Supernotes

The U.S. $10,000 was available till Nixon nixed it in 1969

For the last few years the conversation about cash has been dominated by Ken Rogoff's proposal to remove high-denomination banknotes. In an effort to broaden the discussion, last year I wrote an essay for Cato Unbound about introducing a new U.S. supernote. The value of the current highest denomination note--the $100 bill--has deteriorated over the decades thanks to inflation. Is it time to restore the purchasing power of U.S. cash by bringing out a $1,000 note?

In the same essay I also floated the idea of taxing the supernote. Why a tax? A new $1,000 bill could be used for both good and nefarious purposes. Given that nefarious supernote usage (tax evasion and crime) could impose costs on society, a tax would make up for this by transferring wealth from note users to the rest of us. (I also blogged about the idea of taxing cash here and here). 

Josh Hendrickson, Will Luther, and Jamie McAndrews all had responses. Do read them, as they give a good sense of all the various nuances and complications involved in issuing a supernote and taxing it.

---------------------

Say we introduce a new supernote worth $1,000. What would Walter, a seasoned drug dealer, think about this new policy? Let's walk through the day-to-day costs that Walter absorbs as an illicit cash user.

Walter makes large value payments using banknotes. He also stores plenty of the stuff. A million dollars worth of $100 notes (i.e. 10,000 notes) takes up a lot of space. But one thousand $1000 bills can be packed into a container a tenth the size. This will make Walter's business much easier to expedite. His costs of counting, transporting, storing, and sorting notes will all drop significantly.

The risk of detection will also be much lower with supernotes. Hiding twenty supernotes in a car is a lot easier than hiding two-hundred $100 notes. Detection by authorities imposes costs on Walter and his associates. Banknotes can be seized under civil asset forfeiture laws. In many cases the police can seize cash on mere suspicion of wrongdoing--they don't even have to charge the owner with a crime.

Example of an asset forfeiture case involving cash [source]

These seizures can be contested by Walter and his associates, but this will involve significant time and legal expenses. There are also non-pecuniary losses associated with detection. If Walter or one of his associates is pulled over for speeding and the cops find a bag full of $100 notes in his car trunk, that may provide law enforcement with information and insight into his network.

Finally, Walter also incurs a "tax" on his cash holdings. Specifically, his cash does not earn interest. If Walter regularly stores $100,000 in cash, and the interest rate is 3%, he is effectively forfeiting around $3,000/year. This loss is the same whether Walter holds his stash in $100 notes or supernotes. Walter's $3000/year loss goes directly to the public. He is providing the rest of us with an interest-free loan, or a subsidy.

Weaving this all together, from Walter's perspective the new supernote is a great product. It reduces his storage & handling costs (S) as well as any costs arising from detection (D), and does so without increasing his taxes (T).

Civil society isn't quite as well off with a supernote. We've provided Walter with a superior means of avoiding detection. Not only does this mean that we've increased the odds of Walter staying out of jail. We've also reduced asset forfeiture revenues. Since law enforcement agencies uses forfeitures to fund their operations, any diminution in this flow means that the rest of us will have to pay higher taxes to compensate.

----------------------

Why don't we strike a deal with Walter? If supernotes allow him to enjoy lower S and D, why don't we ask for higher T in compensation? Setting a higher T involves an increase in the tax rate on supernotes relative to $100 notes.

One way to do this is to make the supernote depreciate a bit each day. The central bank will buy the note back today for $1000, but tomorrow it will only buy it back at $999.95. This constitutes a 5¢/day transfer from Walter to the public. At a yearly interest rate of 3%, he also loses around 5¢/day in forgone interest. This combination of a capital loss and forgone interest comprise the supernote tax.

Now when Walter and his colleagues switch from using the $100 bill to the supernote, society's decline in forfeiture income is compensated by higher tax income. Even with the higher tax, Walter prefers the supernote to the $100 because he saves enough on S and D to make it worth his while. So everyone wins if we issue a supernote.

Or as Hendrikson says in his response essay:

"the introduction of the supernote is in this instance welfare-improving (given the premise that illegal trade creates a social cost) because it allows policymakers to engineer a transfer from criminals to law-abiding citizens that would not be available otherwise."

--------------------

There may be some additional improvements in efficiency to be gained by replacing a bad tax--asset forfeiture--with a good one. Having the police directly raise funds by confiscating people's property is ripe for abuse.

Wooooow. This has huge implications, since cities are increasingly relying on fees and fines for their budgets. https://t.co/dnHPNTWYIQ

Thanks for passing this along, @jbenmenachem! pic.twitter.com/s6KMS1MwTg

— Michael Hobbes (@RottenInDenmark) April 16, 2019

By contrast, a supernote tax is automatic, predictable, transparent, and easier to collect.

--------------------

A supernote would provide at least some benefit to non-criminals. Say that Sarah wants to sell her car for $8000. She may be wary of accepting a check from the buyer, Todd, who she doesn't know. If she provides the car to Todd but his check bounces, then she's out of hand. Cash is a simple way to solve this problem. The moment that cash passes hands from Todd to Sarah, the payment is 100% certain.

Without a supernote, Todd will have to pay for the $8000 car with eighty $100s. Wouldn't it be more cost effective for him to make the payment with just eight $1000s? Less counting is required and the bills easily slip into a wallet. So S is reduced. (Detection, or D, is not a cost that licit users need worry about.)

Unfortunately the imposition of a tax will reduce the supernote's potential for improving the lives of non-criminals like Sarah and Todd. Since the tax raises the cost of the supernote relative to alternatives like the $100 note, many people who would otherwise have consumed the supernote just won't bother. Put differently, the  consumer surplus (for licit users) that is created by the introduction of a taxed supernote will be small than if the supernote was untaxed.

If the tax is set quite high, then usage of supernotes may be entirely confined to criminals. This the sort of monetary future that David Birch would probably say was first described by novelist William Gibson in Count Zero. Cash still exists, but it will have disappeared from polite society.

William Gibson imagined a future where 'polite society' won't accept cash. From 'Count Zero' ht @dgwbirch pic.twitter.com/Bh9ZKVDmJz

— JP Koning (@jp_koning) October 3, 2016

-------------------------

A taxed supernote is a neat idea, but does it qualify as a "fancy monetary standard" i.e too abstract and academic to inspire confidence? "Fancy" is the word that Irving Fisher's critics used to denigrate his early ideas about price targeting.

Admittedly a taxed supernote doesn't present a very clean user interface. Having a round face value is one of the conveniences of a note. This feature ensures that it can be easily divided into smaller amounts. But the supernote tax means that the face value of the note will very quickly fall to some inconvenient number like $999.33. As McAndrews points out: 

"...the differential rates of exchange among the different denominations of notes is an inconvenience. The cost of all those calculations required to make change and set different prices based on which note a customer offers must be counted against whatever benefit a tax might achieve."

It might be possible to avoid the rounding problem by finding a different means for assessing the tax. In his paper Taxing Cash, Ilan Benshalom describes a withdrawal tax. This tax would be assessed whenever money is taken out of an ATM or bank teller. However, supernotes will probably circulate for long periods of time without every being deposited, which means the withdrawal tax will rarely be activated.

For now, taxed supernotes are science fiction. But who knows? Irving Fisher's fancy monetary standard was science fiction for decades, but it has slowly become the standard way of doing monetary policy these days.

A tax, not a ban, on high denomination banknotes

Ken Rogoff has famously called for a ban on high denomination banknotes in order to help combat tax evasion and hurt criminals. But rather than banning notes, why not implement a market-based approach such as a tax? Among other advantages, a tax leaves people with flexibility to determine the cheapest way to reduce their usage of the targeted commodity. This is how society is choosing to reduce green house gas emissions. So why not go the tax route for banknotes too?

My recent post for the Sound Money Project on pricing financial anonymity delves into this idea. The anonymity provided by banknotes is both a "good" and a "bad". People have a legitimate demand for financial alone time; a safe zone where neither their friends, family, government, nor any other third-party can watch what they are buying or selling. These days, cash is pretty much the only way to get this alone time.

But cash's lack of a paper trail can be abused when it used to evade taxes. The resulting gap in government finances forces the honest tax-paying majority to pay more than their fair share for government services. This state of affairs isn't just.

One way to fix this inequity is to raise the price of banknote usage high enough so that it includes the costs that tax evaders impose on everyone else. A tax on banknotes, call it a financial privacy tax, can do this. It internalizes the externality, or the harm done to others. 

-------------

Interestingly, financial privacy taxes already exist. For each banknote that it has issued, a central bank typically holds a risk free interest-yielding asset in its vault. In a free market, this interest would flow through to banknote holders, say by the implementation of note serial number lotteries. Rather than allowing the interest to flow through, however, the central bank withholds it. The amount it withholds constitutes the financial privacy tax.

In Canada, for instance, the overnight risk-free interest rate is currently 1.25%. The yield on banknotes being 0%, the Bank of Canada is withholding $1.25 in interest payments for each $100 bill held. So a note-using Canadian is effectively being taxed $1.25 year for each $100 worth of financial privacy he or she chooses to use. Anyone who wants to avoid the tax need only deposit the note into a bank account and earn 1.25% per year.  But once they do that, they will be giving up their privacy.

--------------

Modern taxes on banknotes aren't consciously designed as financial privacy taxes. By that I mean, it's not like central bankers have sat down at a conference table and thought long and hard about the costs and benefits of anonymity only to settle on the most appropriate level for the tax. Rather, the size of the tax has been arrived at by accident. Historically, central bankers have simply assumed that it was technologically impossible for banknotes to yield anything other than 0%. (Fully adjustable interest rates on notes, both positive and negative, are actually quite easy to implement, as I'll show). Which means by default, the privacy tax has always been at least as large as the foregone overnight interest rate.

The overnight rate is in turn a function of an entirely different thought process: monetary policy. Central bankers ratchet the overnight rate up or down in order to to hit their chosen inflation target. The problem with this setup is that two separate decisions have been jumbled together. The level at which the central bank sets its financial privacy tax has become the ill-conceived byproduct of its chosen macroeconomic policy.

Here's an example of this muddle. If the Bank of Canada decides to tighten monetary policy tomorrow by increasing its interest rate from 1.25% to 1.5%, it has simultaneously made an entirely separate decision to increase the privacy tax on banknotes by 0.25%. But whereas the monetary policy decision is guided by plenty of data and number crunching, the increase in the privacy tax is purely arbitrary—no thinking has gone into justifying an increase. It's a fait accompli.

Or think about it from another angle. Say that the Bank of Canada has determined that it is appropriate to increase the financial privacy tax by 0.25%. Using its current toolkit, the only way it can accomplish this is by increasing the overnight rate by 0.25%. But this tightening of monetary policy could potentially send the entire economy into a tailspin, all for the sake of satisfying an entirely different policy goal, that of setting the appropriate tax on privacy.

There's no reason that the two decisions can't be split up. The tool that would allow central bankers to do this is the ability to pay positive and negative interest rates on banknotes. I talked about note serial number lotteries as one way to pay positive interest here. Later on in this post I'll discuss a way to pay negative interest. To see how these tools could successfully split the monetary policy decision from the privacy tax decision, let's return to our previous example. If the Bank of Canada were to increase the overnight rate for monetary policy purposes from 1.25% to 1.5%, but it did not want to alter the financial privacy tax, it could simultaneously increase the interest rate on banknotes from 0% to 0.25%. The original 1.25% privacy tax stays intact. While the owner of a banknote is now forgoing the 1.5% overnight rate, he or she is also collecting 0.25% in interest.  

Conversely, these tools would allow the privacy tax to be increased or lowered without requiring a potentially damaging change in monetary policy. Using our example, to increase the privacy tax from 1.25% to 1.5% per year while keeping monetary policy constant, for instance, the Bank of Canada would move the interest rate on banknotes from 0% to -0.25% while keeping the overnight rate at 1.25%. So a banknote owner is now taxed 1.5% per year, of which 1.25% is due to the forgone overnight rate while the other bit is the 0.25% negative interest rate. This has been accomplished without any tightening or loosening of monetary policy.

So there you go, the monetary policy decision has been split from the privacy tax decision. The advantage of having the ability to split up these two thought processes is that it is now possible to think long and hard about what the proper privacy tax rate should be.

------------

One question we might ask is if the current financial privacy tax on banknotes is sufficiently high. Remember, the problem we are trying to solve is that a small group of citizens are not paying their fair share of income taxes by taking advantage of the untraceability of banknotes. The 1.25%/year financial privacy tax on banknotes that is currently being imposed by the Bank of Canada may not be enough to recoup the damage that this untraceability is doing to everyone else. Maybe we need a 2% tax on banknotes, or 5%, or 10%.

Say we increased the Canadian financial privacy tax rate from 1.25% to 5%. (For now let's not be too concerned about how the tax gets levied. I'll get into that later). One unfortunate side effect is that licit users of banknotes—the unbanked and those who want financial alone time for reasons other than evading taxes and crime—would be caught up in a tax net that is intended for illicit users. This doesn't seem very fair. Might there be a finer sorting mechanism that allow us to tax crooks while letting non-crooks through?

In his controversial book on banning high-denomination notes, Ken Rogoff has proposed exactly this sort of fine sorting mechanism. Based on the assumption that criminal usage of bills is largely confined to high-denomination note, he proposes that only $100s, $50s, and maybe $20 bills be banned. We are interested in a tax in this post, of course, not a ban. But if Rogoff's assumption about criminal usage is right, then a graduated tax on banknotes might be a better option than a flat tax, with higher denominations facing a more aggressive levy than low denomination notes.

All central banks currently tax the full range of banknote denominations at the same rate. In Canada's case, the 1.25% tax rate that is currently applied to a C$1000 bill (yes, we have them in Canada, see top) comes out to the same amount incurred by one hundred $10 bills: $12.50 per year. But a $1000 note is far better for evading taxes because it contains more anonymity services per gram than a $10 note. After all, a bag full of tens is bulky and visible, an envelope with a few $1000 bills isn't.

Given the outsized anonymity provided by the $1000, perhaps we should keep the 1.25% tax rate on $10 bills but boost the tax rate on $1000s to (say) 12.5%. A tax evader who holds a $1000 bill would now incur a tax of $125 instead of just $12.50 while a regular Joe with just a few $10 bills would see no increase in banknote-related taxes. (Heck, it might even be a good idea to reduce the tax on small notes to zero.) By boosting the tax on high denomination banknotes, the Bank of Canada enjoys a larger revenue stream than before. Which means that at least some of the revenue gap due to tax evasion can now be plugged, thus fixing some of the damage inflicted on honest tax payers.

------------

How would we go about increasing the financial privacy tax on high denomination notes?

Central banks currently have a policy of maintaining perpetually fixed exchange rates between various note denominations. Your $10 bill is always convertible into ten $1 bills, and your $100 into ten $10 bills. But this needn't be the case.

To implement the tax, central banks would begin to vary the exchange rate between banknotes. Let's take the U.S. as our example. Instead of redeeming the $100 bill at par, the Federal Reserve would slowly reduce the rate at which it redeems the $100 over time. This ratcheting down of the price of $100s would be passed off to the cash-using public in the form of a capital loss, this capital loss functioning as a tax. (For those with long memories, this is basically Miles Kimball's crawling peg idea, applied to the idea of financial privacy rather than evasion of the zero lower bound).

Let's work through an actual example. Say that the Fed wants to impose an extra 5% financial privacy tax on the $100 bill, but not on other bills. It sets December 31, 2018 as the last day that it will redeem a $100 bill for either: a) $100 worth of central bank deposits; or b) $100 worth of bills in $1s, $5s, $10s, $20s, and/or $50s. On the first day of the new policy—January 1, 2019—a $100 bill can be redeemed for a tiny bit less, say $99.93. Daily reductions continue so that by the end of 2019, the Fed will have scaled its redemption rate back by 5% to $95.

This means that if you deposit a $100 banknote at your bank on December 31, 2019, your bank in turn depositing said note at the Fed, the Fed will credit the bank with just $95 in deposit balances, not $100. In anticipation of this, your bank would have only credited you with $95 when you initially deposited the note. Voila, a financial privacy tax. Everyone holding a $100 note for any period of time will have incurred an 5% annualized tax. But if you hold twenty $5 bills, the tax is avoided.

Continuing with our example, by the end of 2020 the Fed's redemption rate will have declined by another 5% to $90.25. And by the end of 2021, the $100 would be worth $85.74, and on and on.

At some point things start to get a bit silly. By 2031, the market value of the $100 will have fallen below the $50 bill, and by the the first decade of the next century it will be worth less than the $1. To prevent this inversion, the Fed will at some point—say in 2026—demonetize the old issue of $100 bills and introduce a new $100 bill, resetting its market value at $100. The whole process of steady reductions starts anew.

------------  

This post has been a heavy one, so I'll just quickly summarize it before signing off.

The anonymity provided by banknote is often abused, but rather than banning notes why not tax the abusers? We wouldn't have to start from scratch. Banknotes yield 0% when overnight rates are positive, so society is already imposing a financial privacy tax of sorts on notes. Unfortunately, central banks set the privacy tax arbitrarily, as the unplanned by-product of monetary policy. New tools for increasing /decreasing the return on banknotes could facilitate a separation of the two decision-making processes. These tools could be used to set a higher tax on large denomination notes while leaving smaller notes untaxed, the true costs of anonymity being recognized for the first time.

---

P.S. If you're interested in this topic, David Birch has a good post on Austin Houldsworth's Crime Pays System or CPS. It's sort of tongue in cheek, but also quite relevant:

"During this talk, ‘Mr Rogers’ proposed the Crime Pays System, or CPS. Under this system, digital payments would be either “light” or “dark”. The default transaction type would be light, and free to the end users. All transaction histories would be uploaded to a public space (we were of course thinking about the bitcoin blockchain here), which would allow anybody anywhere to view the transaction details. This type of transaction is designed to promote an environment of social accountability.

The alternative transaction type would be dark. With this option, advanced cryptographic techniques would make the payment completely invisible, leaving no trace of the exchange, thus anonymising all transactions. A small levy in the region of 10-20% would be paid per transaction. The ‘Dark Exchange’ would therefore offer privacy for your finances at a reasonable price.

The revenue generated from the use of this system would be taken by the government to substitute for the loss of taxes in the dark economy."

Another worthwhile source is Josh Hendrickson's recent paper "Breaking the Curse of Cash" (written along with Jaevin Park). It's a pretty technical paper, but it explores a model in which coins and paper money circulate, but coins are a burden for illegal traders to use because they make noise, leading to detection.

"If illegal traders impose an externality on society,  the government can generate seigniorage from the illegal traders by setting low rate of return on paper money and providing transfers to legal traders by setting high rate of return on coins. Then the amount of illegal trade is reduced while the amount of legal trade increases. This is a standard solution to an externality problem."

The odd relationship between gangster and central banker

In my recent post for the Sound Money Project, I touched on the odd relationship between central banker and gangster. I want to focus a bit more on this relationship.

An awkward truth of central banking is that one of the central bank's most important lines of business—the business of providing cash, specifically high denomination banknotes—primarily serves hoodlums, gangsters, tax evaders, and the mafia. Yes, non-criminals certainly make some use of high denomination banknotes, say a few notes hidden in the cookie jar in case the electricity goes down. But the largest base of users is comprised of folks who hold notes—not in cookie jars—but by the suitcase full; criminals. Banknotes are anonymous after all, so they are an excellent way for criminal organizations to make large-scale transactions without being traced.

Providing criminals with high-denomination banknotes is a lucrative line of business. For each $100 note put into circulation, a central bank holds $100 worth of interest earning assets in its vaults. Since note holders don't have the right to receive any interest, the central banks gets to keep all this interest income for itself.

For instance, by the end of 2016 the Bank of Canada had placed $80.5 billion worth of banknotes into circulation. Large denomination banknotes—the $50, $100 and $1000 notes—accounted for $58.4 billion of this, or around 72% of all banknotes. The assets standing behind all outstanding banknotes allowed the Bank of Canada to earn $1.53 billion in interest in 2016. Of this amount, around $1.1 billion (72% of $1.53 billion) can be attributed to high denomination banknotes, the majority of which comes courtesy of the largest holders of high denomination notes: gangsters.

So you can begin to see why the Bank of Canada might not want to get out of the business of producing $50, $100, and $1000 notes. $1.1 billion is a lot of profit! Of course, were the Bank to get out of producing high denomination notes altogether, it wouldn't forgo the entire $1.1 billion in yearly income. Criminals might choose to use $10 and $20 notes in the place of the demonetized high denomination notes. However, $10s and $20s are a bulky way to store value. They surely wouldn't be capable of recapturing all of the criminal wealth formerly held in the form of $50, $100, and $1000 notes. Which means that the total amount of banknotes outstanding would fall and Bank of Canada profits would shrink.

Why might central bankers care about their profits? As I wrote here, any government bureaucrat who can provide their master with an ongoing revenue stream will always have more say in their department's fate than a bureaucrat who has to ask for funding each year. And of all government bureaucrats, none is more jealous of their independence than the central banker. The process of ratcheting the interest rate lever higher or lower requires a complete absence of political meddling, so say central bankers. One might imagine that this autonomy is worth so much to central bankers that it justifies taking on a clientele dominated by gangsters.

There is a better reason for why it might be in the public interest for central bankers to continue serving criminals with high denomination banknotes. Consider the fact that if high denomination notes were to be rescinded, criminals would simply use other forms of payment in their place. If the substitute payments medium that criminals select places a new and extremely onerous set of burdens on society, then maybe the public provision of high denomination notes should not be discontinued.

What alternative payments media might criminals use in the place of $100 and $50 notes? In his screed against high denomination banknotes, Ken Rogoff suggests that gold, uncut diamonds, and bitcoin might become popular as a criminal payments media. The fact that these instruments are cumbersome relative to cash would make criminals easier to catch, and Rogoff claims that the crime rate might even drop.

In a provocative article, James McAndrews counters that rather than turning to commodities, criminals will instead select private debts as their preferred payments medium. A thief who sells stolen goods to a fence would accept some sort of IOU as payment rather than cash or diamonds. This IOU wouldn't be anonymous. Like any debt, the debtor and creditor would be a matter of record. But as long as the system of debts is secret—i.e. only criminal participants can see the record—then the users can't be tracked by the authorities, like cash.

When an IOU defaults, the traditional legal system provides a means for sorting things out. But this system would be out of bounds to criminals trafficking in IOUs. What is required is some sort of underground administrator or third-party to act as arbiter. According to McAndrews, the party that is likely to emerge as enforcer of criminal debts is organized crime: the mafia. 

In addition to enforcing IOUs, the mafia would also be in a position to fabricate new IOUs for use in the criminal monetary system. McAndrews uses the example of inflated invoices. The mafia would coerce legitimate businesses into writing IOUs, or invoices, for goods they never bought, or bought  at inflated prices. These invoices would circulate among criminals as money. To assure that the police ignored their extortion of legitimate business, the mafia would resort to stepped up bribery of the police.

All of this changes the calculus of a central bank withdrawal from the business of providing criminals with banknotes. Sure, a demonetization of high denomination notes might lead some gangsters to go legit because the lack of $100 and $50 notes makes their business too expensive to operate. But a whole new range of crimes could emerge. Violence could grow as the mafia executes defaulters in order to maintain the sanctity of the new IOU payments system that has taken the place of high denomination banknotes. Legitimate businesses could get blackmailed into feeding the criminal monetary system, those run by immigrants likely being the most vulnerable. And police departments will be corrupted.

McAndrews uses the public provision of free condoms and clean needles as an analogy. Restrict free condoms and it is possible that the rate of sexual intercourse goes down. But surely there will be an increase in unsafe sex, unplanned pregnancy, and sexually transmitted diseases. As for the provision of clean needles, restrict it and heroin use might fall. However, the prevalence of HIV will rise. Both unsafe sex and dirty needle usage impose costs not only on those directly afflicted but also indirectly on us—i.e. taxpayers who pay increased health care expenditures.

Likewise with cash. A restriction of $50 and $100 notes could very well lead to attrition in the ranks of existing criminals, as Ken Rogoff reasons. However, this could be twinned with an increase in mafia activity and the potential subordination of us—i.e. legitimate business—to the needs of the underground payments system. Keeping high value banknotes may thus be the wise decision, in the same way that choosing to keep free condom and clean needle programs going makes everyone's lives better off.

Demonetization by serial number

This continues a series of posts (1, 2, 3) I've been writing that tries to improve on Indian PM Narendra Modi's clumsy demonetization, or what I prefer to call a policy of surprise note swaps.

The main goal of Modi's demonetization (i.e. note swapping) is to attack holdings of so-called "black money," or unaccounted cash. The problem here is that to have a genuine long-run effect on the behavior of illicit cash users, a policy of demonetization needs to be more than a one-off game. It needs to be a repeatable one. A credible threat of a repeat swap a few months down the road ensures that stocks of licit money don't get rebuilt after the most recent swap. If that threat isn't credible, then people will simply go back to old patterns of cash usage.

It's worth pointing out that the idea of behind demonetization precedes Modi by many decades. In a 1976 article entitled Calling in the Big Bills and a 1980 a follow-up How to Make the Mob Miserable, James S. Henry, who is on Twitter, described what he called "surprise currency recalls."

In 1976, @submergingmkt wrote the original call for an aggressive demonetization: https://t.co/tDro2hnvAZ Does he approve of Modi's effort? pic.twitter.com/wM2EzLjkWB

— JP Koning (@jp_koning) January 10, 2017

Specifically, Henry advocated a sudden cancellation and reissuance of all US$50 and $100 notes as a way to hurt "tax cheats, Mafiosi, and other pillars of the criminal community." Rather than a one-shot action, which would only annoy criminals, the idea was that "the recalls could be repeated, at random, every few years or so, raising the 'transaction costs' of doing illegal business."

In order to credibly threaten a series of repeat note swaps, I'd argue that the quantity of notes recalled in each demonetization must be small. Small batches of notes can be quickly cancelled and replaced without disturbing people's lives. This keeps the economic and political costs of withdrawing demonetized cash (lineups, cash shortages, etc) manageable. If these costs are too high, the threat of repeats isn't credible.

Instead of going small, Narendra Modi decided to go big by having the Reserve Bank of India demonetize both of India's highest value banknotes, the ₹500 and ₹1000 note, which together comprised some 86% of India's cash. This has caused all sorts of problems. For instance, almost four months after the November 8 announcement the amount of cash in circulation is still far below the required levels of ₹17-19 trillion, the RBI unable to run its printing presses fast enough to keep up. The RBI's inability to fill the vacuum left by demonetized notes has been ably explained by James Wilson and is illustrated in the chart below:

Because of the enormous disruption it has caused, Modi's massive demonetization departs from Henry's script—it cannot be repeated, not for decades (a point that Russell A. Green makes here as well). Were Modi to begin discussing another demonetization, say for 2018, Indians would probably rise up in anger at the possibility of more lineups, empty ATMs, and hurdles to making basic purchases. Which means that post-Modi demonetization, it's entirely safe for India's illicit users of cash to wade back into the waters. If cash usage patterns return to normal, it seems to me that the entire demonetization project was an exercise in futility.

In India's case, demonetizing entire note denominations is too powerful a tool to ensure repeatability. Even if Modi had demonetized the ₹1000 note and not the ₹500, for instance, the exercise would still have involved some 30-40% of the nation's cash supply. This would have been an arduous affair for all involved, certainly not one that could be repeated for many years.

Weeding out rupee banknotes according to serial number rather than denomination would have allowed for a more refined policy along the lines advocated by Henry. Here's how it would work. The government begins by declaring that all ₹1000 notes ending with the number 9 are henceforth illegal. Anyone owning an offending note can bring it to a bank to be swapped for a legitimate ₹1000 note (one that doesn't end in 9). However, the government sets a limit on the number of demonetized notes that can be exchanged directly for legitimate notes, say no more than three. Anything above that can only be exchanged in person at a bank teller for deposits, which requires that they have an account (i.e. their anonymity will be lifted). Once an individual has deposited five notes in their account, all subsequent deposits of demonetized notes would require a good explanation for the notes' provenance. Should the requisite paper trail be missing, the depositor gives up the entire amount.

The process begins anew a few months hence, the specific timing and banknote target being randomly chosen. So maybe thirteen months after the first swap, the government demonetizes all ₹500 notes ending in 6. Randomness prevents people from anticipating the move and hiding their illicit wealth in a different high denomination note. 

Too understand how this affects black money owners, consider someone who owns a large quantity of illicit ₹1000 banknotes, say ₹70 million (US$1 million, or 70,000 banknotes). This person faces the threat of losing 10% to the note swap. After all, when the 9s are called, odds are that he or she will have around 7,000 of them, of which only eight can be returned without requiring a paper trail. The owner can simply accept a continuing string of 10% losses each year as a cost of doing business.

Alternatively, they might protect themselves ahead of time by converting their hoard into a competing store of value, say gold, bitcoin or low denomination rupee notes like ₹100s (which are not subject to the policy of ongoing swaps). If they flee high denomination notes to avoid subsequent demonetizations, illicit cash users in a worse position than before the adoption of the policy of note swapping. Gold and small denomination notes have far higher storage and handling costs than ₹1000 banknote. And unlike gold and bitcoin, a banknote is both supremely liquid and stable. So even if large-scale owners of banknotes manage to avoid painful note swaps, they still endure higher costs.

As for licit users of high denomination notes, the fact that the 10% clawback would not apply to them means they needn't change their behavior. Nor would the poor--who are unlikely to be able to provide a paper trail--have to worry about the policy. Demonetizations would only occur in high denominations, in India's case ₹500 and 1000s, and the poor are less likely to own these in quantities above the three note limit.

Incidentally, readers may recognize a policy of repeat demonetizations as akin to a Gesell stamp tax, named after Silvio Gesell, who in 1916 proposed the idea of taxing currency holdings in order to increase the velocity of circulation. Greg Mankiw famously updated Gesell's idea during the 2008 credit crisis to remove the zero lower bound. He did so by using serial numbers as the device for imposing a negative return rather than stamps. This post updates Mankiw's idea, except rather than applying the tax to all cash it strikes only at illicit cash holdings, and does so in the name of an entirely different policy goal—attacking the underground economy, not removal of the zero lower bound.

A series of small serial number-based swaps seems like a better policy than Modi's ham-handed demonetization of all ₹1000 and ₹500s. It would certainly do a better job of promoting a long-term decline in undocumented cash holdings and would do so by imposing a much smaller blast radius on the Indian public. There would be no currency shortages, huge lineups at banks, empty ATMs, or trades going unconsummated due to lack of paper money.

 That being said, while superior to Modi's shock & awe approach, a policy of repeat note swaps certainly has its flaws. In principle, the idea of surprising citizens every few months—i.e. forcing them to keep on guessing—does not seem entirely consistent with the rule of law. Another problem is that once the policy has been ongoing for several years, the list of demonetized serial numbers will be quite long. The process of buying stuff with notes will become evermore difficult given the necessity that the merchant consult this list prior to each deal to ensure that bad notes aren't being fobbed off. Finally, commenting recently on Henry's plan, Ken Rogoff notes that "there is a fine line between a snap currency exchange and a debt default, especially for a highly developed economy in peacetime." Since debt defaults hurt a countries credit standing, serial demonetizations might lead the investment community to be more leery about the nation's other liabilities, say its bonds.

A 21st century U.S. trade dollar

"America's only unwanted, unhonoured coin." 

- John Willem on the silver trade dollar.

The inspiration for this post comes from the old trade dollar, a U.S. silver coin that was minted in the 1870s and 1880s for the sole purpose of circulating in China. Taking the trade dollar as a model, I'm going to discuss the idea of converting the U.S. $100 bill into a trade bill; i.e. to limit it to foreign and not domestic usage.

Why bother modifying the $100 in this way? While not entirely convinced, I do lean towards Ken Rogoff's idea of getting rid of high denomination banknotes like the Canadian $100, the Swiss 1000 franc, and the Europe's €500. These bills are used primarily by criminals and tax evaders; their removal will make these activities more costly. The public's licit demand for a private means of payment can be met by low denomination notes, as can the necessity for a convenient physical payments medium on the part of the unbanked.

But as I wrote here, the Federal Reserve's $100 is categorically different from the above banknotes. The dollar plays a special role as the world's backup medium of exchange and unit of account. Abolish the $100 and not only will those dollarized countries already using U.S. banknotes (many of them poor) be hurt, but so will the desperate citizens of foreign countries who might try to flee to the dollar in the future due to the awful monetary policies of their leaders, usually dictators.*

By converting the $100 into a trade bill, everyone can have their cake and eat it too. Like the old silver trade dollar, the $100 trade bill will be barred from playing a role in the U.S. economy, thus doing damage to the domestic underground economy. But it will be free to be used in places like Venezuela which, thanks to misgovernance, are in urgent need of a better monetary standard.

To help determine the structure of a modern $100 trade bill, let's explore the design of the 19th century silver trade dollar. China had a long history of using silver as money, and as trade with the west grew the Spanish silver dollar—minted in Mexico—had become quite popular with Chinese merchants. U.S. traders were penalized as they had to acquire Mexican dollars at a premium to the coin's intrinsic silver value in order to do business with China. Enter the trade dollar. The idea was to introduce a U.S. equivalent to the Mexican dollar in order to help out U.S. merchants, who would no longer have to pay a premium. The trade dollar would also provide domestic silver producers, an important political constituency, with an outlet for their production.

While U.S. legislators liked the idea of having U.S. silver coins circulate overseas, they did not want the trade dollar to be used in the U.S. After all, the U.S. was in the midst of giving up the old bimetallic standard (silver and gold) in favour of a gold standard, and a new silver coin might interfere with this process.

Thus, we arrive at the Coinage Act of 1873, which simultaneously took the U.S. off of silver (by ending the free coinage of silver) while also introducing the trade dollar. To ensure that the trade dollar would not be "made a part of or be in any way confounded with our monetary system," its legal tender status was limited to $5 i.e. no domestic debt could be extinguished with more than $5 in trade dollars (for a review of legal tender, go here). To further hurt its domestic usefulness, this legal tender status would be completely revoked in 1876.

While the trade dollar was well-received in China (most of them were chopped), it wasn't entirely successful in staying out of domestic U.S. circulation. According to Garnett, of the $35.9 million in trade dollars coined, $29.4 million were exported. Of this amount, $2.1 million returned to the U.S., joining the $6.6 million that had never left the country.

It's important to understand why trade dollars sometimes stayed in the U.S.—after all, the idea of a trade bill simply won't work if $100 notes continue circulating in the U.S. There seems to be two reasons for this. From 1873 until 1876, trade coins still had a limited value as legal tender. At first, this wasn't an issue. Since the intrinsic value of the coins' silver content exceeded their official legal tender value, it made little sense for Americans to use them to settle local debts—debtors would be effectively overpaying if they did so. However, as silver prices fell through the 1870s the official legal tender value of trade dollars began to exceed their intrinsic value, at which point it was profitable for debtors to pay off their bills in overvalued silver trade dollars. This would have diverted trade dollars from China in order to meet local demand.

Secondly, speculators began to buy trade dollars in China and bring them back home on the expectation that the U.S. government would eventually redeem them at their original value of $1, even as they traded at around 80 cents on the dollar. This belief was eventually realized in 1887 when Congress compelled the government to redeem all trade dollars at par.

So with these design flaws in mind, let's design our $100 trade bill. To begin with, on January 1, 2017 the U.S. government will announce  its intention to rescind the legal tender status of $100 bills. That means the $100 can no longer be used by a debtor to discharge any U.S. debt. Legal tender status must be entirely rescinded to avoid the mistakes of the trade dollar.

Next, the Federal Reserve announces that after a certain date (say January 1, 2019), all domestic deposits and withdrawals of $100 notes will be illegal. Until then, the public enjoys a two-year window for bringing bills into banks or Federal Reserve branches for conversion into $20 bills or deposits. To prevent local hoarding of $100 bills, the domestic closure of the "$100 window" must be perceived to be permanent. Remember that trade dollar inconvertibility was perceived to be temporary, thus encouraging domestic demand. Likewise, if they anticipate a re-opening of the "$100 window," Americans will simply keep their $100s at home.

Banning local redemption will likely force all local retailers, wholesalers, and other businesses to stop accepting $100 bills. A retailer like Walmart that receives a $100 bill during the course of business will have to ship it overseas to be spent or deposited, and that would be quite expensive. Likewise, licit person-to-person exchanges of $100s will be crimped. Lacking domestic acceptance by banks and retailers, the $100 will have no liquidity, and regular people will no longer be willing to accept them.

For these same reasons, illicit domestic usage of $100s will suffer. Since no legitimate businesses will accept them, criminals won't be able to spend $100 notes into the local economy. To launder $100 bills, it will now be necessary to send them overseas for deposit into foreign banks. This will impose significant handling costs on money launderers, especially if the government institutes laws that limit large cash exports. These handling costs will  probably be high enough to force domestic illegal currency users to migrate to $20 bills as their preferred medium.

While domestic usage of $100s will rapidly decline, foreign-based banks will be completely free to allow deposits and withdrawals of $100 banknotes, much as they do now. To get $100 notes shipped from the U.S., foreign banks will have to put in orders with a Federal Reserve bank (they tend to prefer the New York Fed's cash office and, in the West, the San Francisco Fed's Los Angeles cash office). To redeposit $100 bills, they will have to send them by plane back to New York.

This setup should be sufficient to flush most $100 bills out of domestic circulation, forcing U.S.-based criminals and tax evaders to fall back on less convenient $20s. And just as the trade dollar successfully met Chinese demand for silver money, the $100 trade bill will meet Panamanian, Zimbabwean, and other foreign demand for U.S. high denomination cash.

---

*Rogoff believes that a policy of removing high denomination notes should only be enacted by developed nations. But since so many undeveloped nations use the dollar, Rogoff is being inconsistent in calling for an end to the $100.

To read more about U.S. trade dollars, here are some good sources:
A Trade Dollar Song and Chorus, 1883 (link)
Collecting Trade Dollars (link)
The History of the Trade Dollar (link)

The British (link), Japanese (link), and French (link) also issued trade dollars

Milton Friedman wrote an excellent account of the switch from bimetallism to the gold standard (pdf).

Aggressive demonetizations

Prime Minister Narendra Modi surprised Indians today by announcing that India's highest denomination notes, the 500 and 1000 rupee, will cease to be legal tender. On first blush, India seems to be enacting Ken Rogoff's idea of cutting down on criminality and tax evasion by phasing out high-denomination notes, which I recently discussed here.

But this isn't the case. Rather than removing the Rs. 500, the Reserve Bank of India is replacing it with a new bill. Furthermore, it will also be issuing a Rs. 2000 note, a new highest denomination note. What India is doing is enacting what I'll call an aggressive demonetization. I'd argue that this is an alternative (though not mutually exclusive) idea to Rogoff's. Both schemes are intended to create a logistical nightmare for money launderers; but whereas Rogoff's entails altering the denomination structure of banknotes to get this effect, Modi's aggressive demonetization keeps that structure intact while using note redemption and re-issuance as its lever.

Demonetizations are usually non-aggressive drawn-out affairs. For instance, when Canada announced that it would withdraw its $1000 note, it gave Canadians an eternal window to bring them in for redemption. The $1000 remains legal tender in Canada, meaning that it can be used to discharge any debt. As another example, take the euro. The introduction of the euro meant an end to all the national European currencies. While each of these currencies lost legal tender status in 2002, many enjoy an unlimited time frame for conversion into euros, including the Deutsche mark and Belgian franc. See below:

India's demonetization is an aggressive one because legal tender status is to be removed immediately and the time limit for redemption is incredibly tight and scripted. Here is Modi's announcement:

All details on the announcements made today can be found here. https://t.co/UoiCjCyupV #IndiaFightsCorruption pic.twitter.com/WKpgsdTcjg

— Narendra Modi (@narendramodi) November 8, 2016

To summarize, Indians have just a few weeks to exchange old notes for new ones at banks or post offices. Proof of ID is required and switches are limited to Rs 4000, around US$60. There is no size limit for directly depositing old notes in bank of post office accounts. But of course, this means that the depositor's identity will be known by the bank and transactions will be traceable. Deposits can be made at banks until the end of the year. After that date, the central bank will exchange old notes until March 31, 2017, although this will require some sort of declaration of origin.

The point of all this is to suss out anyone with large amounts of cash that has been earned from dubious sources. Say you've got one million paper rupees, worth around US$15,000. If you've got the receipts to show why you have that much cash, then you can safely bring it to the bank. But if you don't, you'll have to get rid of it as quick as you can by spending it, say on gold (or any other good). However, this will be an incredibly difficult task given the fact that there will be many other Indians trying to spend their undocumented Rs. 1000 and Rs. 500 notes on gold at that very same time, and only a limited number of gold dealers willing to accept them. After all, any gold dealer who accepts notes now inherits the same problem: what to do with newly-demonetized banknotes. Any gold dealer who starts to bring in larger-than-normal amounts of paper money to their bank for redemption will surely face questions. To compensate for this risk, gold dealers will either impose a large penalty on cash payments or they'll stop accepting cash altogether.

Some undocumented rupees will no doubt be successful in evading Modi's aggressive demonetization, but large quantities will be left stranded. Significant damage will have been dealt to anyone working in the underground economy.

As Tony Yates points out, the most aggressive demonetization in history was probably Saddam Hussein's recall of the Swiss dinar in 1993. Swiss dinars were Iraqi banknotes printed on high quality paper whereas dinars printed after the 1992 U.S. invasion were issued on shoddy and easily counterfeitable material. On May 5, Saddam announced that all Swiss dinars had to be turned into the central bank for an equivalent amount of post-war currency over a tiny six day exchange period. He then proceeded to close the border, preventing Kurds and other foreigners from making the switch. Huge amounts of currency was left stranded, although unlike the Indian situation it was foreigners, not criminals/tax evaders, who were the target. (I went into the Iraq story here. The Burmese kyat and North Korean won demonetizations of 1985 and 1999 were also quite awful, see here.)

If you think Modi's strategy is new, or confined to developing nations, think again. A few years ago, Sweden carried out out a (somewhat less) aggressive demonetization in order to catch illicit cash users. In 2012, the Riksbank announced that all  1000 krona banknotes without foil strips were to be declared invalid by the end of 2013 (each 1000 krona note is worth around $110). Until December 31, 2013, Swedes were permitted to get rid of 1000 krona notes by either using them to buy stuff or depositing them at a bank. To tighten the noose, no anonymous conversions of old notes into existing notes were permitted. Swedes had to have bank accounts, and therefore had to forgo their anonymity, in order to rid themselves of old currency.

Anyone who's seen Breaking Bad knows that laundering money takes time and patience. A Swedish criminal with ten million dollars worth of high denomination krona was suddenly faced with a significant problem; how to get this stash back into the legitimate economy within 400 or so days.

How tough was this challenge? We know that at the start of 2013 there were fourteen million 1,000 krona notes in circulation (worth 14 billion SEK, or US$1.6 billion). After the expiry date, the Riksbank noted that there were still some three million 1,000 krona notes that had not been redeemed, worth around $330 million. This gives a rough indication of the value of banknotes left stranded by criminals and tax evaders, around 25% of all notes outstanding.

After the December 31, 2013 deadline, the Riksbank itself offered to redeem invalid banknotes (it still does), albeit for a 100 krona fee. However, criminal and tax evaders have no doubt steered clear of this offer as the declaration form includes the following question:

Sweden is the only country in the world in which cash holdings are in decline. Might this have had something to do with the damage inflicted by the Riksbank's 2013 demonetization on the psyche of participants in the underground economy?

So let's compare the advantages of Modi's aggressive demonetization to Rogoff's abolition of high denomination notes. If an aggressive demonetization is chosen, then a central bank gets to enjoy high profits, or seigniorage, since it continues to issue an extended range of banknotes, unlike Rogoff's abolition. The more float, or 0% cash liabilities that remain outstanding, the more interest the central bank will earn on its bond portfolio. The central bank also earns significant earnings from 'breakage.' All illegitimate banknotes that never get redeemed are recognized as a one-time unusual gain on the central bank's statement of income. Finally, people engaging in legal activities who enjoy the anonymity afforded by high denomination notes still get to use them; they don't under Rogoff's abolition.

Unfortunately, an aggressive demonetization can only be effective for a little while. It's hard to see why people won't quickly re-adopt the highest denomination note as a medium for evading taxes and engaging in illicit activity. In response, the central bank will have to enact an followup demonetizations every few years, but of course the underground economy will do its best to anticipate these by moving into low-denomination notes or foreign paper whenever it suspects something is afoot.

To create a logistical nightmare for money launderers, maybe Peter Garber's idea beats Rogoff's abolition and Modi's demonetization?:

"Why not simply increase the physical dimensions of high-denomination notes without jumping through the flaming hoop of elimination? Before 1929, U.S. currency was 40 percent physically larger than it is now. Restoring that size or making it even larger would instantly work the wonders of decades of inflation. The iron law for subverting illicit economies: a percentage increase in physical note size is equivalent to the same percentage increase in the price level."

Thoughts on Rogoff's 'Curse of Cash'

The US$5000 banknote, destroyed in 1969 along with the $10,000, $1000, and $500 notes

With the publication of his new book The Curse of Cash, economist Ken Rogoff has ignited a big debate over the future of paper money. Both the book, which is packed with information and accessible to a mainstream audience, and Rogoff's series of blog posts are well worth reading, even if you already disagree with his premise that the way the world currently handles cash needs to be modified.

The key observation motivating Rogoff's book is this one: with $1.3 trillion worth of U.S. currency in existence, a back-of-the-envelope calculation says that the average four person family should be holding around $16,800 in cash. However, this simply doesn't reflect the personal experience of most Americans. Indeed, 2012 survey data shows that consumers generally report holding just $56 per person, leaving the majority of cash unaccounted for. Nor is this anomaly confined to the U.S. Given $78 billion in Canadian currency outstanding, a four person family in Canada should hold around $6,000. Instead, survey data shows the average person only holds a median $38 in their wallets. The same pattern occurs in Europe, Japan, Australia, and elsewhere.

According to Rogoff, much of the unaccounted cash is being held by those who participate in the underground economy, both by those engaged in criminal activity and those employed in legal activity (dentists, contractors, retailers, etc) who use cash as a way to avoid taxes. Rogoff's premise is that if we can alter the institution of cash, then maybe we can flush some of these people out of the underground economy and back into the legal, tax-paying economy.

The denomination structure of cash

Having read through many of the criticisms that Rogoff has received over the last few months, I've noticed that there is a tendency on the part of his opponents to frame this debate as an either/or one. Either keep cash and the personal liberty it provides—anonymity and uncensored access to the payments system—or sacrifice cash and in the process throw out that liberty.

This mischaracterizes the debate. Rogoff isn't advocating an end to cash or the liberties that go with it. Rather, he wants a modification of the existing denomination structure of banknotes such that the $100, $50, and $20 are removed while the $1, $2, $5 and $10 are left in circulation. Over the long-term, he proposes replacing these small bills with heavy coins. The set of personal liberties afforded by cash will be allowed to live on, albeit through the reduced convenience of small banknotes like the $10.

The term denomination structure refers to the top and bottom-most denominations issued by the monetary authority, the spacing between denominations, and the point at which the transition between coins to notes begins. As per Tyler Cowen's second law ("There is a literature on everything"), academics have been writing on the topic of optimal denomination structure for a few decades. The goal of this literature is to find the range and spacing of notes/coins that reduces the amount of monetary work that all participants in a currency system must engage in. By monetary work, I mean the effort that goes into printing money, carrying it, storing it, counting it, making calculations with it, paying with it, and breaking it into smaller amounts. If a denomination structure can be found that allows everyone do a little bit less work, society is much better off.

Rogoff takes the opposite approach. His abolition of large denomination banknotes is designed to increase rather than reduce the amount of monetary work that users of cash must engage in. After all, ten thousand dollars worth of Rogoff's preferred highest value note—the $10 bill—requires far more effort to count, store, and lug around than a hundred $100 bills.

Rogoff believes that the increase in monetary work brought about by a reduction in the purchasing power of the highest value note can be a useful filtering mechanism for improving societal welfare. Assume that there are "bad" and "good" users of cash, the former being criminals and tax evaders and the latter being regular people who want to enjoy the speed, anonymity, and convenience of paper money. "Good" cash users only need small quantities of notes from time to time and therefore will only be slightly inconvenienced by the increase in monetary work caused by a constriction in the purchasing power of the highest denomination note. "Bad" users tend to make regular use of large amounts of cash, and will therefore be severely affected by a constriction.

While Rogoff's abolition won't stop crime or tax evasion, it will surely make these activities trickier. This should in turn push activity out of the non-taxed underground economy into the legal economy.

Burdening cash is the status quo policy  

These ideas aren't entirely novel. In fact, I'd argue that since the 1800s, the U.S. has been implicitly adopting Rogoff's strategy of increasing the amount of monetary work involved in using cash. The chart below illustrates both the nominal and real value (in 2015 dollars) of the U.S.'s highest denomination banknote going back to 1871.

In general, the purchasing power of the highest denomination note has been gradually declining. This has been mostly due to the fact that even as inflation erodes the dollar's value, American monetary authorities have chosen to avoid introducing new higher value notes. Nor is the U.S. unique in this respect. Correct me if I'm wrong, but I can't think of a single developed nation that has introduced a higher denomination note over the last fifty years.

In the U.S.'s case, the decline in the purchasing power of the highest denomination note hasn't been entirely due to the combination of inflation and a lack of new large value U.S. notes. Take a look at what happened in 1969. Throughout the 19th century the U.S. Treasury was an issuer of $10,000 certificates, a practice the Federal Reserve would continue after its founding in 1913. However, on July 14, 1969 the Fed announced that it would put an end to this tradition by destroying all $10,000, $5000, $1000, and $500 denominations, leaving the $100 as the U.S.'s largest denomination. It did so on the very same day that Richard Nixon launched his famous war on drugs. Although the Fed claimed that its decision was motivated by the declining usage of large value banknotes over the previous two decades (PDF pg 624), the timing indicates that Nixon's crime push must have been a big reason.

So largely through a policy of benign neglect (i.e. by passively allowing inflation to eat away at its purchasing power), the U.S. along with most developed nations have been gradually increasing the workload involved in using the highest value note. Assuming inflation of 2%, by 2095 or so the US$100 will buy as much as the $20 does today. By 2130, it will buy as much as the $10 does today.

Rogoff isn't content with the gradual approach to increasing monetary work. He wants to add a one-time increase in the level of monetary work involved in using cash. This would involve a quick Nixon-style "tightening" of the filter, removing in one fell swoop all denominations above the $10 bill. Put differently, rather than waiting till 2130 for the $100 bill to be worth $10, he wants this event to happen now. Once a Rogoff-style high denomination notes abolition has been carried out, inflation will once again determine the rate of increase in the monetary work involved in cash usage.

So ultimately, the great cash debate isn't about cash vs. cashlessness. For decades developed nations have been gradually increasing the burden of using banknotes. Should we stick with the status quo or speed things up a little?

The case of Sweden

Rogoff makes one mistake in his book. As many people may know, Sweden is the only nation in which cash usage is in decline, a precedent Rogoff wants other nations to emulate. Several times in his book, Rogoff mentions that the Swedes have removed their highest denomination note, the 1,000 kronor, and that this removal helps to explain the nation's dramatic drop in cash usage. But this isn't the case. All that the Riksbank did was replace the old 1,000 kroner note in 2013 (which had Gustav Vasa on it) with a new Dag Hammarskjöld version. The 1,000 is still alive and kicking.

This puts Rogoff in a somewhat uncomfortable position. Some other policy than the one he prefers is at work in the very country he puts forth as an example for all to follow. I think I might know what this policy is. As discussed in this excellent post by Martin Enlund, the Swedes implemented a tax deduction in 2007 for the purchase of household-related services such as the hiring of gardeners, nannies, cooks, and cleaners. This initial deduction, called RUT-avdrag, was extended in 2008 to include labour costs for repairing and expanding homes and apartments, this second deduction called ROT-avdrag.

Enlund's chart shows how the decline in krona outstanding closely coincides with the timing of the introduction of RUT and ROT:

Prior to the enactment of the RUT and ROT deductions, a large share of Swedish home-related purchases would have been conducted in cash in order to avoid taxes, but with households anxious to claim their tax credits, many of these transactions would have been pulled into the open. Note the rise in RUT and ROT payments on Enlund's chart, for instance. Calleman reports that  the number of customers using registered domestic service companies rose from 92,000 in 2008 to 537,600 in 2013. Since the implementation of RUT and ROT, Swedish opinions on paying for undeclared work have changed dramatically. In 2006, 17% said it was completely wrong to to hire undeclared labour. In 2012, 47% felt it was completely wrong.

Using data from a survey of the general public conducted by the Swedish tax authority, the charts below show how much knowledge Swedes have about those around them engaged in tax evasion. In the bottom chart, the number of Swedes who are aware of businesses that are evading taxes has fallen from 27% in 2007 to just 9% in 2013. That is an especially large and fast decline. As the tax authority points out, RUT and ROT is the likely explanation.

Rogoff himself maintains in The Curse of Cash that the largest holdings of cash in the underground economy are due not to criminals but those engaged in legal work (like contractors) who are avoiding taxes. By cutting down dramatically on tax evasion among those engaged in household services and repairs, the RUT and ROT deductions may explain a significant chunk of the decline in Swedish currency in circulation.

This post has gone long enough, so let me get to my final point. I agree with Rogoff's general point that it makes sense to burden cash users with ever more work since this burden disproportionately falls on heavy users like criminals. But Rogoff hasn't yet convinced me that the status quo policy of gradually increasing the workload involved in cash usage (via inflation) needs to be sped up by a sudden removal of every bill above the $10. After all, the Swedes are setting an example of how a policy of gradualism can be twinned with tax policy in order to get some of the very effects that Rogoff advocates, namely pulling people out of the underground economy into the legal economy.

Is the Swede's approach better than Rogoff's high denomination note abolition? I'm not sure, I don't know enough about the economics of tax policy to arrive at a firm conclusion. But it seems to me that a more complete analysis of the real reasons for Sweden's cash miracle needs to be conducted before we go about killing the $20, $50, and $100.

How anonymous is cash?

Dutch 10 guilder note. Holland and Lebanon are the only countries to have issued banknotes with bar codes.

One of the interesting things that we've all learnt about Bitcoin is that it isn't actually anonymous, it's pseudo-anonymous. While anyone can deal in bitcoins without providing personal information like a phone number or photo ID, all bitcoin transactions are broadcast to the public. By analyzing these transaction patterns, it may be possible to flush a user's true identity out into the open.

Bitcoin is an attempt to digitally replicate many of the features of the old fashioned banknote, but even banknotes are to some degree pseudo-anonymous. Each banknote has a unique serial number on it. By tracking serial numbers, it may be possible to connect a note to a noteholder and thereby destroy their anonymity. The process of unveiling note users occurs most often in kidnapping cases. When their young son was kidnapped in 1932, the Lindbergh family paid a $50,000 ransom in non-sequential banknotes. In an effort to identify the kidnapper, a list of the serial numbers of notes used to pay the ransom was published in the New York Times and circulated in pamphlet form to banks all over the New York area. Anyone who found the note was to immediately alert the authorities, this information being potentially useful in helping to triangulate the guilty party:

Published list of banknotes the Lindbergh's used to pay the ransom

Kidnappers prefer to be payed in non-sequential numbered bills. The Lindbergh kidnapper is no exception, writing in one of several ransom notes: "Don't mark any bills or take them from one serial nomer [sic]." The reason for this is that it's easy for a bank teller to cross reference incoming notes against a list that contains an easy-to-remember range of sequential numbers. When serial numbers are randomized, the list becomes much harder for the human eye to parse; just try to work through the above example. The non-sequential nature of the ransom payment probably explains why only a few of the Lindbergh blacklisted notes were found...

...at least at first. The final pinpointing of the Lindbergh kidnapper really only became possible when Franklin D. Roosevelt decided to temporarily take the U.S. off the gold standard in 1933. Somewhat serendipitously, the authorities who were helping the Lindbergh family had decided to pay the 1932 ransom in gold certificates, a Treasury-issued instrument that was redeemable in a fixed quantity of gold. At the time, gold certificates circulated along with a motley crew of other private and government-issued note types including Federal Reserve notes, U.S. Notes, Federal Reserve Bank Notes, silver certificates, and National Bank Notes (see here).

As part of the process of going off the gold standard, Roosevelt issued Executive Order 6102 requiring all Americans to bring in their gold, gold coins, and gold certificates to be exchanged for Federal Reserve notes. The Lindbergh kidnapper would only tender a few of his gold certificates in 1933, perhaps worrying that bringing in all $50,000 at once would attract attention.

Subsequent to Roosevelt's Executive Order, gold hoarding became an illegal act. So when the kidnapper bought gas with a $10 gold certificate in September 1934, the gas station attendant—probably worried that he might not be able to deposit it—wrote the license plate of the car on the note. Three days later the station managed to deposit the note at its bank where it was successfully cross-referenced against the black list, a much easier process now that the population of gold certificates was so small. Bruno Richard Hauptmann, the kidnapper, had been unveiled.

Using serial numbers to unveil identity requires the cooperation of private banks as well as some luck, in the Lindbergh's case the coincidental alteration of the monetary standard. However, there is no reason that central banks themselves can't be aggressive in monitoring serial numbers. In 1973 the Dutch central bank, the De Nederlandsche Bank (DNB), set up the first real-time database of banknotes in circulation. All banknote serial numbers are registered in the database. As used banknotes are brought into DNB processing points each day, machines read their serial numbers and update the database to indicate that these notes are no longer in circulation. When these same notes are paid out to banks the next day, the system once again updates its database to indicate that they have re-entered circulation. Over time, the system gleans information about the paths taken by each individual note, including how long it stays in circulation and its geographical exit point. It also provides excellent protection against counterfeits. If the DNB detects two banknotes entering its system with identical serial numbers on the same day, then one of them is by definition a fake.

While many central banks were "intrigued" by the Dutch registration system none of them actually implemented the concept (see page 263 of pdf). As of 2012, the DNB  remains the only central bank to register banknotes on a daily basis, a fact which I find kind of shocking. Why have serial numbers if not for tracking? Decoration?

The upshot is that if you had to choose a place to be kidnapped, Holland would probably be it. As long as the serial numbers are recorded by the authorities before the ransom is paid, then the DNB's registration system can be mobilized to catch kidnappers. For instance, the DNB claims it was instrumental in catching the kidnapper of Gerrit Jan Heijn, an heir to the Albert Heijn supermarket empire, in 1987. When the kidnapper spent NLG 250 to buy groceries, the note was soon deposited at the DNB and read into the database, at which point authorities had enough information to trace it back to the commercial bank and then the supermarket.

Interestingly, there are a number of private banknote trackers on the internet, the most well known of which is Where's George. A user logs into the website and registers a U.S. banknote by entering its serial number. When someone else subsequently registers the same banknote, the ‘route’ of the bill is displayed. Where's George tracks around 266 million bills. EuroBillTracker, the equivalent for the euro, tracks around 160 million notes. Below is a map showing the "hits," or connections it has established over the last week:

Hits registered by EuroBillTracker

So cash is somewhat less than anonymous, or anonymous-ish, since behind the curtain an organization like the DNB may be recording serial numbers, and this data might be useful in learning about users' real life identities. By tracking serial numbers more robustly, the anonymity of cash can be further eroded. Imagine a Where's George world where each time a bills is used, the receiver is required to submit the serial number to a government-run central registry. If so, the banknote system would have attained the same level of pseudo-anonymity as bitcoin, where anyone is free to transact using banknotes but transaction chains are fully public.

We could go further and imagine a world where a central bank like the DNB requires that the circulation of high denomination banknotes, say the €200 note, be confined to 'legitimate' channels only. Cash is perpetually being withdrawn from the central bank, used in payments, and then redeposited at the central bank. To confine €200s to legitimate channels, the DNB would simply announce that it intends to limit redeposits to those notes that have fully verified transactions histories. Verification means that when someone receives a €200 note, they must register it by submitting its serial number to the central bank via an app along with some sort of proof of identity.

When someone fails to either register a note or provide adequate identification, that note effectively falls out of the system. After all, because the DNB won't allow a note with an incomplete chain of verified transactions to be redeposited, banks will refuse to accept any note that hasn't been registered by its current owner. And knowing that banks won't accept them, neither will retailers. Bills that have fallen through the cracks will only have value in an alternative black market where they'd likely trade at a large discount to legitimate notes. Incidentally, establishing a verification system for €200s is very similar to Ken Rogoff's idea of abolishing high denomination notes, except instead of withdrawing €200s, they'd be allowed to stay in circulation in 'cleansed' form.

Thanks to a distinctive earmark—their serial number—the anonymity of banknotes is never fully assured. While serial numbers are rarely used these days for tracing, who knows what might happen in the future. Privacy advocates can take some comfort in the fact that, unlike paper money, coins have no distinctive markings and are therefore capable of serving as a purely anonymous exchange medium. Unfortunately coins have a low value to weight ratio so lugging the stuff around is a pain. The Swiss and Japanese stand out here for issuing the highest value coins, the five franc coin and 500 yen coin respectively, each worth around US$5.

As for cryptocoin fans, tomorrow Zcash will be launching. Whereas the entire history of bitcoin transactions is public, Zcash succeeds in hiding everything about the transaction. That's true anonymity.