Are central banks planning to issue their own digital currencies? If so, is there anything to fear? Those are the questions at hand today as reader Ken asked "Could you post your opinion of Fedcoin?"

What is Fedcoin?

Fedcoin is a digital currency proposal that would use the same blockchain technology as Bitcoin. Every penny could be traced to someone. Unlike Bitcoin, Fedcoin would not have a limited supply.

A Newsweek opinion column by David Andolfatto addressed this question Should the Fed Issue Its Own Bitcoin?

Fed Investigating Fedcoin

David Andolfatto is Vice President of the Federal Reserve Bank of St Louis. That tells you the Fed is seriously investigating Fedcoin.

Andolfatto listed these positives of "Bitcoin".

• First, it's monetary policy reduces the "hot potato" motive of economizing on money balances -- that is, it offers the prospect of being a decent long-run store of value.

• Second, anyone with access to the internet can access an account (a public/private key pair) for free -- like cash, no permission is needed. The public key is like an account number and the private key is like a password. Account balances remain secure as long as the private key remains secure.

• Third, like cash, no personal information is necessary to open an account, so no need to worry about securing private information.

• Fourth, like cash, Bitcoin is censorship resistant -- no one can prevent you from spending/receiving Bitcoin from whomever you like.

• Fifth, Bitcoin can offer a greater degree of anonymity than bank deposit money, but less so than cash (unlike cash, the blockchain ledger is visible and public).

• Sixth, the entire money supply (blockchain) lives on a replicated distributed ledger -- it lives simultaneously everywhere -- so that "sending money somewhere" means updating the ledger on all computers everywhere. There are no banks, there are no borders.

• Seventh, the user cost of transferring value is relatively low.

Those positives pertain to Bitcoin. Point number one does not pertain to Fedcoin. Dollars issued by the US treasury have no maximum amount.

Point number four is false under Bitcoin and Fedcoin. People have been convicted of Bitcoin money laundering.

Andolfatto's Recommendation

My own recommendation is for central banks to consider offering digital money services (possibly even a cryptocurrency) at the retail and wholesale level. There is no reason why, in principle, a central bank could not offer online accounts, the same way the U.S. Treasury presently does (www.treasurydirect.gov).

These accounts would obviously not have to be insured. They would provide firms with a safe place to manage their cash without resorting to the banking or shadow banking sector. They would give monetary policy an additional instrument -- the ability to pay interest on low-denomination money (possibly at a negative rate). To the extent paper money is displaced, there would be large cost savings as well.

It's hard (for me) to see what the downsides are in having a central bank supply digital money. Critics might argue that it leaves people exposed to potentially poor monetary policy. This may be true and, for these people, currency substitutes should be available (including Bitcoin).

I don't think we can expect anything like this in the near future, but it is technologically possible. Of course, people will complain that Fedcoin will inspire illicit trade, etc. But again, the same is true of regular central bank issued cash.

The Downside

Andolfatto glossed over the downside but he did state one key point: "Critics might argue that it leaves people exposed to potentially poor monetary policy."

Yes! That is precisely the concern.

Mandated use of Fedcoin and the elimination of cash would let the government track every dime.

Expiring Money

As long as physical currency circulates, there is likely a limit as to how insane central banks can get with negative interest rates. At some point, people will pull out money and elect to hold cash.

Eliminate cash, and limits on negative rates and expiring money go out the window.

Expiring money is an absurd concept, but it is precisely what economist Greg Mankiw has proposed to defeat deflation (See my April 21 2009 article Economist Mankiw Defends Policy of Theft).

Mankiw's proposal was to look at the last digit of currency and if it ended in a number drawn at random it would be worthless.

Such a proposal would have increased the demand for treasuries, euros, gold, etc., causing an immediate run on banks. Every vending machine in the county would have needed to track the digits on dollars, etc.

There are other oddities that make the proposal idiotic, but Mankiw stood by it.

With Fedcoin, money might not expire the same way, but the same effect could be produced with a tax on money or a tax on money above a certain amount.

Were the latter tried, it would create another immense asset bubble in something.

The downside risks of forced use of digital currencies should not be underestimated. That's yet another reason we need to end the Fed and let the market decide what money should be.

I have no doubt that in the absence of government mandate, the free market would overwhelmingly select gold.