For the first time ever, euro paper money in circulation is shrinking

Why is the paper euro shrinking? Are we at peak cash? 

To begin with, here is the data, charted: 

As the orange line shows, Europe is experiencing its first year-over-year drop in paper money in circulation. 

While it's tempting to attribute this to paper money's declining role in payments, what I suspect is happening is that as the European Central Bank hikes interest rates, Europeans are redepositing spare cash into the banking system so that they can earn yield. And the net result is less cash in circulation.

Just twelve months ago, the ECB's key interest rate was still in negative territory, sitting at -0.5%. At the time, holding a bit of extra cash under a mattress didn't hurt anyone, since there was no interest to be earned by returning it to one's bank. Then, in four swift moves beginning in mid-2022 (July 27, September 14, November 2, and December 21), the ECB jacked up rates to 2%. As of today its deposit rate is at 3.5%.

Suddenly, owning large chunks of cash under one's mattress had an opportunity cost. Queue a mass reverse bank run, one which involved bringing 0% paper money back to banks, and then to the ECB, in order to convert it into interest-earning assets.

One the best examples of this is from European banks themselves. To satisfy customer withdrawal requests, banks typically keep a reserve of banknotes on hand in their vaults. Historically they've always tried to minimize this stock, since they couldn't earn any interest on notes. But this urge to minimize holdings evaporated with negative interest rates, as the chart below shows. Banks let their vault cash double in size from 2014 to 2020.

When interest rates finally jumped from negative territory back to 0% in late July 2022, the opposite happened. As the chart shows, banks rapidly emptied their vaults and brought their banknotes back to the ECB in order to convert them into central bank deposits, even though those deposits only yielded 0%. Paper money incurs storage costs, so banks will generally prefer a 0% deposit, which doesn't incur storage costs, to a 0% banknote. And now that deposits at the ECB are yielding 3.5%, there's just no contest. Paper money is out, digital money is in.

We can get a broader picture of the rush to redeposit notes by looking at the European Central Bank's banknote flow data, illustrated below. Every month, banks withdraw notes from the ECB (orange line) and return notes to the ECB (blue line), in order to satisfy the public's demand for cash. Banks generally withdraw more notes than they redeposit, the net result being the steadily rising stock of paper currency that we see in the top-most chart. 

On the heels of the ECB's July 27, 2022 rate hike, the ECB experienced its highest rate of note redeposits in almost ten years, coming in at €106 billion in August. Much of that would have been the aforementioned banks returning some €40 billion in vault cash to the ECB. But banks wouldn't have been the only large actors to empty their mattresses.

European retailers probably let themselves get sloppy after 2014, holding a lot of extra cash in their store tills and safety deposit boxes rather than depositing it only to earn a negative return. With rates now positive, these retailers are probably being much more vigilant in sweeping up all spare company cash and redepositing it to the banking system. Other likely culprits include investment companies who, rather rather than holding negative yielding bonds, opted to store as many banknotes as possible, and are now changing their investment strategies.

In sum, the paper euro is shrinking, but it's probably due to higher interest rates, not fewer cash payments. Nor is this peak cash. After an interest rate-induced pause, the upwards rise in paper euros in circulation will probably continue.

How the Bank of Canada's balance sheet went from $118 billion to $440 billion in eight weeks

Ever since the coronavirus hit, the Bank of Canada's balance sheet has been exploding. In late February its assets measured just $118 billion. Eight weeks later the Bank of Canada has $440 billion in assets. That's a $320 billion jump!

To put this in context, I've charted out the Bank of Canada's assets going back to when it was founded in 1935. (Note: to make the distant past comparable to the present, the axis uses logarithmic scaling.)

The rate of increase in Bank of Canada assets far exceeds the 2008 credit crisis, the 1970s inflation, or World War II. Some Canadians may be wondering what is going on here. This blog post will offer a quick explanation. I will resist editorializing (you can poke me in the comments section for more colour) and limit myself to the facts.

We can break the $320 billion jump in assets into three components:

1) repos, or repurchase agreements
2) open market purchases of Federal government bonds
3) purchases of Treasury bills at government auctions.

Let's start with repos, or repurchase operations. Luckily, I don't have to go into much detail on this. A few weeks back Brian Romanchuk had a nice summary of the Bank of Canada's repos, which have been responsible for $185 billion of the $320 billion jump.

With a repo, the Bank of Canada temporarily purchases securities from primary dealers, and the dealers get dollars. This repo counts as one of the Bank of Canada's assets. Some time passes and the transaction is unwound. The Bank gets its dollars back while the dealers get their securities returned. The asset disappears from the Bank of Canada's balance sheet.

The idea behind repos is to provide temporary liquidity to banks and other financial institutions while protecting the Bank of Canada's financial health by taking in a suitable amount of collateral. If the repo counterparty fails, at least the Bank of Canada can seize the collateral that was left on deposit. This is the same principle that pawn shops use. The reasons for providing liquidity to banks and other financial institutions is complex, but it goes back to the lender of last resort function of centralized banking. This is a role that central banks and clearinghouses inherited back in the 1800s.

How temporary are repos? And what sort of collateral does the Bank of Canada accept? In normal times, repos are often  unwound the very next day. The Bank also offers "term repos". These typically have a duration of 1 or 3-months. The list of repo collateral during normal times is fairly limited. The Bank of Canada will only accept Federal or provincial debt. That's the safest of the safe.

But in emergencies, the Bank of Canada is allowed to extend the time span of its repos to as long as it wants. It can also expand its list of accepted collateral to include riskier stuff. Which is what it did in March 2020 as it gradually widened the types of securities it would accept to include all of the following:

Source: Bank of Canada

That's a lot of security types! (The list is much larger if you click through the above link to securities eligible for the standing liquidity facility, see here. Nope, equities are not accepted as collateral.)

As for the temporary nature of these repos, many now extend as far as two years into the future. See screenshot below:

Source: Bank of Canada

(Note that the Bank of Canada has a very specific procedure for moving from "regular" purchases to "emergency" purchases. Part of this was implemented due to its initial reaction in 2007 to the emerging credit crisis. It accidentally began to accept some types of repo collateral that were specifically prohibited by the Bank of Canada Act. The legislative changes implemented in 2008 remedied some of the problems highlighted by this episode and codified the process for going to emergency status. Yours truly was involved in this, click through the above link.)

Anyways, we've dealt with the $185 billion in repos. Now let's get into the second component of the big $320 billion jump: open market purchases of long-term government bonds, or what the Bank of Canada refers to as the Government of Canada Bond Purchase Program (GBPP). This accounts for another $50 billion or so in new assets.

Whereas a repo is temporary, an outright purchase is permanent. Some commentators have described the purchases that the GBPP is doing as "quantitative easing". But the Bank of Canada has been reticent to call it that. When it first announced the GBPP, it said that the goal was to "help address strains in the Government of Canada debt market and enhance the effectiveness of all other actions taken so far."

This is a non-standard reason. Large scale asset purchases are normally described by central bankers as an alternative tool for stimulating aggregate demand. Usually central banks use interest rate cuts to get spending going. But when interest rates are near 0% they may switch to large scale asset purchases. (The most famous of these episodes were the Federal Reserve's QE1, QE2, and QE3). But the Bank of Canada seems to be saying that its large scale purchases are meant to fix "strains" in the market for buying and selling government bonds, not to stoke the broader economy. 

Together, the GBPP and repos account for $235 billion of the $320 billion jump.

Let's deal with the last component. Another $65 or so billion in new Bank of Canada assets is comprised of purchases of government Treasury bills (T-bills). A T-bill is a short term government debt instrument, usually no more than one year. This is interesting, because here the Bank of Canada can do something a lot of central banks can't.

Most central banks can only buy up government debt in the secondary market. That is, they can only purchase government bonds or T-bills that other investors have already purchased at government auctions. The Bank of Canada doesn't face this limit. It can buy as much government bonds and T-bills as it wants in the primary market (i.e. at government securities auctions).

Since the coronavirus crisis began, the Federal government under Justin Trudeau has revved up the amount of Treasury bills that it is issuing. As the chart below illustrates, in the last two Treasury bill auctions (which now occur weekly instead of every two weeks) it has raised $35 billion each.

For its part, the Bank of Canada bought up a massive $14 billion at each of these auctions. That's 40% of the total auction. In times past, the Bank of Canada typically only bought up around 15-20% of each auction. This 15-20% allotment was typically enough to replace the T-bills that the Bank already owned and were maturing.

By moving up to a 40% allotment at each Treasury bill auction, the Bank of Canada's rate of purchases far exceeds the rate at which its existing portfolio of T-bills matures. And that's why we're seeing a huge jump in the Bank of Canada's T-bill holdings.

(So who cares whether the Bank of Canada buys government bonds/T-bills directly at government securities auctions instead of in the secondary market, as it is doing with the GBPP?  It's complicated, but part of this controversy has to do with potential threats to the independence of the central bank. But as I said at the outset, I'm resisting editorializing.)

These three components get us to $300 billion. The last $25 billion is due to other programs. I will list them below and perhaps another blogger can take these up, or I will do so in the comments section or in another blog post:

+$5 billion in Canada Mortgage Bonds
+$5 billion in purchases via the Provincial Money Market Purchase Program (PMMP)
+$1 billion in Provincial bonds
+$8 billion in bankers' acceptances via the Bankers' Acceptance Purchase Facility (BAPF)
+$2 billion in commercial paper
+$1 billion in advances

And that, folks, is how the Bank of Canada's assets grew to $440 billion in just two months.

Death of a Northern Irish banknote

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

Source: First Trust

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

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

Now there are just eleven.

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

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

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

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

— JP Koning (@jp_koning) February 13, 2019

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

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

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

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

£100 million "Titan" note.

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

— JP Koning (@jp_koning) February 17, 2019

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

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

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

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

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

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

-------

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

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

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

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

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

Demonetization by serial number

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

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

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

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

— JP Koning (@jp_koning) January 10, 2017

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

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

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

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

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

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

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

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

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

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

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

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

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

Kocherlakota on cash

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

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

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

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

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

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

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

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

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

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

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

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

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

---

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

Those new Japanese safety deposit boxes must all be empty

Remember all the hoopla about Japanese buying safety deposit boxes to hold cash in response to the Bank of Japan's decision to set negative rates? Here is the Wall Street Journal:

Look no further than Japan’s hardware stores for a worrying new sign that consumers are hoarding cash--the opposite of what the Bank of Japan had hoped when it recently introduced negative interest rates. Signs are emerging of higher demand for safes—a place where the interest rate on cash is always zero, no matter what the central bank does.

Well, three month's worth of data shows no evidence of unusual cash demand. As the chart below illustrates, the rate at which the Bank of Japan is printing the ¥10,000 note shows no discontinuity from its pre-negative rate rise. In fact, demand for the ¥10,000 is far below what it was in the 1990s, when interest rates were positive.

I should remind readers that the Bank of Japan, like any central bank, doesn't determine the quantity of banknotes in circulation; rather, the public draws those notes into circulation by converting deposits into notes. So this data is a pure indicator of Japanese cash demand.

The lack of interest in switching into yen notes should come as no surprise given the experience of other nations that have set negative interest rates. Data from Sweden, Denmark, and Switzerland has consistently shown that it takes more than just a slight dip into negative territory before the dreaded "lower bound," the point at which the public converts all their deposits into banknotes, is encountered.

For instance, despite the setting of a -0.5% repo rate by Sweden's Riksbank, Swedish cash in circulation continues to decline. I won't bother to provide a chart, you can go see the data here.

As for the Danes, the growth rate in Danish cash demand continues to hover near its long term average of 3.7%/year. This despite the fact that the Danmarks Nationalbank, the nation's central bank, is setting a deposit rate of -0.65%. I've charted it out below:

Definitely no lower bound in Denmark, at least not yet.

Finally, we have Switzerland where the Swiss National Bank has maintained a -0.75% rate since December 2014. Back in February, the WSJ and Zero Hedge were making a fuss out of the sudden jump in the demand for the 1000 franc note, in effect blaming the build up on the lower bound. I wrote a rebuttal at the time, Are Swiss fleeing deposits and hoarding cash, pointing out that the demand for Swiss francs is often driven by safe haven concerns. The observed increase in 1000s might therefore have very little to do with the SNB hitting the effective lower bound and everything to do with worries about falling equity prices, China, deteriorating credit quality, and more.

With many of these concerns subsiding in 2016, one might expect the safe haven demand for 1000 franc notes to be falling again. And that's exactly what we see in the chart below; the Swiss are accumulating notes at a decelerating pace, even though the SNB has not relaxed its negative deposit rate one iota.

What these charts all show is that the effective lower bound to central bank deposit rates has not yet been engaged, even after many months in negative territory. You can be sure that the global community of central bankers is watching this data too; it is telling them that, should the need arise, their respective interest rates can be pushed lower than the current low-water mark that has been set by the SNB and Danmarks Nationalbank at -0.75%, say to -0.85% or even -1.0%.

There are a few factors that might be dampening the demand for paper notes. Remember that the Swiss and the Japanese have installed cash escape inhibitors; mechanisms that reduce the incentive for banks to convert central bank deposits into cash. I've written about them here.

Secondly, the SNB and the BoJ, along with the Danes, have set up an array of interest rate tiers. While the marginal deposit earns a negative rate, the majority of the tiers are only lightly penalized or not penalized at all. This tiering represents a central bank subsidy to commercial banks; in turn, banks have passed this subsidy on to their retail depositor base in the form of higher-than-otherwise interest rates, the upshot being that very few banks have set negative deposit rates on retail customers. This has helped stifle any potential run on deposits.

Tiering and cash escape inhibitors have helped dissuade cash withdrawals by two members of the public, retail depositors and banks, but not the third; large non-bank institutions. That these latter institutions haven't bolted into cash shows that the natural costs of storing wads of paper are quite high, and that the effective lower bound quite deep.

A 21st century gold standard

Imagine waking up in the morning and checking the hockey scores, news, the weather, and how much the central bank has adjusted the gold content of the dollar overnight. This is what a 21st century gold standard would look like.

Central banks that have operated old fashioned gold standards don't modify the gold price. Rather, they maintain a gold window through which they redeem a constant amount of central bank notes and deposits with gold, say $1200 per ounce of gold, or equivalently $1 with 0.36 grains. And that price stays fixed forever.

Because gold is a volatile commodity, linking a nation's unit of account to it can be hazardous. When a mine unexpectedly shuts down in some remote part of the world, the necessary price adjustments to accommodate the sudden shortage must be born by all those economies that use a gold-based unit of account in the form of deflation. Alternatively, if a new technology for mining gold is discovered, the reduction in the real price of gold is felt by gold-based economies via inflation.

Here's a modern fix that still includes gold. Rather than redeeming dollar bills and deposits with a permanently fixed quantity of gold, a central bank redeems dollars with whatever amount of gold approximates a fixed basket of consumer goods. This means that your dollar might be exchangeable for 0.34 grains one day at the gold window, or 0.41 the next. Regardless, it will always purchase the same consumer basket.

Under a variable gold dollar scheme the shuttering of a large gold mine won't have any effect on the general price level. As the price of gold begins to skyrocket, consumer prices--the reciprocal of a gold-linked dollar--will start to plummet. The central bank offsets this shock by simply redefining the dollar to contain less gold grains than before. With each grain in the dollar more valuable but the dollar containing fewer grains of the yellow metal, the dollar's intrinsic value remains constant. This shelters the general price level from deflation.

This was Irving Fisher's 1911 compensated dollar plan  (see chapter 13 of the Purchasing Power of Money), the idea being to 'compensate' for changes in gold's purchasing power by modifying the gold content of the dollar. A 1% increase in consumer prices was to be counterbalanced by a ~1% increase in the number of gold grains the dollar, and vice versa. Fisher referred to this fluctuating definition as the 'virtual dollar':

From A Compensated Dollar, 1913

Fisher acknowledged that 'embarrassing' speculation was one of the faults of the system. Say the government's consumer price report is to be published tomorrow and everyone knows ahead of time that the number will show that prices are rising too slow. And therefore, the public expects that the central bank will have to increase its gold buying price tomorrow, or, put differently, devalue the virtual dollar so it is worth fewer ounces of gold. As such, everyone will rush to exchange dollars for gold at the gold window ahead of the announcement and sell back the gold tomorrow at the higher price. The central bank becomes a patsy.

Fisher's suggested fix  was to introduce transaction costs, namely by setting a wide difference between the price at which the central bank bought and sold gold. This would make it too expensive buy gold one day and sell it the next. This wasn't a perfect fix because if the price of gold had to be adjusted by a large margin the next day in order to keep prices even, say because a financial crisis had hit, then even with transaction costs it would still be profitable to game the system.

A more modern fix would be to adjust the gold content of the virtual dollar in real-time in order to remove the window of opportunity for profitable speculation. Given that consumer prices are not reported in real-time, how can the central bank arrive at the proper real-time gold price? David Glasner once suggested targeting the expectation. Rather than aiming at an inflation target, the central bank targets a real-time market-based indicator of inflation expectations, say the TIPS spread. So if inflation expectations rise above a target of 2% for a few moments, a central bank algorithm rapidly reduces its gold buying price until expectations fall back to target. Conversely, if expectations suddenly dip below target, over the next few seconds the algorithm will quickly ratchet down the content of gold in the dollar to whatever quantity is sufficient to restore the target (i.e. it increases the price of gold).

Gold purists will complain that this is a gold standard in name only. And they wouldn't be entirely wrong. Instead of defining the dollar in terms of gold, a compensated dollar scheme could just as well define it as a varying quantity of S&P 500 ETF units, euros, 10-year Treasury bonds, or any other asset. No matter what instrument is being used, the principles of the system would be the same.

A compensated dollar scheme isn't just a historical curiosity; it may have some relevance in our current low-interest rate environment. Lars Christensen and Nick Rowe have pointed out that one advantage of Fisher's plan is that it isn't plagued by the zero lower bound problem. Our current system depends on an interest rate as its main tool for controlling prices. But once the interest rate that a central bank pays on deposits has fallen below 0%, the public begins to convert all negative-yielding deposits into 0% yielding cash. At this point, any further attempt to fight a deflation with rate cuts is not possible. The central banker's ability to regulate the purchasing power of money has broken down.*

Under a Fisher scheme the tool that is used to control purchasing power is the price of gold, or the gold content of the virtual dollar, not an interest rate. And since the price of gold can rise or fall forever (or alternatively, a dollars gold content can always grow or fall), the scheme never loses its potency.

Ok, that is not entirely correct. In the same way that our modern system can be crippled under a certain set of circumstances (negative rates and a run into cash), a Fisherian compensated dollar plan had its own Achilles heel. If gold coins circulate along with paper money and deposits, then every time the central bank reduces the gold content of the virtual dollar in order to offset deflation it will have to simultaneously call in and remint every coin in circulation in order to keep the gold content of the coinage in line with notes and deposits. This series of recoinages would be a hugely inconvenient and expensive.

If the central bank puts off the necessary recoinage, a compensated dollar scheme can get downright dangerous. Say that consumer prices are falling too fast (i.e. the dollar is getting too valuable) such that the central banker has to compensate by reducing the gold content of the virtual dollar from 0.36 grains to 0.18 grains (I only choose such a large drop because it is convenient to do the math). Put differently, it needs to double the gold price to $2800/oz from $1400. Since the central bank chooses to avoid a recoinage, circulating gold coins still contain 0.36 grains.

The public will start to engage in an arbitrage trade at the expense of the central bank that goes like this: melt down a coin with 0.36 grains and bring the gold bullion to the central bank to have it minted into two coins, each with 0.36 grains (remember, the central bank promises to turn 0.18 grains into a dollar, whether that be a dollar bill, a dollar deposit, or a dollar coin, and vice versa). Next, melt down those two coins and take the resulting 0.72 grains to the mint to be turned into four coins. An individual now owns 1.44 grains, each coin with 0.36 grains. Wash and repeat. To combat this gaming of the system the government will declare the melting-down of  coin illegal, but preventing people from running garage-based smelters would be pretty much impossible. The inevitable conclusion is that the public increases their stash of gold exponentially until the central bank goes bankrupt.

This means that a central bank on a compensated dollar that issues gold coins along with notes/deposits will never be able to fight off a deflation. After all, if it follows its rule and reduces the gold content of the virtual dollar below the coin lower bound, or the number of grains of gold in coin, the central bank implodes. This is the same sort of deflationary impotence that a modern rate-setting central bank faces in the context of the zero lower bound to interest rates.

In our modern system, one way to get rid of the zero lower bound is to ban cash, or at least stop printing it. Likewise, in Fisher's system, getting rid of gold coins (or at least closing the mint and letting existing coin stay in circulation) would remove the coin lower bound and restore the potency of a central bank. Fisher himself was amenable to the idea of removing coins altogether. In today's world, the drawbacks of a compensated dollar plan are less salient as gold coins have by-and-large given way to notes and small base metal tokens.

In addition to evading the lower bound problem, a compensated dollar plan would also be better than a string of perpetually useless quantitative easing programs. The problem with quantitative easing is that commitments to purchase, while substantial in size, are not made at any particular price, and therefore private investors can easily trade against the purchases and nullify their effect. The result is that the market price of assets purchased will be pretty much the same whether QE is implemented or not. Engaging in QE is sort of like trying to change the direction of the wind by waving a flag, or, as Miles Kimball once said, moving the economy with a giant fan. A compensated dollar plan directly modifies the price of gold, or, alternatively, the gold content of the dollar, and therefore has an immediate and unambiguous effect on purchasing power. If central bankers adopted Fisher's plan, no one would ever accuse them of powerlessness again.

---

*Technically, interest rates need never lose their potency if Miles Kimball's crawling peg plan is adopted. See here.

Are the Swiss fleeing deposits and hoarding cash?

Have Swiss interest rates fallen so low that the public is finally bolting into cash? The Wall Street Journal and Zero Hedge think so. They both point to big jump in 1000 franc notes outstanding as evidence that Switzerland has finally breached the effective lower bound to interest rates.

Let's not get too hasty. Yes, the current run into paper francs may have something to do with Switzerland having hit its effective lower bound, the point at which paper francs provide a superior return to electronic francs. But Swiss francs also serve as a global safe haven asset. And this safe haven demand, operating entirely independent from effective lower bound demand, could be motivating people to amass 1000 franc notes in vaults.

The effective lower bound problem is the idea that if a central bank drops rates low enough, a tipping point will be reached at which it becomes cheaper to hold 0% yielding banknotes and incur storage fees than to stay invested in negative yielding deposits. The large spike in demand for the 1000 franc note, Switzerland's largest value note and thus the lowest cost Swiss storage option, may be the first indication that a tipping point has been reached.

Let's look at the data. Below is a chart that shows the year-over-year change in Swiss franc banknotes outstanding as well as deposits. For comparison sake I've divided the banknote data into a 1000 franc series and all other franc notes.

The current jump in demand for 1000 notes, the blue line, is just one of six spikes over the last two decades. You can see that some of these spikes have been accompanied with jumps in demand for smaller notes and deposits, and some haven't.

In the next chart I've subtracted the yearly percentage change in Swiss bank deposits outstanding from the percent change in 1000 franc notes in circulation to show the degree to which the demand for large value cash is exceeding that of deposits.

If we are at the effective lower bound, we'd expect to see simultaneous implosion in deposit growth and an explosion in cash growth. The blue line should be at its highest point ever. What we actually see is a mere 10.3% differential. The quantity of notes in circulation is growing at 11% while deposits are growing at just 0.7%. This level is by no means extreme; five other spikes in the cash-to-deposit differential are apparent in the chart, most of which plateaued at or above the current level. These previous spikes in demand for 1000 notes occurred when Swiss interest rates were above zero, so something other than lower bound concerns must have motivated them. What are they?

The jump in 1999 is certainly Y2K-related as people fretted that the banking system would collapse and thus hoarded paper francs. And the 2001-02 spike in demand for 1000 franc notes is probably linked to 9/11 as well as the ongoing collapse in stock markets. The sudden rise in demand in 2008 coincides nicely with the credit crisis. Finally, the 2011-12 rise occurred in parallel with growing fears about Target2 imbalances and a potential euro break up, the run into 1000 franc notes coming to a halt almost to the month of Draghi's famous speech to do 'whatever it takes.'

So the lesson is that Swiss 1000 notes play a role as a safe haven asset. When bad things happen, they are preferred to other note denominations and franc deposits.

Fast forward to the present, I can use this safe haven status to tell a story about the current spike in demand. The coming to power of Syriza late in 2014 and a slow-moving euro crisis led to a sudden preference for 1000 franc notes, much like how the period of euro skepticism in 2011-12 stoked demand for Swiss cash. Concerns over China, the oil price collapse, growing credit worries, and a bear market in equities have further incited investor movement into large denomination francs. At the same time, deposit growth is relatively neutral, a pattern reminiscent of the credit crisis. As these concerns abate, the run into 1000 franc notes will subside, even if Swiss interest rates stay locked in negative territory.

I think that's a pretty reasonable story. The upshot is that while the run into 1000 franc notes could certainly indicate that the effective lower bound has been triggered, it is by no means the only explanation. People may simply be accumulating the 1000 as a safe asset in the context of growing global worries. Absent a smoking gun, Tommy Jordan, head of the Swiss National Bank, will probably not be using the increase in large denomination notes outstanding as a reason to avoid further rate cuts, at least not yet. When demand growth for 1000 notes is exceeding that of deposits by 30% or so, then he should be concerned.

---

Previous articles on Swiss cash demand:

- - {1} - -The ZLB and the impending race into Swiss CHF1000 bank notes
- - {2} - - Central banks' shiny new tool: cash escape inhibitors
- - {3} - - Plumbing the depths of the effective lower bound

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.

Central banks' shiny new tool: cash escape inhibitors

Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank

Negative interests rates are the shiny new thing that everyone wants to talk about. I hate to ruin a good plot line, but they're actually kind of boring; just conventional monetary policy except in negative rate space. Same old tool, different sign.

What about the tiering mechanisms that have been introduced by the Bank of Japan, Swiss National Bank, and Danmarks Nationalbank? Aren't they new? The SNB, for instance, provides an exemption threshold whereby any amount of deposits that a bank holds above a certain amount is charged -0.75% but everything within the exemption incurs no penalty. As for the Bank of Japan, it has three tiers: reserves up to a certain level (the 'basic balance') are allowed to earn 0.1%, the next tier earns 0%, and all remaining reserves above that are docked -0.1%.

But as Nick Rowe writes, negative rate tiers—which can be thought of as maximum allowed reserves—are simply the mirror image of minimum required reserves at positive rates. So tiering isn't an innovation, it's just the same old tool we learnt in Macro 101, except in reverse.

No, the novel tool that has been created is what I'm going to call a cash escape inhibitor.

Consider this. When central bank deposit rates are positive, banks will try to minimize storage of 0%-yielding banknotes by converting them into deposits at the central bank. When rates fall into negative territory, banks do the opposite; they try to maximize storage of 0% banknote storage. Nothing novel here, just mirror images.

But an asymmetry emerges. Central bankers don't care if banks minimize the storage of banknotes when rates are positive, but they do care about the maximization of paper storage at negative rates. After all, if banks escape from negative yielding central bank deposits into 0% yielding cash, this spells the end of monetary policy. Because once every bank holds only cash, the central bank has effectively lost its interest rate tool.

If you really want to find something innovative in the shift from positive to negative rate territory, it's the mechanism that central bankers have instituted to inhibit the combined threat of mass paper storage and monetary policy impotence. Designed by the Swiss and recently adopted by the Bank of Japan, these cash escape inhibitors have no counterpart in positive rate land.

The mechanics of cash escape inhibitors

Cash escape inhibitors delay the onset of mass paper storage by penalizing any bank that tries to replace their holdings of negative yielding central bank deposits with 0%-yielding cash. The best way to get a feel for how they work is through an example. Say a central bank has issued a total of $1000 in deposits, all of it held by banks. The central bank currently charges banks 0% on deposits. Let's assume that if banks choose to hold cash in their vaults they will face handling & storage costs of 0.9% a year.

Our central bank, which uses tiering, now reduces deposit rates from 0% to -1%. The first tier of deposits, say $700, is protected from negative rates, but the second tier of $300 is docked 1%, or $3 a year. Banks can improve their position by converting the entire second tier, the penalized portion of deposits, into cash. Each $100 worth of deposits that is swapped into cash results in cost savings of 10 cents since the $0.90 that banks will incur on storage & handling is an improvement over the $1 in negative interest they would otherwise have to pay. Banks will very rapidly withdraw all their tier-2 deposits, monetary impotence being the result.

To avoid this scenario, central banks can install a Swiss-style cash escape inhibitor. The way this mechanism works is that each additional deposit that banks convert into vault cash reduces the size of the first tier, or the shield, rather than the second tier, the exposed portion. So when rates are reduced to -1%, should banks try to evade this charge by converting $100 worth of deposits into vault cash they will only succeed in reducing the protected tier from $700 to $600, the second tier still containing the same $300 in penalized deposits. This evasion effort will only have made banks worse off. Not only will they still be paying $3 a year in negative interest but they will also be incurring an extra $0.90 in storage & handling ($100 more in vault cash x 0.9% storage costs).

Continuing on, if the banks convert $200 worth of deposits into vault cash in order to avoid -1% interest rates, they end up worsening their position even more, accumulating $1.80 in storage & handling costs on top of $3.00 in interest. We can calculate the net loss that the inhibitor imposes on banks for each quantity of deposits converted into vault cash and plot it:

The yearly cost of holding various quantities of cash at a -1% central bank deposit rate

Notice that the graph is kinked. When a bank has replaced $700 in deposits with cash, additional cash withdrawals actually reduce its costs. This is because once the first tier, the $700 shield, is used up, the next deposit conversion reduces the second tier, the exposed portion, and thus absolves the bank of paying interest costs. And since interest costs are larger than storage costs, overall costs decline.

If banks go all-out and cash in the full $1000 in deposits, this allows them to completely avoid the negative rate penalty. However, as the chart above shows, storage & handling costs come out to $9 per year ($1000 x 0.9%), much more than the $3 banks would bear if they simply maintained their $300 position in -1% yielding deposits.

So at -1% deposit rates and with a fully armed inhibitor installed, banks will choose the left most point on the chart—100% exposure to deposits. Mass cash conversion and monetary policy sterility has been avoided.

How deep can rates go?

How powerful are these inhibitors? Specifically, how deep into negative rate territory can a central bank go before they start to be ineffective?

Let's say our central banker reduces deposit rates to -2%. Banks must now pay $6 a year in interest ($300 x 2%). If banks convert all $1000 in deposits into cash, they will have to bear $9 in storage and handling costs, a more expensive option than remaining in deposits. So even at -2% rates, the cash inhibitor mechanism performs its task admirably.

If the central bank ratchets rates down to -3%, banks will now be paying $9 a year in interest ($300 x 3%). If they convert all $1000 in deposits into cash, they'll have to pay $9 in storage & handling. So at -3%, bankers will be indifferent between staying invested in deposits or converting into cash. If rates go down just a bit more, say to -3.1%, interest costs are now $9.30. A tipping point is reached and cash will be the cheaper option. Mass cash storage ensues, the cash escape inhibitor having lost its effectiveness.

The chart below shows the costs faced by banks at various levels of cash holdings when rates fall to -3%. The extreme left and right options on the plot, $0 in cash or $1000, bear the same costs.

The yearly cost of holding various quantities of cash at a -3% central bank deposit rate

So without an inhibitor, the tipping point for mass cash storage and monetary policy impotence lies at -0.9%, the cost of storing & handling cash. With an inhibitor installed the tipping point is reduced to -3.1%. The lesson being that cash escape inhibitors allow for extremely negative interest rates, but they do run into a limit.

The exact location of the tipping point is sensitive to various assumptions. In deriving a -3.1% escape point, I've used what I think is a reasonable 0.9% a year in storage and handling costs. But let's assume these costs are lower, say just 0.75%. This shifts the cash tipping point to around -2.5%. If costs are only 0.5%, the tipping point rises to around -1.7%.

This is where the size of note denominations is important. The Swiss issue the 1000 franc note, one of the largest denomination notes in the world, which means that Swiss cash storage costs are likely lower than in other countries. As such, the Swiss tipping point is closer to zero then in countries like the Japan or the U.S.. One way to push the tipping point further into negative terriotry would be a policy of embargoing the largest note. The central bank, say the SNB, stops printing new copies of its largest value note, the 1000 fr. Banks would no longer be able to flee into anything other than small value notes, raising their storage and handling costs and impinging on the profitability of mass cash storage.

Good old fashioned financial innovation will counterbalance the authorities attempts to drag the tipping point deeper. Cecchetti & Shoenholtz, for instance, have hypothesized that in negative rate land, a new type of intermediary could emerge that provides 'cash reserve accounts.' These specialists in cash storage would compete to reduce the costs of keeping cash, pushing the tipping point back up to zero.

The tipping point is also sensitive to the size of the first tier, or the shield. I've assumed that the central bank protects 70% of deposits from the negative deposit rate. The larger the exempted tier the bigger the subsidy central banks are providing banks. It is less advantageous for a bank to move into cash when the subsidy forgone is a large one. So a central bank can cut deeper into negative territory the larger the subsidy. For instance, using my initial assumptions, if the central bank protects 80% of deposits, then it can cut its deposit rate to -4.6% before mass paper storage ensues.

Removing the tipping point?

There are ways to modify these Swiss-designed cash escape inhibitors to remove the tipping point altogether. The way the SNB and BoJ have currently set things up, banks that try to escape negative rates only face onerous penalties on cash conversions as long as the first tier, the shield, has not been entirely drawn down. Any conversion after the first tier has been used up is profitable for a bank. That's why the charts above are kinked at $700.

If a central bank were to penalize cumulative cash withdrawals (rather than cash withdrawals up to a fixed ceiling) then it will have succeeded in snipping away the tipping point. This is an idea that Miles Kimball has written about here. One way to implement this would be to require that the tier 1 exemption, the shield, go negative as deposits continue to be converted into cash, imposing an obligation on banks to pay interest. The SNB doesn't currently allow this; it sets a lower limit to its exemption threshold of 10 million francs. But if it were to remove this lower limit, then it would have also removed the tipping point.

What about retail deposits?

You may have noticed that I've left retail depositors out of this story. That's because the current generation of cash escape inhibitors is designed to prevent banks from storing cash, not the public.

As central bank deposit rates fall ever deeper into negative territory, any failure to pass these rates on to retail depositors means that bank margins will steadily contract. If banks do start to pass them on, at some point the penalties may get so onerous that a run develops as retail depositors start to cash out of deposits. The entire banking industry could cease to exist.

To get around this, the FT's Martin Sandbu suggests that banks could simply install cash escape inhibitors of their own. Miles Kimball weighs in, noting that banks may start applying a fee on withdrawals, although his preferred solution is a re-deposit fee managed by the central bank. Either option would allow banks to preserve their margins by passing negative rates on to their customers.

Even if banks don't adopt cash escape inhibitors of their own, I'm not too worried about retail deposit flight in the face of negative central bank deposit rates of -3% or so. The deeper into negative rate territory a central bank progresses, the larger the subsidy it provides to banks via its first tier, the shield.  This shielding can in turn be transferred by a bank to its retail customers in the form of artificially slow-to-decline deposit rates. So even as a central bank reduces its deposit rate to -3% or so, banks might never need to reduce retail deposit rates below -0.5%. Given that cash handling & storage costs for retail depositors are probably about the same as institutional depositors, banks that set a -0.5% retail deposit rate probably needn't fear mass cash conversions.

So there you have it. Central banks with cash escape inhibitors can get pretty far into negative rate land, maybe 3% or so. And with a few modifications they might be able to go even lower.