There's water everywhere, but John Taylor wants us all to be thirsty

"Water water everywhere, and not a drop to drink" - Rime of the Ancient Mariner (Gustave Doré woodcut)

In a recent paper, John Taylor rhapsodizes about bringing back the good ol' federal funds market:

I think the case can be made for such a framework. Peter Fisher ran the trading desk at the New York Fed for many years, and knows well how these markets work. His assessment is that such a framework would work, saying “we could get back and manage it with quantities; it’s not impossible. We could just re-engineer the system and go back to the way we were.” I spent time in the markets for federal funds watching how they operated in those days, and I wrote up an institutional description of how good experienced people traded in these markets, and I developed a model showing how the market worked.

The fed funds market is currently moribund, but just a few years ago it was buzzing with activity. Banks that didn't have enough reserves at the end of the day to meet requirements could go to the fed funds market and buy them from banks who had excess reserves, the price they negotiated referred to as the fed funds rate.

I disagree with John Taylor. Resuscitating the fed funds market is not a good idea. The fed funds market is no longer used because the Federal Reserve has stuffed the market with so many reserves that banks no longer need to buy them from other banks to meet their requirements. But this cornucopia is a good thing. Any effort to bring back the fed funds market would ruin it.

Let's set up an analogy. Imagine a country called Waterland that gets tons of rain and has plenty of lakes and rivers. Since everyone has immediate access to water, there is no market for the stuff. The price of water is zero. Say that the government establishes control over the waterways and rainfall. It decides to limit the amount of water that is available to the citizens of Waterland. In response to this artificially-imposed scarcity, a market develops in which citizens buy and sell water among each other. 

Markets are great. They allow those with too little of something to trade with those who are good at conserving what they need, both sides improving their lot in life. But this particular market should never have existed in the first place. Water is plentiful in Waterland, and so it should be a free good, not a market-traded one. The entire apparatus that has been built around the exchanging of water—informed dealers, speculators, exchanges, warehouses, networks for transporting water to and from market, auditors and lawyers involved in verifying water transactions—represents a waste. By consuming resources in constructing and operating the market, other more important projects never see the light of day. If the absurd water scarcity were to be removed, the market for water would disappear, freeing up resources for more socially beneficial uses. 

Reserves, like water in the previous example, should by all rights be free. The only effort the Fed incurs in introducing a new unit of reserves into circulation is a keystroke or two. This means that the Fed can provide a bunch of new reserves, say by conducting open market operations, without incurring any costs whatsoever. As the Fed continues to mouse-click new reserves into existence, the demand that each individual bank has for reserves will eventually be satiated. Once that point is reached not a single bank will need to bid for the reserves of another bank, and so there will be no activity in the market for reserves. The fed funds market is effectively dead, as is currently the case.

Taylor wants to bring back the fed funds market. But this would mean putting an artificial constraint on the amount of reserves that the Fed supplies, much like Waterland's frivolous constraint on water. Banks, their satiation for reserves now being replaced by an artificial hunger, would suddenly be willing to pay a fee to other banks in order to get their hands on some reserves.

A whole fed funds trading apparatus would re-emerge. Traders would have to be hired and trained to to fill newly-formed fed funds desks. Bank resources would be diverted away from other valuable projects towards plotting the best way to time outgoing payments, the idea being to reduce the need to hold reserves in order to lend them out in the fed funds market. The Fed itself would have to rehire Peter Fisher to run its open market desk. All of this would be an expensive investment of time and money, diverting resources from other more socially beneficial activities.

In calling for a return to the days of an active fed funds market, it is as if Taylor were advocating for an artificial constraint to Waterland's supply of water, solely because he admired the market for water that emerged. Never mind that the whole water trading apparatus, though wonderfully efficient, represents a massive missallocation of resources. Given that I'm pretty sure Taylor would not want to kickstart a water market in a hypothetical Waterland, I don't understand why he is so keen to reboot the fed funds market.

Paying interest on cash

Freigeld, or stamp scrip, is designed to pay negative interest, but it can be re-purposed to pay positive interest.

Remember when global interest rates were plunging to zero and all everyone wanted to talk about was how to set a negative interest rate on cash? Now that interest rates around the world are rising again, here's that same idea in reverse: what about finally paying positive interest rates on cash? I'm going to explore three ways of doing this. As for why we'd want to pay interest on cash, I'll leave that question till the end.

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The first way to pay interest on cash is to use stamping. Each Friday, the owner of a bill—say a $50 note—can bring it in to a bank to be officially stamped. The stamp represents an interest payment due to the owner. When the owner is ready to collect his interest, he deposits the note at the bank. For example, say that 52 weeks have passed and 52 stamps are present on the $50 note. If the interest rate on cash is 5%, then the banknote owner is due to receive $2.50 in interest.

Alternatively the note owner can collect the interest by spending the $50 note, say at a local grocery store. The checkout clerk will count the number of stamps, or interest due, and tack that on to the face value of the note. With 52 stamps, the owner of a $50 note should be able to buy $52.50 worth of groceries, not $50. After all, the store has the right to bring the $50 note to its bank and collect the $2.50 in interest for itself.

Stamped currency seems like a pretty big hassle to me. The clerk behind the counter must count out the stamps on the note by hand, and the owner of the note has to trek back and forth to the bank each week to get the stamp affixed. Instead, imagine that each banknote has a magnetic strip that records how long the bill had been in circulation. This would remove some of these hassles. Weekly trips to the bank for stamping would no longer be necessary, and a note reader installed at a bank or retailer would automatically record how much interest was due, precluding painstaking counting of stamps.

"They use this magnetic strip to track you." says Byers to Agent Scully, The X-Files

Apart from stoking conspiracy theories, there's still a major problem with a magnetic strip scheme. Because each note has entered circulation at a different time, each is entitled to a varying amounts of interest. And this means that banknotes are no longer fungible. Fungibility—the ability to cleanly interchange all members of a population—is one of the features of money that makes it so easy to use. Remove it and money becomes complicated, each piece requiring a unique and costly effort to ascertain its value.

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Our second way of paying interest on money doesn't destroy the fungibility of banknotes. The central bank needs to sever the traditional 1:1 peg between deposit money and cash, and then have cash slowly appreciate in value relative to deposits.

For instance, a central bank might start by setting an exchange rate of $1 note = $1 deposit on January 1, but on January 2 it adjusts this rate so $1 note is equal to $1.0001 deposits, and on January 3 adjust this rate to $1:$1.0002, etc. So the cash in your wallet is benefiting from capital gains. By December 31, the exchange rate will be around $1 note to $1.0365. Anyone who has held a banknote for the full year can deposit it and will have earned 3.65 cents in interest, or 3.65%. 

The major drawback with this scheme is the calculational burden imposed on the population by breaking the convenient 1:1 peg between cash and deposits. Assuming that retailers price their wares in terms of deposits, anyone who wants to pay in cash will have to make a currency conversion using that day's exchange rate. For instance, if the central bank's peg is currently being set at $1 note = $1.50 in deposits, then a popsicle that is priced at $1 will require—hmmm... let me check my calculator—$0.667 in cash. Phones will make this exchange rate calculation easy, but it is still likely to be a bit of a nuisance.

There are other hassles too. Would a capital gains tax have to be paid on the appreciation of one's cash? How would existing long-term contracts deal with the divergence? For instance, if my employer is paying me $50,000 per year, obviously I'd prefer this sum be denominated in steadily appreciating cash rather than constant deposits, and she will prefer the latter. What becomes the standard unit of account?

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The last way to pay interest (at least as far as I know) is to run lotteries based on banknote serial numbers, an idea independently proposed by Hu McCulloch and Charles Goodhart back in 1986.

It's surprisingly easy to get banknotes to pay interest. Run a lottery based on note serial numbers. Hu McCulloch dreamt this scheme up in 1986, but no central bank has ever tried it. Source: https://t.co/pUUf1liuhH pic.twitter.com/5mil9B62FN

— JP Koning (@jp_koning) January 14, 2018

Central banks would periodically hold draws entitling the winning serial numbers to large cash prizes. For example, if there was $100 billion in banknotes in circulation, the central bank could set the interest rate on cash at 5% by offering prizes over the course of the year amounting to 5% of $100 billion, or $5 billion.

This technique of paying interest on cash solves the fungibility problem that plagues the earlier stamping technique. Every note has the same chance of winning the lottery, and non-fungible winners are immediately withdrawn. And unlike the crawling peg idea, banknotes and deposits remain equal to each other so burdensome exchange rate calculations don't need to me made.

However, it introduces the threat of bank runs. The day before the big lottery is set to occur, everyone will withdraw deposits for cash so that they can compete in the draw. To prevent a bank run, it may be necessary to randomize the date of the big lottery so that no one knows when to withdraw notes, an idea proposed by Tyler Cowen. Another way to preclude bank runs is to have a regular stream of small weekly lotteries rather than one or two big ones each year.

Another drawback to note lotteries is the cost that is imposed on society by having everyone constantly checking serial numbers. As Brian Romanchuk points out, employees who are working behind their employer's tills may be tempted to switch out winning notes with losers. Employers may protect themselves by setting up scanning hardware to read in serial numbers as banknotes enter the tills, maintaining their own internal database of cash inventories so that winners can quickly be isolated and returned. But all of that is costly. Would it be worth it?

Interestingly, there is some precedent for these sorts of lotteries. In Taiwan, receipts are eligible for a receipt lottery, a neat way to incentivize people to avoid under-the-table transactions (ht Gwern). Lotteries can also be useful in attracting depositors, as outlined in this Freakonomics podcast (ht Ryan). George Selgin and William Lastrapes have gone into the idea of lottery-linked money in some detail:

Though the suggestion may appear far fetched, in many countries lotteries are presently being used with considerable success to market bank deposits. According to Mauro Guillen and Adrian Tschoegl (2002), “lottery-linked” deposit accounts have been especially popular with poorer persons, including many who might otherwise remain “outside the banking system.” ... In two popular Argentine schemes, for instance, depositors receive one ticket or chance of winning for every $200 or $250 on deposit (ibid., p. 221). Lottery-linked banknotes, in contrast, would themselves serve as tickets, allowing persons to play for as little as the value of the lowest note denomination, and with no apparent cost to themselves save that of occasionally inspecting their note holdings.

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Some readers may recognize these three techniques for paying interest on cash as the inverse of the three go-to ways of applying negative interest rates to cash being discussed a few years ago. For instance, one of the most well-known ways of imposing negative interest rates on owners of cash is to apply a Silvio Gesell style stamp scheme (see picture at top), whereby a currency owner must buy a stamp and affix it to the note in order to renew the validity of their currency each month. (I once discussed Alberta's experiment with Gesell's "shrinking money" here). Without the appropriate number of stamps, the note is illegitimate. In my first example above, Gesell's stamp tax has been re-engineered into a stamp subsidy. As for the magnetic strip modification, this is Marvin Goodfriend's 1999 update of Gesell, flipped around to award interest rather than docking it.

Miles Kimball has written extensively on escaping the zero lower bound to interest rates by setting a crawling peg on currency. But just as Kimball's crawling peg can impose a negative interest rate on banknotes, it can be used to pay interest, as I described above. Indeed, Miles (along with Ruchir Agarwal) frequently mention this possibility in his blog posts and papers (see this pdf).

Finally, remember Greg Mankiw's controversial 2009 article on imposing negative interest rates by serial number? He wrote:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

Mankiw's idea is just the reverse of Goodhart and McCulloch's earlier lottery idea, the lottery replaced by with a demonetization.

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So why pay interest on currency? I can think of two reasons. One is based on fairness, the other on efficiency.

The decision to avoid paying the market rate of interest on currency amounts to a tax on currency users. Who pays this tax? Cash is often the only means for the poor, new immigrants, and unbanked to participate in the economy. So the tax falls on those who can least afford it. This hardly seems fair. By conducting note lotteries or stamping notes, those consigned to the cash economy can get at least the same return on banknotes as the well-off banked receive on deposits.

Now hold up JP, some you will be saying at this point. What about criminals? Yep, the other group of people who suffer from the lack of interest on banknotes are criminals and tax evaders. Rewarding them with interest hardly seems appropriate. One would hope that if central banks did adopt a mechanism for rewarding currency with interest, it would be capable of screening out bad actors. For instance, criminals may be leery of collecting their interest or lottery prize if making a claim at a bank means potentially being unmasked. Another way to set up the screen would be to pay interest or prizes on small denominations like $1-$10 notes, and not on $20s and above. Since criminal organizations prefer high denomination notes due to their compactness, they wouldn't benefit from interest.

As for the efficiency argument, this is nothing but the famous Friedman rule that I described in my previous post. All taxes impose a deadweight loss on society. When a good or service is taxed, people produce and consume less of it than the would otherwise choose, tax revenues not quite compensating for this loss. From a policy maker's perspective, the goal is to reduce deadweight loss as much as possible by selecting the best taxes.

In the case of cash, the deadweight loss comes from people holding less of it than they would otherwise prefer, incurring so-called shoe leather costs as they walk to the bank and back to avoid holding too much of the stuff. If a 0% return on cash is an inefficient form of taxation relative to other alternatives types of taxes, then it would be better for the government to just pay interest on the stuff and recoup the lost revenues elsewhere, say through consumption taxes or income taxes.

Floors v corridors

David Beckworth argues that the U.S. Federal Reserve should stop running a floor system and adopt a corridor system, say like the one that the Bank of Canada currently runs. In this post I'll argue that the Bank of Canada (and other central banks) should drop their corridors in favour of a floor—not the sort of messy floor that the Fed operates mind you, but a nice clean floor.

Floors and corridors are two different ways that a central banker can provide central banking services. Central banking is confusing, so to illustrate the two systems and how I get to my preference for a floor, let's start way back at the beginning.

Banks have historically banded together to form associations, or clearinghouses, a convenient place for bankers to make payments among each other over the course of the business day. To facilitate these payments, clearinghouses have often issued short-term deposits to their members. A deposit provides clearinghouse services. Keeping a small buffer stock of clearinghouse deposits can be useful to a banker in case they need to make unexpected payments to other banks.

Governments and central banks have pretty much monopolized the clearinghouse function. So when a Canadian bank wants to increase its buffer of clearinghouse balances, it has no choice but to select the Bank of Canada's clearing product for that purpose. Monopolization hasn't only occurred in Canada of course, almost every government has taken over their nation's clearinghouse.

One of the closest substitutes to Bank of Canada (BoC) deposits are government t-bills or overnight repo. While neither of these investment products is useful for making clearinghouse payments, they are otherwise identical to BoC deposits in that they are risk-free short-term assets. As long as these competing instruments yield the same interest rate as BoC deposits, a banker needn't worry about trading off yield for clearinghouse services. She can deposit whatever quantity of funds at the Bank of Canada that she deems necessary to prepare for the next day's clearinghouse payments without losing out on a better risk-free interest rate elsewhere.  

But what if these interest rates differ? If t-bills and repo promise to pay 3%, but a Bank of Canada deposit pays an inferior interest rate of 2.5%, then our banker's buffer stock of Bank of Canada deposits is held at the expense of a higher interest elsewhere. In response, she will try to reduce her buffer of deposits as much as possible, say by reallocating bank resources and talent to the task of figuring out how to better time the bank's outgoing payments. If more attention is paid to planning out payments ahead of time, then the bank can skimp on holdings of 2.5%-yielding deposits while increasing its exposure to 3% t-bills.

Why might BoC deposits and t-bills offer different interest rates? We know that any differential between them can't be due to credit risk—both instruments are issued by the government. Now certainly BoC deposits provide valuable clearinghouse services while t-bills don't. And if those services are costly for the Bank of Canada to produce, then the BoC will try to recapture some of its clearinghouse expenses. This means restricting the quantity of deposits to those banks that are willing to pay a sufficiently high fee for clearing services. Or put differently, it means the BoC will only provide deposits to banks that are willing to accept an interest rate that is 0.5% less than the 3% offered on t-bills.

But what if the central bank's true cost of providing additional clearinghouse services is close to zero? If so, the Bank of Canada should avoid any restriction on the supply of deposits. It should provide each bank with whatever amount of deposits it requires without charging a fee. With bankers' demand for clearing services completely sated, the differential between BoC deposits and t-bills will disappear, both trading at 2.5%.

There is good reason to believe that the cost of providing additional clearinghouse services is close to zero. It is no more costly for a central bank to issue a new digital clearinghouse certificate than it is for a Treasury secretary or finance minister to issue a new t-bill. In both cases, all it takes is a few button clicks.

Let's assume that the cost of providing clearinghouses is zero. If the Bank of Canada chooses to  constrain the supply of deposits to the highest bidders, it is forcing banks to overpay for a set of clearinghouse services which should otherwise be provided for free. In which case, the time and labour that our banker will need to divert to figuring out how to skimp on BoC deposit holdings constitutes a misallocation of her bank's resources. If the Bank of Canada provided deposits at their true cost of zero, then her employees' time could be put to a much better use.

As members of the public, we might not care if bankers get shafted. But if our banker has diverted workers from developing helpful new technologies or providing customer service to dealing with the artificially-created problem of skimping on deposits, then the public directly suffers. Any difference between the interest rate on Bank of Canada deposits and competing assets like t-bills results in a loss to our collective welfare.

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Which finally gets us to floors and corridors. In brief, a corridor system is one in which the central bank rations the number of clearinghouse deposits so that they aren't free. In a floor system, unlimited deposits are provided at a price of zero.

When a central bank is running a corridor system, as most of them do, the rate on competing assets like t-bills lies above the interest rate on central bank deposits. Economists describe these systems as corridors because the interest rate at which the central bank lends deposits lies above the interest rate on competing safe assets like t-bills and repo, and with the deposit rate lying at the bottom, a channel or corridor of sorts is formed.

For instance, take the Bank of Canada's corridor, illustrated in the chart below. The BoC lets commercial banks keep funds overnight and earn the "deposit rate" of 0.75%. The overnight rate on competing opportunities—very short-term t-bills and repo—is 1%. The top of the corridor, the bank rate, lies at 1.25%. So the overnight rate snakes through a corridor set by the Bank of Canada's deposit rate at the bottom and the bank rate at the top. (The exception being a short period of time in 2009 and 2010 when it ran a corridor floor).

Let's assume (as we did earlier) that the BoC's cost of providing additional clearinghouse services is basically zero. Given the way the system is set up now, there is a 0.25% rate differential (1%-0.75%) between the deposit rate and the rate on competing asset, specifically overnight repo. This means that the Bank of Canada has capped the quantity of deposits, forcing bankers to pay a fee to obtain clearing services rather than supplying unlimited deposits for free. This in turn means that Canadian bankers are forced to use up time and energy on a wasteful effort to skimp on BoC deposit holdings. All Canadians suffer from this waste.

It might be better for the Bank of Canada (and any other nation that also uses a corridor system) to adopt what is referred to as a floor system. Under a floor system, rates would be equal such that the rate on t-bills and repo lies on the deposit rate floor of 0.75%--that's why economists call it a floor system. The Bank of Canada could do this by removing its artificial limit on the quantity of deposits it issues to commercial banks. Banks would no longer allocate scarce time and labour to the task of skirting the high cost of BoC deposits, devoting these resources to coming up with new and superior banking products. In theory at least, all Canadians would be made a little better off. All the Bank of Canada would have to do is click its 'create new clearinghouse deposits'  button a few times.

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The line of thought I'm invoking in this post is a version of an idea that economists refer to as the optimum quantity of money, or the Friedman rule, first described by Milton Friedman back in the 1960s. Given that a central bank's cost of issuing additional units of money is zero, Friedman thought that any interest rate differential between a monetary asset and an otherwise identical non-monetary asset represents a loss to society. This loss comes in the form of people wasting resources (or incurring shoe leather costs) trying to avoid the monetary asset as much as possible. To be consistent with the zero cost of creating new monetary assets, the rates on the two assets should be equalized. The public could then hold whatever amount of the monetary asset they saw fit, so-called shoe leather costs falling to zero.

In my post, I've applied the Friedman rule to one type of monetary asset: central bank deposits. But it can also be applied to banknotes issued by the central bank. After all, banknotes yield just 0% whereas a t-bill or a risk-free deposit offers a positive interest rates. To avoid holding large amounts of barren cash, people engage in wasteful behaviour like regularly visiting ATMs.

There are several ways to implement the Friedman rule for banknotes. One of the neatest ways would be to run a periodic lottery that rewards a few banknote serial numbers with big winnings, the size of the pot being large enough that the expected return on each banknote as made equivalent to interest rate on deposits. This idea was proposed by Charles Goodhart and Hugh McCulloch separately in 1986.

Robert Lucas once wrote that implementing the Friedman rule was “one of the few legitimate ‘free lunches’ economics has discovered in 200 years of trying.” The odd thing is that almost no central banks have tried to adopt it. On the cash side of things, none of them offer a serial number lottery or any of the other solutions for shrinking the rate differential between banknotes and deposits, say like Miles Kimball's more exotic crawling peg solution. And on the deposit side, floor systems are incredibly rare. The go-to choice among central banks is generally a Friedman-defying corridor system.

One reason behind central bankers' hesitation to implement the Friedman rule is that it would threaten their pot of "fuck you money", a concept I described here. Thanks to the large interest rate gaps between cash and t-bills, and the smaller gap between central bank clearinghouse deposits and t-bills, central banks tend to make large profits. They submit much of their winnings to their political masters. In exchange, the executive branch grants central bankers a significant degree of independence... which they use to geek out on macroeconomics. Because they like to engage in  wonkery and believe that it makes the world a better place, central bankers may be hesitant to implement the Friedman rule lest it threaten their flows of fuck you money, and their sacred independence. 

That may explain why floors are rare. However, they aren't without precedent. To begin with, there is the Fed's floor that Beckworth describes, which it bungled into by accident. At the outset of this post I called it a messy floor, because it leaks (George Selgin and Stephen Williamson have gone into this). The sort of floor that should be emulated isn't the Fed's messy one, but the relatively clean floor that the Reserve Bank of New Zealand operated in 2007 and Canada did from 2009-11 (see chart above). Though these floors were quickly dropped, I don't see why the couldn't (and shouldn't) be re-implemented. As Lucas says, its a free lunch.

Fedcoin

Recent posts by Adrian Hope Baille and Sina Motamedi have got me thinking again about the idea of the Federal Reserve (or any other central bank for that matter) adopting bitcoin technology. Here's an older post of mine on the idea, although this post will take a different tack.

The bitcoin ethos enshrines the idea of a world free from the totalitarian control of central banks. So in exploring the idea of Fed-run bitcoin-style ledger, I realize that I run the risk of being cast as Darth Vader (or even *yikes* the Emperor) by bitcoin true believers. So be it. While I do empathize with the bitcoin ideal—I support freedom in banking—I rank the importance of bitcoin-as-product above bitcoin-as-philosophy. And at the moment, bitcoin is not a great product. While bitcoin has many useful features, these are all overshadowed by the fact that its price is too damn volatile for it to be be taken seriously as an exchange medium. This volatility arises because bitcoin lacks a fundamental value, or anchor, a point that I've written about many times in the past. However, there is one way to fix the crypto volatility problem...

Enter Fedcoin

Setting up the apparatus would be very simple. The Fed would create a new blockchain called Fedcoin. Or it might create a Ripple style ledger by the same name. It doesn't matter which. There would be an important difference between Fedcoin and more traditional cryptoledgers. One user—the Fed—would get special authority to create and destroy ledger entries, or Fedcoin. (Sina Motamedi gives a more technical explanation for how this would work in the case of a blockchain-style ledger)

The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types—paper money and electronic reserves—and Fedcoin at a rate of 1:1. The outcome of this rule would be that Fedcoin could only be created at the same time that an equivalent reserve or paper note was destroyed and, vice versa, Fedcoin could only be destroyed upon the creation of a new paper note or reserve entry.

So unlike bitcoin, the price of Fedcoin would be anchored. Should Fedcoin trade at a discount to dollar notes and reserves, people would convert Fedcoin into these alternatives until the arbitrage opportunity disappears, and vice versa if Fedcoin should trade at a premium.

As for the supply of Fedcoin, it would effectively be left free to vary endogenously, much like how the Fed currently let's the market determine the supply of Fed paper money. This flexibility stands in contrast to the fixed supply of bitcoin and other cryptocoins. The mechanism would work something like this. Should the public demand Fedcoin, they would have to bring paper dollars to the Fed to be converted into an equivalent number of new Fedcoin ledger entries, the notes officially removed from circulation and shredded. As for banks, if they wanted to accumulate an inventory of Fedcoin, they would exchange reserves for Fedcoin at a rate of 1:1, those reserves being deleted from Fed computers and the coins added to the Fedcoin ledger.

Symmetrically, unwanted Fedcoin would reflux to the central bank in return for either newly-created cash (in the case of the public) or reserves (in the case of banks), upon which the Fed would erase those coins from the ledger. The upshot is that the Fed would have no control over the quantity of Fedcoin—it would only passively create new coin according to the demands of the public.

Apart from that, Fedcoin would be similar in nature to most other cryptoledgers. All Fedcoin transactions would be announced to a distributed network of listening nodes for processing and verification. In other words, these nodes, and not the Fed, would be responsible for maintaining the integrity of the Fedcoin ledger.

Why implement Fedcoin?

The main reasons that the Fed would implement Fedcoin would be to provide the public with an innovative and cheap payments option, and to provide the taxpayer with tax savings.

The public would enjoy all the benefits of bitcoin including fast transaction speeds, cheap transaction costs, and the ability to transact almost anywhere and with almost anyone as long as all parties to a transaction had a smartphone and the right software. At the same time Fedcoin's stability would immediately differentiate it from bitcoin. No longer would users have to fear losing 50% of their purchasing power prior to making a transaction.

Fedcoin's distributed architecture would be both complementary and in many ways superior to Fedwire, a centralized system which currently provides for the transferal of Fed electronic reserves among banks. I won't bother getting into the specifics: see this old post.

By introducing Fedcoin, the Fed would also lower its costs. While I haven't done the calculations, I have little doubt that running a distributed cryptoledger is far cheaper than maintaining billions of paper notes in circulation. Paper currency involves all sorts of outlays including designing and printing notes, collecting, processing and storing them, as well as constantly defending the note issue against counterfeiters. A distributed ledger does all this at a fraction of the cost. As Fedcoin begins to displace cash, and I think that this would steadily happen over time due to its superiority over paper, the Fed's costs would fall and its profits rise to the benefit of the taxpayer.

Fedcoin would have no impact on monetary policy

Fed officials might balk at giving the idea a shot if they feared that adopting a Fed cryptoledger would impede the smooth functioning of Fed monetary policy. They needn't worry.

The Fed currently exercises control over the price level by varying the quantity of reserves and/or the interest paid on reserves. The existence of cash doesn't get in the way of this process, nor has it ever gotten in the way. Bringing in a third liability type, Fedcoin, the quantity of which is designed to fluctuate in the same way as cash, would likewise have no impact on monetary policy. The Fed would continue to lever the return on reserves in order to get a bite on prices while allowing the market to independently choose the quantity of Fedcoin and cash it wished to hold.

Well, almost none: Interest on Fedcoin and the zero lower bound

Ok, I sort of lied in the last paragraph. While it happens only rarely, there are times when cash does get in the way of monetary policy, and so would Fedcoin if it were implemented. If the Fed needs to reduce rates on reserves to negative levels in order to hit its price and employment targets, the existence of cash impedes the smooth slide below zero. With reserves yielding -2% and paper notes yielding 0%, reserves would quickly be converted en masse into cash until only the latter remains. At that point the Fed would have lost its ability to alter rates—cash doesn't pay interest nor can it be penalized—and would no longer be capable of exercising monetary policy. This is called the zero-lower bound, and it terrifies central bankers.

Fedcoin has the potential to alleviate the zero lower bound problem. Here's how.

As Fedcoin adoption grows among the public, cash would steadily be withdrawn. And while it might not shrink to nothing—the public might still choose to use some cash—at least the Fed would have a good case for entirely canceling larger denominations like the $100 and $50.

Consider also that it would be possible for interest to be paid on each Fedcoin  (unlike bitcoin and cash), the rate to be determined by the Fed. And just as Fedcoin could earn positive interest, the Fed could also impose a negative rate penalty on Fedcoin. This would effectively solve the Fed's zero lower bound problem. After all, if the Fed wished to reduce the rate on reserves to -2 or -3% in order to deal with a crisis, and reserve owners began to bolt into Fedcoin so as to avoid the penalty, the Fed would be able to forestall this run by simultaneously reducing the interest rate on Fedcoin to -2 or -3%. Nor could reserve owners race into cash, with only low denomination and expensive-to-store $5s and $10s available.

So by implementing something like Fedcoin, the Fed could safely implement a negative interest rate monetary policy.

(Lastly, monetary policy nerds will notice that the displacement of non-interest yielding cash with interest-yielding Fedcoin is a tidy way to arrive at Milton Friedman's optimum quantity of money, or the Friedman rule.)

The big losers: banks

Fedcoin has the potential to tear down the private banking system. Interest yielding Fedcoin would be able to do everything a bank deposit could do and more, and all this at a fraction of the cost. As the public shifted out of private bank deposits and into Fedcoin, banks would have to sell off their loan portfolios, the entire banking industry shrinking into irrelevance.

One way to prevent this from happening would be for the Fed to make an explicit announcement that any bank could be free to create its own competing copy of Fedcoin, say WellsFargoCoin. Like the Fed, Wells Fargo would promise to offer two-way convertibility between its deposits/cash/Fedcoin and WellsFargoCoin at a rate of 1:1 to ensure that the price of its new ledger entries were well-anchored. The bank could then implement features to compete with Fedcoin such as higher interest rates or complimentary financial services. Even as Wells Fargo's deposit base steadily shrunk due to technological obsolescence, its base of WellsFargoCoin liabilities would rise in a compensatory manner.

The resulting lattice network of competing private bank crypto ledgers built on top of the Fedcoin ledger would work in a similar fashion to the current banking system. Wells Fargo would make loans in WellsFargoCoin and take deposits of FedCoin as well as competing bankcoins, say CitiCoin or BankofAmericaCoin. Intra-bank cryptocoin payments would be cleared on the books of the Federal Reserve with reserves transfers over the Fedwire funds system, although Fedcoin might eventually take the place of Fedwire. A change in the value of Fedcoin or reserves due to a shift in monetary policy would be transmitted immediately into a change in the value of all private bankcoins by virtue of  the convertibility of the latter into the former.

Nor would it be necessary to start with Fedcoin and then introduce bankcoins. Why not begin with the latter and skip Fedcoin altogether? Why aren't private banks at this very moment switching out deposits and replacing them with cryptoledgers?

KYC: Know your customer

'Know your customer' regulations would make implementation difficult, but not impossible.

With bitcoin, the location of a coin (its address) is public but the identity of the owner is not. However, laws require banks to gather information on their customers to protect against money laundering. As these laws are unlikely to change with the advent of new technology, banks would probably require anyone wanting to use bank cryptoledgers to have an account with a regulated bank. This would not be too onerous given that most Americans already have bank accounts.  However, it compromises anonymity, one of the key ideals of bitcoin, since each coin would be traceable by the authorities to a real person.

Perhaps there is still a way to preserve some degree of anonymity. Historically the Fed has always been spared from KYC rules since it has never had to document who uses cash. By grandfathering KYC exemption to Fedcoin, any user who wanted to preserve their anonymity could use Fedcoin rather than any of the multiple bankcoin ledgers, just like today they prefer to use anonymous Fed cash rather than bank accounts to transact.

In summary

So that's a rough sketch of Fedcoin—a decentralized, flexible, and well-backed payments system that grants one user, the Fed, a set of special privileges and responsibilities. Feel free to modify the idea in the comments section.

And just so we are keeping tabs, these are the institutions that Fedcoin could eventually make obsolete: bank deposits, banks (unless the latter are allowed to innovate their own bankcoins), the credit card networks Visa and Mastercard, bank notes, Fedwire, and even bitcoin itself, which would be unable to compete with a stable-value copy of itself.

Bitcoin true believers may not like this post, but perhaps they can take something constructive from it. Fedcoin is one of the potential competitors in the distant horizon. Now is the time for the rebels to figure out how to create a stable-price version of bitcoin, before Darth Vader does it himself. Otherwise they may someday find themselves closing down their bitcoin startups in order to write code for the Empire.

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Note: My apologies to readers for my having succumbed to the constant temptation to adorn all blog posts with Star Wars references.