Setelinleikkaus: When Finns snipped their cash in half to curb inflation

On the last day of 1945, with World War II finally behind it, Finland's government announced a new and very strange policy.

All Finns were required to take out a pair of scissors and snip their banknotes in half. This was known in Finland as setelinleikkaus, or banknote cutting. Anyone who owned any of the three largest denomination Finnish banknotes — the 5000 markka note, the 1000, or the 500 — was required to perform this operation immediately. The left side of the note could still be used to buy things, but at only half its value. So if a Finn had a 1000 markka note in their wallet, henceforth he or she could now only buy 500 markka worth of items at stores. As for the right side, it could no longer be spent and effectively became a bond (more on this later).

Source: Hallitus kansan kukkarolla, by Antti Heinonen

Setelinleikkaus was Finland's particular response to the post-War European problem of "monetary overhang," described in a 1990 paper by economists Rudi Dornbusch and Holger Wolf. After many years of war production, price controls, and rationing, European citizens had built-up a substantial chest of forced savings, or involuntary postponed consumption, as Dornbusch & Wolf refer to it. With WWII now over, Europeans would soon want to begin living as they had before, spending the balances they had accumulated on goods and services. Alas, with most factories having been configured to military purposes or having been bombed into dust, there wasn't nearly enough consumption items to make everyone happy.

It was plain to governments all across Europe what this sudden making-up of postponed consumption in a war-focused economy would lead to: a big one time jump in prices.

This may sound familiar to the modern day reader, since we just went through our own wartime economy of sorts: the 2020-21 battle against COVID and subsequent return to a peacetime economy. The supply chain problem caused by the COVID shutdowns combined with the big jump in spending as lockdowns expired, spurred on by a big overhang of unspent COVID support cheques, led to the steepest inflation in decades. 

According to Dornbusch and Wolf, European authorities fretted that the post-WWII jump in prices could very well spiral into something worse: all-out hyperinflation, as had happened after the first World War. Currencies were no longer linked to gold, after all, having lost that tether when the war started, or earlier, in response to the Great Depression. 

To prevent what they saw as imminent hyperinflation, almost all European countries began to enact monetary reforms. Finland's own unique reform — obliging their citizens to cut their stash of banknotes in two — would reduce the economy's stock of banknotes to just "lefts," thereby halving spending power and muting the wave of post-wartime spending. After February 16, 1946 the halves would be demonetized, but until then the Finns could continue to make purchases with them or bring them to the nearest bank to be converted into a new edition of the currency.

As for the right halves, they were to be transformed into a long-term investment. Finns were obligated to bring each right half in to be registered, upon which it would be converted into a Finnish government bond that paid 2% interest per year, to be repaid four years later, in 1949. It was illegal to try and spend right halves or transfer their ownership to anyone else (although it's not apparent how this was enforced).

In theory, turning right halves into bonds would shift a large part of the Finnish public's post-war consumption intentions forward to 1949, when the bonds could finally be cashed. By then, the economy would have fully transitioned back to a civilian one and would be capable of accepting everyone's desired consumption spending without hyperinflation occurring.

To our modern sensibilities, this is a wildly invasive policy. Had setelinleikkaus been proposed in 2022-23 as a way to dampen the inflationary effects of the reopening of COVID-wracked economies, and we all had to cut our dollar bills or yen or euros in half, there probably would have been a revolt.

With the benefit of hindsight, we know that setelinleikkaus didn't work very well. Finland continued to suffer from high inflation in the years after the war, much more so than most European countries did.

Why the failure? As Finish economist Matti Viren has pointed out, the reform only affected banknotes, not bank deposits. This stock of notes only comprised 8% of the total Finnish money supply, (Finns being  uncommonly comfortable with banks) so a major chunk of the monetary overhang was left in place.

Another glitch appears to have been the public's anticipation of setelinleikkaus. According to
former central banker Antti Heinonen, who wrote an entire book on the subject, banks began to advertise their services as a way to avoid the dangers of the upcoming monetary reform (see images below). So Finns deposited their cash prior to the final date, the monetary overhang to some degree evading the blockade.

Finnish bank advertisements warning of the upcoming note cutting
Left: "Bank accounts are fully secured in the banknote exchange."
Right: "Depositors are protected."
Source: Hallitus kansan kukkarolla, by Antti Heinonen (Translations via Google Translate)

If the Finnish experiment was a dud, other European responses to the post WWII overhang — either  redenominations, temporarily blocking of funds, or all-out write offs of bank accounts — were more successful. Germany's monetary reform of 1948, which introduced the Deutschmark and was later dubbed the "German economic miracle", is the one that captures the most attention, but here I want to focus on a lesser known reform.

Belgium's Operation Gutt, named after Belgium's Minister of Finance, Camille Gutt, was the earliest and perhaps the most dramatic of the post-war monetary operations. Taking place over four days in October 1944, Belgium contracted its entire money supply, both banknotes and deposits, from 165 billion to 57.5 billion francs. That's a two-thirds decline! You can see it illustrated in the chart below, along with the monetary reform enacted by the Dutch the following year, inspired by the Belgians.

A chart showing the incredible contraction of Belgium's money supply in 1944
Source: Federal Reserve Bulletin, October 1946 (red arrow is my emphasis)

It's not just the size of Operation Gutt that is striking to the modern eye. It's also the oddity of the tool being used. Today, we control inflation with changes in interest rates, not changes in the quantity of money. To soften the effect of the global COVID monetary overhang, for instance, central banks in the U.S., Canada, and Europe began to raise rates in 2022 from around 0% to 4-5% in 2024. 

By making it more lucrative for everyone to save and less attractive to borrow, central bankers were trying to reduce our propensity to spend our COVID support payments, and with less spending, prices wouldn't get pushed up as fast. This reliance on interest rates as our main tool of monetary policy is a relatively new phenomenon. In times past, central banks tended to lean heavily on changes in the supply of money, which may explain why in 1945, their main response — in Europe at least —  was to obliterate the public's money balances rather than to jack up interest rates to 25% or 50%.   

It's worth exploring in some more detail how Operation Gutt was designed. On October 9, 1944, Belgian bank depositors had 90% of the money held in their accounts frozen, leaving just 10% in spendable form.

As for holders of banknotes, there was no Finnish-style cutting. Rather, Belgians had four days, beginning October 9, to bring all their banknotes to the nearest bank, only the first 2,000 francs qualifying for conversion to newly printed versions. All notes above that ceiling got blocked in a separate account (along with excess deposits), some of which would be released slowly over the next few years—while the rest would remain frozen forever, subject to whether the owner was deemed to have been a collaborator who got rich during the occupation. (Finland's setelinleikkaus also had this same "cleansing" motivation.)

In 1944, a line forms at the National Bank of Belgium to exchange notes.
Source: National Bank of Belgium on Flickr

In this sense, the post-WWII European monetary reforms were not only designed to reduce inflation, but also had a moral basis. Think of them as progenitors to India's 2016 demonetization, which was designed to catch so-called "black money," although it failed to do so.

Did Operation Gutt work? Incredibly, the decimation of two-thirds of the money supply in just a few days did not cause an immediate fall in Belgian prices. According to Belgian economic historians Monique Verbreyt and Herman Van der Wee, the Belgian retail price index stood at 260 the month of the reform, but had risen to 387 by September 1945. So it would seem that the whole operation failed. This surely draws into question the quantity theory of money, one of the basic tenets of monetary economics. A decline in the money supply, all things staying the same, is supposed to cause a fall in prices. Here is a glaring case in which it didn't.

However, the National Bank of Belgium (NBB), the country's central bank, strikes a more constructive tone. In a recent retrospective on Operation Gutt, the NBB describes the reform as a gamble that paid off over time, eventually inspiring the "Belgian Economic Miracle", a period of low inflation and fast growth lasting from 1946-1949. By contrast, France did not embark on its own monetary reforms, the NBB takes pains to point out, and it thereby "paid the consequences of post-World War II inflation well into the 1960s." Belgium's inflation rate was also much lower than Finland's in the four or five years after the war. 

Which gets us back to Finland. Unlike the Belgian central bank, Finland's central bank — Suomen Pankki — notably avoids almost all mention of its post-war reform on its website. According to Matti Viren, setelinleikkaus led to "distrust towards the authorities and economic policy for decades," so there may be some sheepish reticence on the part of the central bank to draw attention to it.

But setelinleikkaus and Operation Gutt aren't just archaic monetary policy dead-ends. One day I suspect they'll be back. Not just as a special tool for responding to emergencies, but as a day-to-day policy wrench, albeit in a new and refined form. 

Cash, which is awkward to immobilize for policy reasons, will be gone in a decade or two, leaving the public entirely dependent on bank deposits and fintech balances which, thanks to digitization and automation, can be easily controlled by the authorities. To rein in a jump in inflation, central bankers will require commercial banks and companies like PayPal to impose temporary quantitative freezing on their clients'  accounts, but unlike Finland's 1945 blockade, the authorities will be able to rapidly and precisely define the criteria, say by allowing for spending on necessities — food, electricity, and gas— while embargoing purchases of luxury cars and real estate.

The future version of setelinleikkaus won't be clumsy, it'll be a precise and surgical inflation-fighting tool, albeit a controversial one.

Inflation as a tax

Last week I explored how Henry VIII resorted to coin debasement as a way to raise revenues in order to fight his wars. This provided Henry with the financial firepower to annex the city of Boulogne from the French in 1544, albeit at the price of England experiencing one of its greatest inflations ever.

Zoom forward five hundred years and Rishi Sunak, the Prime Minister of the UK, has ignited a controversy by referring to inflation as a tax, and further suggesting that the "best tax cut I can deliver for the British people is to halve inflation." His BBC interviewer disputed the claim, saying that inflation isn't a tax, a stance that the BBC upholds on its fact checking page.

Rishi Sunak, "The best taxt cut that I can deliver for the British people is to halve inflation."

Laura Kuenssberg, "Inflation is not a tax"

Rishi Sunak, "Inflation is a tax" pic.twitter.com/6LgMbeaprY

— Farrukh (@implausibleblog) October 1, 2023

If you recall, my previous article showed how Henry VIII's debasement functioned very much like a tax, say a new customs duty on wine or a beard tax. It did so by incentivizing people to flock to English mints to have their precious metals turned into coinage, Henry extracting a small fee on each coin. But the 21st century monetary system is very different from that of the middle ages. Is Rishi Sunak right to characterize inflation as a tax?

First, we need to better define our terms.

What do the BBC interviewer and Sunak mean by inflation? In the western world, prices have been rising at a regular pace of 2-3% each year for decades as result of central bank policy, which targets a low and steady inflation rate. Is this the definition they are using? Alternatively, Sunak and his interviewer may be referring to inflation as a *change in the change* in price. Since 2022 or so, that 2-3% rate has leapt to 8-9% all over the western world. Is it this jump that Sunak and his interviewer are talking about?

For the sake of this article, we'll assume that the conversation between Sunak and the BBC refers to the latter, a spike in the rate of inflation.

Secondly, what is meant by the word tax? Sometimes when we say that something is a tax we mean that it causes suffering. That is, inflation is taxing: it makes people's lives harder by increasing the cost of living, with salaries failing to keep up. It creates unfair changes in winners and losers.

Fair enough. But the more precise view I want to broach in this article is that inflation is actually a tax, where we define a tax as a formal charge or levy, set by the political process, that leads to cash flowing from the population to the government.

What does the data show?

Interestingly, a surprise jump in inflation leads to the very same effects as a new tax. All things staying the same, a new tax leads to an increase in government revenues. This improves the government's fiscal balance, or the difference between its revenues and expenses. A recent IMF paper by Daniel Garcia-Macia using data from 1962 to 2019 shows how an inflation shock typically achieves this exact same end result, boosting government revenues and improving its fiscal balance. This effect lasts for a few quarters, even up to two or three years, then recedes.

The IMF's chart below breaks down exactly how an inflation shock tends to improve government finances using quarterly data going back to 1999:

Charts source: IMF

Total tax revenue (the first panel) immediately begins to rise after the inflation shock at about the same rate as inflation.That's because most taxes are set by reference to values or prices, say like the prices of goods and services, or the price of labor, or the value of corporate profits. Since inflation pushes these amounts higher, this gets quickly reflected in tax revenues.

Income taxes and profits taxes (the second panel) rise particularly fast. Inflation is presumably pushing tax payers into higher income tax brackets, a process known as "bracket crreep," and so the government very quickly starts to collect a proportionally-larger amount of income tax.

Meanwhile, the government's total expenditures, the third panel, typically stay flat or only marginally rises in the quarters after the inflation shock hits. Notably, the amount of wages that are paid to government employees and social benefits (panels 4 & 8) tend to fall.

The net effect is an improvement in the government's fiscal balance. More specifically, for a 1% increase in inflation, the government's overall balance tends to improve by about 0.5% of GDP. And so an inflationary shock ends up at the same endpoint as a new tax: higher revenues and a better budget. That doesn't necessarily mean that inflation is itself a tax. Taxes have a degree of intentionality. They get implemented through a political process that has a certain set of goals in mind. By contrast, the extra revenue that an inflation shock raises is often (though not always) accidental, the result of external forces rather than political decision making.

So while it may not fall under the dictionary definition of a tax, the tax implications of a modern inflation shock resemble that of a new tax.

Everything I've written above applies to an inflation shock, say a rise from a 2-3% to 8-9%. Next I want to show that even constant 2-3% inflation can have the same revenue implication as a tax. Here's how.

Banknotes and seigniorage

Governments usually have a monopoly over the issuance of two key financial instruments: banknotes and settlement balances (also known as reserves). We all know what banknotes are, but what are settlement balances? Commercial banks find it useful to keep a stock of settlement balances on hand to make crucial large-value payments to other banks. The central bank, which the government controls, is the monopoly provider of these balances. (Sometimes banks are required by law to keep a a fixed number of settlement balances on hand, often above and beyond their day-to-day needs, a policy referred to as required reserves.)

Historically, interest rate on both types of central bank-issued money have been set at 0%. At the same time, the rates on short-term credit instruments (Treasury bills, commercial paper, bankers acceptances, etc) are determined by the market, typically hovering at a positive rate ranging between 0.25% to 5% over the last thirty years. These yields are priced to compensate investors for inflation.
 
The interest rate gap this gives rise to allows central banks to earn a steady stream of revenues, borrowing at an artificially cheap rate of 0% from both the banknote-using public and banks, and reinvesting at, say, 3%. Most of the revenues that the central bank collects from this interest margin flows back to the government. Economists usually refer to these revenue stream as seigniorage.

So seigniorage performs the same function as a consumption tax or an income tax: it takes resources from the public and gives it to the state. Likewise, a reduction in seigniorage would be very much like a tax cut.

If politicians wanted to, they could do away entirely with this form of raising government revenues. They have two ways of going about this. One way would be to have the central bank reduce price inflation to zero. By doing so, the interest rate on short-term credit instruments like Treasury bills would also fall to 0%, or thereabouts, since these instruments no longer need to compensate investors for inflation. And so the gap between the 0% rate at which central bank fund themselves and the rate at which they reinvest would cease to exist, seigniorage effectively shrinking to zero.

Over the last few decades, governments have taken a second route to removing seigniorage: they have begun to pay a market-linked yield on settlement balances. Canada, for instance, adopted this policy in 1999, and the Bank of England did so in 2006. By paying a market-based return, central banks no longer extract seigniorage from banks by forcing them to hold 0% assets. 

However, that still leaves banknotes as a significant source of seigniorage. We can calculate how much the UK government roughly earns from banknote seigniorage. With £95 billion in banknotes outstanding in October, and interest rates at 5.1%, the Bank of England's banknote-related seigniorage comes out to around £5 billion per year, much of which flows back to the government. That sounds like a lot, but it's only a small chunk of the £790 billion in taxes the UK government collected last year.

Banknote seigniorage isn't set in stone. It's a policy choice. If governments wanted to, they could reduce this form of seigniorage by paying interest on banknotes. One way to go about this would be to introduce a banknote serial number lottery. This lottery would offer around £5 billion in cash prizes to holders of winning banknote serial numbers, equating to a 5% interest rate on banknotes. Doing so would be akin to enacting a tax cut on British citizens.

To sum up, the fact that both an inflation shock and steady 2-3% inflation have implications for government revenues suggests that while inflation may not quite qualify as a tax, it is certainly tax-like.

How to debase the coinage in order to pay for wars

Henry VIII, after Hans Holbein the Younger

It's fun to imagine traveling back in time and engaging with the then-prevailing technologies. Would you be able to ride a boneshaker or use a counting board? It's probably harder than you think: kids today can't even use a 1980s rotary phone. In this post I'm going to write about one specific techno-institution, the mint, and a particular function that it sometimes played many centuries ago; funding wars.

If you had to go back to 16th century Europe, and you were asked to operate the mints in a way such that they raised enough revenues so that your patron, the king, could wage war against a neighbouring country, how would you go about that?

I think the general sense that most of us have is that you'd need to somehow "debase" the coinage. The majority of coins back then were made of precious metals. If you could sneakily remove some of the silver and gold from each coin, and replace it with cheaper copper, then you'd be able to amass a hoard for the king (albeit at the expense of the public), and he could use that to hire an army.  

Now, if you went back in time with the above hazy notion of debasement, you wouldn't have much luck, and might even get your head chopped off. There's a grain of truth to it, but much of it won't work.

So before you head off in a time machine, here's what you need to know about the business of minting.

The first thing you need to know is that the King (or Queen) owns the royal mints, which they rent out to private parties to operate. Another important fact is that the public brings their own personal supply of precious metal – raw silver, silver cutlery and dishes, old coins, etc – to the mint, and then after waiting a week or two for the order to be processed, walks out with the final product; newly-minted coins.

But the mint's customers don't leave with as much silver (or gold) as they arrived. For each ounce of precious metals that gets minted into coin, the King collects a fee, known as "seigniorage", usually around 5% in the case of silver. The private individual who runs the mints gets a much smaller cut too, called brassage.  

If you're scrambling for a modern analogy, I suppose you could think of the medieval business of minting as very much like a modern laundromat, where customers bring their clothes, have them processed, and leave with their clothes, paying a small fee to the laundromat owner, who in turn pays a big chunk of this to the franchisor.

Like a laundromat owner, the monarch would have earned a fairly steady stream of revenues from their mints. Coins were more useful and liquid than raw silver, so there was an ever-present demand to convert raw silver into coin for transactional purposes. But remember, the challenge you face isn't just to generate regular profit. The king wants a massive surge in revenue. He's got a war to wage. How are you going to repurpose the mints to provide this gusher?

Your first attempt to raise money for the king might be to boost the minting fee from the low single digits to 20-25%. That might work. And you wouldn't be the first to go this route. For centuries, the English seigniorage rate on silver typically hovered around 5%, as illustrated in the chart below from a paper entitled The Debasement Puzzle, by Rolnick, Velde, and Weber. For gold, the minting fee was typically at 0.5% to 2%. To help fund his war against the Scots and the French, Henry VIII raised the seigniorage on silver to a remarkable 50-60% in the 1540s. Gold fees skyrocketed to 15%.

Source: Rolnick, Velde and Weber [pdf]

Mind you, fee hikes alone aren't going to work. Dissuaded by sky-high costs, many people will stop bringing their silver and gold to the mint to be coined, and the King's seigniorage revenues will dry up. A bothersome coin shortage will probably develop, too. Off with your head! says the King.

After thinking about it some more, you realize that, like a modern laundromat owner keen to make more revenue, you need to dramatically increase the amount of material going through the mint. How to do so?

You've got a few levers to increase throughput. One option is to introduce new products. If you offer new denominations of coins, for instance, people may bring more silver to the mint because those denominations are useful to them.

There's certainly precedent for that. To help pay his armies, Henry VIII brought back the testoon, a coin worth 12 pennies (or a shilling) in the hope that there would be significant demand for them, and that this would boost throughput and thus mint revenues. Testoons complemented Henry's silver halfpennies, pennies, groats (4 penny pieces), and sixpence (six pennies), in addition to a range of high denomination gold coins.

Below is an example of one of Henry's testoons, first minted in 1542. Because they had so much copper in them (more on that later), many of the testoons that exist today have a greenish tinge (due to copper oxidation). In the 1540s, Henry VIII's silver coins still hadn't turned green, but had a reddish tinge, which tended to reveal itself on his nose. Which is why Henry's nickname was Old Coppernose.

English groat (4 pence) issued 1547-49. Source: The British Museum

But introducing new denominations probably isn't going to generate a huge rush to the mints, since a new denomination will to some extent cannibalize existing demand for other denominations. Anyone who orders more testoons is likely to order fewer groats, for example. You'll have to do more.

In addition to introducing new coins, another strategy you might try is to cancel old ones. By having the King demonetize a popular coin, or declare it to be "no longer current," those coins will cease being legal tender or acceptable for taxes. The public will be forced to bring their demonetized coins to the mint to be converted into legal coins, the rush to do so creating a revenue windfall for the King.

And indeed, Henry VIII's successor Edward VI (who continued his father's wars) did this exact same move in 1548, declaring the testoons his father had reintroduced just four years before to be no longer current, as recounted in a paper by C.E. Challis (1967). I've clipped the relevant part below:

The demonetization of testoons is announced. Source: C.E. Challis

But we still haven't broached the main method: debasement. This is where the gusher begins.

Together with the King, you announce to the public that anyone who brings precious metals to the mint will now get more coins than before, for the same weight of precious metal. So for example, if someone used to be able to bring, say, 10 grams of pure silver to the mint and got 100 pennies minted, now they can bring 10 grams and get, say, 200 pennies. Same amount of silver, more coins.

As the operator of the mint, you could enact this change by cutting the weight of each penny by half, or, if you wanted to be more clever, maintain the same weight but reduce its fineness by 50%, by introducing more cheap copper to the mix. Either way, you've just debased the currency.

But how exactly does this raise revenues for the King?

Let's think about this change from a merchant's perspective. Say that our merchant owes a supplier 1 pound (a pound is 240 pennies). He's about to pay his debt off with everything he has, 240 pennies, when the debasement is announced. He can now bring his 240 pennies to the mint and have them recoined into 480 pennies. That allows him to pay off his debt, which is still denominated at 1 pound, and still have 240 pennies for himself. What a great opportunity! The merchant heads off to the mint with his silver.

Or imagine our merchant need to buy some property that's priced at 10 pounds, or 2,400 pennies. If he has only 1,200 pennies on hand, he can't afford it. But with the debasement having just been announced, the merchant can now convert those 1,200 pennies into 2,400 pennies and make the purchase.

Congratulations, you've created a revenue gusher! What you've effectively done is offer a short-term arbitrage opportunity to those who are paying attention, most likely the rich and well-connected, at the expense of the not-so-aware. To take advantage of a profitable situation, these enterprising individuals will immediately bring all their silver and gold to the mint. And you'll collect a toll on all that metal as it passes through.

But that arbitrage opportunity won't last forever. Debts will be recalibrated to account for the 50% decline in the penny's silver content. Prices of things like property will eventually double to reflect the new true value of the penny. At that point it will no longer be advantageous to bring one's silver to the mint to be recoined, and the revenue gusher you've created will subside.

You might try announcing debasements every few years or so, thus milking your mint's throughput on a continual basis. Too many debasements, though, and this trick will stop working, since that portion of the population that is the victim of the arbitrage you've created – the less aware – eventually wises up and protects itself by quickly increasing prices whenever a debasement occurs.

A constant series of debasements is exactly what Henry VIII and his son Edward enacted between 1542 and 1551 to keep paying their soldiers. Using data from a paper by John Munro, The Coinages and Monetary Policies of Henry VIII, I've charted out (above) how the penny's silver content changed over that time period. Going into the 1500s, an English penny contained 0.72 grams of pure silver. At the end of the Great Debasement, (the term used for Henry VIII's operations on the coinage) the penny contained just 0.11 grams of silver, constituting an 85% reduction in silver content.

We can further split out how Henry VIII's debasements were distributed between changes in fineness and changes in weight. Going into 1542, the English penny was 92.5% fine. Nine years later its purity stood at just 25% silver, the other 75% being base metal such as copper. As for weight, a penny weighed 0.79 grams in the early 1500s, but only 0.43 grams by 1551. 

These changes are illustrated in the chart below.

Thus it was diminutions in purity, not weight, that drove the biggest chunk of the penny's debasement, although weight did have a role to play.

How successful were these policies in creating a financial gusher for Henry and his son?

The charts below from Rolnick, Velde, and Weber (which I've clipped from  a second paper authored by the trio) show how the combination of mintage policies enacted in the 1540s – debasement, new testoons, and a demonetization of the testoon – led to a large influx of silver and gold to the English mints.

Source: Rolnick et al

According to Challis, the combination of these inducements, along with a big boost in fees, resulted in minting profits of £1.3 million for the two kings from 1542 to 1551. This would have paid for a big chunk of the £3.5 million in military expenditures over that same period, much more than actual taxation, which only yielded £976,000.

Of course, the final result of all this was a significant number of deaths, and what one account describes as "an episode of sixteenth-century ethnic cleansing which in its aims and implementation was not dissimilar from ...the former Yugoslavia in the 1990s or, most recently, with the Myanmar government’s actions against the Rohingya." It also caused one of the worst episodes of price inflation that England had ever seen. According to Munro, the English consumer price level rose by 123% between 1541 and 1555.

So there you have it. If you had a time machine, you now know how to go back to medieval Europe and operate the royal mints in order to fund big ticket items like wars. (Whether you should actually do so is another question.)

Cross-checking ShadowStats

Last week I wrote about Balaji Srinivasan's idea of creating a decentralized version of the Billion Prices Project. The post got me thinking again about the topic of alternative inflation indexes.

One of the most well-known of the alt-inflation indexes is John Williams' ShadowStats, often cited by gold bugs and bitcoin maximalists. As of August 2011, ShadowStats puts U.S. inflation at 13% versus official inflation of 5%, as illustrated in the chart below.

Source: ShadowStats

That's a huge gap. One of the two data series has to be wrong.

I've always dreamt about writing a blog post on ShadowStats, but never had the gumption or statistical chops for it. So I was happy to see that economist Ed Dolan announced on Twitter that he was  republishing a 2015 blog post in which he carefully critiqued ShadowStats. It's such a good article that I'm not going to bother writing my own ShadowStats post anymore.

ShadowStats attracts a lot of sneers from the econ commentariat. What makes Dolan's post so effective is that he gracefully takes Williams' arguments on their merits and then proceeds to analyze them. Put differently, he doesn't try to damn ShadowStats with straw man arguments. He steel-mans it (or steelwomens it).   

Anyways, do read the post. 

Dolan saves his best criticism for the end. When Dolan was writing his post in 2015, the gap between official inflation and ShadowStats inflation was a whopping 7% (see chart above). What Dolan finds is that the majority of this 7% gap can be attributed to a simple double-counting error committed by Williams. By correcting this double-counting error, the ShadowStats inflation number shrinks. And so the gap between it and the official CPI is actually far less menacing than Williams' anti-government fans like to make out.

Dolan challenges Williams to correct his double-counting mistake. But you can see why Williams might find this difficult to do. He has been selling his data for many years on a subscription basis. Admitting that his product contains errors could anger his customer base.

The other part of Dolan's blog post that I want to draw attention to is a set of simple cross-checks he performs to see whether official inflation or ShadowStats is more accurate. For instance, taking grocery prices from a 1982 advertisement and projecting them forward with both inflation indexes, Dolan finds that the official CPI does a better job of predicting where modern grocery prices actually ended up.

It would be unfair to do just one set of crosschecks. Which is why Dolan does a bunch of them. It's worth reading through each one. ShadowStats does not make out well. (For instance, in order for ShadowStats to be right, you've got to believe that the U.S. economy has been in a recession for the last two decades.)

To finish my blog post off, I'm going to add to Dolan's list of cross-checks by adding one of my own. This cross-check is meant specifically for one of the main consumers of ShadowStats data: gold bugs.

If gold investors think ShadowStats data is right, and many of them do, then they also have to accept that gold has lost 91% of its value since January 1980 (see chart below of the gold price adjusted for ShadowStats inflation). Which means that the yellow metal is an awful hedge against inflation, and anyone who buys it for that reason is making a big mistake.

Source: Bullionstar

The far more reasonable position to take is that the ShadowStats data is wrong, and that gold has actually been a decent hedge against inflation since 1980. Using official inflation numbers rather than ShadowStats, the price of gold today is almost even with its 1980 level.

So gold bugs, you can relax. You haven't lost your sanity -- gold is not an awful inflation hedge. Rather, ShadowStats is an awful measure of inflation.

A decentralized version of MIT's Billion Prices Project

Balaji Srinivasan, an angel investor, wants to kick start an updated version of MIT's Billion Prices Project. He will invest $100,000 in the project that best envisions how to create a publicly-available decentralized inflation dashboard, one that relies on scraped data from retailer websites.

A truly global inflation dashboard would be the next coinmarketcap. It'd be bigger than that, in fact.

So we're offering a little prize to build one. https://t.co/OtZJS8FRWA

— Balaji Srinivasan (@balajis) August 5, 2021

Many years ago I was a big fan of the MIT's Billion Prices Project, so I perked up when I read about Srinivasan's contest. Created by economists Roberto Rigobon & Alberto Cavallo, the Billion Prices Project collected, or scraped, data from retailers' websites and used it to generate an alternative version of various government-tabled consumer price indexes. (I wrote about the Project here.) Members of the public could get access to Billion Prices U.S. data, albeit with a small delay.

This was incredibly useful! Because government consumer price indexes are published monthly, but websites can be scraped 24/7, the Billion Prices Project was far more responsive to price changes than government consumer price indexes are. It gave you insights into tomorrow's CPI announcement, today.

The Billion Prices Project also garnered attention because it revealed how Argentinean authorities had distorted official statistics to make inflation appear more muted than it really was. Conversely, the Billion Prices Project regularly confirmed the accuracy of U.S. Bureau of Labor Statistics' consumer price indexes, making it a useful tool for whacking gold bugs and inflation truthers over the head.  

While I like Srinivasan's general idea of bringing real-time scraped inflation data to the masses, I see three big problems.

The first problem is over-reliance on scraped data. Scraping is fast and cheap, but only a portion of the global economy's prices are scrape-able. Amazon and Walmart may sell almost every type of physical good under the sun here in Canada and the U.S., but they don't sell services. So while it's easy to find scraped prices of laptop computers, forget about prices for haircuts, rent, or healthcare.

That leaves a pretty big hole. Government statistical agencies such as the Bureau of Labor Statistics (BLS) or Statistics Canada are able to capture services prices because they send out human inspectors to check the prices of things like haircuts and back-rubs. Lacking price data on these items, Srinivasan's inflation dashboard will never be as accurate as the dashboards published by Statistics Canada or the BLS.

Consider too that goods in many developing and undeveloped countries are not available online. Amazon, for instance, isn't going to provide any clues into what is going on with vegetable prices in Afghanistan, or shoe prices in Yemen. Srinivasan says that he wants an "internationally useful" dashboard, but he's certainly not going to get one by relying on scraping alone. He's going to get a rich folks' dashboard.

Which leads into the second problem: the business model won't work. Compiling inflation indexes is costly, but Srinivasan wants his decentralized inflation dashboard to be made public, and presumably free. That's just not possible.

Rigobon & Cavallo's own Billion Prices Project is a good example of this dilemma.

Mere grants weren't enough to fund the Billion Prices Project. Yes, scraping may be cheaper than using physical data collectors, but it's still expensive to compile price indexes. Bills had to be paid. And so the whole Billion Price Project sold out. It was folded into a company called PriceStats and sold as a proprietary product to rich investors and central banks.

At first PriceStats continued to offer some free public dashboards. But this was never going to last. Rigobon & Cavallo's data had commercial value because it was quicker than government data, and could be used by traders to beat the market. Making even a portion of that data available to the public destroyed its commercial value. And so over time the public-facing parts were all discontinued. The Billion Prices Project, at least the public service side of it, is effectively dead. 

How data from PriceStats/The Billion Prices Project overlapped with US consumer price indexes [source]

Srinivasan's proposal faces the same tradeoffs as the Billion Prices Project. Price data is expensive to collect, compile, store, and process. Government agencies like the BLS are funded by taxes, not profits, and so they can give it away for free. We all benefit from this public service. But the calculus is different for private companies. To fund data collection, they must implement some sort of pay-wall. Srinivasan wants to make a public inflation dashboard, much like the BLS does. But he can't. He's not a government. 

(And no, an inflation dashboard won't be able to rely on advertising revenues, say like how Coinmarketcap does. Frenetic gamblers are addicted to checking coin prices. Inflation data doesn't attract eyeballs).

The last problem with Srinivasan's project is the basket problem. The introductory page that describes the project focuses on how to scrape for data. But this omits one of the biggest challenges to compiling any consumer price index: determining what the consumer price basket actually is. That is, what exactly is the "basket" of goods and services that the average consumer consumes each month?  

Government statistics agencies such as the Bureau of Labor Statistics solve this problem by conducting national surveys. For instance, the BLS's baskets are based on interviews with 24,000 Americans each quarter about their spending habits. The BLS gets even more precise data by having 12,000 of those participants keep a detailed diary that lists all expenses for a week.

But that's an incredibly resource-intensive process.

To avoid having to run costly surveys in order to build a representative consumption basket, the Billion Prices Project had a simple solution: it borrowed the BLS's baskets. But Srinivasan's project has declared this solution to be out of bounds. The project's website describes inflation as a "government-caused problem," and so the project can't rely on "government statistics."

Which means that Srinivasan's project will have to build its own representative price basket using its own surveys. Unless it can bring the same amount of financial resources to bear as the BLS, I don't see how it can pull this off.

Alternatively, the project will have to use the BLS's "untrustworthy" data. But that means contradicting its stated philosophy.

To sum up, Srinivasan envisions his decentralized inflation dashboard as being a superior alternative to untrustworthy government dashboards. But government consumer price indexes are far better than he is making them out to be, given the huge amount of money, time, and expertise committed to statistics agencies. (Yes, there are exceptions like Argentina). If any inflation dashboard is likely to be untrustworthy, I fear it will be Srinivasan's built-on-the-cheap dashboard.

(By the way, you'll notice I didn't discuss the decentralized aspect of the inflation dashboard. The project has enough challenges already, before even getting to the decentralized bit.)

All that being said, I'm in the same camp as Srinivasan. Scraped inflation data is neat and useful, and I think the public should be getting access to it. But my preferred solution is different than the one put forth by Srinivasan. Hey, BLS and Statistics Canada! When are you ever going to unveil some sort of free real-time consumer price index that relies on scraped data?

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Srinivasan responds. Joe Weisenthal blogs.

Is fiat money to blame for the Iraq war, police brutality, and the war on drugs?

I often encounter memes claiming that fiat money is to blame for all sorts of government evils. Here is one example from Kraken bitcoin strategist spokesperson & bitcoin meme factory Pierre Rochard:

The military-industrial complex that deliberately creates wars is financed by inflationary State fiat currencies.

— Pierre Rochard (@pierre_rochard) January 8, 2020

The rough idea behind this family of memes is that the Federal Reserve, the world's largest producer of "fiat" money (i.e. irredeemable banknotes), is responsible for financing all sorts of examples of government over-reach, say foreign invasions, police brutality, and the twin wars on terrorism and drugs. It does so by producing seigniorage, or profit, which it passes on to the state. Replace fiat-issuing central banks like the Fed with bitcoin or a gold standard, and seigniorage would cease to exist. With the government's purse strings having been cut, a relatively peaceful society would be the result.

This meme's premise is wrong. In practice, central bank seigniorage in both the U.S. and other developed nations is a very small part of overall  government revenues. And so even if fiat money were to be displaced, say by bitcoin or a gold standard, it wouldn't change the state's ability to fund the war on drugs and adventures in the Middle East.

Let's look at the U.S. Below are two charts showing how much income the Federal Reserve has contributed to the Federal government's overall receipts going back to 1950. (Beware. One chart relies on a regular axis, another a logarithmic axis. But they use the same data). The Fed's contribution has been steadily growing over time. In 2019, it sent about $53 billion to the Federal government.

You may be wondering how the Fed generated $53 billion in profit, or seigniorage, in 2019. Most of this income comes from issuing banknotes, or cash. For each $1 in banknotes that it issues to the public, the Fed holds an associated $1 of bonds in its vault. These bond have typically yielded 3-4% in interest. But the Fed only pays 0% interest to the owners of its banknotes. Which means that it gets to keep the entire 3-4% flow of bond interest for itself. It forwards this income to the Federal government at the end of the year.*

Seigniorage tends to grow over time. (But not always. Below I'll show how Sweden's seigniorage has been shrinking). The larger the quantity of banknotes that the public wants to own, the more interest-yielding bonds the Fed gets to hold, which means more seigniorage. In general, banknote demand increases with economic and population growth.

Interest rates are another big driver of seigniorage. If bond interest rates rise from 4% to 8%, the Fed earns more on the bonds it owns in its vault. Banknotes continue to yield 0% throughout, so the Fed keeps the entire windfall for itself (and ultimately for the Federal government).

By the way, a big driver of nominal interest rates is inflation. If inflation is expected to double, then bond owners will require twice the interest to compensate them for inflation risk. So inflation boosts seigniorage (because it boosts the interest rate that the Fed earns on the bonds in its vaults), and deflation hurts seigniorage (because it reduces interest rates). In the chart above, the one with the logarithmic axis, you can see how the Fed's seigniorage increased during the inflationary 1970s. It flatlined from the mid-1980s to the early early 2000s, which coincides with inflation subsiding.

US seigniorage is relatively small. In addition to enjoying revenues from the Federal Reserve, the U.S. Federal government also gets money from individual and corporate income taxes, social insurance and retirement receipts, excise taxes, duties, and more. Below I've charted the relative sizes of these contributions.

As you can see, the Fed's contribution (the grey line) is a rounding error.

Below is a chart showing what percentage of total government revenue is derived from the Fed.

In 2019 the Fed contributed just 1.5% of total U.S. Federal government receipts. This contribution has hovered between 1% to 3% over the last four decades. So the meme that fiat money abetted the Iraq War, the expansion of the police state, or the U.S.'s military industrial complex is mostly hyperbole.

What about other developed nations?

The Bank of Canada provided $1.2 billion in earnings to the Canadian Federal government in 2018. But the Federal government took in $313 billion in revenues that year, which means that the Bank contributed a tiny 0.4% fraction of total revenues. The reason for the big gap between the Bank of Canada's tiny 0.4% contribution and the Fed's 1.5% contribution is the global popularity of the US$100 bill. Canadian cash doesn't enjoy a big foreign market.

I mentioned Sweden earlier. Below is a chart of seigniorage earned by the Swedish central bank, the Riksbank.

Sweden's central bank, @riksbanken, used to earn a handsome profit by issuing banknotes, ie seigniorage.

With cash usage wilting & interest rates hitting zero, seigniorage has collapsed. If these trends continue, issuing cash could become a financial burden for the Riksbank. pic.twitter.com/LCYOJ3q8dZ

— John Paul Koning (@jp_koning) August 28, 2019

Sweden is one of the only countries in the world where banknote ownership has been falling. This de-cashification is compounded by interest rates that have fallen close to 0%. Which means that the Riksbank's bond portfolio isn't earning as much as it used to. This combination has just decimated the Riksbank's seigniorage. In 2018 its seigniorage amounted to a paltry SEK 267 million (US$29 million). This is just 0.00003% of all Swedish central government receipts.

So in sum, central banks in places like the US, Canada, and Sweden are not a big source of government funding. If you want to stop governments from engaging in bad policies like the war on terror, the war on drugs, and foreign meddling, you've got to work within the system. Vote, send letters, go to protests. Sorry, but buying bitcoin or gold in the hope that it somehow defunds these activities by displacing the Fed is not a legitimate form of protest. It's a cop-out.

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P.S. By the way, I am not saying that control of the nation's money supply hasn't been used to finance wars in the past. Obviously it has. Greenbacks helped pay for the Union's war against the Confederates. Henry VIII paid for his wars by dramatically reducing the supply of silver in the English coinage.

*The Fed enjoyed a big spike in seigniorage after the 2008 credit crisis. This is because it issued a bunch of deposits to bank (known as reserves) via quantitative easing. The Fed only had to pay 0.25% interest on these reserves, but the bonds that backed them were earning 2-3%. This QE-related income has declined as the Fed has unwound QE (since reversed) and long-term interest rates have declined.

The life and death of an internet monetary meme

Over the last few years I've increasingly crossed paths with the following claim on the internet: "The average life expectancy for a fiat currency is 27 years." Is this claim true? What definitions are being used? I mean, are we talking about inconvertible paper money here, or currency that was convertible into gold, too?

I finally got curious enough that I decided to chase down the source of this meme. After all, without knowing what data it is based on, it's hard to evaluate the claim's truthfulness. Below I give a description of my trek through internet history.

The average-life-of-fiat meme has become particularly popular among cryptocurrency types. For instance, here is Jimmy Song, a popular bitcoin educator/developer, confidently invoking the slogan back in 2017:

"When a society lacks prudence, what happens is that the society collapses or goes into chaos. It’s not a coincidence that the average lifespan of a fiat currency is only 27 years."

A long list of cryptocurrency luminaries have dutifully mentioned the meme including Dan Held (2018), Taylor Pearson (2019), Barry Silbert (2019), Tuur Demeester (2015), Francis Pouliot (2018), and Adam Back (2019). Grayscale Investments, a firm that provides cryptocurrency-based investment products, even includes it in their marketing material:

Hey @GrayscaleInvest. You say on your website that fiat currencies have "an average life expectancy of just 27 years." Do you have the data to back up your claim? https://t.co/sscStL8efj @barrysilbert pic.twitter.com/bIj7D3ZWaS

— John Paul Koning (@jp_koning) September 17, 2019

As is often the case these days, crypto bugs have cribbed their ideas from their older cousins, the gold bugs. Nathan Lewis, author of Gold: The Once and Future Money, mentioned the idea in written testimony to Congress in 2012. Ralph Benko, a gold standard advocate, invoked the meme in a 2011 article. And Max Keiser, a long-time gold bug turned cryptocurrency advocate, began mentioning it as early as 2013. Where did Keiser, Benko, and Lewis get the meme from?

One of the meme's earliest and most cited appearances comes from Washington's Blog, a platform for a group of anonymous financial writers. We know little about this group except for the fact that George, "website owner and lead writer – is a busy professional, a former adjunct professor, an American and a family man." 

In August 2011, Washington's Blog published an article with the brutally long title The Average Life Expectancy of a Fiat Currency is 27 Years... Every 30 to 40 Years the Reigning Monetary System Fails And Has To Be Retooled. The author failed to explain how the 27 years claim was derived. Instead, he/she relied on another article by a writer named Chris Mack for backup. In a disclaimer the author noted that "I don't know Chris Mack," and thus couldn't vouch for the figures. "However," he/she went on to say, "the general concept is correct."

That's an odd way to do analysis, no? I've got this number for you, 27. I don't know how the number was generated, or who came up with it. But it's good enough. So go ahead and use it.

After a bit of hunting, I found Chris Mack's article here (the link at Washington's blog is dead). It is dated January 2011, pushing back the meme's genesis by another few months. At the time, Mack was President of Trade Placer, a "real-time marketplace where you can buy or sell items such as gold, silver, platinum, wine and other collectibles." Now he is the CEO at Levidge, a platform for trading cryptocurrencies. Note again the well-trodden corridor between gold buggery and crypto buggery.

Anyways, in 2011 Mack wrote:

"According to a study of 775 fiat currencies by DollarDaze.org, there is no historical precedence for a fiat currency that has succeeded in holding its value. 20 percent failed through hyperinflation, 21 percent were destroyed by war, 12 percent destroyed by independence, 24 percent were monetarily reformed, and 23 percent are still in circulation approaching one of the other outcomes.

The average life expectancy for a fiat currency is 27 years, with the shortest life span being one month. "

Mack mentions a study by DollarDaze, but doesn't provide a link to the article. Aha, the missing data! I hopped over to DollarDaze's website, a blog dedicated to talking about the failings of the U.S. dollar. But there are no blog posts older than 2018. No study, folks.

This puts all the meme users – Jimmy Song, Grayscale, Max Keiser, and the rest – in an absurd situation. There are some words on some websites about a study, but ask our meme users where the study is and none of them can actually find it. Did it ever exist? Why are they so confidently transmitting data when there is no data? DollarDaze has got to be right, no? How could you doubt it, JP?

Since no one was able to help me, I turned to the Wayback Machine to see if I could pull up older versions of the DollarDaze website. It took a while, but I finally found pay dirt. Back in 2009 the editor of DollarDaze, Mike Hewitt, wrote an article entitled The Fate of Paper Money. I tried to track Hewitt down, but he seems to have disappeared from the internet.

No matter. Finally, some data to evaluate! In his article, Hewitt claims to have counted 176 currencies in circulation and 599 currencies that are not in circulation. Of the 599 in his discontinued list, Hewitt comments that the "median age for these currencies is only fifteen years!" He provides links to both lists (1 and 2).

I downloaded Hewitt's list of 599 defunct currencies and put it into an Excel spreadsheet. The median age is indeed 15 years, as Hewitt claims, and the average is 27 years, as Mack claims in his subsequent 2011 article. So voila, we finally have the basis for the modern internet meme that the average age of a fiat currency is just 27 years. It's based on Hewitt's list of 599 dead currencies, with Mack taking the average duration. (They conveniently don't include the list of 176 existing currencies in their calculation, which would have increased the number). 

Now for my criticisms.

The 27-years meme has been used for many years now as a prop for making gold and cryptocurrencies look good. "Ha ha, suckers! Only 27 years until your paper is worthless!" But many of the 599 defunct currencies in Hewitt's list weren't failures. Rather, they were replaced for political, economic, and cultural reasons.

And things haven't improved much from there other than getting better at not imploding in 5months flat, tho there are appalling stats about the lifetime of fiat currencies since inception (27 years average). the oldest is the GBP at 317 years and even it lost > 99.5% of value.

— Adam Back (@adam3us) July 31, 2019

For instance, the list contains all of the pre-euro currencies (Dutch gulder, French franc, Italian lira, etc). These currencies had good reasons for disappearing: they were swapped for a new monetary unit. Existing currency holders weren't robbed. They were fairly compensated for this switch.

Another example of monetary reorganization occurred in East Africa. From 1919 to the 1960s, Britain's former east African colonies relied on the East African shilling, produced by the East African Currency Board. When these countries gained their independence, the currency board was dismantled. In its place Kenya began issuing its own shillings at par with the old ones, as did  Tanzania and Uganda.

In each case, existing owners of East African shillings could convert their holdings into new currency. No wealth was being destroyed during any of these switches. But people who throw around the phrase the average life expectancy for a fiat currency is 27 years as a criticism of the very institution of currency are using the data in a way that implicitly assumes that the East African experience – and others like it – were negative. They weren't.

So the idea that Hewitt's list somehow measures the length of time between a fiat currency's birth and its impending worthlessness is just wrong. I'd go even go so far as to say that the plasticity of the listed currencies is one of their strengths. As national borders change and political circumstances shift, the writing on the bills should be updated too. 

Hewitt's list contains many data errors. He makes the odd claim that the Japanese gold oban and silver momme were created in 1904 and met their end in a hyperinflation in 1905. But these were both historic Japanese coins that had existed for centuries. Hewitt also lists the U.S. greenback ("US Paper Dollar) as lasting from 1862 to 1878. But this isn't correct. Greenbacks were repegged to gold in 1878, but they continued to be issued for many decades after.

Or take Hewitt's categorization of British Military Authority (BMA) lira as dying in hyperinflation. This is an odd claim to make. BMA Lira were issued in Libya by occupying British forces both during and after World War II to provide the nation with a circulating medium. These notes were basically a military version of the British pound, with 480 lira equal to a pound sterling. In 1951 BMA Lira notes were converted into Libyan pounds, issued by Libya's new currency board, at a rate of 480-to-1. No hyperinflation here.

Finally, take Hewitt's claim that the Hawaiian dollar was "destroyed" by WWII. Not so. I've written about the Hawaiian overprints before. To protect against a potential Japanese invasion of Hawaii (and a confiscation of dollars by Japanese soldiers) all dollars on Hawaii were overprinted. Once the threat of Japanese invasion had disappeared they were swapped for regular U.S. dollars and withdrawn . But not a single Hawaiian lost anything during the entire process.

I don't want to nitpick too much, but given that it only took me a few minutes to find these four mistakes, one can only conclude that the rest of Hewitt's list is riddled with errors.

Finally, there are some semantic issues. Fiat currency is generally considered to be inconvertible money. It can't be redeemed for gold or silver. The world really only shifted onto a fiat standard between 1968-71 as the dollar ceased to be redeemed in gold. But Hewitt's list is replete with many metallic currencies (i.e. the riksdaler riksmynt). Are people using his data to make a claim about currencies in general, or just fiat ones? The meme isn't clear on this.

So having examined the life of an internet monetary meme, I'd like to kill it. It's time for us to retire the idea that says that "the average life expectancy for a fiat currency is 27 years." God knows there's plenty of problems with currencies. But good criticism requires diligence and accurate data. The meme in question is an example of sloppy work and bad data.

I know that the crypts and the bugs and the fiats are engaged in constant meme warfare, the bugs and the fiats for many decades now, the crypts only joining the battle a few years ago. Messages must be crafted for best efficiency, whether this be to pump bitcoin to the moon, or to push gold into the stratosphere, or to lock the fiat system in place. But most of the serious people involved in these debates, no matter which side, still keep at least one foot in the truth. Let's flush the 27-years meme down the toilet, folks.  

When a rising stock market is a bad thing

If the world had a single cauldron for mixing various monetary phenomena, it would be Zimbabwe. Over the last two decades, it has experienced pretty much everything that can happen to money, from hyperinflation to deflation, demonetization to remonetization, dollarization and de-dollarization, bank runs, bank walks, and more.

Adding to this mix, the Zimbabwe Industrial Index—an indicator of local stock prices—has recently gone parabolic, having more than tripled over the last twelve months. That's a good sign, right? Beware, these gains aren't real. As is often the case in Zimbabwe, the rise in stock prices is a purely monetary phenomenon.

Ever since the great Zimbabwean hyperinflation led to the domestic currency becoming worthless in 2008, U.S. dollars have served as the nation's currency and unit of account. However, Zimbabwe's central bank, the Reserve Bank of Zimbabwe (RBZ), has spent much of the last two or so years surreptitiously bringing a new parallel monetary unit into circulation. These new units, informally referred to as RTGS dollars, are a digital form of money, specifically a deposit held at the central bank. (I described them here).

At the outset, RTGS dollars were denominated in U.S. dollars and supposedly convertible into genuine U.S. banknotes. We now know these units were only masquerading as U.S. dollars. By early 2016, huge lineups began to appear outside banks as Zimbabweans unsuccessfully tried to convert their deposits into real U.S. cash. When conversions finally became possible it was only because the RBZ had introduced its own paper currency, a 'bond note', in late 2016. These bond notes were themselves supposed to be fully fungible with U.S. dollars thanks to a promise of 1:1 convertibility, at least if you believed the nation's central banker, but this has never been the case.   

Over the last year a great redenomination has been occurring as all Zimbabwean prices—including that of ZSE-listed stocks—are shifted over from a genuine U.S. dollar standard to an RTGS dollars/bond note standard. Prior to 2016, if you sold a stock or received a dividend, you'd get U.S. dollars, or at least a pretty decent claim on the real thing. Now, you get RTGS dollars—which can only be cashed out into an equally dodgy parallel currency, bond notes.

The incredible 300% rise in the Zimbabwe Industrial Index is a reflection of the redenomination of stocks into an inferior monetary unit and that unit's continued deterioration. For instance, if you were willing to sell your shares of Delta Brewing for $10 prior to the redenomination, you'd only be willing to sell them at a much higher level post-redenomination, say $15, in order to adjust for the diminished purchasing power of the money you'll receive upon sale. RTGS dollars are not U.S. dollars. After adjusting the Zimbabwe Industrial Index for the decline in the value of the money in which stocks are denominated, things certainly wouldn't look as bullish as the chart above indicates.

What is the actual exchange rate between RTGS dollars/bond notes? We can get a pretty good idea by looking at the prices of dual-listed shares. The shares of Old Mutual, a global financial company, trade in both Harare and on the London Stock Exchange. See chart below, courtesy of Gareth on Twitter.

Old Mutual investors have the ability to deregister their shares from one exchange and transfer them for re-registration on the other. Arbitrage should keep the prices of each listing in line. After all, if the price in London is too high, investors need only buy the shares in Zimbabwe, transfer them to London, sell, and repurchase in Zimbabwe, earning risk-free profits. If the price in Zimbabwe is too high, just do the reverse.

The ratio of the two Old Mutual listings (the green line above) provides us with the implicit exchange rate between genuine U.S. dollars and dollars held in Zimbabwe. In 2009 the two listings traded close to parity (i.e. around $2 each), which makes sense because Zimbabwe had dollarized by then, and dollars-in-Zimbabwe were fungible with regular dollars. From 2010 to 2016 the dollar-denominated price in London was above the price in Zimbabwe. This discrepancy may be due in part to the fact that Harare-listed Old Mutual shares aren't very liquid, so they suffer a liquidity discount. Another reason is that the authorities place a ceiling (i.e. fungibility limits) on the number of Old Mutual shares that can be deregistered from the Harare market and dropshipped into London. With all of the space under the ceiling having presumably been used up, it would have been impossible to arbitrage the difference between the two prices, the Harare counter falling to a permanent discount.

So the Old Mutual ratio was probably not a good indicator of the implicit exchange rate between 2010 and 2016. However, in June 2016 this ceiling was raised, at which point arbitrage would have once again been possible. As such, the ratio would have probably returned to providing a decent indicator of the exchange rate between a dollar-in-Zimbabwe and a genuine dollar. 

You can see that Old Mutual is currently valued at $5.80 in Zimbabwe whereas it only trades in London for around $2.66 per share (after converting from pounds into US dollars). This means that Zimbabweans are willing to put $5.80 in one end of the sausage maker in order to get $2.66 out from the other. So a dollar-in-Zimbabwe, which was trading at par to U.S. dollars just two years ago, is now worth just 46 cents. That's quite the inflation rate. I don't see things slowing down, either.

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P.S.: Some investors will no doubt want to say the same thing is going on with the US and Europe with loose monetary policy creating so-called asset price inflation. I disagree.

P.P.S: Gareth has provided another chart. It shows the implied exchange rate between dollars-in-Zimbabwe and genuine U.S. dollars using the only other fully transferable dual-listed counter, PPC, a cement company that is also listed in Johannesburg. Note how close the PPC rate follows the Old Mutual rate.