should equal liabilities plus equities. This relationship is often referred to as “the accounting equation.”

Whose Liability Is It?

When people spend money digitally today with a debit card, the money in the corresponding checking account is a liability of the bank (e.g., Bank of America or Capital One). Similarly, when people spend money digitally today with a prepaid card, the balance is a liability of the private company that issued the card (e.g., Visa or Mastercard). In either case, the financial institution owes the customer the funds that are deposited in the account. When a customer transfers that money to make a payment, the financial institution that has the liability is responsible for transferring the money.

In the case of a CBDC, however, the digital money would be a liability of the central bank itself. That is, it would be the government that has the direct responsibility to hold, transfer, or otherwise remit those funds to the ostensible owner. This feature creates a direct link between citizens and the central bank.

Why Does a CBDC’s Liability Status Matter?

As mentioned in the initial accounting primer, something can be a liability to one person and an asset to another. However, something cannot be a liability owned by two separate parties (Note: the word “separate” is used here to exclude agreements like joint partnerships). In the context of a CBDC, this distinction means that a CBDC cannot be a liability on both the Federal Reserve’s balance sheet and a bank’s balance sheet. That condition matters because the basic business model for banks has long involved a strategy of using deposits (i.e., their liabilities) to fund loans (i.e., their assets).

If the number of deposits is cut down as people put their money in CBDC wallets instead of bank accounts, then the number of loans will be cut down, too (see Figure 2). As the supply of private loans decreases (Q1 to Q2), the price of those loans will start to increase (P1 to P2). In other words, this issue is about more than just bank profits. Yes, some banks would likely go out of business or merge with larger banks as the price of loans increases and cuts into profit lines, but this disruption would also make loans more expensive for everyone.

Why Would People Choose a CBDC Over a Bank Account?

There are many civil liberty concerns that might make people hesitant to adopt a CBDC. However, setting those concerns aside, there are reasons people may still be swayed to use a CBDC. Consider two situations that people may face in financial markets: a time of panic during a bank run and a time of peaceful planning during a period of financial stability.

Bank runs are instances when customers lose faith in their bank for one reason or another (often due to bad news about the bank’s finances) and, as the name suggests, run to the bank to withdraw all their money. In the past, that primarily meant people ran to get their money out in cash. Yet, as far as a run for cash is considered, the time waiting in line, the amount of cash available in the vault, the difficulty in carrying cash, and the security risk of storing cash all act as frictions that slow down runs. In contrast, as explained by the Federal Reserve itself, “The ability to quickly convert other forms of money—including deposits at commercial banks—into CBDC could make runs on financial firms more likely or more severe.” In other words, rather than run to the bank to get physical cash, a person could instead choose to transfer their balances into a CBDC without leaving their home. Not only that, but the money might be kept as a CBDC for prolonged periods because it would essentially be digital money that is “100 percent insured” and, unlike cash, people would not need to worry about storing, securing, or carrying a large sack of money.

While running for cash was more common in the past, technological advances have since led to digital runs where people instead wired or otherwise transferred their money directly to another bank instead of withdrawing cash (see Panel A in Figure 3). To be clear, the speed of these digital runs does pose a challenge. Yet, there is a silver lining with this development: this type of run is largely limited to the initial institution in question and does not affect the larger supply of deposits. Rather than leave the system, the money transferred flows into other institutions and stays within the financial system. The problem posed by a CBDC in this scenario is that people would instead transfer their money out of the financial system and into their digital wallets and purses—the digital equivalent of placing one’s money under a mattress (see Panel B in Figure 3).

It is also likely that incentives could be used—even without a crisis or failure to spark a bank run—to encourage people to leave the existing financial system. For example, some CBDC proponents have called for CBDCs to offer things like “high interest compared with ordinary bank accounts and full government backing with no need for deposit insurance.” For many people, the allure of above-market interest rates would likely make transferring to a CBDC a quick decision. In fact, proponents have specifically recognized that these offerings would crowd out alternatives in the private sector. When weighing the costs and benefits, one proponent went so far as to say that disrupting the banking system is the number one advantage of creating a CBDC even though doing so would lead to “profound systemic changes that threaten entire lines of business within banks and credit card companies.”

Theory is not the only source for concern when considering how government incentives might lead people to leave the banking system. For those that might not recall, the U.S. Postal Savings System operated from 1911 to 1966 on the premise of offering “safe and convenient places for the deposit of savings at a comparatively low rate of interest.” That low rate of interest, however, was set in stone by bureaucrats and later became comparatively high when market rates fell during the Great Depression—a period that coincided with a significant number of bank failures. So in addition to people leaving banks in pursuit of a higher return, studies have shown that other people moved their money to the Postal Savings System directly in response to the announcement of local bank suspensions. From 1929 to 1933, the amount of money deposited in the Postal Savings System had increased nearly eightfold from $154 million to $1.2 billion.

So both in times of panic and times of peace, a CBDC could destabilize the financial system.

Can’t You Just Store CBDC at the Bank?

With a general understanding of both liabilities and bank runs in hand, let’s dive deeper and explore how a CBDC might be used by the public. A common question that comes up when discussing CBDC risks is: Why can’t people just keep their CBDC at the bank? There are really three options for a consumer looking to store their CBDC—partially depending on what CBDC model is ultimately used.

With a retail CBDC provided directly by the central bank, people would store their CBDC in accounts directly managed by the Federal Reserve. That means every dollar held as a CBDC is a dollar that has either been taken out of the banking system or converted from cash. Any dollar stored as a CBDC here would be off-limits to banks. This arrangement sort of turns the Federal Reserve into a payments processor like PayPal or Cash App. However, rather than solely handling money like those services do today, the Federal Reserve would also be providing money directly to the public—another deviation from the current system.

With an intermediated CBDC supported by private intermediaries, people would store their CBDC in a digital wallet that banks (or other private institutions) maintain on behalf of the Federal Reserve. Although the bank would incur costs for things like processing payments, cybersecurity, and regulatory compliance, putting a CBDC into this wallet does not mean that the CBDC becomes the bank’s liability. Rather, storing a CBDC in this wallet is more akin to storing valuables in a safety deposit box. Banks will maintain the account, but they can’t touch what is inside or have ownership of it—as ultimately, those accounts are being maintained on behalf of the Federal Reserve.

With either of those two CBDC designs, people could instead exchange their CBDC for bank deposits—though, it’s a bit of a roundabout process. Behind the scenes, the bank would send the customer’s CBDC to the Federal Reserve in exchange for a credit that would then be used to balance a newly created deposit of equal value. This method would allow banks to use deposit accounts to fund loans and consumers to continue using the financial system like they already do, but the owner of the account would no longer be using a CBDC. A payment from that account would be a regular debit transaction like what already happens—without a CBDC—over 240 million times a day in the United States.

This last option is akin to what happens with cash, or paper money, that is deposited at a bank. When someone deposits cash, they no longer get to use an anonymous, physical money. Instead, they spend money by initiating transfers to and from a deposit account. Exchanging a CBDC for a deposit account would resemble this process as people would no longer have access to the features of the CBDC.

Hold On, Isn’t Cash a Direct Liability of the Central Bank?

At this point, some people might still be wondering how a CBDC poses a unique threat when cash is also a direct liability of the central bank and involves a similar exchange process when deposited at banks. It’s a good question to consider.

First, the existence of cash does facilitate disruptions to the financial system considering it gives consumers a final means of payments that they can run to. In fact, similar arguments could be made about physical gold during the gold standard era. Yet, a CBDC poses a unique threat because consumers would likely be able to pull out their money faster than ever before and store the funds easily without significant storage or security costs. It’s for this reason that the Federal Reserve said a CBDC would make bank runs “more likely” and “more severe.” The digital nature of a CBDC would increase the impact of a run and delay the return to normal relative to cash (see Figure 4).

The CBDC Tradeoff

Many others have also recognized that the risk of destabilizing the financial system is a serious threat posed by CBDCs. George Selgin (Cato Institute), Andrea Maechler (Swiss National Bank), Greg Baer (Bank Policy Institute), Rob Morgan (American Bankers Association), and researchers at the European Central Bank, Massachusetts Institute of Technology, and University of Michigan have all described similar concerns about CBDCs destabilizing the financial system. In fact, the Federal Reserve has acknowledged that the introduction of a CBDC, “could reduce the aggregate amount of deposits in the banking system, which could in turn increase bank funding expenses, and reduce credit availability or raise credit costs for households and businesses.”

Not ready to throw in the towel, some CBDC proponents have proposed making CBDCs intentionally bad to discourage and limit their use. For instance, the Federal Reserve and the European Central Bank have proposed not paying interest on CBDCs, limiting the amount of CBDC a person can hold, or limiting the amount of CBDC a person can accumulate over time. In other words, there won’t be interest payments, total CBDC holdings will be limited, and the amount that can be transferred over time will be limited.

William Luther, director of AIER’s Sound Money Project, has described this issue as the “CBDC Tradeoff.” Consider two extremes. On the one hand, a CBDC could pay interest, offer subsidized payments, and even tax discounts. These offerings would lead people to leave the banking system, but it would mean that the CBDC gains enough users to maintain a stable network. On the other hand, a CBDC could pay no interest, have some low cap like $10,000, and restrict how many transactions people can make. In this case, people probably wouldn’t leave their bank any time soon, but then the CBDC probably would not have enough users to be considered a worthwhile effort. In short, the tradeoff becomes a question between making something people will want at the expense of the larger financial system or making something no one will want at the expense of taxpayer resources.

Faced with this tradeoff, the best choice is to not introduce a CBDC at all.

Conclusion

Let’s quickly recap the ground that has been covered here.

Introducing a CBDC risks destabilizing the banking system and worsening panics. The Federal Reserve tried to lessen that risk by “including” banks in the process by proposing an intermediated CBDC. Yet, with an intermediated CBDC, banks would have to cover regulatory and overhead costs to maintain CBDC accounts even though they would have no loan revenue from those funds since the CBDC is still a liability of the central bank. Moreover, shrinking the supply of deposits would likely lead to costlier credit. That means loans will be more expensive for everyone.

Today’s financial system is not perfect, but it usually works so well that people rarely stop to ask: “Whose liability is it anyway?” Yet, being a direct liability of the central bank is a defining feature of a CBDC. In practice, that trait means destabilizing the financial system is a defining feature of a CBDC. Consequently, the risk posed to financial markets is just another reason why Congress should prohibit the Federal Reserve and Treasury from issuing a CBDC.

Recently, CMFA published an article and a working paper that detailed the Federal Reserve’s departure from rules-based governance following the financial crisis of the late 2000s. As per academics and Fed officials, the era of rules-based governance facilitated the Great Moderation – a stable economic period characterized by less volatile macro indicators such as inflation, output gap, and unemployment. In academic parlance, macroeconomists refer to this situation as determinacy. Despite conflicting evidence, the prevailing view is that the Fed facilitated the Great Moderation by establishing a determinate economic environment through rules-based governance that focused on keeping inflation low. Previous CMFA papers had posited the question as to whether the Fed’s departure from this “successful” era of monetary policy may have instead led to indeterminacy. This article provides evidence that indeterminacy did occur during this period.

Determinacy is a feature of an economic system whereby outcomes such as inflation, output, etc., can be precisely determined based on a given set of initial conditions and policy rules. Under determinacy, the economy (as represented by a mathematical model) has a unique equilibrium outcome. In simple terms, under determinacy, the economy has only one possible resting state and is also stable with no large spirals or variability. Conversely, indeterminacy occurs when there are multiple possible equilibria that could result from the same initial conditions and policy rules. This state can create uncertainty in predicting the future state of the economy, as different equilibria may lead to significantly divergent economic outcomes. Simply put, the economy could end up in multiple possible states, some of which may be highly volatile, depending on how individuals form their expectations and make decisions.

Academics generally believe that a strong Fed response to inflation (a more than one-to-one increase in the target federal funds rate to inflation changes) can ensure a determinate system. This is known as the Taylor Principle. A greater than one-to-one response to inflation is deeply entrenched in the economic literature; most empirical macroeconomic studies simply assume determinacy and fix the Fed’s response to inflation at a number higher than one or use estimation techniques that entirely exclude the possibility of indeterminacy. This determinacy bias has serious implications for policy analysis because economic models (such as those used by the Fed) exhibit significantly different dynamics in an indeterminate system. Additionally, even approaches that account for indeterminacy, including seminal papers, fail to take consumers’ inflation expectations seriously. As noted above, expectations matter drastically when determining equilibrium selection. They should be included in the datasets used by empirical methods.

I utilize a simple macro model – connecting output gap, inflation, and the federal funds rate – to test the determinacy of the U.S. economy during the period when the Fed abandoned rules-based governance (2009 through 2022). I use actual U.S. time series data for the three variables listed above as well as a measure of consumers’ inflation expectations – one year ahead inflation expectations collected from the Michigan Survey of Consumers.[1] I fit the macro model to the data using a Bayesian estimation procedure under both determinacy and indeterminacy to see which fits the data better.

I find that the model under indeterminacy significantly outperforms its determinate counterpart in fitting the data set. That is, the model under indeterminacy has a much higher “goodness-of-fit” versus determinacy. Goodness-of-fit values from Bayesian analysis are unlike the usual R² value reported from regressions. Bayesian model comparison is conducted through marginal likelihoods which are then converted to an odds ratio (similar to betting odds) called the Bayes factor. The estimated odds of determinacy to indeterminacy are 1 to 1.5 x 10¹⁵ – making determinacy an extremely unlikely event. To understand exactly how unlikely, let us compare these odds to another extremely unlikely event – being struck by lightning. The odds of being struck by lightning are much higher in comparison: 1 to 1.5 x 10⁴. In other words, the odds of being struck by lightning are significantly higher than the odds that the U.S. economy was determinate from 2009 through 2022.

Consequently, the probability that the U.S. economy was indeterminate following the financial crisis is nearly 100%. The (indeterminate) model with a 0.57 estimated inflation response coefficient fits the data better than the (determinate) model with a 1.13 coefficient estimate. The results confirm that the Fed did not target inflation in line with the Taylor Principle.

These findings raise an important question: how responsible is the Fed in keeping the economy determinate with a unique and stable outcome? If it is, as several academics and Fed officials have claimed, then they must answer why they did not conduct policy in a way that ensured the economy’s determinacy. If they are not responsible for keeping the economy determinate (as several recent studies are now finding), then the Fed’s reputation for stabilizing the economy is undeserved, and the public should question why an unelected governmental agency exerts such a high degree of influence over the political economy discourse if it is ineffective in maintaining prices or keeping the economy stable. A forthcoming paper will further examine the history of the Fed’s effectiveness in achieving determinacy.

The author thanks Jerome Famularo for providing research assistance during the preparation of this essay. For more information on the model, empirical methodology, and posterior distribution please click here.