The difference between two colourful bits of rectangular paper

David Andolfatto had a provocative and open-ended tweet a few days back:

The difference between money and debt. pic.twitter.com/CSQuLzUJPU

— David Andolfatto (@dandolfa) April 26, 2019

We see two coloured pieces of paper, both with an old dead President on it. They each have a face value of $500. Both are issued by a branch of the government, the $500 McKinley banknote (at right) by the Federal Reserve while the $500 Treasury bond (at left) by the Treasury. Both are bearer instrument: anyone can use them.

So why do we bestow one of them the special term "money" while the other is "credit"? I mean, they seem to be pretty much the same, right?

The word money is an awful word. It means so many different things to different people that any debate invoking the term is destined to go off-track within the first fifty characters. So I'm going to try and write this blog post without using the term money. Why are the two instruments that David has tweeted about fundamentally and categorically different from each other?

One of them is the medium of account, the other isn't

Being a veteran of the monetary economics blogosphere, David's tweet immediately made me think of the classical debates between Scott Sumner and Nick Rowe about the the medium-of-exchange vs medium-of-account functions of assets like banknotes and deposits and coins. (For those who don't remember, here are some posts.)

As Scott Sumner would probably say, one of the fundamental differences between the two bits of paper is that the McKinley $500 Federal Reserve note has been adopted as the U.S.'s medium-of- account. The $500 Treasury bond  hasn't.

Basically, if Jack is selling his car for $500, this price is represented by the $500 note (and other sub-denominations like the $50, $20 etc), not a $500 bond. Put differently, the bill is used as the medium for describing the accounting unit, the $. The bond does not have this special status. Now it could be that Jack is willing to accept bonds as payment, but since he doesn't use bonds to describe his sticker prices, he'll have to do some sort of calculation to convert the price into bond terms. When something is the medium of account, the entire language of prices is dictated by that instrument.

So why has society generally settled on using banknotes and not the bonds as our medium of account?

First, let's learn a bit more about the bond in question. The image that David has provided us with isn't actually a bond, it's a bond coupon. A coupon is a small ticket that the bond owner would periodically detach from the larger body of the bond in order to claim interest payments. The full bond would have looked more like this:

This format would have hobbled the bond's usefulness as a medium of exchange. The bond principal of $100 is represented by the largest sheet of paper. Attached to it are a bunch of coupons (worth $1.44 each) that haven't yet been stripped off. To compute the purchasing power of the bond, the $100 principal and all of the coupons would have to be added up. Complicating this summation is the time value of money. A coupon that I can clip off tomorrow is more valuable than the one I can clip off next year.

So if Jack is selling a car, and Jill offers him a $500 Treasury bond rather than a banknote, he'll have to spend a lot more time puzzling out the bond's value. A $500 McKinley note, which pays 0%, is much easier on the brain, and thus less likely to hit some sort of mental accounting barrier. (Larry White wrote a paper on this a while back).

Another hurdle is that there are many vintages of $500 Treasury bonds. A $500 bond that has been issued last year will be worth more than one that has been issued ten years ago and has had most of its coupons  stripped off. Put differently, Treasury bonds are not fungible. Banknotes, on the other hand, don't come in vintages. They are perfectly interchangeable with each other. So in places like stores and markets where trade must occur quickly, banknotes are far more convenient.

Further complicating matters is capital gains tax. Each time the $500 Treasury bond changes hands its owner must go back into their records to find the original price at which they received the bond, compute the profit, and then submit all this information to the tax authority. The $500 note doesn't face a capital gains tax. Better to use hassle-free banknotes, and not taxable bonds, to make one's day-to-day purchases.

Which finally gets us to why notes and not bonds are the medium-of-account. Since banknotes are such a convenient medium of exchange, everyone will have a few on hand. And this makes it convenient to set our prices in terms of notes, not Treasury bonds.

Why is it convenient? Say that Jack were to set the price of the car he is selling at $500, but tells his customers that the sticker price is in terms of Treasury bonds. So the $500 Treasury bond will settle the deal. But which Treasury bond does he mean? As I said earlier, at any point in time there are many vintages of $500 bonds outstanding. The 1945 one? The 1957 one? So confusing!

Jack's customers will all have a few notes in their wallet, having left their bonds locked away at home. But if Jack sets prices in terms of bonds, that means they'll have to make some sort of foreign exchange conversion back to notes in order to determine how many note to pay Jack. What a hassle!

If Jack sets the sticker price in terms of fungible notes he avoids the "vintages problem". And he saves the majority of his customers the annoyance of making a forex conversion from bond terms back into note terms. Since it's better to please customers than anger them, prices tend to be set in terms of the most popular payments instrument. Put differently, the medium-of-account tends to be married to the medium-of-exchange.

Alpha leaders vs beta followers

There is another fundamental difference between the two pieces of paper. Say that the Treasury were to adopt a few small changes to the instruments it issues. It no longer affixes coupons to Treasury bonds. And rather than putting off redemption for a few years, it promises to redeem them on demand with banknotes at any point in time. This new instrument would look exactly like the McKinley note. Without the nuisances of interest calculations, Treasury bond transactions should be just as effortless as the those with Federal Reserve notes.

But a fundamental difference between the two still exists. Since the Treasury promises to redeem the bond with banknotes, the Treasury is effectively pegging the value of the Treasury bond to the value of Federal Reserve notes. However, this isn't a reciprocal relationship. The Federal Reserve doesn't promise to redeem the $500 note with bonds (or with anything for that matter).

This means that the purchasing power of the bond is subservient to that of the banknote. Or as Nick Rowe tweets, "currency is alpha leader, bonds are beta follower."

Bonds promise to pay currency. Currency does not promise to pay bonds.
There's an asymmetric fixed (future) exchange rate between bonds and currency. Issuers of bonds peg to currency; issuers of currency do not peg to bonds.
So currency is alpha leader, bonds are beta follower.

— Nick Rowe (@MacRoweNick) April 26, 2019

This has much larger implications for the macroeconomy. In the long-run, the US's price level is set by the alpha leader, the Federal Reserve, not by the beta follower, the Treasury.

The Treasury could remove the peg. Now both instruments would be  0% floating liabilities of the issuer. Without a peg, their market values will slowly diverge depending on the policy of the issuer. For instance, a few years hence the $500 Treasury bond might be worth two $500 Federal Reserve notes. We could imagine that in certain parts of the U.S., custom would dictate a preference for one or the other as a medium of exchange. Or maybe legal tender laws nudge people into using one of them. And so certain regions would set price in terms of Treasury bonds while others will use Federal Reserve notes as the medium of account.

The Treasury's monetary policy would drive the price level in some parts of the U.S., whereas the Fed's monetary policy would drive it in the rest. This would be sort of like the 1860s. Most American states adopted Treasury-issued greenbacks as the medium of exchange during the Civil War, but California kept using gold coins issued by the US Mint. And thus prices in California continued to be described in terms of gold, and held steady, whereas prices in the East inflated as the Treasury printed new notes. (I wrote about this episode here.)

In conclusion...

So in sum, the two instruments in David's tweet are fundamentally and categorically different because one is the medium of account and the other isn't. Treasury bonds just aren't that easy to transact with, so people don't carry them around, and thus shopkeepers don't set sticker prices in terms of Treasury bonds. But even if the Treasury were to modify its bonds to be banknote look-alikes, they are still fundamentally different. Treasury paper is pegged to notes, but not vice versa.

This peg can be severed. But for convenience's sake, one of the two instruments will come to be used as the medium-of-account within certain geographical areas. And thus in its respective area, the issuer of that medium-of-account will dictate monetary policy.

Should governments finance themselves through their central bank?

In places like the U.S. and Europe, it is actually difficult—if not impossible—for a government to have its central bank pay for government programs. All government spending must be financed by issuing bonds to the public or collecting taxes.

Canada, my home country, is an interesting counter-example. The financial relationship between the Federal government and the Bank of Canada—our central bank—is fairly permeable. The government has the authority to ask the Bank of Canada to directly fund a portion of its spending.

This avenue is rarely taken, however. Justin Trudeau, our current Prime Minister, currently uses bonds and taxes to fund almost all of the Federal government's spending. Just one small and unknown government program is directly funded by the Bank of Canada: the prudential liquidity management plan, an old Stephen Harper-era program. (I wrote about it here and here). The goal of the prudential liquidity plan is to provide a cash cushion that the Federal government can rely on to “safeguard its ability to meet payment obligations in situations where normal access to funding markets may be disrupted or delayed.”

The details of the program aren't really that important. The point I want to make is that the Federal government hasn't had to issue bonds to the public in order to fund the prudential liquidity management plan, nor has it had to wait for taxes to be paid. All it did was tell the Bank of Canada to create some dollars for it out of nothing, and the Bank of Canada shrugged and complied.

So would it make sense for Justin Trudeau to have the Bank of Canada fund other programs than just the prudential liquidity management plan? Why not get it to fund the Federal government's share of health spending, or national defence, or Old Age Security?

Let's take the example of national defence. Say that the Trudeau government has been planning to follow conventional funding procedure and intends to issue $400 million in new treasury bills to pay the salaries of our soldiers for the months of April and May. But Trudeau changes his mind and tasks the Bank of Canada to create $400 million in fresh deposits for the government, ex nihilo. As the soldiers' salaries come due, the dollars will be wired to the commercial banks where the soldiers do their banking, these banks in turn crediting the soldiers' accounts.

Are there any real differences between the two funding scenarios? Under both the treasury bill and Bank of Canada routes, the soldiers will get paid. What about cost savings? The Bank of Canada is obligated to pay interest to banks on the $400 million in new balances it has created. It pays a rate of 1.75% or so, which is pretty much equivalent to what the government would have paid on $400 million in new treasury bills.

Thus, from a cost savings perspective there's really no difference between the two scenarios. Either way, the government is going to be paying 1.75% in interest to whomever happens to be holding the instruments it has issued.

So my initial reaction is: meh, who cares which way Trudeau funds soldiers' salaries.

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

There is one asymmetry that might worry me as a citizen. Treasury bills are a useful instrument for individuals and businesses (like insurers) because they are quite safe. Bank of Canada deposits are likewise very safe, but whereas anyone can buy a treasury bill, deposits are exclusive. Only commercial banks can keep an account at the central bank. So if our soldiers are to be paid $400 million by the Bank of Canada, the supply of treasury bills will contract by $400 million leaving folks like me with fewer options for investing.

But there's an easy way to fix this shortage. Introduce central bank accounts for all. In short, allow non-banks like insurers and individuals to keep accounts at the Bank of Canada. A similar fix would be to provide a means for commercial banks to establish 100%-reserve pass-through accounts. Life insurers and individuals who open a pass-through accounts at a bank would be assured that these accounts are 100% backed by Bank of Canada deposits, the interest flowing straight from the Bank of Canada to the account holder. These accounts would function just like treasury bills.

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

There is one other potential asymmetry. It has to do with the unit-of-account function of money.

Like the metre, kilogram, or minute, the dollar is a key element of Canada's system of weights and measures. The dollar is by far the most complex of these standardized measurements. Unlike metres, kilograms, or minutes, Canadian prices are measured in terms of a set of items—banknotes and Bank of Canada deposits—that are constantly fluctuating in value. By carefully regulating these items, the Bank of Canada tries to keep the pricing standard as stable as possible.

Treasury bills have no role to play in the pricing standard. If a car has a sticker price of $10,000, this indicates ten thousand one-dollar banknotes, or a thousand ten-dollar banknotes. The "$10,000" indicated on the sticker is not represented by a given quantity of treasury bills.

This has important implications. If all Canadians simultaneously decide that they want to reduce the quantity of Bank of Canada notes and deposits that they hold, then every price in the Canadian economy will have to rise. After all, these instruments are the standard media that people use for describing prices. But if all Canadians decide they want to hold fewer treasury bills, goods and services prices needn't adjust—treasury bills aren't the media that Canadians use to describe the dollar. Only the price of treasury bills will have to adjust.  

So if Trudeau decides to use Bank of Canada deposits for financing, he is involving himself with the standard itself. Every price in the Canadian economy may have to adjust to his actions. But if Trudeau relies solely on treasury bills/bonds for financing, he avoids implicating himself in Canada's pricing standard, and so his influence will be much more muted. It would be better if Trudeau's political ambitions couldn't entangle Canada's system of weights and measures... more on this later.

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

It may be useful to work through an example in which Trudeau decides to use the Bank of Canada for a large percentage of government spending. Say that Justin is fighting for his political survival, so he comes up with a bright idea. Let's increase the number of Canadian provinces by occupying Burkina Faso. That way Canadians will have a warm place to go in the winter. Trudeau promises voters that he will carry out the invasion without burdening Canadians with new taxes. That very month he tells the Bank of Canada to start creating billions in new deposits and quickly spends them on military equipment.

At some point the recipients of these new deposits (anyone with a Bank of Canada account) will suffer deposit bloat. They will try to get rid of their excess, and as they do so prices across the Canadian economy will start to rise.

In order to preserve the standard unit, the Bank of Canada has a useful tool for halting this incipient inflation. It can increase the interest rate it pays on reserves. A higher reward will coax those who would otherwise have spent their unwanted Bank of Canada deposits into keeping them on ice. And this should alleviate the pressure on prices.

But what happens if Trudeau keeps on spending? His next idea is to send a fully-manned space mission to Pluto without raising taxes or issuing treasury bills to fund the mission. He tells the Bank of Canada to create $50 billion and immediately starts to spend it on building a rocket.

The Bank of Canada can of course raise rates again. But if you think about it, the Bank of Canada gets the money to pay higher interest by issuing more brand new dollar deposits. If the underlying cause of the inflation is Trudeau bringing too much money into existence, issuing even more of the stuff as an inducement to hold what has already been created doesn't seem like a long-term solution. At some point, the Bank of Canada will have to attack the root of the problem--the bloat of deposits itself--by reducing the supply.

There are a couple of ways to reduce the supply of deposits. The first would be to "sterilize" Trudeau's spending. The Bank of Canada can try and coax depositors to lock their funds into central bank term deposits rather than keeping them in their regular Bank of Canada accounts. Transferring the funds to a term deposit renders them non-spendable and removes the bloat, at least temporarily.

But Trudeau keeps on spending new Bank of Canada deposits, this time on the construction of a 5-metre high border wall between Canada and U.S. The Bank of Canada will have to convince an ever-growing crowd of deposit owners into locking away their funds. At some point the demand for term deposits will be saturated, and the Bank of Canada will have to increase the carrot they provide by raising term deposit rates. Additional deposits will have to be created to generate this reward. But as before, fixing an excess of deposits with more new ones only kicks the can down the road.

The Bank of Canada has a permanent way of removing the deposit bloat: it can buy deposits back and cancel them. But to do this, it needs to have some real assets sitting in its vaults. Gold, property, mortgage-backed securities, bonds, etc. Because Trudeau has been spending deposits into the economy willy-nilly, the Bank of Canada simply doesn't have assets to carry out a buy-back.

Which leaves the Bank of Canada with one last option for removing supply. Rather than repurchasing deposits, it can just destroy them outright. By declaring that x% of all deposits that have been issued will simply cease to exist, it can remove the bloat once and for all. Thus ends the inflation.

But the Bank of Canada doesn't have the power to annihilate depositors' funds. This would basically constitute a tax, and democracies don't generally give central bankers the power to tax (understandably so). Which means that only Trudeau can carry this operation out on behalf of the Bank of Canada.

To do so, he will have to levy a new tax and then destroy the proceeds. (He can't re-spend the deposits, this would only recreate the problem). Once destroyed, the deposit bloat has been remedied. But if Trudeau is determined to follow through on his vote gathering strategy of spending on programs without raising taxes, then he won't see much to be gained in carrying out the annihilation. So the inflation will continue.

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

I think that all of these threads can be brought together to provide an argument for why we don't want Trudeau to rely too much on the Bank of Canada for funding.

Low and consistent inflation is valuable to Canadians. Just as our measures of time, volume, and weight stay consistent (the metre doesn't get longer or shorter from one year to the next), the dollar unit should be reliable. If we all have a pretty good idea where average prices will be down the road, we can better coordinate our long-term plans. Price stability is also the fairest way to ensure neither debtors nor creditors benefit at the other's expense.

The Bank of Canada has all the tools to provide this service to the public, save one. In the extreme event that the Prime Minister decides to resort to the Bank of Canada for financing of a bunch of novel government services, and the inflation target is exceeded, the Bank of Canada can't salvage things by resorting to the definitive response: annihilating deposits. Instead it must rely on Trudeau to destroy deposits on its behalf via a tax. If the Prime Minister refuses to do this, then the reliability of the unit of account is effectively sacrificed.

Were Trudeau to rely on treasury bills and bonds rather than central bank financing to invade Burkina Faso, send a rocket to Pluto, and build a border wall with the U.S., then the Bank of Canada would never have to ask the Prime Minister to annihilate deposits in order to hit its inflation target. And so the dependability of the unit of account would be assured. Instead of every price in the economy having to adjust to Trudeau's new programs, only the market price of treasury bills and bonds would have to bear the burden of adjustment.

So should governments finance themselves through their central bank? In general, it's probably harmless. For instance, it makes no difference whether the prudential liquidity plan is financed by the Bank of Canada, the taxpayer, or government-issued treasury bills.

But in a scenario where the government is being wildly imprudent, a degree of separation between the Prime Minister and the Bank of Canada is advisable. Imagine if the whims of Canada's politicians could cause metre sticks all over Canada to grow or shrunk a bit each year. That would make for a confusing system of weights and measures, wouldn’t it? The dollar is one of Canada's most important weights & measures. It too deserves to be immunized from the political process.

What happens when a central bank splits in two?

Say the San Francisco Fed decided to secede from the Federal Reserve System or the Bank of Greece started to print its own euro notes without the consent of the Eurosystem. What happens to a nation's currency when the central bank is split into parts? There is a possibility we might be seeing such a situation developing in Libya with the emergence of two different Libyan dinars.

Libya's political scene is ridiculously complicated so I'll paint the picture in broad brush strokes. The Central Bank of Libya has several offices, the two relevant ones being the western one in Tripoli and the eastern one in Bayda. Prior to the Arab spring, each area was under the control of the Gaddafi government but both have since come under the control of competing regimes. Tripoli is run by the U.S.-backed Government of National Accord (GNA) while Bayda is under the control of the Tobruk-based House of Representatives.

As I understand it, over the last few years of strife the two offices have usually been able to work together despite being under different regimes.Yesterday, however, the Bayda branch announced that it would be putting new 20 and 50 dinar denomination notes into circulation. Both the Tripoli government and their U.S. backers quickly declared that the new issue was illegitimate. The U.S. Embassy's statement on Facebook said that "the United States concurs with the Presidency Council's view that such banknotes would be counterfeit and could undermine confidence in Libya's currency and the CBL's ability to manage monetary policy to enable economic recovery."

This brings up an interesting conundrum. Say the Bayda branch of the Central Bank of Libya starts to spend the new 'counterfeit' dinars and the U.S.-backed Tripoli branch refuses to recognize them. Will the public accept the new issue of Bayda dinars, and if so, at what rate will the notes trade relative to Tripoli's notes? Could Libya end up with two different dinar currencies?

Were the two note issues identical, it would be impossible for Libyans to discriminate between them. They'd happily accept the new notes and all dinars would continue to be fungible. But this doesn't seem to be the case. Unlike Libya's legacy note issue, which was printed by De La Rue in the U.K., the Bayda branch's new dinars are printed by Goznak in Russia. Apparently Goznak has used different watermarks and a horizontal serial number rather than a vertical one. Most importantly, the new notes bear the signature of the head of the Bayda office while the old notes have the Tripoli branch's chief on them.

If it does not recognize Bayda's 'counterfeit' notes as its liability, the Tripoli branch voids its responsibility to buy them back in order to maintain their value, effectively walling off its resources from the Bayda branch. These resources include any foreign reserves it might have, U.S. financial backing, and financial support from the local regime. And without any guarantee that those notes will have a positive value, the public—which can easily differentiate between the two bits of paper—may simply refuse to accept Bayda dinars at the outset when the Bayda branch tries to spend them into circulation. Long live the Tripoli dinar.

The Bayda branch might try to promote the introduction of Baydar dinars by pegging them at a 1:1 rate to existing Tripoli dinars. This is how the euro, for instance, was kickstarted. But that peg will be tested. Libyans will bring Bayda dinars to the Bayda branch to exchange for Tripoli dinars. If the branch runs out of Tripoli banknotes, it will have to buy more of them in the open market to maintain the peg, but with what? If it lacks the resources to buy them, the peg will be lost and Bayda dinars will fall to zero, or to a very large discount.

But the Bayda branch isn't without its own resources. First, it has the financial support of the local regime. Furthermore, according to this surreal article there is a vault in Bayda that contains 300,000 gold and silver sovereigns minted in honour of the late Colonel Gaddafi, worth nearly £125 million. The Bayda branch doesn't know the combination and Tripoli refuses to provide it. If the safecrackers that the Bayda branch has hired are able to get in, that amount will provide it with enough firepower to buy back Bayda dinars and help support the peg. In which case the two notes would circulate concurrently and be fungible.

If two dinars emerge, which central bank would control monetary policy? That depends on which brand of dinar Libyans choose to express prices and debts. As long as the existing Tripoli dinar is the medium of account—the physical object that people use as the definition of the dinar unit ل.د.—then any policy change adopted by Tripoli's central bankers will be transmitted to the entire Libyan price level, both the east and west. Usage of Tripoli dinars rather than Bayda dollars for pricing is likely to prevail for the same reason we all use QWERTY keyboards when better alternatives exist, force of habit is difficult to overcome. Even if Bayda dollars do emerge as a medium of account, as long as they are pegged to the Tripoli dollar, then Tripoli still gets to call the shots.

The situation isn't resolved yet—the Tripoli branch could very well accept Bayda dinars as its liability, thus defusing the situation. In any case, it will be interesting to follow. Incidentally, Libya's situation reminds me of one of the ideas put forth during the 2015 Greek crisis; a secession of the Bank of Greece from the Eurosystem so that Greeks could print their own type of euro. If Greece boils over again and the separation idea pops up, Libya may serve as a reference point.

Don't kill the $100 bill

Last week I asked whether the Federal Reserve could get rid of the $100 bill. This week let's discuss whether it should get rid of the $100. I don't think so. The U.S. provides the world with a universal backup monetary system. Removing the $100 would reduce the effectiveness of this backup.

Earlier this week the New York Times took up the knell for eliminating high value bank notes, echoing Larry Summers' earlier call to kill the $100 in order to reduce crime which in turn was a follow up on this piece from Peter Sands. More specifically, Summers says that "removing existing notes is a step too far. But a moratorium on printing new high denomination notes would make the world a better place."

As an aside, I just want to point out that Summers' moratorium is an odd remedy since it doesn't move society any closer to his better place, a world with less crime. A moratorium simply means that the stock of $100 bills is fixed while their price is free to float. As population growth boosts the demand for the limited supply of $100 notes, their price will rise to a premium to face value, say to $120 or $150. In other words, the value of the stock of $100 bills will simply expand to meet criminals' demands. Another problem with a moratorium is that when a $100 bill is worth $150, it takes even less suitcases of cash to make large cocaine deals, making life easier—not harder—for criminals. To hurt criminals, the $100 needs to be withdrawn entirely from circulation, a classic demonetizaiton.

With that distinction out of the way, let's deal with three of the motivations for demonetizing high denomination notes: to reduce criminality, to cut down on tax evasion, and to help remove the effective lower bound.

Criminality

Summer's idea is to kill the $100 bill so that criminals have to rely on smaller denominations like $20s. Force criminals to conduct trade with a few suitcases filled with $20 bills rather than one suitcase filled with $100 bills and they'll only be able to jog away from authorities, not sprint. What sorts of criminals would be affected? The chart below (from this article by Peter Sands) builds a picture of cash usage across the different types of crime.

As the chart illustrates, the largest illegal user of cash is the narcotics industry. So presumably the main effect of a ban of $100s will be to raise the operating costs of drug producers, dealers, and their clients.

But should we be sacrificing the benefits of the $100 bill in the name of what has always been a very dubious enterprise; the war on drugs? An alternative way to reduce crime would be to redefine the bounds of punishable offences to exclude the narcotics trade, or at least certain types of drugs like marijuana. Law enforcement officers could be re-tasked to focus on the cash intensive crimes that remain, like human trafficking and corruption. In that way crime gets more costly and we get to keep the $100 to boot, which (as I'll show) has some very important redeeming qualities.

Tax Evasion

Cash is certainly one of the best ways to evade taxes, but there are other methods to reduce tax evasion. For instance, Martin Enlund draws my attention to a tax deduction implemented by Sweden in 2007 for the purchase of household related services, or hushållstjänster, including the hiring of gardeners, nannies, cooks, and cleaners. In order to qualify the services must be performed in the taxpayer’s home and the tax credit cannot exceed 50,000 SEK per year per person. This initial deduction, called RUT-avdrag, was extended in 2008 to include labour costs for repairing and expanding homes and apartments, this second deduction called ROT-avdrag.*

Prior to the enactment of the RUT and ROT deductions, a large share of Swedish home-related purchases would have been conducted in cash in order to avoid taxes, but with households anxious to get their tax credits, many of these transactions would have been pulled into the open.

We can evidence of this in the incredible decline in Swedish cash demand ever since:

@t0nyyates @jp_koning Starting in July 2007 it became 50% cheaper to buy services (cleaning, ironing, baby-sitting) pic.twitter.com/4EHshRAHWR

— Martin Enlund (@enlundm) February 18, 2016

Sweden has the distinction of being the only country in the world with declining cash usage. The lesson here is that it isn't necessary to sacrifice the $100 in order to reduce tax evasion. Just design the tax system to be more lenient on those market activities that can most easily be replaced by underground production.

Escaping the lower bound

Yep, those advocating a removal of $100s are right. Central banks can evade the effective lower bound on interest rates and go deeply negative if they kill cash, starting with high denomination notes.

But as economists such as David Beckworth have pointed out, you can keep cash and still go deeply negative. All a central banker needs to do is adopt Miles Kimball's proposal to institute a crawling peg between cash and central bank deposits. This effectively puts a penalty on cash such that the public will be indifferent on the margin between holding $100 bills or $100 in negative yielding deposits.

Another way to fix the lower bound problem is a large value note embargo whereby the Fed allows its existing stock of $100 bills to stay in circulation but doesn't print new ones (much like Summers' moratorium). This means that if Yellen were to cut deposit rates to -2% or so, the price of the $100 would quickly jump to its market-clearing level, cutting off the $100 as a profitable escape route. As for the lower denominations, the public wouldn't resort to them since $20s are at least as costly to hold as the negative rate on deposits. Unlike Miles' proposal a large value note embargo doesn't allow for a full escape from the lower bound, but it does ratchet the bound downwards a bit, and it keeps the $100 in circulation.

Why should we keep it?

The $100 bill is the monetary universe's Statue of Liberty. In the same way that foreigners have always been able to sleep a little easier knowing that Ellis Island beckons should things go bad at home, they have also found comfort in the fact that if the domestic monetary authority goes rotten, at least they can resort to the $100 bill.

The dollar is categorically different from the yen, pound or euro in that it is the world's back-up medium of exchange and unit of account. The citizens of a dozen or so countries rely on it entirely, many more use it in a partial manner along with their domestic currency, and I can guarantee you that future citizens of other nations will turn to the dollar in their most desperate hour. The very real threat of dollarization has made the world a better place. Think of all the would-be Robert Mugabe's who were prevented from hurting their nations because of the ever present threat that if they did so, their citizens would turn to the dollar.    

I should point out that the U.S. gets compensation for the unique role it performs in the form of seigniorage. Each $100 is backed by $100 in bonds, the interest on which the U.S. gets to keep. So don't complain that the U.S. is providing its services as backup monetary system for free.

Foreigners who are being subjected to high rates of domestic inflation will find it harder to get U.S dollar shelter if the $100 is killed off; after all, it costs much more to get a few suitcases of $20 overseas than one case of $100. This delayed onset of the appearance of U.S. dollars as a medium of exchange will also push back the timing of a unit of account switch from local units to the dollar. As Larry White has written, money's dual role as unit of account and medium of exchange are inextricably linked. People will only adopt something as a unit of account after it is has already been circulating as a medium of exchange. A switch in the economy's pricing unit is a vital remedy for the nasty calculational burden imposed on individuals and businesses by high inflation. The quicker this tipping point can be reached, the less hardship a country's citizens must bear. The $20 doesn't get us there as quick as the $100.

So contrary to Summers, I think we should think twice before killing the $100. The U.S. has a very special to role to play as provider of the world's backup monetary system; it should not take a step back from that role. Criminals, tax evaders, and the lower bound can be punished via alternative means. I'd be less concerned about killing other high denomination notes such as the €500, 1000 Swiss franc, or ¥10,000. That's because inflation-prone economies don't euroize or yenify—they dollarize.


Addendum: If Summers is genuinely interested in combing the world of coins and bills for what he refers to as a 'cheap lunch', then there's nothing better the U.S. can do than stop making the 1 cent coin, which is little more than monetary trash/financial kipple. Secondly, replace the $1 bill, which is made out of cotton and supported by the cotton lobby, with a $1 coin. The U.S. lags far behind the rest of the world in enacting these simple cost cutting efforts.


*See here and here for more details on RUT and ROT avdrag,
** Martin Enlund has a great post here on Sweden's cash policies.

A Visa/MasterCard theory of recessions

Statistical agencies employ data collectors who walk up and down aisles with hand-held computers gathering sticker prices for things like frozen french fries and bicycles. The data they collect gets amalgamated into an index and passed on to central bankers who use it as the basis for rate change decisions. It seems simple enough, but what happens if the source material has been corrupted? Might central bankers be reacting to mere shadows on the wall?

Here's how prices might go bad. Start with the U.S. and Canadian payments systems. For each credit card payment, a North American merchant must pay 1-2% in fees to the card networks Visa and MasterCard. Retailers in both countries have very different strategies for coping with this burden. In the U.S., retailers are permitted to offload network fees onto customers by asking them to pay a surcharge on each credit card payment. Because Canadian retailers are prohibited from surcharging customers, they react by marking up every sticker price in their store by a percent or two, the extra margin they collect sufficient to cover the card network fees. (Canadian retailers almost never offer cash discounts.) For a more complete explanation, see here.

This arcane difference in payments habits has the potential to result in a divergent evolution of prices, vastly different monetary policies, and an uncoupling of North American economic growth.

Consider what happens when the Visa and MasterCard networks decide to offer North American customers a universal 5% cash back reward. The networks fund this bonus by requiring merchants to submit a 5% fee on each card transaction. U.S. retailers cope with this levy by boosting the surcharge they apply on each card transaction to 5% or so, forcing the card-paying customer to bear the cost. Those Americans who pay with cash i.e. banknotes continue to get the sticker price, which stays constant. Without the ability to surcharge, Canadian retailers cope by boosting sticker prices by 5%, thereby indirectly passing the costs of the cash-back bonus onto the customer.

Marching up and down the aisles, U.S price collectorsdon't notice a thing. As a result, the U.S. consumer price index stays the same and the Fed doesn't lift a thumb. Canadian price collectors, however, find that prices have risen. Upon reception of this data, the Bank of Canada anxiously raises rates. This is because Bank officials believe that the rapidly rising price level indicates that the economy-wide rate of return (the natural rate of interest) has risen above the Bank's market rate, breeding inflation. A rate hike is necessary to bring the two rates back in lane, thus choking off the incipient inflation that seems to be developing. The natural rate hasn't budged, of course. All that has changed is the card networks' fee policy. Instead of bringing the market rate of interest in line with the natural rate, the Bank of Canada has been fooled into moving the market rate of interest above the natural rate.

If the card networks again increase the cash back reward, say to 10%, Canadian prices will rise even more. U.S. prices stay flat. The Bank of Canada once again confuses the effects a new cash-back policy with a rise in the natural rate of interest, tightening while the Fed stays pat.

Assuming that prices react rapidly and fluidly to central bank policy, then the Bank of Canada's tightening will simply drive consumer prices back down and restore equality between the natural rate of interest and the market rate. But if changes in monetary policy have effects on the real economy, then we've got problems. It could be that certain prices are sticky downward so that markets can't clear, the result being inventories of goods going unsold. Or perhaps the fact that debts are nominally denominated creates a Fisherian debt deflation. If so, then the Bank of Canada could end up unnecessarily driving Canada into a recession. The Federal Reserve, reacting to the very same set of stimuli, does not.

Now of course I'm exaggerating things. In real life such large increases in cash-back policy are unlikely. Nevertheless, we have seen a progressive increase in network fees over the years, enough to have probably inspired Canadian retailers to ratchet up sticker prices. As a result, Canadian CPI may be slightly over-stating actual inflation. On the U.S. side, consider that American retailers only recently gained the power to surcharge credit cards. As U.S. retailers roll out surcharge policies and reduce sticker prices, CPI will be pressured down. This may fool Fed officials into believing that the economy is slowing and draw them into an unnecessary rate cut when in realtiy all that has changed is credit card pricing habits. One wonders if the monetary authorities take into account these arcane features of our payment system when they set their monetary policies.

---

This answers a question I asked more than a year ago.

Cracks in the zero-lower bound

Shibboleth, by Doris Scalcedo

John Cochrane writes an interesting post that makes the case that removing or penalizing cash would not remove an economy's 0% lower bound. Briefly, the zero lower bound problem arises when a central bank tries to reduce the interest rate on central bank deposits below zero. Because cash always yields a superior 0% yield, everyone will race to convert their deposits into cash, thus preventing a negative interest rate from ever emerging. By removing cash, this escape route is plugged and a central bank can safely guide rates to -4 or -5%.

Cochrane's point is that even if cash is removed, there are a number of alternative 0% yielding 'exits' to which people will flee, the effect being that rates will be inhibited from falling much below 0%. The examples he provides includes prepayment of taxes, bills, and mortgage payments, and the hoarding of gift cars or stored value cards like subway passes. In a follow-up post, he mentions a strategy of rolling over cheques.

There are two points I want to make:

1. Even with alternatives, a central bank can still create inflation

Scott Sumner points out that even in a cashless world at the zero lower bound, the existence of these alternatives cannot impede a central bank from driving up inflation. This is because the other alternative assets that Cochrane discusses are not media of account. To be a medium of account is to be that good which defines the $ unit that appears on a retailer's website and their aisles. What this means is that the the sorts of dollars that a retailer has in mind when setting sticker prices are those issued by the nation's central bank (in a cashless world, this would be central bank deposits). Retailers aren't using gift card dollars or stored value card dollars as the 'reference dollar' for their sticker prices.

Keep in mind that the use of central bank deposits as the medium of account does not preclude retailers from accepting gift cards in payment at the till. However, if they accept them, they'll probably apply some sort of reduction/addition to a good's advertised sticker price. If we assume that gift cards have become quite liquid in the absence of cash, I think it's conceivable that retailers would offer a reduction (ie. take gift cards at a premium) since gift cards would be a better asset than a deposit; in addition to being useful as media of exchange, they yield 0% rather than negative yielding deposits. We could imagine a range of different gift card premia developing based on their perceived quality, with cashiers consulting some sort of electronic guide to calculate the final bill.

In any case, Sumner's point is that as the central bank reduces rates into negative territory, sticker prices will all rise, despite the fact that alternative media exist that can be used to make payments. I think he's dead right.

2. Alternative escape routes will be resolved by simple product alterations, not a legal revolution

Cochrane's posts emphasize that in a negative rate world, all sorts of odd financial loop holes will be exploited in order to earn superior 0% returns. I think he's right on this. However, Cochrane seems to believe that that the government will have to upend 'centuries of law' in order to plug these alternative 0% instruments. I am more sanguine than him. If someone is exploiting a loophole in order to earn a superior 0% return, someone else is bearing that negative return. Institutions forced to bear the negative impacts of these loopholes will have an incentive to quickly evolve simple strategies to plug them, thus precluding any need for either Cochrane's rather dramatic 'legal revolution' or the heavy hand of the government.

Take Cochrane's first 'escape', gift cards. Consider a retailer that issues 0% gift cards in various denominations like $50s and $100s. Assume that in a world without cash, these cards have become relatively liquid. The central bank suddenly pushes rates to -5%. People who own negative yielding bank deposits will flock to buy the retailer's gift cards (assume that both instruments are equally risky) with the goal of immediately improving their expected return from -5% to 0%. The retailer, however, is left holding a -5% asset while owing a 0% liability, an awful position to be in. To remove the burden of this negative spread, our retailer need only reduce the return on newly-issued gift cards to -5%, say be introducing a redemption fee of 5%. A gift card worth $100, when redeemed, now only buys you $95 worth of stuff. Either that or just stop issuing the things. The loophole is closed and the problem solved.

The same goes for Cochrane's other 0% exit, prepayment if bills. A firm that allows for prepayments is accepting a 0% liability on itself; it effectively owes x dollars worth of some service or item. So we are back to our gift card example above, since gift cards are basically prepayments. Impose an appropriately sized fee on those who want to prepay and the problem is solved. Banks have always charged prepayment penalties on mortgages, car loans, and business loans, so this is nothing revolutionary in turning to this solution.

The next of Cochrane's 0% exits is a string of constantly renewed personal cheques. Rather than cashing a personal check, a cheque holder waits for that cheque to go 'stale', usually after 6-months, and then asks the issuer to issue a new one, rinsing and repeating as often as necessary. As physical bearer instruments, cheques (much like cash) cannot be made to pay negative interest, which allows the holder of a cheque to earn a perpetual 0% return. The unfortunate issuer of the cheque is left bearing a 0% liability in a world where their assets are yielding just -5%. This problem will quickly be resolved by people no longer writing checks. There is a less extreme alternative. Banks, unwilling to lose revenues from their cheques businesses, will simply increase cheque cancellation fees. Before a stale check is re-issued, it must be canceled, which traditionally incurs a cancellation fee. If the person running the scheme is required to pay an appropriately sized fee to carry over the cheque, the scheme can be rendered no more profitable than owning a -5% deposit.

Cochrane also points to Kenneth Garbade and Jamie McAndrews's scheme whereby depositors can purchase certified cheques from banks and thereby evade negative rates. According to Garbade and McAndrews, commercial banks "might find their liabilities shifting from deposits (on which they charge interest) to certified cheques outstanding," with this shift imposing significant costs on banks since certified cheques are less stable than deposits. If such a shift were to occur, banks would find themselves bearing a negative spread (liabilities yielding 0% while assets yielding -5%), a position they would be quick to remedy. One option would be to cease the issuance of certified cheques altogether. Alternatively, banks have always charged a fee for certified cheques. They could simply increase this fee to the point that the cost of holding a certified cheque is brought in line with the negative deposit rate. Once again, problem solved.

This fee strategy shouldn't be unfamiliar. It is the mirror image of the strategy adopted by U.S. commercial banks when interest rates were capped during the inflationary 1960s and 70s. Unable to reward depositors with sufficiently high interest rates, banks evaded the ceilings by offering implicit interest in the form of under-priced banking services, say by reducing fees on certified cheques. In our modern era in which deflation is pushing rates towards an equally artificial 0% barrier (in this case arising from the circulation of personal and certified cheques rather than a government imposed cap), all those services that a bank had been underpricing or pricing at market will now be adjusted upwards so that they are overpriced.

In sum, no revolutions here, just markets adaptation via boring old fee changes.

In closing, Cochrane has much more legitimate worries about two other problems: Big Brother and the disproportionate effect on the poor if cash is removed. Agreed, these are big issues. Now it could be that the emergence of cryptocurrencies such as bitcoin solves the Big Brother problem so that there is no role left for cash in preserving anonymity. Let's put bitcoin aside though. The simple answer to both of Cochrane's concerns is that we don't need an outright ban on cash to remove the 0% lower bound. Just adopt Miles Kimball's proposal for a crawling peg between cash and deposits. Kimball's peg is designed in a way that it would impose the same penalty on cash as that incurred by deposits. This would allow central banks to push rates to zero without mass flight into cash, all the while preserving the institution of cash for the poor and those requiring anonymity. (I've written in support of Kimball's plan here and here)

There is also my lazy man's route toward getting below the lower bound (here, here, here). I call it lazy since it's not nearly as complete as Kimball's solution, nor as complicated. Simply withdraw high denominations of bills like $100s, $50s, and $20s. When a central bank sends rates to -3% or -4%, people will balk at fleeing from deposits into $1s, $5s, and $10s since low denominations are very inconvenient to store. That way the poor still get to use cash and the zero lower bound can be breached.

A brief history of the Guinea

1685 Guinea with the bust of James II (link)

The guinea makes a fascinating story because its evolution reveals so many different monetary phenomena. It began its life in 1663 in the Kingdom of England as a mere coin, one medium of exchange in a whole sea of competing exchange media that included crowns, bobs, halfpennies, farthings, not to mention all the foreign coins that circulated in England, Bank of England paper notes, as well as the full range of portable property—like jewelery and art—and property-not-so-portable, say houses and land and such. If things had stayed that way, the guinea's life would be a boring one and I wouldn't be writing about it.

But in the late 1600s the guinea crossed a line and became a very different thing. Rather than functioning as just one exchange medium among many, the guinea suddenly emerged as one of Britain's two media of account, the items used to define a nation's unit of account, in this case the £. Within a few decades it had wrested the medium of account function for itself, holding this pre-eminent spot until 1816, at which point the guinea was decommissioned.

Interestingly, while the guinea ceased to exist in 1816, its memory was sufficiently strong that it continued to function as a unit of account, albeit a relatively unimportant one, well into the 1900s. More on that later.

Just a regular coin

Whereas most of England's coinage at the time was silver,  the guinea was a gold coin. Introduced in 1663 during the reign of Charles II, it was initially rated at 20 shillings, or one pound (£), by the monetary authorities (the mint and the king). Pounds, shillings, and pence, or £sd, comprised the English unit of account—the set of signs that merchants affixed to their wares to indicate prices. The pound unit had been defined in terms of silver coins for centuries, but the the decision by the mint to give a 1 pound (or 20 shilling) rating to the guinea meant that the pound would now be dually defined in terms of both gold and silver coins.

However, according to Lord Liverpool, both the public and the authorities ignored this 20 shilling rating so that a market-determined price emerged for the guinea. In this way the guinea was no different from any other item of merchandise; its price floated independently according to the whims of buyers and sellers.

This stands in contrast to England's silver coinage. Silver pennies, halfpennies, and farthings had an extra function; they served as the nation's medium of account. The pound unit, the £, the symbol with which merchants set prices or denominated debts, was defined by the nation's silver coinage. Put differently, by setting a farm's price at £10, a seller was stipulating that the farm was worth the amount of silver residing in a collection of pennies and farthings.

When something serves as the medium of account, it's price doesn't float independently. Rather, the whole universe of other prices shifts to accommodate changes in the value of the medium of account. For example, if the value of silver were to have risen in the 1670s due to increased demand for silver jewelery, then the entire English price level would have had to fall. Alternatively, if the amount of silver in the nation's coinage was debauched, then the English price level would have risen. A change in the demand for gold in the 1670s, however, would have produced an entirely different result; the relative price of the guinea would have shifted, but little else. That's why a medium of account is so special. Unlike all other items, the price of everything pivots around it.

The fact that the guinea's initial 1663 rating had been ignored was very important. Imagine that the authorities had been stern about enforcing it. Returning to our farm example, in setting the farm's price at £10, our seller would have been stipulating that the farm was worth either the amount of sliver residing in a collection of pennies and farthings, or the amount of gold residing in the guinea. A very different monetary system would have emerged; bimetallism. But more on that later.

Liverpool tells us that the guinea fluctuated between 21 and 22 shillings in its first decades, but in 1695 its price rose rapidly to 30 shillings. This wasn't because of an increase in the demand for gold but a function of the quickening pace of clipping and sweating of pennies, which reduced the quantity of silver in the coinage. Guineas weren't the only commodity to rise in 1695; the entire array of English prices had to pivot around the diminishing value of the silver penny. Once the silver coinage was reformed (its silver content being restored) in the Great Recoinage of 1696, the price of guineas quickly returned to 22 shillings.

The switch to bimetallism

Things all changed in 1697 when the Exchequer, the department responsible for receiving taxes, announced that all guineas were to be accepted by the Exchequer's tellers at 22 shillings. Prior to then, the Exchequer had accepted guineas at the going market rate. As Sykes points out, after 36 years of floating this was tantamount to fixing the price of the guinea relative to silver. Guinea couldn't circulate for less than this stipulated amount, say 21 shillings, because an arbitrageur would mop up those guineas at 21 shillings and use them to pay 22 shillings worth of taxes, earning him or herself a 1 shilling gain. (The next year, the Exchequer would reduce this rate to 21 shillings 6 pence.)

Britain, which had been on a silver standard up to 1697, was now on a bimetallic standard, with the £ unit defined as the amount of silver residing in the English penny, and simultaneously the amount of gold residing in the guinea.

The guinea takes over

The problem with the new standard was that in setting the guinea at 21s 6p, the Exchequer had overvalued gold relative to the market price, more specifically the silver-to-gold ratio prevalent in the rest of the world. By how much? In 1702 Sir Isaac Newton, Master of the Mint since 1699, concluded that 'Gold is therefore at too high a rate in England by about 10 pence or 12 pence in the Guinea.' In other words, the Exchequer should have announced it would only accept guineas at around 20s 6p, or 4.6% less than it had.

What were the consequences of this over-valuation? All of the silver pennies began to leave Britain, gold coins filling the void. Given the choice between paying a debt or a tax in either an overvalued or undervalued instrument, people will always select to use the overvalued one. After all, buying 20 shillings 6 pence's worth of gold in France and using it to discharge a 21s 6p shilling tax liability in England resulted in a 4.6% profit (less transportation and minting costs). The undervalued instrument, in this case silver, is best used in other parts of the world where it is capable of purchasing a larger real amount of goods (or discharging a larger real quantity of taxes) than in the country in which it is artificially undervalued. This is, of course, Gresham's law; the bad drives out the good.

So our guinea, which had started its young life as a mere medium of exchange, had not only graduated to becoming one of only two English media of account, but was responsible for the mass flushing out of silver from England.

By 1717, the silver outflow was getting significantly bad that the authorities decided to do something about it. Newton, still Master of the Mint, noted that the market price for the guinea was around 20s 8d, given the exchange rate between silver and gold in other European markets, and suggested an initial rate reduction from 21s 6d to 21 shillings.

But even at this lower price the English authorities were still overvaluing the yellow metal. They had now fixed the silver to gold ratio at 15.069 to 1, but because the rate was 14.8 to 1 in Holland and France, a profit still remained on exporting silver and importing gold. This silver outflow would continue over the decades until most silver was gone. England had gone from a bimetallic standard to a monometallic standard. Though it was still de jure bimetallic, de facto it had become a gold standard. And the guinea, which was now the controlling element in English prices, was to blame (or at least the decision to misprice it was).(1)

The end of the guinea

For the next century, the English price level pivoted around the value of the gold guinea, until the Great Recoinage of 1816, at which point the guinea's life suddenly came to an end. Since the days of Isaac Newton, the guinea had been awkwardly rated at 21 shillings, or one pound one shilling. This must have made payments somewhat arduous since there was no coin that could satisfy an even 1 pound bill or debt, and people like round numbers. The decision was made to introduce a less awkward gold coin, the sovereign, with slightly less gold. The sovereign was conveniently rated at exactly 1 pound, or 20 shillings, the upshot being that the pound unit of account still contained just as much physical gold as before, but now a coin existed that corresponded with the exact pound unit. The guinea was dead.

_______________________


Well, not entirely. Though is was no longer being minted, the guinea continued to be used as a way to price items. According to Willem Buiter (pdf), auction houses and "expensive and pretentious shops" continued to set prices in terms of guineas through the 1800s and 1900s. Bespoke tailoring and furniture, for instance, was quoted in the legacy gold coin. The unit used was g, or gn, with the plural being gs or gns, although payments were made in sovereign coins or Bank of England notes.

Gillette advertisement (link)

Doctor's and lawyer's fees, often known as "Guinea fees" we're advertised in terms of the legacy gold coin. Whereas common laborers were paid in pounds, payments in guineas was considered more gentlemanly. You can see it pop up in the literature of the time. In Arthur Conan Doyle's Sherlock Holmes tale the Adventure of the Engineer's Thumb a stranger offers Mr Hatherly, a hydraulic engineer who is down on his luck, a unique proposal. "How would fifty guineas for a night's work suit you?"

An ad from 1929 (link)

The standard rate paid by Charles Dickens for contributions to his weekly periodicals Household Words and All The Year Round was half a guinea a column or a guinea a page. In his novels, the guinea pops up often. In Oliver Twist (set in the 1840s), a 5 guinea reward for information on Oliver is posted by the kind Mr. Brownlow.

In more modern times, horses continue to be auctioned in terms of guineas.

Dancing Rain sold for 4 million guineas (link)

Now of course this is a bit of a come-down for the once almighty guinea. Serving as the unit at Tattersalls isn't the same as underpinning the entire price level. But at least its better than the sovereign, the coin that replaced the guinea, which has gone silent, or most other medieval coins for that matter, which neither circulate nor serve as legacy units.

---

(1) The 1717 reduction of the guinea to 21 shillings was accompanied by the requirement that those guineas be accepted as legal tender at that price. Prior to then, only silver had functioned as legal tender, meaning that a debtor could only discharge a debt with silver coins. After the change, a debtor could choose to use either guineas or silver coins to pay off their debt, a decision made easier given gold's overvaluation.

Some References:

Lord Liverpool, A Treatise on the Coin of the Realm, 1805.
Sargent & Velde, The Big Problem Of Small Change, 2001.
Selgin, Good Money, 2008.
Sykes, Banking and Currency, 1905. 
Macleod, Bimetallism, 1894.

Getting rid of the monetary triumvirate

The textbook definition of money is anything that functions simultaneously as a store of value, a medium of exchange, and a medium of account. This is the monetary triumvirate, and we need to get rid of it.

The first problem with this explanation is that all goods and assets function as stores of value, some better than others. Items that can't 'store' value would be be worthless because their lives would be too fleeting to provide any utility. Even an ice cream cone serves as a store of value, at least for a few minutes.

So if everything serves as a store of value, then money must be that peculiar good that functions as both a medium of exchange and a medium of account, right?

Wrong. All valuable things function as media of exchange, or, put differently, they all have a degree of exchangeability. A head of cabbage is a cabbage farmer's medium of exchange, since he uses it exchange with a food distributor, and it also functions as one of the distributor's many media of exchange, since he uses it to exchange with a grocer, and it also functions as one of the grocer's many media of exchange, since the grocer holds an inventory of cabbage in order it to exchange with the public. We can quibble over the general acceptability of any given medium of exchange; a dollar bill is more exchangeable than a cabbage, after all. But a dollar bill, like a cabbage, is not universally acceptable—try buying a house with it, or Microsoft stock.

So if everything serves as a store of value to some degree or other, and everything serves as a medium of exchange to some degree or other, then money must be that peculiar good that functions as a medium of account.

The upshot is that the only binary difference between the various goods and assets in this world is along the medium of account-or-not axis, both the store of value and medium of exchange functions being ranges or spectra, not binary categories. This means that a good is either a medium of account, or it isn't. There's no point in using an umbrella word like "money" anymore, since medium-of-account stands on its own as a useful definition.

A medium of account, if you don't remember, is the good that we use to quote prices. There are only a handful of media of account in the world, with the great majority of things not functioning as media of account. Dollar bills are certainly a medium of account. Credit cards (combined with network fees) also function as a medium of account. There are weird artificial media of account, like whatever is used to define Chile's Unidad de Fomento. Commodities like cloth, or macutes, have served as media of account in West Africa, as have silver pennies in Europe.

So let's retire that tired old triumvirate. The word money is redundant and meaningless; if we really want to divide the world into these and those, the medium-of-account bucket is about all we need. The other two functions, store of value and medium of exchange, are pervasive rather than exclusive (everything has at least a little bit of each), and therefore can't serve as the basis for drawing strict lines between goods.

Gresham's law and credit cards

This is a follow up to my previous post on the monetary effects of credit cards. In this post I'll explore the idea that the use of credit cards in payments is driving a modern Gresham effect, the result of which is a displacement of cash and an inflationary race to the bottom of sorts. This downward spiral resembles the same dynamic set off by coin clippers in the medieval age, the era when Gresham's Law was first enunciated.

First, we need to revisit the idea of Gresham's law, or the idea that the bad money drives out the good. Imagine that it's 1592 and you're a fish monger in a busy market in London. Like everyone else, the unit of account that you use to price your wares is the pound unit of account, further subdividable into twelve shillings and 240 pennies. The actual medium that you and most other merchants have chosen to represent that unit (ie. the medium of account) is the English penny, coined by the Royal Mint from twenty-four grains of silver.

However, not all English pennies are the same! You've been selling fish for most of your career at 1d (d is the sign for the penny unit). But lately you've noticed that a growing number of the pennies you've been receiving have been altered. Small notches have been clipped from these coin's edges. The imprints on them look increasingly worn, and you hear stories about people who "sweat" coins. These ruffians are putting pennies into a sack, shaking them, and removing the small pieces of silver that have been scratched off.

Which means that in a growing minority of your transactions you are receiving the same amount of coin per fish but earning less silver. Clippers and sweaters are stealing the difference. To solve this problem, what you'd really like to do is weigh and assay each penny proffered and charge a unique price based on that coin's silver content. But you don't have the expertise to do this, and in any case, the chaos of the market doesn't offer enough time. Even if you could, accepting coins by weight rather than tale (their face value) is probably punishable by something grisly like getting your finger chopped off.

So instead you raise your prices a bit. By selling fish for 1¼d, you get more pennies than before, but roughly the same amount of silver. What you've done here is switch the medium you use to define the "d" unit of account, or your medium-of-account. You've adopted clipped and sweated shillings as your definition of the penny unit rather than full bodied shillings.

Here's where Gresham's law kicks in. Anyone who has undebased pennies (i.e. good pennies) in their pockets now has to pay 1¼d for your fish rather than 1d. But this is a bad deal for them. Our fish buyer can simply pay with with clipped and sweated pennies that contain less silver, say twenty-three grains of silver... and buy the same quantity of fish. Good pennies containing twenty-four grains of silver are being undervalued in the market place. Owners of these good pennies will choose to hoard them in their pockets and never use anything other than bad pennies to buy things or pay debts.

Where will all the good pennies go? They'll eventually be sent to wherever their silver is not being undervalued. In 1592, people would most likely have melted their good coin down into bullion and shipped this bullion across the Channel to France, only to have it re-minted into French coin and used to buy a larger quantity of fish (or more likely some durable good) than the London market allowed. That is Gresham's Law: when the price of various exchange media are fixed by law or custom, if the true market value of these media diverge, the market will tend to adopt the overvalued medium as their preferred payments option. In short, the bad English pennies drove out the good.

Now it's 2014 and you're a fish monger in a busy market in downtown Toronto. You use the dollar unit of account, the medium that represents this unit being Canadian banknotes.

However, not all dollars are the same! You've been selling fish for $10 for the past few years, but lately you've noticed that the use of credit cards has increased. Furthermore, the credit card networks are charging you ever higher transaction fees, say twenty cents rather than just two cents. This means that people are paying you the same amount of dollars per fish, but after fees you're earning the equivalent of just $9.80 worth of paper dollars in your account.

To solve this deficit, you'd like to charge the transactor a 20c fee, similar to how in 1592 you would have liked to assay each coin and charge a discount to face value based on the coin's actual silver content. By placing a 20c surcharge on credit card transactions, you'd end up with $10 per fish. However, the credit card companies stipulate in their contract with you that card payments can't be surcharged, the penalty being banishment from the card network. (Banishment certainly seems more humane than having your finger cut off.)

So instead you raise your prices a bit, just like you did in 1592. By selling fish for $10.20 you receive more in payment than before, but once the twenty-cent fee kicks in you end up with the same $10 quantity of paper dollars. Just like the medieval fish monger switched from full bodied pennies to clipped pennies, you've switched the medium you use to define the $ unit of account from paper money to credit card money. By doing so, you've preserved your margins.

As it did in 1592, Gresham's law kicks in. All things staying the same, anyone with paper money in their pocket now has to pay $10.20 for a fish rather than $10. But this is a bad deal for them since it undervalues their paper dollars. Better to pay $10.20 in credit card money and get all the associated rewards (air miles, cash back, etc) then pay $10.20 in cash and get no rewards. People will keep their paper dollars in their pockets and only make purchases by credit card.

Where will all the hoarded banknotes be exported? Well, people can't ship them down to the U.S. Americans aren't fond of Canadian dollars. But there will still be places in Canada that don't undervalue banknotes, namely all those retailers who only accept cash. Perhaps there's a competing fishmonger on the other side of town, say Scarborough, who won't accept credit cards and still charges $10 per fish. People will export undervalued banknotes to Scarborough where their dollars earn their full value. Or maybe they'll be exported to Toronto's drug market, or its prostitution market, or anywhere else where cash is still king. At the end of the line is the Bank of Canada, which will always offer to repurchase and shred all of the unwanted old notes that it has issued.

So the point of my little exercise has been to illustrate how 1592 is no different from 2014. Just substitute out the word "coin" with "credit cards" and the same Gresham effects are generated.

In both eras, one of the ways to remedy the displacement of good money by bad money would be to allow the price of the various exchange media to float. In the case of medieval coins, if merchants were allowed to charge varying prices based on the quality of coins proffered, then good coins would once again be properly valued and return into circulation. In the modern case of cash and credit cards, if retailers could charge surcharges on credit card payments, then cash would no longer be undervalued and would return to universal circulation.

In Australia and the U.S., authorities have adopted policies that should relieve these modern Gresham effects. Merchants in both nations are allowed to put surcharges on credit cards transactions. In Canada, surcharges are not allowed, despite efforts by the Competition Bureau to allow them. Gresham's law, it would seem, is still in effect up here.

Left unchecked, the Gresham effects kickstarted by both coin clippers and credit card networks contribute  a race to the bottom of sorts. In 1592, the incentives to clip coin would have been huge since the payor would be able to buy a greater real quantity of goods with a clipped coin than an unclipped coin. In reaction to the appearance of newly clipped coin, merchants would defensively raise their prices. The rest of the populace could only tag along and adopt the newly clipped coin as their standard payment medium. After all, using their good coin in local trade would be madness, since good coin was always and everywhere undervalued. The clippers would attack once more, prices would rise, and once again non-clippers would have to shift their cash holdings into inferior coin. Unless something was done to break out of this downward spiral, there was a tendency for the standard to be perpetually debased and prices to rise forever.

The same dynamic set off by clippers also emerges when credit card networks issue new premium cards that offer better rewards. Say that the networks introduce a "super" card that offers 5% cash back. Early-moving consumers will quickly adopt these cards—after all, they can buy the same quantity of goods at the same price... and get a large cash reward to boot. The higher the reward, the higher the fees a merchant must pay. They now find themselves ponying up 5% of the value of each transaction to the networks. In defense, merchants will belatedly raise their prices.

However, while early movers have adopted 5% cards, the general populace may still only be using cards that allow, say, a measly 1% cash back reward. Their existing cards are now undervalued, since merchants' prices are implicitly being marked up to a 5% card standard. What retailed for $100 now retails for $105. Anyone purchasing $105 worth of goods and getting only $1 cash back incurs a loss of $4. To avoid real losses, the population has no choice but to play catch up and apply for 5% cash back cards. By then, the card networks may be offering 6% cash back cards, which early movers will quickly adopt in order to enjoy the increased purchasing power that these cards afford. Once again merchants will raise prices to defend their margins, adopting a 6% card standard (in other words, their chosen medium-of-account is now 6% cards). But now the 5% cash back cards adopted earlier by the general populace will be undervalued, forcing them to transition to the use of 6% cash back cards. And on and on and on till we have a 100% cash back Visa card standard.

Empirically, we can see this effect over the last decade by the proliferation of premium credit cards, as well is the growing fees that merchants must pay to the card networks.  See this GAO report, especially Figure 3 which I've appended below.

In closing, here's a rare bit of practical advice from the Moneyness blog. If you live in a nation that doesn't allow credit card surcharges (like Canada), and you use cash to pay for most things, YOU ARE LOSING MONEY. Many merchants are implicitly setting prices based on the expectation that credit cards will be used and are pricing in a premium to cover the fees they must pay to the card networks. Either demand a 2-3% cash discount on everything you buy, or get yourself a credit card that yields decent rewards. Save your cash for buying stuff at your local farmer's market or any other cash-only venue where your cash isn't being undervalued. Put differently, if you aren't behaving according to the strictures of Gresham's law, you should be.

Credit cards as media of account

What is this gas station using as a medium of account? Visa/Mastercard dollars or Federal Reserve dollars?

In this post I'll argue that in many cases, a nation's medium-of-account doesn't consist of base money issued by its central bank, but credit card money created by Visa and Mastercard. This may have some interesting implications for monetary policy. Whoever issues, creates, or manages a nation's medium-of- account determines the general level of prices, and this makes it a monetary superpower.

But before I get to that, let's revisit the meaning of the word medium-of-account.

I've written a number of posts on the idea of medium-of-account because it has always seemed to me like an important concept, although admittedly it's taken me a while to zero-in on a satisfactory understanding of the term. What I like about medium-of-account is that along with the ideas of unit-of-account and moneyness, it allows us to pretty much remove "money" from the list of terminology we use when talking about monetary phenomena. No single word is so widely-used yet so imprecise as money. And because of this, no word has bred as many bitter econblog battles. By splitting apart the various ideas associated with "money" and passing these meanings on to alternative words like medium-of-account, some of this morass can hopefully be unclogged.

Without further ado, here are the definitions. By the way, these aren't mine. I've picked them up from folks like Jurg Niehans, who coined the term medium-of-account; Scott Sumner; and Bill Woolsey—hopefully nothing has been lost in translation.

The unit-of-account is a word or symbol like $, ¥, £. Inherent in the idea of UOA is the subdivision of the unit, so that $1 is comprised of 100 cents. (1)

The thing (or things) that defines that unit is (are) the medium-of-account. When a merchant chooses to sell a painting for $100, for instance, he is selecting the unit in which he prices, say the $, as well as the specific medium that defines the $ unit. This last choice is important because dollars might appear in any number of different mediums, or forms, including Federal Reserve paper money, Federal Reserve deposits, branded private bank deposits, cheques, credit cards, and more.

Isn't it the case that a merchant chooses "all of the above media of account" when choosing to price in dollars? After all, one dollar is just as good as another.

Not necessarily. For instance, we know that in the early to mid-19th century a plethora of dollar-denominated exchange media circulated, much like now. There were dollar coins, which the U.S. Mint coined out of a certain number of grains of silver and/or gold. There were also privately-issued dollar banknotes, these being the most prevalent exchange media since coins rarely circulated. However, when merchants set sticker prices, the medium they had in mind when defining the $ unit was the less-common coin, not the more-prevalent notes. Notes were only accepted by merchants at varying discounts to their face value, despite the fact that most banknotes were branded as "dollars".

For example, if our merchant listed a painting for $100, then it could be purchased with one-hundred one dollar coins, or, alternatively, $102 in banknotes from a certain bank, or $103 from another.

If the value of all banknotes simultaneously inflated, what would happen to prices? Given that the value of the coin had remained constant, the merchant's price as well as the general price level would not have changed during this inflation. All that would adjust would be the varying discounts applied to the whole range of private banknotes. The painting would still be listed at $100, and it could still be purchased with the same quantity of coins, but it might take $110 or $115 worth of notes to purchase it.

However, if the U.S. Mint had chosen to reduce the quantity of gold or silver in a coin, then the merchant would increase his sticker price for the painting to $110 or so. The general price level would inflate.

So a unique feature of the medium of account is that the general price level pivots around the MOA's value. If the owner or issuer of the medium of account, in our example the U.S. Mint, has the wherewithal, it can control these economy-wide price changes by modifying the nature of the media it emits, say by reducing the metal content of coins. Few institutions have this sort of monetary superpower because only a few institutions create media that also happen to be media-of-account. Because 19th century private banks didn't issue media of account, they were not monetary superpowers.

Let's bring this back to the present. What is the modern medium of account? Who controls it and thereby earns the mantle of the U.S.'s reigning monetary superpower? Scott Sumner argues that central bank base money serves as the medium of account. I don't doubt that he's right. But in a large subset of transactions, I'd argue that Visa and Mastercard dollars are the medium of account. And this means that Visa and Mastercard rival (in theory at least) the Fed as monetary superpowers.

To understand why Visa and Mastercard dollars serve as media of account, you need to know a bit about how credit cards work. Merchants who accept credit cards as payment must pay a small percentage of each transaction's value to the credit card networks (comprised of the Visa and Mastercard associations, plus the banks that issue cards and process payments). So if someone buys $1.00 worth of stuff, the merchant might get $0.995, the remaining half cent going to the card network.

The fee that the merchant must pay varies by the quality of card. Basic cards might result in the merchant giving up 0.5% to 1% to the card network while premium cards, those offering better rewards, might bring a fee of 2-4%. Merchant fees have been rising over time, especially as card rewards become more exotic.

Merchants hate seeing credit cards, especially premium cards. They hate them because they are required to pay the card fees but cannot pass these costs off to the customer. Why? Well the best way to pass these costs off would be for the merchant to put a surcharge on each credit card transaction equal to the fee the card network charges the merchant. A surcharge policy would mean that it would cost any customer wishing to buy a $100 painting with Visa or Mastercard $102 or $103.

However, as a condition of using the card networks, merchants are prohibited from discriminating against card users. Surcharges are 'illegal'. Visa and Mastercard can extract these sorts of promises from merchants because they are oligopolies. If you are exiled from their networks for breaking their rules, you're as good dead.

So the upshot is that if a customer buys a $100 painting with cash (or debit), the merchant gets $100; if they buy it with a basic Visa card, the merchant might get $98; but if the customer buys it with a premium card, the merchant will only get $96. I'd hate premium cards too if I only got 96 cents on the dollar.

To get around these rules, merchants who accept cards have come up with an ingenious strategy: change the medium of account. Basically, the unit of account that merchants use, the $, stays the same, but whereas the merchant's original medium of account was Federal Reserve dollars, they now switch over to defining the $ in terms of Visa/Mastercard dollars. In the eyes of a merchant, a credit card dollar is only worth around 97 or 98 cents. Having adopted Visa/Mastercard as his MOA, our merchant will proceed increase his sticker prices by a percent or two across the board. The painting which retailed for $100 is now priced at ~$102. When someone buys the painting with a credit card, two dollars of this amount goes to the card network, leaving the merchant with $100. He earns the same real income as before.

This switch in MOAs allows our merchant to inflate their prices and thereby pass off card fees to their customers without illegally imposing surcharges. Fed cash has ceased to be the MOA, but will still be a popular exchange medium. But now customers who prefer paying in cash must request a cash discount at the merchant's till. Given the $102 sticker price on the painting, they should be able to buy the painting for around ~$100 Fed dollars.

Since Visa and Mastercard now manage the medium of account for a large proportion of American merchants, they have become monetary superpowers and can exercise their own brand of monetary policy. If Visa and Mastercard increase the rewards on their cards, merchants will be docked larger fees. Merchants will react by increasing sticker prices across the board. Thus we get inflation. If rewards are lowered so that the merchant is penalized less, then merchants will lower their sticker prices. This is deflation. These price changes are independent of any action taken by the Federal Reserve.

That's not to say that the Fed would have lost its monetary superpowers. It can still cause inflation or deflation by engaging in open market operations are adjusting the interest rate on reserves. However, in an extreme scenario, we could imagine the Fed's effort to increase prices being offset by Visa and Mastercard's efforts to decrease prices. A monetary battle of sorts could erupt.

I think that a good analogy to help understand this is to return to the 19th century example of dollar coins issued by the U.S. Mint. If gold prices rose, the price level would fall. But if the U.S. Mint were to simultaneously reduce the gold content of dollar coins, the MOA, it could entirely offset this fall and create stable prices. Just like the U.S. Mint can offset any change in the value of gold by increasing or decreasing gold content of coins, Mastercard and Visa as issuers of MOA can (in theory at least) offset any change to the value of Fed dollars by increasing or decreasing the reward content of Visa/Mastercard dollars.

An interesting bit of news worth pointing out is that in 2013, Visa and Mastercard finally allowed U.S. merchants to introduce surcharges on credit card transactions. I'd expect that merchants will slowly start to transition back to using Federal Reserve dollars as their medium of account. We should see the various types of credit cards dollars being priced at varying discounts to Federal Reserve dollars, similar to how banknotes in the 19th century were priced, with each note earning a discount relative to the dollar coin. Premium cards will face large surcharges, and regular cards small surcharges.

This means that in the U.S., Visa and Mastercard have effectively lost their monetary superpowers. They can no longer effect the general price level. In other places like Canada, however, courts have allowed the no-surcharge policy to continue, which means that Visa and Mastercard dollars will continue to be MOA. The card networks will remain as Canadian monetary superpowers.

There's a lot more material that I'd like to add to this already-dense post, but I'll hold off for now. In sum, in this post I'm "kicking the tires" of the basic definitions that folks like Scott Sumner and Bill Woolsey provide us. In applying them to the world around us, it sure seems to me like credit card media-of-account currently coexist with the standard Fed dollar medium-of-account. But I'm curious to see if others agree with my interpretation.

P.S. Here are two interesting tangents I plan on writing about next month:

1) A bimetallic monetary system has two media of account; gold and silver. When the market rate between gold and silver shifts, the system suffers from Gresham's Law. If we have a monetary system that uses Federal Reserve dollars and Visa/Mastercard dollars as the two media of account, what does a modern version of Gresham's Law look like?

2) The Fed gathers price data so it can better target a 2% decline rate in the CPI value of the "dollar". But if some merchants are pricing goods in terms of a different dollar medium of account, isn't the Fed gathering inappropriate data? If credit card networks are pushing up prices via fee increases, the Fed might misinterpret these changes as being Fed-inspired and adopt the wrong monetary policy. How might the Fed adjust its methodology to account for the use of credit card MOA?

---

(1) As Tom Brown points out, some economists describe the unit-of-account not just as a sign, but also as a fixed quantity of the medium-of-account. So if the unit of account is the $, and the medium-of-account is gold, than the number of grains of gold that defines the dollar is rolled into the concept of unit-of-account. Alternatively, we can leave the unit-of-account as a mere sign, and refer to the medium-of-account not just gold but a given quantity of gold grains. Thirdly, we could give the quantity of the medium of account that defines the $ an entirely different term, say the "Tom Brown multiple". As long as we remember that there's a sign, the thing that represents that sign, and the quantity of that thing then we can avoid unnecessary semantic debates