After twelve years of writing about bitcoin, here's how my thinking has changed

What follows is an essay on how my thinking on bitcoin has changed since I began to write on the topic starting with my first post in October 2012. Since then I've written 109 posts on the Moneyness Blog that reference bitcoin, along with a few dozen articles at venues like CoinDesk, Breakermag, and elsewhere.

An early bitcoin optimist

I was excited by Bitcoin in the early days of my blog. The idea of a decentralized electronic payment system fascinated me. Here's an excerpt from my second post on the topic, Bitcoin (for monetary economists) - why bitcoin is great and why it's doomed, dated November 2012:

"Bitcoin is a revolutionary record-keeping system. It is incredibly fast, efficient, cheap, and safe. I can send my Bitcoin from Canada to someone in Africa, have the transaction verified and cleared in 10 minutes, and only pay a fee of a few cents. Doing the same through the SWIFT system would take days and require a $35 fee. If I were a banker, I'd be afraid." [link]

I was relatively open to Bitcoin for two reasons. First, I like to think in terms of moneyness, which means that everything is to some degree money-like, and so I welcome strange and alternative monies. "If you think of money as an adjective, then moneyness becomes the lens by which you view the problem. From this perspective, one might say that Bitcoin always was a money," I wrote in my very first post on bitcoin. Second, prior to 2012 I had read a fair amount of free banking literature—the study of private money—so I was already primed to be receptive to a stateless payments system, which is what Bitcoin's founder, Satoshi Nakamoto, originally meant his (or her) creation to be. 

A lot of bitcoin-curious, bitcoin-critics and bitcoin-converts were attracted to the comments section of my blog, and we had some great conversations over the years. My bitcoin posts invariably attracted more traffic than my non-bitcoin ones, all of us scrambling to understand what seemed to be a newly emerging monetary organism.

My early thoughts on the topic were informed by having bought a few bitcoins in 2012 for the sake of experimentation, some of my earlier blog posts describing how I had played around with them. In 2013 I wrote about the first crop of bitcoin-denominated securities market (which I dabbled in)—predecessors to the ICO market of 2017. I also used my bitcoins to buy altcoins, including Litecoin, and in late 2013 wrote about my disastrous experience with Litecoin-denominated stock market speculation. In Long Chains of Monetary Barter I described using bitcoin as an exotic bridging currency for selling XRP, a new cryptocurrency that had just been airdropped into the world. I didn't notice it at the time, but in hindsight most of these were instances of bitcoin facilitating illegal activity, i.e. unregistered securities sales, which was an early use case for bitcoin.

Although Bitcoin excited me, I was also critical from the outset, and in later years my critical side would only grow, earning me a reputation among crypto fans as being a salty no-coiner. In a 2013 blog post I grumbled that playing around with my stash of bitcoins hadn't been "as exciting as I had anticipated." Unlike regular money, there just wasn't much to do with the stuff, my coins sitting there in my wallet "gathering electronic dust."

 "...the best speculative vehicles to hit the market since 1999 Internet stocks."

What my experimentation with bitcoin had taught me was that the main reason to hold "isn't because they make great exchange media—it's because they're the best speculative vehicles to hit the market since 1999 Internet stocks." But that wasn't what I was there for. What had tantalized me was Satoshi's vision of electronic cash, a revolutionary digital payments system. Not boring old speculation.

In addition to my practical complaints about bitcoin, I also had theoretical gripes with it. The "lethal" problem as I saw it back in my second post in 2012 is that "bitcoin has no intrinsic value." Over the next decade this lack of intrinsic value, or fundamental value, would underly most of my criticisms of the orange coin. Back in 2012, though, the main implication of bitcoin's lack of intrinsic value was the ease by which it might fall back to $0. As I put it in a 2013 article:

"Bitcoin is 100% moneyness. Whenever a liquidity crisis hits, the only way for the bitcoin market to accommodate everyone's demand to sell is for the price of bitcoin to hit zero—all out implosion" [link]

But if the price of bitcoin were to fall to zero then it would cease to operate as a monetary system, which would be a huge disappointment to those of us who were fascinated with Satoshi's electronic cash experiment. Adding to the danger was the influx of bitcoin lookalikes, or altcoins, like litecoin, namecoin, and sexcoin. In theory, the prices of bitcoin and its competitors could "quickly collapse in price" as arbitrageurs create new coins ad infinitum, I worried in 2012, eating away at bitcoin's premium. The alternative view, which I explored in a 2013 post entitled Milton Friedman and the mania in copy-paste cryptocoins,  was that "the earliest mover has superior features compared to late moving clones," including name brand and liquidity, and so its dominance was locked-in via network effects. Over time the latter view proved to be the correct one.

The "zero problem"

Despite my worries, I was optimistic about bitcoin, even helpful. One way to stop bitcoin from falling to zero might be a "plunge protection team," I offered in 2013, a group of avid bitcoin collectors that could anchor bitcoin's price and provide a degree of automatic stabilization. In a 2015 post entitled The zero problem, I suggested that bitcoin believers like Marc Andreessen should consider donating $21 million to a bitcoin stabilization fund, thus securing a price floor of $1 in perpetuity. 

No fan of credit cards, in a 2016 post Bitcoin, drowning in a sea of credit card rewards, I suggested that bitcoin activists encourage retailers that accept bitcoin payments to offer price discounts. This carrot would put bitcoin on an even playing field with credit card networks, which use incentives like reward points and cashback to block out competing payment systems.

My growing disillusionment

By 2014 or 2015, I no longer saw much hope for bitcoin as a mainstream payments system or generally-accepted medium-of-exchange. "For any medium of exchange to displace another as a means for buying stuff, users need come out ahead. And this isn't happening with bitcoin," I wrote in a 2015 post entitled Why bitcoin has failed to achieve liftoff as a medium of exchange, pointing to the many costs of making bitcoin payments, including commissions, setup costs, and the inconveniences of volatility.

In another 2015 post I focused specifically on the volatility problem, which stems from bitcoin's lack of intrinsic value. If an item has an unstable price, that militates against it becoming a widely used money. After all, the whole reason that people stockpile buffers of liquid instruments, or money, is that these buffers serve as a form of insurance against uncertainty. If an item's price isn't stable—which bitcoin isn't—it can't perform that role. 

Mind you, I did allow in another 2015 post, The dollarization of bitcoin, that bitcoin might continue as "an arcane niche payments system for a community of like minded consumers and retailers." I even tracked some of these arcane payments use cases, such a 2020 blog post on retailers of salvia divinorium (a legal drug in many U.S. states) falling back on bitcoin for payments after the credit card networks kicked them off, followed by a 2021 post on kratom sellers (a mostly-legal substance) doing the same. But let's face it, a niche payments system just wasn't as impressive as Satoshi's much broader vision of electronic cash that had beguiled me in 2012, when I had warned that "if I was a banker, I'd be afraid." 

The dollarization of bitcoin

By 2015 a lot of my pro-bitcoin blog commenters began to see me as a traitor. But I was just changing my thinking with the arrival of new data.

Searching for Bitcoin-inspired alternatives: Fedcoin and stablecoins

Bitcoin's deficiencies got me thinking very early on about how to create bitcoin-inspired alternatives. By late 2012 I was already thinking about stablecoins:

"What the bitcoin record-keeping mechanism needs is an already-valuable underlying asset to which it can be tethered. Rather than tracking, verifying, and recording the movement of intrinsically worthless 1s and 0s, it will track the movement of something valuable." [link]

Later, in 2013, I speculated about the emergence of "stable-value crypto-currency, not the sort that dangles and has a null value." These alternatives would "copy the best aspects" of bitcoin, like its speed and safety, but would be linked to "some intrinsically valuable item." A few months later I predicted that "Cryptocoin 2.0, or stable-value cryptocoins, is probably not too far away." This would eventually happen, but not for another few years.

My dissatisfaction with bitcoin led me to the idea of decentralized exchanges, or DEXs, in 2013, whereby equity markets would "adopt a bitcoin-style distributed ledger." That same year I imagined central banks adapting "bitcoin technology" to run its wholesale payments system in my post Why the Fed is more likely to adopt bitcoin technology than kill it off. In 2014 I developed this thought into the idea of Fedcoin, an early central bank digital currency, or CBDC, for retail users.

If not money, then what is bitcoin?

By 2017 or so, even the most ardent bitcoin advocates were being forced to acknowledge that Satoshi's electronic cash system was not panning out: the orange coin was nowhere near to becoming a popular medium-of-exchange. This was especially apparent thanks to a growing body of payments surveys (which I began to report on in 2020) showing that bitcoin users almost never used their bitcoins to make payments or transfers, preferring instead to hoard them. So the true believers pivoted and began to describe bitcoin as a store-of-value, or digital gold. It was a new narrative that glossed over Satoshi's dream of electronic cash while trying to salvage some monetary-ish parts of the story.

I thought this whole salvage operation was disingenuous. In 2017 I wrote about my dissatisfaction with the new store-of-value narrative, and followed that up with a criticism of the digital gold concept in Bitcoin Isn’t Digital Gold; It’s Digital Uselesstainium. (The idea that store-of-value is a unique property of money is silly, I wrote in 2020, and we should just chuck the concept altogether.)

But if bitcoin was never going to become a generally-accepted form of money, and it wasn't a store-of-value or digital gold, then what exactly was it? 

I didn't nail this down till a 2018 post entitled A Case for Bitcoin. We all thought at the outset that bitcoin was a monetary thingamajig. But we were wrong. Of the types of assets already in existence, bitcoin was not akin to gold, cash, or bank deposits. Rather, it was most similar to an age-old category of financial games and zero-sum bets that includes poker, lotteries, and roulette. The particular sub-branch of the financial game family that bitcoin belonged to was early-bird games, which contains pyramids, ponzis, and chain letters. Here is a taxonomy:

A taxonomy showing bitcoin as a member of the early-bird game family

Early-bird games like pyramids, ponzis, and chain letters are a type of zero-sum game in which early players win at the expense of latecomers, the bet being sustained over time by a constant stream of new entrants and ending when no additional players join. Pyramids and ponzis are almost always administered by thieves who abscond with the pot. Bitcoin, by contrast, was not a scheme nor a scam. And it was not run by a scammer. It was leaderless and spontaneous, an "honest" early-bird game that hewed to pre-set rules. Here is how I described it in a later post, Bitcoin as a Novel Financial Game:

"Bitcoin introduces some neat features to the financial-game space. Firstly, everyone in the world can play it (i.e., it is censorship-resistant). Secondly, the task of managing the game has been decentralized. Lastly, Bitcoin’s rules are automated by code and fully auditable." [link] 

This ponziness of bitcoin was actually a source of its strength, I suggested in 2023, because "it's tough to shut down a million imaginations." By contrast, if bitcoin had an underlying real anchor, like gold, then that would give authorities a toe hold for decommissioning it.

Bitcoin-as-game gave me more insight into why most bitcoin owners weren't using bitcoin as a medium-of-exchange. Its value as a zero-sum bet was overriding any functionality it had for making payments. In a 2018 post entitled Can Lottery Tickets Become Money?, I worked this out more clearly:

"Like Jane's lottery ticket, a bitcoin owner's bitcoins aren't just bitcoins, they are a dream, a lambo, a ticket out of drudgery. Spending them at a retailer at mere market value would be a waste given their 'destiny' is to hit the moon." [link]

If bitcoins weren't like bank deposits or cash, how should we treat them from a personal finance perspective? Feel free to play bitcoin, I wrote in late 2018, but do so in moderation, just like you would if you went to Vegas. "Remember, it's just a game."

Bitcoin is innocuous, don't ban it

By 2020 or 2021, the commentary surrounding bitcoin seemed to be getting more polarized. As always there was a set of hardcore bitcoin zealots who thought bitcoin's destiny was to change the world, of which I had been a member for a brief time in 2012. But arrayed against them was a new group of strident opponents who though bitcoin was incredibly dangerous and were pushing to ban it.

A vandalized 'Bitcoin accepted' sign in my neighborhood

I was at odds with both sides. Each saw Bitcoin as transformative, one side for the good, the other for the bad. But I conceived of it as an innocuous gambling device, one that only seemed novel because it had been transplanted into a new kind of database technology, blockchains. We shouldn't ban bitcoin for the same reason that we've generally become more comfortable over the decades removing prohibitions on online gambling and sports betting. Better to bring these activities into the open and regulate them than leave them to exist in the shadows.

Thus began a series of relax-don't-ban-bitcoin posts. In 2022, I wrote that central bankers shouldn't be afraid that bitcoin might render them powerless. For the same reason that casinos and lotteries will ever be a credible threat to dollar's issued by the Fed or the Bank of Canada, neither will bitcoin.

Illicit usage of bitcoin was becoming an increasingly controversial subject. Just like casinos are used by money launderers, bitcoin had long become a popular tool for criminals, the most notorious of which were ransomware operators. My view was that we could use existing tools to deal with these bad actors. Instead of banning bitcoin to end the ransomware plague, for instance, I suggested in a 2021 article that we might embargo the payment of ransoms instead, thus choking off fuel to the ransomware fire. Alternatively, I argued in a later post that the U.S. could fight ransomware using an existing tool: Section 311 of the Patriot Act. Which is what eventually happened with Bitzlato and PM2BTC, two Russian exchanges popular with ransomware operators that were put on the Section 311 list.    

Nor should national security experts be afraid of enemy actors using bitcoin to evade sanctions, I wrote in 2019, since existing tools, in particular secondary sanctions, are capable of dealing with the threat. The failure of bitcoin to serve as an effective tool for funding the illegal Ottawa protests, which I documented in a March 2022 article, only underlined its low threat potential:

"Governments, whether they be democracies or dictatorships, are often fearful of crypto's censorship-resistance, leading to calls for bans. The lesson from the Ottawa trucker convoy and Russian ransomware gangs is that as long as the on-ramping and off-ramping process are regulated, these fears are overblown." [link]

Other calls to ban bitcoin were inspired by its voracious energy usage. In a 2021 blog post entitled The overconsumption theory of bitcoin, I attributed bitcoin's terrible energy footprint to market failure: end users of bitcoin don't directly pay for the huge amounts of electricity required to power their bets, so they overuse it. No need to ban bitcoin, though. The way to fix this particular market failure is to introduce a Pigouvian tax on buying and/or holding bitcoins, which I described more clearly in a 2021 blog post entitled A tax on proof of work and a 2022 article called Make bitcoin cheap again for cypherpunks! 

Lastly, whereas bitcoin's harshest critics have been advocating a "let it burn" policy approach to bitcoin and crypto more generally, which involved leaving gateways unregulated and thus toxic, I began to recommend regulating crypto exchanges under the same standards as equities exchanges in a 2021 article entitled Gary Gensler, You Should be Watching How Canada is Regulating Coinbase. Yes, regulation legitimizes a culture of gambling. But even Las Vegas has stringent regulations. A set of basic protections would reduce the odds of the betting public being hurt by fraudulent exchanges. FTX was a good test case. After the exchange collapsed, almost all FTX customers were stuck in limbo for years, but FTX Japan customers walked out unscathed thanks to Japan's regulatory framework, which I wrote about in a 2022 post Six reasons why FTX Japan survived while the rest of FTX burned.  

So when does bitcoin get dangerous?

What I've learnt after many years of writing about bitcoin is that it's a relatively innocuous phenomena, even pedestrian. When it does lead to bad outcomes, I've outlined how those can be handled with our existing tools. But here's what does have me worried. 

If you want to buy some bitcoins, go right ahead. We can even help by regulating the trading venues to make it safe. But don't force others to play.

Whoops, You Just Got Bitcoin’d! by Daniel Krawisz

Alas, that seems to be where we are headed. There is a growing effort to arm-twist the rest of society into joining in by having governments acquire bitcoins, in the U.S.'s case a Strategic Bitcoin Reserve. The U.S. government has never entered the World Series of Poker. Nor has it gone to Vegas to bet billions to tax payer funds on roulette or built a strategic Powerball ticket reserve, but it appears to be genuinely entertaining the idea of rolling the dice on Bitcoin.  

Bitcoin is an incredibly infectious early-bird game, one that after sixteen years continues to find a constant stream of new recruits. How contagious? I originally estimated in a 2022 post, Three potential paths for the price of bitcoin, that adoption wouldn't rise above 10%-15% of the global population, but I may have been underestimating its transmissibility. My worry is that calls for government support will only accelerate as more voters, government officials, and bureaucrats catch the orange coin mind virus and act on it. It begins with a small strategic reserve of a few billion dollars. It ends with the Department of Bitcoin Price Appreciation being allocated 50% of yearly tax revenues to make the number go up, to the detriment of infrastructure like roads, hospitals, and law enforcement. At that point we've entered a dystopia in which society rapidly deteriorates because we've all become obsessed on a bet.

Although I never wanted to ban Bitcoin, I can't help but wonder whether a prohibition wouldn't have been the better policy back in 2013 or 2014 given the new bitcoin-by-force path that advocates are pushing it towards. But it's probably too late for that; the coin is already out of the bag. All I can hope is that my long history of writing on the topic might persuade a few readers that forcing others to play the game you love is not fair game.

Death of a Northern Irish banknote

I was disappointed to see that First Trust Bank, a commercial bank based in Northern Ireland, will stop issuing its own brand of banknotes. Under different names, First Trust has been in the business of providing paper money for almost two hundred years, starting with the Provincial Bank of Ireland back in 1825.

Source: First Trust

99.9% of the world's population uses government-issued banknotes. A small sliver of us—those who live in Northern Island, Scotland, Hong Kong, and Macau—get to use privately-issued banknotes. Prior to First Trust's announcement, I count twelve private issuers scattered across the globe:

Northern Ireland: Bank of Ireland, Danske Bank (formerly Northern Bank), First Trust Bank, and Ulster Bank
Scotland: Bank of Scotland, Clydesdale Bank and The Royal Bank of Scotland
Hong Kong: HSBC, Standard Chartered, Bank of China (Hong Kong)
Macau: Banco Nacional Ultramarino, Bank of China (Macau)

Now there are just eleven.

To our modern sensibilities, privately-issued banknotes seem just strange. But before central banks emerged on the scene, privately-issued banknotes were the norm. Larry White and George Selgin have chronicled how the Scots were particularly adept at this task. Scotland's banking system, which was much more free than the British one, had relatively few bank failures in the 1700 and 1800s compared to the British one, which tried to put limits on banks' ability to issue notes.

In the 1800s this Scottish "free banking" system was imported into my country, Canada, by Scottish immigrants. People might assume that private banknotes were risky instruments, and that's why we needed governments to do the task. But as the chart below shows, between 1868 and 1910 Canadians experienced almost no losses on banknotes.

Canada had no central bank (until 1935) or deposit insurance (until 1967).

But look how safe it was to own banknotes issued by private Canadian banks in the 1800s & early 1900s. No losses! Private banks can do a good job handling the note issue.
Source: https://t.co/tUpAahouyg pic.twitter.com/jdHlpZUlHO

— JP Koning (@jp_koning) February 13, 2019

Only a minute trace of our private banknote heritage remains. In addition to the four jurisdictions that have been allowed to maintain the tradition, a few central banks are still publicly-traded—a vestige of their old status as private issuers. In the case of banks in Northern Ireland and Scotland, their ability to issue notes has been grandfathered. Only the seven existing licenses are allowed and no new entrants are permitted. Once First Trust gives up its banknote franchise, it can never get it back.

First Trust says that its exit from the banknote game is a commercial decision. Let's take a quick look at the profitability (or not) of issuing banknotes. First Trust ATMs and branches can either dispense government-issued Bank of England banknotes or its own brand. If First Trust dispenses its own brand, then it must incur an extra set of costs including printing & design, note destruction, and policing against counterfeits. If it stocks its ATMs with Bank of England notes, it avoids these costs.

But there is a benefit to issuing its own brand of notes. For each note it issues, First Trust "earns the spread". Unlike its other forms of debt, First Trust needn't pay any interest to its banknote holders. But like its other forms of debt, it can earn income on the set of associated assets it holds to "back" those liabilities. If this income outweighs production costs, then it makes sense for First Trust to issue its own notes.

How much does First Trust make on its note issue? For each paper pound that Northern Irish and Scottish banks issue, they are obliged to lodge 1) 60 pence at the Bank of England in the form of banknotes and 2) 40 pence in the form of deposits. Given that Scottish and Irish banks have issued around £7.6 billion in private notes, this means they have collectively invested in some £4.6 billion worth of Bank of England banknotes. Since regular notes like £50 are bulky, the Bank of England issues massive 'Titans' and 'Giants' to cut down on storage costs.

£100 million "Titan" note.

Scottish & Northern Irish private banks have issued £7.6 billion in banknotes. They must back 60% of this—or £4.6b—with Bank of England notes. Better to use Titans than £50 notes... it takes just 46 Titans to store £4.6b compared to 92 million £50s. pic.twitter.com/UuZ4PUBMoh

— JP Koning (@jp_koning) February 17, 2019

For issuers like First Trust, the £4.6 billion worth of Titans and Giants is dead money—they don't earn any interest on it. But the other £3 billion or so in backing assets held in the form of deposits earns interest. The gap between an issuer's 0% funding costs and interest income paid by the Bank of England is what generates a profit for their banknote franchise.

On Twitter, John Turner points out that it was once very profitable for Northern Irish and Scottish banks to issue notes, but new regulations in 2009 changed this:

"Prior to legislation passed in 2009, issuing notes was extremely lucrative for banks because they only had to hold backing assets (essentially reserves at the Bank of England) at the weekend, leaving those funds free to generate income during the trading week.  Some estimates suggest that this generated £70m per year for Northern Irish banks alone.  Since the passage of the Banking Act (2009), banks are required to hold backing assets against their note issue at all times." (source)

Another reason seigniorage has shrunk is a decade of low interest rates. Northern Irish and Scottish banks currently earn just 0.75% on the deposits held at the Bank of England, but in the 2000s they would have been earning as much as 5.75%.

All four Northern Irish issuers (and the Scottish ones too) will have suffered from both the 2009 legislative change and generally low rates, but First Trust particularly so—its banknote issue is far smaller than that of Bank of Ireland and Ulster. Looking at its 2017 Annual Report, First Trust issued just £333 million of the £2.6 billion worth of Northern Irish banknotes in circulation. Which means it earned just £990,000 in seigniorage last year (£333 million x 40% x 0.75%). It's hard to imagine that this is enough to compensate it for its printing and other costs.

By comparison, the Bank of Ireland has issued around £1.2 billion in banknotes with Ulster Bank accounting for another £800 million. Both of these competitors can spread their fixed costs around far more efficiently than First Trust can.

-------

First Trust's announcement puts me in a bit of a conundrum. I think the financial privacy provided by cash is important. And so is the robustness that it engenders. Banknotes are a decentralized payment instrument that can't break down in the face of disasters. Cash systems are also open: no one can be censored from using them.

At the same time, I see no reason why commercial banks shouldn't be allowed to issue banknotes. But what happens when the private provision of cash breaks down? In countries like Northern Ireland with privately issued cash, we are seeing low interest rate go hand-in-hand with banks eliminating cash. And this in turn means less financial privacy, openness, and robustness.

In short, when interest rates fall to zero, private banks will try to preserve their spreads by pushing the interest rate that they pay on their short-term liabilities (like savings and chequing accounts) into negative territory, say by implementing higher account maintenance fees. But they can't do this with cash. A banknote's rate is fixed at 0%. Rather than absorbing losses from banknotes, private issuers will simply cancel their note issue, much like First Trust has done, forcing everyone into account-based products.

If the UK's low rates persist for another few years (and fall even further) then the remaining private issuers in Northern Ireland and Scotland—Clydesdale Bank, Bank of Scotland, Ulster, Danske, etc—would also be forced to stop printing notes. Both countries would become cash-free zones. And since cash is the best way to transact anonymously, Scotts and Northern Irish would have little to no financial privacy. All transactions would proceed through easily-censored account-based payments systems that break when the power goes down. 

Luckily for the Scots and Northern Irish, they have a backup. The Bank of England can fill any void left by commercial banks with its own notes. Unlike commercial issuers like First Trust, the Bank of England isn't driven by profits. Even as its banknote profits shrinks to nothing, the central bank can keep on supplying currency—and thus financial privacy, openness, and robustness—to the people. Perhaps there is a role after all for public issuers of paper money to play.

Should we have to line up for money or not?

I finally had some time to read George Selgin's excellent Floored! over the Christmas holiday.

Some family members saw me reading the book and asked me what it was about. The subject that George is tackling—two types of central bank operating systems—is quite technical, so I wasn't sure how to break it down for them. But in hindsight, here's how I would go about it. I'm going to explain what the issues are in terms of an instrument we all use and understand: good ol' fashioned banknotes. 

-------

Imagine that when you go to your bank this morning to withdraw $200 in cash, you can only get $100 out of the ATM. The bank manager says that it is expecting another shipment of cash later in the day, so come back then. But be early, he warns, since a lineup is sure to develop.

What explains this odd situation? The central bank has started to ration the amount of banknotes it issues. For instance, the Bank of Canada currently supplies Canadians with $85 billion in banknotes. But say it has decided to only provide half that, $45 billion.

A world in which banknotes are rationed would be very different from our actual world. When we march up to an ATM, we are accustomed to getting as much cash as we want. If everyone in my neighbourhood were to suddenly decide that they wanted to cash out their bank accounts, the Bank of Canada will print whatever amount of currency is necessary to meet that demand. Central bank don't keep cash scarce, they keep it plentiful.

Strange things happen in a world with rationed cash. Imagine that everyone wants to hold $200 in banknotes in their wallet but can only get $100 from the ATM. Further, assume that people need to hold a bit of cash because certain transactions can only be consummated with banknotes. To cope with this chronic cash shortage, a spare-cash market will emerge. For a fee, those who have a bit of extra cash on hand will lend to those who are short.

The spare-cash market would look a bit like this. To top her existing cash balance of $100 up to her desired $200, Jill makes a deal with Joe to lend her $100 in cash. She provides security for the loan by transferring $100 from her bank account to Joe's bank account. A day later Jill repays Joe with $100 in banknotes, and he returns her $100 security deposit, less a $1 fee. Jill has effectively paid $101 to get $100. Or put differently, she has paid Joe 1% in interest to get $100 in cash for a day.

We could even imagine informal person-to-person trading posts springing up outside of popular ATMs where those who are short of cash meet up with lenders like Joe who specialize in locating and lending spare cash. An Uber-style app would be created where the credit history of borrowers are documented, reducing the risk to lenders. People might be able to order up cash from home, delivered by bike courier.

The spare-cash market that I've just described is not a market we are accustomed to. As I said earlier, central banks keep cash plentiful. But it's similar to another market we are all familiar with: the secondary market for concert tickets. Tickets are necessarily rationed because there are only so many seats in a concert venue. Professional ticket scalpers line up ahead of time and buy these tickets so they can on-sell them at a premium.

Like the scalped ticket market, the spare-cash market is a natural response to scarcity. Those who can't spare enough time to stand in an ATM queue but need banknotes, like Jill, can pay those with spare time to stand in line, like Joe. Both are made better of. Joe's lot has improved because he earns more standing in ATM lines and lending cash than he did in his previous occupation. Jill is better off because she attains her desired amount of cash.

Once cash stops being a free good, cash payment delays emerge. Say that Jill prefers to go shopping in the morning for groceries and other necessities, before her hair dressing salon opens. But because acquiring cash is costly, she sometimes delays her shopping trip till later in the day, in the hope that someone might walk into her salon and pay with cash. That way she can avoid paying interest to Joe. 

However, if over the course of the day no one pays Jill with banknotes, she will have to borrow in the spare-cash market at the last minute. If everyone is following the same strategy as Jill, there will be an end-of-day spike in cash demand. Joe may run out of cash to provide his customers, and so Jill may have to go without food that night.

So now that we've outlined the contours of a world where cash is rationed and ATM lineups develop, would it be preferable to a world in which cash is plentiful and there are no lineups?

-------

Let me start by arguing why an alternative world in which cash is rationed might be more desirable than our current world with plentiful cash.

Thanks to cash rationing, Joe and Jill are forced to transact with each other. Perhaps a 'citizen-lender' like Joe can get additional incites insights into Jill's capacity to bear credit, the sorts of incites insights that a banker cannot. This extra bit of person-to-person monitoring may prevent folks like Jill from over- or underborrowing. 

This oversight function that Joe fulfills never emerges in the plentiful cash world since the two aren't forced into an economic relationship. And thus the credit market in a plentiful cash world may be less efficient than it would be if cash were rationed.

Now let me argue the opposite, why the world of plentiful cash may be superior.

There is an underlying logic to rationing concert tickets. A venue has just x seats, and so only x tickets can be sold. But there is no equivalent reason for a central bank to limit the size of its banknote issue. It does not face a capacity restraint, and the extra cost involved in printing new banknotes is tiny. And so any decision to ration cash is a purely arbitrary one.

Under rationing, citizens are forced to engage in a host of time-consuming activities that they wouldn't otherwise have to engage in, including locating a reliable cash lender, providing personal and potentially intrusive credit data to this lender, and then setting up an appointment to settle the debt at a later date. To avoid the hassles and expenses of dealing in the spare-cash market, folks like Jill may try to avoid making cash trades until later in the day, but that means she can't follow her preferred shopping schedule. 

If cash were plentiful, the millions of citizen-hours spent in coping with these annoyances would be freed up for alternative uses. Jill might be able to enjoy the extra minutes she now has with her children, or work on upgrading her salon. Instead of paying for Joe to stand in an ATM line-up, she can hire him to help in the construction, surely a much more socially useful activity than lining up.   

So which world do you prefer? Joe's extra credit monitoring is certainly beneficial. But does it outweigh all of the costs and nuisances that a cash shortage imposes on people's lives? This is a tough calculation to make. If you support cash rationing because you like the fact that it leads to a secondary market in cash loans (and thus more credit monitoring), why not create shortages in other financial markets, say by forcing banks to also ration deposits?

---------

Let's wrap this all up. We've explored the difference between a world in which cash is rationed and one in which it is plentiful.

But George's book isn't about cash, it's about another instrument issued by central banks: reserves. Unlike cash, reserves are an exclusive financial instrument. Only banks can hold them. Since reserves aren't part of our day-to-day experience, I've tried to explain things in terms of banknotes, a far more mundane central bank-issued instrument. 

George argues in his book for rationing reserves. It would be as-if he were arguing for the rationing of cash in the scenario I sketched out above. Note that I am not saying that George wants cash to be rationed (as a free banker he would probably be against it), but I am saying that many of his arguments in favor of reserve rationing can be recast in terms of a banknote rationing.

In particular, George speaks favorably of the secondary market in reserves that springs up thanks to rationing. In the U.S., this is usually referred to as the fed funds market, but more generally it is known as the interbank market. The interbank market is exactly like the spare-cash market that I've described above. Just as Joe lends to Jill in the spare-cash market, banks lend reserves to each other in the interbank market. George provides much evidence that the self-monitoring that banks engage in by transacting in the interbank market is a valuable function. 

What George doesn't touch on is that this increase in the amount of credit monitoring, far from being free, comes at the cost. Like Jill, banks must spend time and resources coping with a perpetual reserve scarcity. If this artificial shortage was removed, banks could stop allocating internal resources to this coping effort and deploy it instead to other uses. In the same way that plentiful money meant that Jill could hire Joe to upgrade her salon rather than paying him to stand in line, a bank can move employees from its defunct fed funds department to bolster its lending department, or customer service, or technology effort.

The question shouldn't be: do we want interbank peer monitoring? Rather, do we want interbank peer monitoring at all costs? I think this makes the calculation much more difficult.

Kocherlakota on cash

Narayana Kocherlakota, formerly the head of the Federal Reserve Bank of Minneapolis and now a prolific economics blogger, penned a recent article on the abolition of cash. Kocherlakota makes the point that if you don't like government meddling in the proper functioning of free markets, then you shouldn't be a big fan of central bank-issued banknotes. For markets to clear, it may be occasionally necessary for nominal interest rates to fall well below zero. Cash sets a lower limit to interest rates, thus preventing this rebalancing from happening.

I pretty much agree with Kocherlakota's framing of the point. In fact, it's an angle I've taken before, both here and in A Libertarian Case for Abolishing Cash. Yes, my libertarian and other free-marketer readers, you didn't misread that. There is a decent case for removing banknotes that is entirely consistent with libertarian principles. If you think usury laws are distortionary because they impose a ceiling on interest rates—and there are some famous libertarians who have railed against usury—then an appeal to symmetry says that you should be equally furious about the artificial, and damaging, interest rate floor set by cash.

Scott Sumner steps up to the plate and defends cash here. He brings up some good points, but I'm going to focus on his last one. Scott says that a cashless economy would create a "giant panopticon" where the state knows everything about you. I quite like Nick Rowe's response in which he welcomes Scott to the Margaret Atwood Club for the Preservation of Currency. In Atwood's dystopian Handmaid's Tale, a theocratic government named the Republic of Gilead has taken away many of the rights that women currently enjoy. One of the tools the Republic uses to control women is a ban on cash, all transactions now being routed digitally through something called the Compubank:

I agree that we don't want to abolish cash if it is only going to lead to Atwood's Compubank. But Scott misses the fact that even though Kocherlakota wants the government to exit the cash business, he simultaneously wants fintech companies to take up the mantle of anonymity services provider. Like Sumner, Kocherlakota doesn't seem to want a Compubank.

For instance, in a recent presentation entitled The Zero Lower Bound and Anonymity: A Monetary Mystery Tour, Kocherlakota highlights the potential for cryptocoins Zcash and Monero to substitute for central bank cash. Unlike bitcoin, these cryptocoins provide full anonymity rather than just pseudonymity. If you want to learn more about Zcash, I just listened to a great podcast with Zcash's Zooko Wilcox-O'Hearn here. As for Monero, Bloomberg recently covered its spectacular rise in price.

As Monero illustrates, cryptocoins are incredibly volatile. Is anonymity too important of a good to be outsourced to assets that behave like penny stocks? I'm not sure. And as Nick Rowe points out, the concurrent circulation of deposits (pegged to central bank money) and anonymity-providing cryptocoins would create havoc with the traditional way of accounting for prices. Retailers would probably still set prices in terms of central bank money but anyone wanting to purchase something anonymously would have to engage in an inconvenient ritual of exchange rate conversion prior to consummating the deal. Perhaps these are simply the true costs of enjoying anonymity?

Kocherlakota doesn't mention it explicitly, but should cash be abolished in order to remove the lower bound to interest rates, a potential replacement would be a new central bank-issued emoney, either Fedcoin or what Dave Birch has dubbed FedPesa. A good example of a Fedcoin-in-the-works comes from the People's Bank of China, which vice governor Fan Yifei expects to "gradually replace paper money." As for Birch's FedPesa, a real life example of this is provided by Ecuador's Dinero electrónico, a mobile money scheme maintained by the Central Bank of Ecuador (CBE) for use by the public.

Should a government decide to abolish cash and implement a central bank emoney scheme in its place, it would be possible to set negative interest rates on these tokens while at the same time promising to provide both stability and anonymity. One wonders how credible the latter promise would be. The CBE requires that citizens provide national identity card before opening accounts. And consider that the PBoC's potential cyptocoin will be designed to provide "controlled anonymity," whatever that means. Unless significant safeguards are set, it's hard not to worry that a potential Atwood-style Compubank is waiting in the wings.

An alternative way to coordinate a smooth government exit from the cash business is Bill Woolsey's idea of allowing private banks to step into the role of providing banknotes. In this scenario, the likes of HSBC, Bank of America, Wells Fargo, Deutsche Bank, and Royal Bank of Canada would become sole providers of circulating banknotes. Wouldn't this simply re-establish the zero lower bound? Not necessarily. As I wrote back in 2013, the moment a central bank sets deeply negative interest rates, private banks will face huge incentives to either 1. get out of the business of cash or 2. stay in the game while modifying arrangements, the effect being that the zero lower bound is quickly ripped apart.

The provision of anonymity services via the issuance of private banknotes has some advantages over cryptocoins like Zcash. Since they'd be pegged to central bank money, private banknotes would provide 'fixed-price' anonymity. Nor would the public have to constantly do exchange rate conversions between one currency type or the other. On the other hand, Zcash payments can be made instantaneously over long distances; you just can't do that with banknotes. And of course, there's also the stablecoin dream, i.e. the possibility that private cryptocoins like Zcash might themselves be stabilized by pegging them to central bank cash, as Will Luther describes here (for a more skeptical take, read R3's Kathleen B here)

Because of what he calls "over-issue" problems, Kocherlakota is more confident in the prospects for cryptocoins than private banknotes. I'm not so worried. The voluminous free-banking literature developed by people like George Selgin, Larry White, and Kevin Dowd teaches us that as long as silly regulations are avoided, the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded. Don't look to the so-called U.S. Wildcat banking era for proof. During that era, note-issuing banks were too encumbered by strict laws against branch banking and cumbersome backing rules to effectively supply notes, as Selgin points out here. Rather, the Scottish and Canadian banking systems of the 1800s provide evidence that banks can responsibly issue paper money.

Wouldn't the private provision of banknotes require the passing of new laws? Funny enough, U.S. commercial banks can already issue their own banknotes. In a fascinating 2001 article, Kurt Schuler points out that federally-chartered banks have been free to issue notes since 1994 when restrictions on note issuance by national banks was repealed as obsolete by the Community Development Banking and Financial Institutions Act. So the floodgates are open, in the U.S. at least, although as of yet no bank has taken the lead.

If governments are going to remove the zero lower bound by getting out of the business of providing anonymous payments, I say let a thousand flowers bloom. If the void is to be filled, don't put up any impediments to the creation of anonymity-providing fintech options like Zcash, but likewise don't prevent old fashioned banks from getting into the now-vacated banknote game either. Let the market decide which anonymity product they prefer... and celebrate the fact that the government's artificial floor to interest rates has been dismantled.

---

P.S. It would be remiss of me to omit pointing out that there are sound ways to dismantle the zero lower bound without removing cash, Miles Kimball's plan being one of them.

A libertarian case for abolishing cash

Last week Citi's Willem Buiter published a note on the three ways to get rid of the effective lower bound to nominal interest rates, one of which is to abolish cash. He goes on to say that

politically, the abolition of currency would run into opposition from some of the legitimately cash-dependent poor and elderly, from those for whom the anonymity of cash is desired because they are engaged in illegal activities and from libertarians. The first constituency can be helped, the second can be ignored and the third one should take one for the team.

I think that Buiter is wrong to characterize libertarians as necessarily opposed to the abolition of cash. Their take on cash is probably (or at least should be) a bit more nuanced. Since libertarians generally advocate government withdrawal from lines of business like health care or liquor retailing, an exit of central banks from the cash business should be a desirable outcome.

What Buiter is advocating is a bit more extreme than just government exit, however. An across-the-board banning of cash would not only take the government out of the cash business but also prevent individuals and businesses from entering the product niche. The participation of the private sector in the provision of cash isn't just science fiction. Historically, commercial banks were intimately involved in the production of paper currency. In modern times, the majority of banknotes that circulate in Scotland are issued by three private banks—the Bank of Scotland, the Royal Bank of Scotland, and the Clydesdale Bank, while in Hong Kong, the major commercial banks are charged with issuing currency.

Buiter would probably object to private banknotes. After all, if private banks are able to issue negotiable bearer instrument that pay a zero nominal interest rate, a central banker will continue to be plagued by the problem that he/she can't reduce interest rates below zero—instead of fleeing into 0% government paper, the public will hide in private banknotes. It's the same liquidity trap as before, with private currency in the place of central bank currency.

However, there would be one key difference. Private banks must abide by the Darwinian calculus of profit and losses, central banks don't have to. Take a world with privatized cash. A recession hits and the rate of return on capital falls plummets. At the same time, the central bank drops its deposit rate deep into negative territory. As a private bank tries to match with deposit rate reductions of its own, say to -2%, customers will convert negative yielding deposits into the bank's higher-yielding 0% bank notes. The bank, whose survival depends on a healthy spread between the rates on borrowing and lending, faces a sudden spike in borrowing costs to 0%, the rate on their cash base. Spreads will shrink, even invert. Bankruptcy looms.

In order to avert this disaster, private issuers will quickly institute limits on their cash business. This could involve adopting any one of Buiter's three remedies: 1) cancel their note issue; 2) impose a fee on cash, or; 3) remove the fixed exchange rate between deposits and cash. Thus,the lower bound probably wouldn't be a problem in a banking system characterized by privatized paper issuance. The necessity of maintaining a spread would force private banks to rapidly innovate any one of these three escapes come recession and negative nominal rates. Upon recovery, they can remove these limitations and continue with their regular cash business.

Imagine that private banks all choose the first option when nominal rates fall below zero, cancellation. With cash no longer in existence, banks will have succeeded in restoring their margins to health. The population, however, will have effectively lost their ability to make anonymous transactions. This puts a libertarian in a tough philosophical position. On the one hand, a cashless world poses a serious threat to personal liberty. John Cochrane calls it an "Orwellian nightmare," and Chris Dillow has referred to banning cash as "a grossly illiberal measure - the banning of capitalist acts between consenting adults."

On the other hand, if cash threatens a bank's existence, no libertarian would advocate the use of force to prevent said bank from exiting the business of cash provision. Capitalistic acts cannot be forced upon non-consenting adults, or, put differently, Jack's desire for anonymity-providing products doesn't justify Jill being put into chains in order to provide those products. Therefore, a withdrawal of cash by banks as nominal rates fall below zero, and the loss of anonymity that comes with it, is consistent with libertarianism.

So oddly, Buiter's proposed end point—a cancellation of cash in order to rid the world of the lower bound—is very similar to what a libertarian end point could look like. Both institutions will elect to withdraw cash from circulation because it interferes with their institutional prerogatives. For a central bank, this mission boils down to the targeting of some nominal variable like inflation while in the case of a private bank it is its ability to earn a competitive return. That's not to say that a libertarian ought to support Buiter's abolition, only that the subject is more nuanced than it might seem upon a superficial reading.  

As a postscript, it's worth noting that neither Buiter's central banker nor a libertarian's private banker need go as far as abolishing cash in order to remove the effective lower bound. Buiter provides two other options, the best of which (in my opinion) is removing the fixed exchange rate between cash and deposits. Miles Kimball has gone through this option exhaustively. I've outlined some even less invasive, though not as effective, options here.

---

Related links: 

Does the zero lower bound exist thanks to the government's paper currency monopoly? (link)
Is legal tender an imposition on free markets or a free market institution? (link)
Bill Woolsey on how the private sector would withdraw cash at negative rates (link | link )
FTAlphaville: Buiter on the death of cash ( link )

Note: I changed some wording on September 26, 2015. The message remains the same.

Does the zero lower bound exist thanks to the government's paper currency monopoly?

Many moons ago Matt Yglesias wrote that the "zero lower bound is a pure artifact of the existence of physical cash."  In this post I'll argue that the zero-lower bound, or ZLB, is an artifact of our modern central bank-managed monetary system, and not the existence of cash. In a free banking system in which private banks issue banknotes, competitive forces would force bankers to rapidly find ways to pierce below the ZLB, rendering the bound little more than a fleeting technicality.

What is the zero lower bound? When the economy's expected rate of return drops significantly below 0%, interest rates charged by banks should follow into negative territory. But if banks set sub-zero interest rates on deposits, everyone will quickly convert them into central bank-issued paper currency. After all, why hold -2% yielding deposits when you can own 0% yielding cash? The inability to set negative interest rates is the zero-lower bound problem.

As I'll illustrate, the threat of getting stuck at the zero-lower bound would impose such huge losses on private note-issuing banks that bank managers would quickly find creative ways to circumvent the problem. Central bankers, who aren't beholden to the same financial motivations as private bankers, needn't pursue these same zero-lower bound innovations with such zeal. This distinction has significant implications for the economy. Insofar as policies designed to remove the ZLB can prevent large macroeconomic distortions, central bankers are more likely to avoid such policies and destabilize the macroeconomy than private banker who, driven by bottom line concerns, will be quick to adopt ZLB-avoiding innovations.

Let's set up our free banking system. Say that the Fed ceases issuing paper currency and only creates deposits. Into this void, private banks begin issuing their own paper dollar banknotes which can be exchanged for bank deposits at a rate of 1:1. This isn't such a strange idea—for much of its history, Canada has enjoyed a privately-supplied paper currency. A few years later the economy nosedives and pessimism reigns. Private banks are desperate to decrease deposit rates into negative territory, say -4% or so. After all, banks earn income from the spread between the rate at which they borrow and the rate at which they invest. If, during bad times, a banker is investing at a -2% loss, he or she needs to be borrowing at -4% in order to earn spread income.

Unfortunately for our private banker, the intervening ZLB impedes rates from dropping into negative territory. Any attempt to cut to -4% and bank depositors will flock to convert negative yielding deposits into the bank's 0% yielding banknotes. Very quickly the bank's entire liability structure will be comprised of banknotes, a disastrous outcome since a bank that funds itself at 0% while investing at -2% will go broke very quick.

In a negative return world, profit-maximizing private banks would solve their ZLB problem using several strategies:

1. Remove Cash

If banks remove all of their already-issued cash from the economy in return for deposits, the deposits-to-cash escape route will be effectively erased, thereby clearing the way for banks to reduce deposit rates to -4%. One way to do this, courtesy of Bill Woolsey, would be for banks to issue cash with a call feature. Much like a convertible bond allows the bond issuer to force conversion upon investors, bank notes would carry a conversion clause permitting the issuing bank to call in all cash when it desires to reduce deposit rates below zero. [1]

2. Cease conversion into cash

Note-issuing banks might simply close the cash conversion window while allowing existing cash to remain in circulation. This would cut off any rush to convert deposits into cash upon a reduction of deposit rates to -4%. The price of existing cash would jump to a high enough level such that it would be expected to decline at a rate of 4% a year. Conversion stoppages are not without precedent. In 18th century Scotland, banks often issued notes with an option clause that allowed them to cease redemption should a bank run begin.

3. Penalize cash

By penalizing cash, a bank imposes a large enough cost on cash holders so that negative yielding deposits are no longer inferior to cash. There are plenty of ways for a bank to do this. One way is to impose a negative interest rate on cash by requiring cash holders to pay to "update" their bank notes lest they expire. This update fee, which would amount to around 4% a year, would forestall depositors from making a dash for cash when the bank sets deposit rates at -4%. In times past, locally-issued "scrip" like Worgl have had negative interest rates attached to them.

Another creative way for a banker to penalize cash is to impose a capital loss on cash holders. Rather than offering permanent 1:1 cash-to-deposit exchanges, banks might commit themselves to buying back cash (ie. redeeming it) in the future at an ever worsening rate to deposits. As long as the loss imposed on cash amounts to around 4% a year, depositors will not convert their deposits to cash en masse when deposit rates are cut to 4%.

In sum, a number of innovative routes are available for note-issuing banks to let their borrowing costs drop into negative territory. By necessity, private note-issuing banks will adopt these strategies in order to protect their shareholders from the painful effects of mass conversion of cheap deposit funding into relatively costly 0% cash.

That's all fine and dandy, but our note-issuing mechanism is run by a centralized monopoly, not competing private banks. Because the ZLB is no less binding for central banks than it is for free banks, over the last few years economists and pundits have come up with all sorts of draconian techniques for central banks to escape the ZLB. There have been calls to ban cash, penalize it, and destroy it. At first I was somewhat appalled by these ideas as they seemed to be gross infringements on people's ability to use cash. Over time I've realized that these authoritarian solutions are, somewhat paradoxically, the very same innovations that competing bankers would devise in a free banking world in order to free themselves of the ZLB problem. In other words, we can back out what a monopolist currency issuer *should* be doing  to combat the ZLB by imagining what a network of competing banks *would* do. [2]

For instance, in a negative rate world a central bank ban on paper currency would be the equivalent of competing note-issuing banks simultaneously calling in their entire issue of paper currency in order to protect their solvency. If free banks were to penalize cash by redeeming it at ever deteriorating rates, this would be exactly the same strategy that Miles Kimball advocates central banks adopt in order to escape the ZLB.

That central banks have been so slow to evolve strategies for escaping from the ZLB could be due to any number of factors. Central banks aren't privately owned nor are they disciplined by competition, and central bankers don't have a mandate to turn a profit. Free banks, burdened by all of these checks, would be forced to rapidly adopt ZLB-escaping strategies or perish.

Further hampering efforts to get central banks like the Fed to innovate solutions to the ZLB is that these efforts might conflict with other goals. Withdrawing cash, penalizing it, or limiting conversion will put an end to, or at least diminish, the circulation of US paper dollars overseas. It might even result in the circulation of some other nation's 0% yielding currency in the US. But the universal circulation of greenbacks is one of the most potent symbols of US hegemony, real or perceived. In the interests of protecting this symbol, innovations for escaping the ZLB may get short shrift. In a free banking system, these sorts of non-pecuniary motives are unlikely to outweigh the profit and loss calculation that dictates the necessity of adopting such innovations.

So the zero lower bound problem isn't a problem with cash per se, it's just a function of monopolistic intransigence. If you really want to short circuit the ZLB, better to devolve the provision of notes to profit-seeking private banks. Until then, hopefully evangelists like Miles Kimball succeed in getting central banks to adopt  free banking-style contingency plans in preparation for the next time we experience a crisis that necessitates sub-zero interest rates.

---

[1] I confess that much of this post was inspired by ideas in two Bill Woolsey posts that I thought deserved wider circulation.

[2] The idea that harsh central bank policies like banning cash or penalizing currency might mimic free banking responses is a recurring theme on this blog. Here, I hypothesized that in a world characterized by free banking, legal tender laws might evolve naturally as the result of market choice. It's a strange world.

Strange money: privately-issued $6 and $7 notes

In you were living in Canada between 1870 and 1880 there's a good change that you might have held in your wallet the odd beast that was the private $7 note pictured above. Below is a $6 note issued by Banque Nationale in 1870, a bank that continues to operate in Canada today.

The first striking aspect of the $7 note is that the issuer is Molsons, the very same Molsons that brews one of Canada's best selling beers. Molsons Bank would eventually merge itself with the Bank of Montreal in the 1920s.

Going back a bit in history, the brand name on these notes isn't so unusual. Most Canadians are probably not aware that the entrance of the Bank of Canada into the business of issuing paper money is relatively new. Established in 1935, the BoC has only been a money printer for 78 or so years. Private Canadian chartered banks, on the other hand, began to issue paper banknotes as early as 1819. Until they gave up their right to issue notes in 1935, these banks had been continuously issuing notes for some 125 years. So Molsons notes aren't an anomaly—if anything, they've been the norm up here in Canada, it's the BoC that's a bit weird.

So why would anyone want a $7 note? Why not just carry one $5 and two $1s?

First, we should note that issuing banknotes is a cost-effective way for an institution to fund itself. Why? Notes don't pay out interest. In comparison, bond or deposit funding are pricier funding alternatives since interest must be paid on outstanding obligations. Fierce competition emerged among early Canadian banks to see who could keep their notes in circulation and "enjoy the float". The float refers to seigniorage, or the difference between the cost of maintaining banknotes in circulation and the interest that can be earned by investing note proceeds.

While the Canadian government no doubt wanted to share in this interest-free financing, a proposal by Lord Sydenham in 1841 to end the private issue of notes and monopolize issuance at a central bank never got off the ground. The next effort to move into the business of note issuance did get traction. But rather than establish a monopoly central bank, the Provincial Notes Act of 1866 only allowed for the issuance of $8 million in Province of Canada Notes. These instruments would later come to be known as Dominion notes. Much like US greenbacks, Dominion notes were direct obligations of the government, not of a central bank, and they circulated in competition with the notes of private banks.

Having gained for itself a toe-hold in the banknote issuance business, the Canadian government proceeded to shoehorn its way into a more dominant position. In 1870, the Feds required banks to surrender the issuance of small notes, or any denomination below $4.

Without the ability to issue $1s and $2s, chartered banks could not legally provide the public with hand-to-hand payment media to facilitate transactions that totaled $6, $7, or $11, and made it inconvenient to reach amounts like $26, $32, etc. The response of the Canadian banks was rather cheeky—they decided to print out $6s and $7s ($4 notes already being widely used in Canada). These new denominations allowed a bank to provide its clients with convenient payment media sufficient to total any transaction that clients might incur. An outstanding debt of $26, for instance, could be settled with one $20 note and a $6 note rather than one $10 and four $4s.

In 1880 legislation was passed that raised minimum private denominations to $5 and only permitted multiples of five. Thus ended ten years of oddly-denominated Canadian private notes. From that point on, only $1 and $2 denominated Dominion notes could provide Canadians with the flexibility to meet odd payment amounts.

Canadian $6 and $7 are an early example of regulatory-inspired financial innovation. No doubt the clamping down on private $1s and $2s was justified at the time by an appeal to Adam Smith's Wealth of Nations. While Smith usually advocated the free-banking position, he favored banning notes in denominations below £5. Small denominations were typically used by poorer classes whose ability to monitor notes for credit quality might be less than adequate. Without proper due diligence, wrote Smith, issuers of these notes would be able to overissue and cause credit booms and busts, hurting those least able to afford it.

I don't know what portion of the Canadian government's motivation for pushing into the banknote business emerged from the regulator-as-wise-outsider view and what portion from regulator-as-profit-seeking-monopolist view. But it makes me wonder how much of modern banking regulation is motivated by well-reasoned economic thinking and a genuine Smithian concern for the poor, and how much is motivated by interest groups co-opting the state to provide them with monopoly rents. Perhaps a bit of both. In any case, we shouldn't naively assume that bank regulation will solve all our financial woes.

PS: Many of these facts come from Roeliff Morton Breckenridge's The Canadian Banking System 1817-1890

Is legal tender an imposition on free markets or a free market institution?

Robert the Bruce: Scottish  £20 issued by Clydesdale Bank. Not legal tender

This is my last post on legal tender. It builds on my initial posts on legal tender, various comments, and discussion at Bob Murphy's blog. If you're getting to the debate a bit late, here are the first two posts.

1. Legal Tender 101
2. How do legal tender laws affect purchasing power?

Are today's legal tender laws an imposition on monetary freedom?

My short answer: not really. In the US, legal tender is comprised of Federal Reserve notes and United States coin. That means that all debts can be discharged with government coins and notes. It might seem that this would impose the circulation of coins and notes on the marketplace. But as I pointed out in my initial post, debtor and creditor can easily get around legal tender rules by negotiating their own settlement media into the terms of a debt contract.

As commenter MF points out, there is one debt obligation that's tough to negotiate around: the government's tax obligation. Since citizens must pay taxes, and the government sets legal tender, surely notes and coin are forced upon the populace. In theory yes, but in practice no. The IRS asks that people do not send notes or coin to discharge their tax obligation. As a result, most taxes are paid with non-legal tender like cheques, direct deposit etc. Legal tender laws, it would seem, have no bite since the IRS itself ignores them.

But let's assume the government did indeed require tax payments in legal tender coin and notes. Let's return to my favorite McDonald's analogy (see here and here). Imagine that McDonald's Corporation forces customers to pay their "Big Mac tax" with McDonald-issued coupons. This is equivalent to a government that requires people to submit legal tender in order to discharge a tax obligation.

As I pointed out, people don't have to submit to McDonald's tax requirements, insofar as they are willing to eat at Burger King which (let's say) doesn't require coupons to pay for Whoppers. The same goes for US legal tender. If the US government requires citizens to settle their taxes with US legal tender (which, as I've pointed out above, is not the case in practice), then people can avoid this imposition by no longer doing business with the US. Go live in Scotland, which like Burger King, has no legal tender rules. Or find some other nation that doesn't have legal tender. You'll still have to pay taxes, of course, but settlement media won't be dictated to you.

As we know from Lawrence White's Free Banking in Britain, Scotland has a long history of free banking. Even today the majority of bank notes that circulate in Scotland are issued by three private banks—The Bank of Scotland, the Royal Bank of Scotland, and the Clydesdale Bank. These notes aren't legal tender. Nor are Bank of England notes, which also circulate in Scotland. For a brief time between 1954 and 1988, Bank of England notes with denominations below £5 were legal tender. But the withdrawal of the £1 notes from circulation in 1988 left Scotland with no paper legal tender. Scots accept both local Scottish notes and Bank of England notes as settlement media not because they must, but because it's convenient.

Legal tender as a free market institution?

Having shown that modern legal tender laws aren't necessarily a huge imposition on the free choice of payment media, I'll go one further and say that in a world characterized by free banking and governed by lex mercatoria (i.e. private merchant law) legal tender laws might evolve naturally as the result of market choice.

Huge amounts of debts are created in a day’s worth of business. Negotiating settlement media into each and every contract takes time, so transactors may choose to omit that bit. If so, a subsequent situation may arise in which a debtor arrives to pay a creditor, but the creditor refuses to accept the proffered settlement media, thereby forcing the debtor into unnecessary default. To avoid having court rooms being swamped by frivolous default cases, I could imagine merchant law evolving a list of common media that must always be accepted in the settlement of those debts for which a settlement medium was not already specified. If the marketplace were to accept these laws, then legal tender rules would arise in the same way that VHS beat Beta—they provide a cheap and useful set of standards around which everyone can coordinate their plans and actions.

Naturally, all sorts of interested parties would lobby jurists to have that list include their preferred asset. Nevertheless, there seems to me to be a certain “market” logic to legal tender. The real barriers to monetary freedom are not legal tender laws, but laws that restrict the issuance of notes to a monopoly issuer, and laws that force private banks to join a monopoly clearing house. But that's a different post.