CAMBRIDGE – Many countries’ governments, most notably China’s, are continuing to experiment with central bank digital currencies (CBDCs). Money 3.0 is moving full speed ahead, and with its recent white paper, entitled “The US Dollar in the Age of Digital Transformation,” the US Federal Reserve, a conspicuous laggard, has finally started to weigh in, if only tepidly. The Fed’s caution is understandable, but is it excessive?

The Fed sets an extremely high bar for introducing a retail digital dollar. For starters, we are told that the new form of money must provide benefits more effectively than other methods, presumably meaning dollar-linked digital stablecoins and existing bank accounts. For example, one purported benefit of a digital dollar is to provide “real time clearing” for small payments, which of course paper currency already achieves, and the Fed plans to introduce 24-hour electronic payments through banks soon. The digital currency also must protect privacy (then again, the Chinese authorities say that, too) and must not facilitate criminal activity, which is ironic given the popularity of the $100 bill in the global underground economy.

Most challenging of all is the Fed’s requirement that the expected gains from introducing a digital dollar outweigh any risks it might create. This is a very tough, but reasonable hurdle. For all the flaws of the world’s existing financial infrastructure, its inner workings have remained largely intact for decades. Imagine a nightmare scenario in which a poorly designed digital dollar left open a “back door” that allowed a hostile foreign power to shut down the entire dollar-based global financial system in one fell swoop.

Risks aside, it is not difficult to fathom why the Fed is especially resistant to any quantum change in the existing financial system. After all, the dollar’s international dominance brings the United States myriad benefits. It lowers the interest rates that American citizens and corporations have to pay, not to mention those for the world’s biggest borrower, the US government – what Valéry Giscard d’Estaing, then France’s finance minister, famously called America’s “exorbitant privilege.”

Dollar dominance also gives US authorities leverage over the global financial system’s plumbing, including privileged access to information on worldwide dollar transactions. Moreover, it allows the US to impose significant financial sanctions. Russia has been subject to targeted financial sanctions since its 2014 annexation of Crimea, but President Joe Biden’s administration is now threatening much stronger steps in the event of a Russian invasion of Ukraine.

As other central banks lead the charge to introduce digital currencies, some worry that the Fed might find itself in the position of Eastman Kodak (which once made a fortune processing film) when digital photography arrived, or of Swiss mechanical watchmakers when digital timepieces became ubiquitous.

But there is another, more subtle reason for the Fed’s digital-dollar reluctance: The US is still fundamentally a democracy and a market economy. Although the government has considerable regulatory and legal power to enforce adoption of its digital currency, this applies only up to a point. The American public cannot be forced to accept a transition it does not want. Remember when the Treasury tried to popularize $2 bills because it would save money on printing singles?

So, when the US does try to introduce a retail digital dollar – as I believe it eventually will – it may get only one bite at the apple. At the moment, the range of technologies and options for CBDCs is almost limitless. (The Monetary Authority of Singapore recently held a contest to design the digital Singapore dollar, and the final round – for which I was one of the judges – had no fewer than 15 diverse entries.) If the Chinese government decides it picked the wrong technology for its CBDC, it can pretty much tell everyone that it wants a do-over. But if the Fed’s first try at a digital dollar fails, owing to a lack of public interest and political pushback, it might have to wait decades before trying again.

One issue conspicuously absent from the Fed’s white paper is how the Fed plans to regulate the decentralized financial technologies of Web 3.0, a domain where US authorities so far have too often been missing in action. In particular, US regulators urgently need to do much more to guide and restrain the growth of private cryptocurrencies and their many derivatives. As US Senator Elizabeth Warren has put it, “crypto is the new shadow bank.” The common view that cryptocurrencies are basically just used for investment and not for transactions and capital flows – a view to which the Fed paper subscribes – is wishful thinking, as recent research has shown.

Fed Chair Jerome Powell has argued that introducing a US CBDC will undercut demand for crypto. That is one of the Fed’s motivations for producing its white paper. But a lot of the demand for cryptocurrencies such as Bitcoin is from the global underground economy, whether for illegal drug purchases on the dark web, sanctions evasion by Russian oligarchs, capital flight, money laundering, or tax evasion.

There is no getting around the need for strict regulation of advanced economies’ cryptocurrency use now, and of other countries’ CBDCs as they come into international use. The Fed’s reluctance to rush into launching a digital dollar is understandable, but that is no excuse for the slow pace of regulatory reform.

Kenneth Rogoff, a former chief economist of the International Monetary Fund, is Professor of Economics and Public Policy at Harvard University.

© Project Syndicate 2022

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