The desert dollar industry

January 1, 2021

Jessie Smith, who owns a dusty motel in Beowawe, Nevada, had to turn away customers yesterday. No vacancy, Smith told the recent arrivals, the first time she has uttered those words since she bought the motel twenty years ago.

These days, the desert is swimming in cash... literally. Over the last six months, a booming business in illegal cash storage has sprung up in Nevada, New Mexico, and Arizona where analysts estimate that $30 billion worth of $100 notes have been hidden. By day, smugglers drive deep into the desert, SUVs loaded down with suitcases full of Ben Franklins. Once they've found an ideal spot, they wait till the sun goes down and frantically dig a hole, only to drive away the next morning with nothing but the cache's GPS coordinates and a drone or two to guard it. When asked about the sorts of people staying at her motel these days, Smith shrugs. "I don't ask who they are and they pay cash."

This is life in the Great Deflation. What began as a steady disinflation early last decade (a decline in the global rate of inflation) slowly turned into all out deflation by the turn of the decade. In response, central bankers around the world simultaneously increased their inflation targets from 2% to 4% and fully re-loaded their quantitative easing programs. To their embarrassment, consumer prices only continued to decline, crescendoing into what the press has dubbed hyperdeflation; annual global price declines of 2-3%. The Fed is currently in its fifth round of QE and, along with most central banks, has kept its key interest rate at the effective lower bound of -1.25% since 2019. To no avail.

Consensus among central bankers is that -1.25%, and not 0%, is the lowest interest rate that the public will endure before converting deposits into 0%-yielding cash. This level emerged as the consensus when the Swiss National Bank reduced rates to -1.5% back in 2018. A stampede into Swiss banknotes ensued. When the Bank dialed the rate back to -1.25%, the Swiss public re-deposited notes back into their bank accounts. Since then, no central banker has dared reduce rates below this magic level. If they did, they'd risk losing control of monetary policy (as if they haven't already) as well as causing a run on the banking system.

But wait. The world's newest monetary experiment is about to be unveiled...

Throughout 2019 and 2020 the world's monetary architects have been steadily dismantling effective lower bounds in many large economies, giving central bankers, until now stuck at -1.25%, the ability to reduce interest rates deep into negative territory. Many say that the world is on the cusp of something so new that we don't even have a word for it. The opposite of disinflation (disdeflation?), the dawning phenomenon of gradually declining deflation is being dubbed by the econblogosphere the Great Reflation. Some are forecasting that we'll soon be moving back up to -2 or -1% deflation... maybe even zero.

The Europeans started to dismantle their lower bound in 2019. They did so by having the ECB cancel all 500, 100, and 50 notes, leaving only the lowly 20 to circulate as the eurozone's highest denomination bill. And when a new 20 euro note was issued in January of last year, the ECB doubled its surface area from 72x133 mm to a cumbersome 108x200 mm. A standard suitcase now only fits half as much raw value, thus burdening noteholders with extra storage and handling costs. Even when folded in half, a single 20 note no longer fits snugly into a pocket. Which means that when the ECB drops rates into deeply negative territory (which it is expected to do at its next meeting), the European public probably won't bother converting deposits into clunky cash.

The U.S. was soon to follow. Unlike Euro notes, American bills are 70% cotton. So when the Fed first floated the possibility of removing $100 and $50 denominations from circulation last year, the cotton lobby exerted enough pressure that Fed officials decided to rethink their strategy. Instead of withdrawing $100s and $50s, the Fed asked Congress to make mass cash storage illegal. As of July 2020, any member of the public caught holding more than $1000 in bills risks having their stash confiscated, with corporations and financial institutions facing cash limits of their own. In theory, this should allow the Fed to set deeply negative interest rates.

Which explains why Nevada's deserts are being punched full of holes. The $1000 limit, combined with the possibility of deeply negative rates next year, means that storage of 0%-yielding paper has the potential to be incredibly profitable. To combat the so-called desert dollar industry, the U.S. Secret Service's counterfeit currency team has been retasked with patrolling vast empty patches of desert. So far their raids have had mixed success; smugglers have been diverting their hoardes across the border into Mexico or Canada. New legislation is being tabled to restrict cash exports and should be passed later this month. In any case, the significant costs that smugglers face in evading the Secret Service means that the Fed should be able to safely bring rates to -3% or so at its next meeting without facing mass flight into paper dollars.

Despite having dismantled its lower bound, the Fed held back from a rate cut at its recent policy meeting. Why? There is a growing faction in the Fed that says that reducing interest rates could very well prove disastrous. Not only would a cut not stoke inflation, it could exacerbate the existing hyperdeflation. To replace hyperdeflation with inflation, you need to raise interest rates, not drop them, claim members of this faction. Ratchet the interest rate up to 3% and arbitrage dictates that a gentle inflation will be restored. After all, if the Fed is compensating investors with a 3% return on its highly-liquid risk-free liabilities, then those investors will be content with an expected decline in the purchasing power of those liabilities, say a 1-2% inflation.

Once a taboo idea, the ongoing inability on the part of central banks to reign in deflation has brought this sort of turn-the-wheel-left-to-go-right thinking into vogue. Not only are central bankers finding it increasingly difficult to understand their traditional interest rate tool—it may not do what they always thought it did—but bond traders have been thrown into confusion. For years, the ECON 101 courses they learnt in college taught them that a reduction in interest rates leads to higher prices, not lower ones. Now they're not sure.

Jessie Smith, however, is 100% sure where she casts her lot; whichever direction keeps the cash flowing into Nevada. She's hoping that the Fed plunges rates to -5% next year, which would only increase her customers' incentives to store cash. As for a hike back into positive territory, the thought makes her shudder. Why hold 0% cash when you can earn 2 or 3% in the bank? Nevada's desert, now full of cash, would rapidly return to normal, and Smith's hotel would go back to having vacancies again.

Sign Wars

Does a lowering of a central bank's interest rates create inflation or deflation? Dubbed the 'Sign Wars' by Nick Rowe, this has been a recurring debate in the economics blogosphere since at least as far back as 2010.

The conventional view of interest rate policy is that if a central bank keeps its interest rate too low, the inflation rate will steadily spiral higher. Imagine a cylinder resting on a flat plane. Tilt the plane in one direction —a motif to explain a change in interest rates—and the cylinder, or the price level, will perpetually roll in the opposite direction, at least until the plane's tilt (i.e. the interest rate) has been shifted enough in a compensatory way to halt the cylinder's roll. Without a counter-balancing shift, we get hyperinflation in one direction, or hyperdeflation in the other.

The heretical view, dubbed the Neo-Fisherian view by Noah Smith (and having nothing to do with Irving Fisher), is that in response to a tilt in the plane, the cylinder rolls... but uphill. Specifically, if the interest rate is set too low, the inflation rate will jump either instantaneously or more slowly. But after that, a steady deflation will set in, even without the help of a counter-balancing shift in the interest rate. We get neither hyperinflation nor hyperdeflation. (John Cochrane provides a great introduction to this viewpoint).

Many pixels have already been displayed on this subject, about the only value I can add is to translate a jargon-heavy academic debate into a more finance-friendly way of thinking. Let's approach the problem as an exercise in security analysis.

First, we'll have to take a detour through the bond market, then we'll return to money. Consider what happens if IBM announces that its 10-year bond will forever cease to pay interest, or a coupon. The price of the bond will quickly plunge. But not forever, nor to zero. At some much lower price, value investors will bid for the bond because they expect its price to appreciate at a rate that is competitive with other assets in the economy. These expectations will be motivated by the fact that despite the lack of coupon payments, the bond still has some residual value; specifically, IBM promises a return of principal on the bond's tenth year.

Now there's nothing controversial in what I just said, but note that we've arrived at the 'heretical' result here. A sudden setting of the interest rate at zero results in a rapid dose of inflation (a fall in the bond's purchasing power) as investors bid down the bond's price, followed by deflation (a steady expected rise in its value over the next ten years until payout) as its residual value kicks in. The bond's price does not "roll" forever down the tilted plane.

Now let's imagine an IBM-issued perpetual bond. A perpetual bond has no maturity date which means that the investor never gets their principle back. Perpetuals are not make-believe financial instruments. The most famous example of perpetual debt is the British consol. A number of these bonds float around to this day after having been issued to help pay for WWI. When our IBM perpetual bond ceases to pay interest its price will quickly plunge, just like a normal bond. But it's price won't fall to zero. At some very low level, value investors will line up to buy the bond because its price is expected to rise at a competitive rate. What drives this expectation? Though the bond promises neither a return of principal nor interest payments, it still offers a fixed residual claim on a firm's assets come bankruptcy, windup, or a takeover. This gives value investors a focal point on which they can price the instrument.

So with a non-interest paying perpetual bond, we still get the heretical result. In response to a plunge in rates, we eventually get long term deflation, or a rise in the perpetual's price, but only after an initial steep fall.  As before, the bond's price does not fall forever.

Now let's bring this back to money. Think of a central bank liability as a highly-liquid perpetual bond (a point I've made before). If a central banker decides to set the interest rate on central bank liabilities at zero forever, then the purchasing power of those liabilities will rapidly decline, much like how the cylinder rolls down the plane in the standard view. However, once investors see a profit opportunity in holding those liabilities due to some remaining residual value, that downward movement will be halted... and then it will start to roll uphill. Once again we get the heretical result.

The residual claim that tempts fundamental investors to step in and anchor the price of a 0% yielding central bank liability could be some perceived fixed claim on a central bank's assets upon the bank's future dissolution, the same feature that anchored our IBM perpetual. Or it could be a promise on the part of the government to buy those liabilities back in the future with some real quantity of resources.

However, if central bank liabilities don't offer any residual value whatsoever, then we get the conventional result. The moment that the central bank ceases to pay interest, the purchasing power of a central bank liability declines...forever. Absent some residual claim, no value investor will ever step in and set a floor. In the same way, should an IBM perpetual bond cease to pay interest and it also had all its residual claims on IBM's assets stripped away, value investors would never touch it, no matter how low it fell.

So does central bank money boast a residual claim on the issuer? Or does it lack this residual claim? The option you choose results in a heretical result or a conventional result.

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What does the data tell us, specifically the many cases of hyperinflation? As David Beckworth has pointed out, the conventional explanation has no difficulties explaining the Weimar hyperinflation; the Reichsbank kept the interest rate on marks fixed at very low levels between 1921 and 1923 so that the price level spiraled ever upwards. Heretics seem to have difficulties with Weimar—the deflation they predict never set in.

Here's one way to get a heretical explanation of the Wiemar inflation. Let's return to our analogy with bonds. What would it take for the price of an IBM perpetual bond to collapse over a period of several years, even as its coupon rate remained constant? For that to happen, the quality of the bond's perceived residual value would have to be consistently deteriorating. Say IBM management invested in a series of increasingly dumb ventures, or it faced a string of unbeatable new competitors entering its markets. Each hit to potential residual value would cause fundamental investors to mark down IBM's bond price, even though the bond's coupon remained fixed.

Now assuming that German marks were like IBM perpetual bonds, it could be that from 1921 to 1923, investors consistently downgraded the value of the residual fixed claim that marks had upon the Reichsbank's assets. Alternatively, perhaps the market consistently reduced its appraisal of the government's ability to buy marks back with real resources. Either assumption would have created a consistent decline in the purchasing power of marks while the interest rate paid on marks stayed constant.

Compounding each hit to residual value would have been a decline in the mark's liquidity premium. When the price of a highly-liquid item begins to fluctuate, people ditch that item for competing liquid items with more stable values. With less people dealing in that item, it becomes less liquid, which reduces the liquidity premium it previously enjoyed. This causes the item's purchasing power to fall even more, forcing people to once again turn to alternatives, thus making it less liquid and igniting another round of cuts to its liquidity premium and therefore its price, etcetera etcetera. In Weimar's case, marks would have been increasingly replaced by dollars and notgeld.

So consistent declines in the mark's perceived residual value, twinned with a shrinking in its liquidity premium, might have been capable of creating a Weimar-like inflation, all while the Reichsbank kept its interest rate constant.

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That's not to say that central bank liabilities do have a residual value and that the heretical result is necessarily the right one. Both possibilities make sense, and both can explain hyperinflations. But to determine which is right, we need to go in and do some gritty security analysis to isolate whether central bank money possesses a fixed residual claim on either central bank assets or future government resources. Parsing the fine print in central bank acts and government documents to tease out this data is the task of lawyers, bankers, historians, fixed income analysts, and accountants. And they would have to do a separate analysis for each of the world's 150 or so central banks and currencies, since each central bank has its own unique constituting documents. In the end we might find that some currencies are conventional and others are heretic, so that some central banks should be running conventional monetary policies, and others heretic policies. 

In closing, a few links. I've taken a shot at a security analysis of central bank liabilities in a number of posts (here | here | here), but I don't think that's the final word. And if you're curious how the Weimar inflation ended, go here.