Friday, July 31, 2020

How the pandemic has clogged the global economy with paper currency

The outbreak of Covid-19 has caused a global increase in the amount of cash in the economy. I think I've got a pretty neat explanation for why.

But before I tell you what it is, let me show what the cash build-up looks like. Here's what has happened to banknotes in circulation in Canada so far in 2020:

Meanwhile, here is the US:

And here is the UK:
Each chart shows an unusual increase in banknotes in the economy starting in March or April, when the pandemic first hit western countries. These cash bulges show no signs of shrinking. And they are quite big. In the case of the U.S., I'd estimate that there are $150 billion extra paper dollars in circulation thanks to the virus.

I recently came up with a surprising explanation for why this is happening. But before we get to it, we need to review what determines the amount of cash held in the economy. Here's an analogy. Think about how the water level in a reservoir might rise. There are two ways this can happen. More water can run into the reservoir, or less water can flow out. (Conversely, the water level can fall when either less water enters, or more is withdrawn.)

The same principle applies to the amount of cash held in the economy. If more people are taking cash out from ATMs and banks then the amount of cash in the economy will grow. But the amount of banknotes in the economy can also grow without a rise in withdrawals. That can happen when the public (i.e. individuals & businesses) returns less of the stuff than before to ATMs and banks. So more of it stays floating around in the economy.

Now, I must confess that in previous blog posts and tweets I had assumed that the big increase in cash-in-circulation during the pandemic was due to an increase in withdrawals. People were worried about the virus, I thought, so they wanted to take more banknotes out of their bank accounts and hold it under their mattresses. "Cash restocking makes sense in an emergency like the one we are living through," I wrote back in April. And here: "The coronavirus reminds us of the fragility in our infrastructure. And so we rebuild some of our banknote balances."

But now I think that I was wrong. The big increase in cash-in-circulation is not due to an increase in withdrawals of cash. Sure, some people are taking out a few more $50s or $100s to hold under their mattress. But with the virus shutting down the economy, most of us are making less purchases than before. The few transactions that we continue to make tend to be digital, say like buying from Amazon with a card. The net effect is that since March we have been withdrawing far less cash than normal.

If so, then why has the level of cash in the economy jumped? The only explanation is that there is much less cash being returned to banks and ATMs. Businesses and individuals simply aren't redepositing their banknotes. There's some sort of clog or blockade that is gumming up the system and preventing a regular flow of returns. I'll try and explain the precise nature of this clog, but first lets look at some data that confirms that returns of cash have dried up.

The European Central Bank (ECB) is unique. Most central banks only provide public data on the net amount of cash that is in circulation. But the ECB goes the extra step and offers data on both the flow of banknotes being issued into the economy and the flow being withdrawn from the economy. And so we can actually see which half of the equation is responsible for the big jump in cash: more withdrawals or less returns.

As you can see, Europe has seen a large and anomalous jump in cash-in-circulation in 2020, just like Canada, the US, and UK. I've charted this below:

Now let's see what the ECB's disaggregated data has to say:

In general, withdrawals of euro banknotes (the blue line) has exceeded returns (the orange line) from 2007 to 2020. That's why the amount of cash in the European economy has generally increased over time. During the 2008 credit crisis, there was a big jump in withdrawals, no doubt to worries about the safety of the banking system. But during the pandemic, cash withdrawals (blue line) have actually fallen, not increased. In fact, the level of withdrawals is at its lowest point in over a decade!

Returns of cash (orange line) have plunged by even more than withdrawals. They are at their lowest level ever!

So what does this mean? Thanks to the pandemic, European individuals & businesses have become less interested in taking cash out of the bank. But they are even less interested in returning cash to the bank. It is this outsized collapse in returns, the orange line, that is causing the big build-up in euro banknotes in circulation.

For those who like analogies, let's revisit our reservoir imagery for a moment. The amount of water (i.e. cash) flowing into the reservoir (i.e. the economy) has slowed to a trickle. Normally this trickle would lead to a fall in the water level. But because even fewer people are removing water (i.e. doing cash returns) from the reservoir, the incoming trickle is sufficient to push the water level higher.

I think there's a good chance that what is happening in Europe is happening in the U.S., Canada, and U.K. too. Thanks to the virus, no one is redepositing their banknotes. But I'd have to see the data to be sure.

Now we can finally get to my theory for what is clogging up the system. The peculiar feature we need to explain is people are so much less willing (or able) to return their notes during the pandemic than they are willing to withdraw them. Or put differently, why did the orange line fall so much more dramatically than the blue line did? It suggests some sort of asymmetry in people's usage of cash. My theory is that this asymmetry can be found in the nature of the black market, illegal drug markets, the mob, the underground economy, etc.

The specific asymmetry is this: it is quite easy for a drug buyer to withdraw $200 from an ATM to buy heroin or cocaine. Banks don't surveil people who are taking out cash. But it is far more complicated for a drug seller to redeposit that $200. Redeposits are surveiled. To get banknotes back into the system a crook has to launder them, say be sneakily mixing the drug money with legitimate cash earned by cooperating cash-intensive businesses like restaurants, casinos, or cornerstores.

Let's work through how this specific asymmetry has collided with the pandemic. It's unlikely that drug users have stopped buying drugs during the pandemic. (Maybe people are buying even more drugs? Thanks to shut downs, there's not much to do!) So the flow of cash from a drug users' ATMs to a drug dealers' pockets has not slowed at all during the pandemic.

But the network of restaurants and other businesses that drug dealers rely on to launder their funds have all shut down thanks to virus fears and lockdowns. These closures would have put drug dealers, crooks, the mob, etc. in a tough position. Throughout the pandemic they have been accumulating ever more cash from drug using customers, with no place to offload it.

So to sum up, the big increase in cash in the economies of Canada, Europe, US, and the UK is probably being driven by an unwanted accumulation of cash by crooks. Their regular money laundering arrangements aren't functioning.

I don't have any personal experience with being a criminal. But it's fun to speculate about what their lives have been like during the pandemic. The Tony Sopranos, Walter Whites, and Stringer Bells of the world are currently scrambling around for safe places to store their ever burgeoning stores of physical cash. In their houses, at a warehouse storage unit, or at a bank.

And since they can't convert their cash hoards into spendable money in a bank account, I'd imagine these crooks are having problems paying legitimate bills like mortgage payments and the cost of sending their kids to posh schools. With criminal enterprise handling so much extra cash, I'd also imagine that law enforcement agencies are seizing record amounts of cash via civil forfeiture. We could also be seeing a big jump in gang warfare as competing drug outfits raid each other for cash. To recover all of these extra costs of doing business, criminals are probably jacking up drug prices. Yep, I'd imagine it's not an easy time to be a criminal.

As the pandemic subsides and restaurants and other confederate businesses start to open, criminals will be able to restart their money laundering operations. But they won't be able to return their entire accumulated hoard at once. If they were to do so, the cash receipts of the businesses they are using for laundering would stick out, potentially drawing the attention of the tax authority and law enforcement. No, they'll have to slowly reintroduce their dirty money.

Which means the big global jump in banknotes that I illustrated in my first set of charts will take much longer to be worked off than it was accumulated.

PS: I wonder if we can get some other good insights from the data, specifically about the size of the underground economy. Looking at my topmost chart, I'd estimate that the amount of cash in the Canadian economy is about $6 billion higher than it would otherwise be. Let's say that this bulge is entirely due to criminals being unable to launder their drug proceeds. We know Canada has 32 million adults. So Canadians have spent $6 billion on illegal drugs since the pandemic began, or around $200 per adult. That's about $12 billion a year. Seems reasonable, no? (Yes, I am making a load of assumptions here.)  

Tuesday, July 21, 2020

Pennies as state failure

We can all think of examples of state failure. The most obvious include the inability to protect citizens from criminals, failure to provide drinkable water, and incapacity to cope with a public health crisis like COVID-19. I would argue that the ongoing existence of the penny within a nation's borders is another example of state failure.

The poster child for this particular example of state failure is the U.S. and its Lincoln penny. Many (though not all) developed nations have already rid themselves of their lowest denomination coin. (Well-run New Zealand has managed to cancel two of them, the penny in 1989 and the nickel in 2006!) My own country, Canada, was a disappointing failure on this front. But in 2012 we worked up our resolve and put an end to our orange one-cent discs.

In this post I'm going to explore why this particular example of state failure continues to plague the U.S. 

But first, let me make the argument for why pennies constitute a failure of the state.

Any government that still provides pennies is hurting its citizens

Most examples of state failure occur when the government doesn't provide a service or poorly provides one. In the case of the penny, the U.S. Mint, is ably providing us with a service, pennies. But this particular service is a frivolous one, sort of like offering free high fives or back slaps.

Actually, it's worse than silly. Pennies impose a tiny burden on each given individual. But when summed up across the entire population, each of those tiny burdens becomes a huge societal inconvenience. 

Let's take a moment to explore the penny supply chain. The U.S. Mint allocates a large chunk of its manpower and resources to producing pennies, as if these precious little discs were some sort of vital national service. Of the 4.9 billion coins the Mint has produced in 2020, 55% have been pennies.

Fresh pennies then get transported to banks. Stores dutifully buy the tiny discs from banks so that they can give them out as change to customers. But pennies are of too little value to be of any use to us shoppers. We mostly throw them in the garbage or forget them in jars. The conscientious among us redeposit them into the system using Coinstar machines or at the bank. This penny charade goes on and on and on, every hour of the day.

It's a costly charade. The U.S. Mint expends 1.6 cents for each penny it produces. But that's only a small part of the waste. Large quantities of time and resources are expended by all of us—banks, shops, transport companies, consumers—in moving pennies, storing them, counting them, sorting them, and moving them again.

Get rid of the penny and this whole charade ends. Everyone can stop pretending they are providing and/or enjoying an important public service.

So why hasn't the U.S. managed to exorcise itself of the penny? There are two theories. The most popular one is corporate capture. I'll explore that one first. My own personal theory, which I'll get into after, is American monetary populism. This populism gets in the way of the most basic of monetary reforms. (The two theories aren't mutually exclusive.)

The corporate capture theory of the penny

If you explore the oral history of the penny, you quickly learn about the penny lobby. Tennessee-based Jarden Zinc Products (recently rebranded as ARTAZN) is one of the largest producers of coin blanks in the world. Jarden is owned by One Rock Capital Partners, a private equity firm. Its main customer is the U.S. Mint, which buys and converts Jarden's zinc blanks into pennies.

We can dig into the U.S. Mint's financial statements get a good idea how much Jarden earns from the penny. In 2019 the U.S. Mint's costs of goods sold for pennies came out to around $124.9 million (2018: $145.7 million). I get that from the Mint's 2019 Annual Report (see screenshot below with yellow highlights). As the sole supplier of one-cent blanks to the Mint, Jarden Zinc Products gets most (if not all) of this $124 million stream of income. That's a big contract!

Source: US Mint 2019 Annual Report

Jarden has spent decades lobbying Congress to keep the penny in circulation. Below are its annual lobbying expenses going back to 2006, which I get from OpenSecrets. As you can see, Jarden paid its lobbyist, one Mark Weller, $120,000 in 2019. So far it has paid him $50,000 in 2002 2020. That doesn't seem like a bad investment if you want to protect a $124 million revenue stream.

Data from OpenSecrets

Below I've screenshotted a list of all the issues that Mark Weller has addressed in the first quarter of 2020 on behalf of Jarden. Most glaringly, he lobbied the Senate, Treasury, and House of Representatives on "issues related to the one cent coin." This issue consistently appears in each quarterly lobbying report going back to as early as 2009.

Another interesting item on Jarden's list of issues is the Payment Choice Act of 2019, which if passed would oblige retailers to always accept cash. No doubt Jarden is a big supporter of this particular bit of legislation; millions of retailers and banks would be forced to continue stocking one-cent coins, and that would mean more profit for Jarden shareholders.

Lobbying activity for Jarden Zinc in the first quarter of 2020. Data from OpenSecrets.

Nor is Jarden the only corporate culprit.

Coinstar, the company which provides Americans with ubiquitous coin-cashing machines, also benefits from the penny. Earlier this year Coinstar lobbied the government on both the Payment Choice Act of 2019 and the Cash Always Should be Honored Act, or CASH Act, which would make it unlawful for any physical retail establishment to refuse to accept cash as payment. Coinstar also regularly lobbies law makers on "issues related to minting and coinage." I'm going to assume this has something to do with keeping the penny and nickel in circulation, and perhaps converting the paper dollar into a coin. (Note that Coinstar's corporate name was changed to Outerwall in 2013).

Below is a chart showing how much Outerwall (i.e. Coinstar) has paid to its lobbyist going back to 2014.

Coinstar is owned by Outerwall Inc. Data is from Opensecrets

So according to the corporate capture theory, companies like Jarden Zinc Products and Coinstar have managed to twist the legislative process to serve their own agenda.

I should point out that a counter-lobby exists. Citizens to Retire the Penny is an anti-penny group run by MIT physics professor Jeff Gore. Here is its website. But according to the corporate capture theory of the penny, heroes like Gore lack the resources and expertise to out-muscle a slick Washington lobbyist like Mark Weller. The set of groups who are harmed by the penny—banks, citizens, shops—are too diffuse to provide much of a push-back.  And thus the final result is state failure. The U.S. citizenry is being mis-served by its penny-issuing government.

Just because I've shown numbers proving the existence of the penny lobby doesn't mean that the U.S.'s failure to remove the penny is necessarily a result of lobbying. We need more to complete the picture.

After all, we also have lobbyists up here in Canada. And we Canadians still managed to get rid of the penny. Australia, New Zealand, and Singapore also have lobbyists, but none of those fine countries have pennies anymore. To complete the story we need to be able to show that U.S. policy makers are more beholden to special interests than policy makers in other countries. And if so, that would explain why the U.S. is stuck with its orange burden, but the rest of us aren't. But I'm not an expert on differences in national lobbying, so I'll defer on this topic. Anyone have any good insights into this?

Now let's get to our second theory: monetary populism.

The monetary populist theory of the penny

I've spent about ten years writing about both the Canadian and U.S. monetary systems. And one of the consistent differences between the two countries is that Americans of all backgrounds have strong opinions about monetary issues. We Canadians generally don't express much interest on the topic of money and central banking.

I think it's great that Americans get so involved in these issues. Americans are critical and curious and want to know what their central bank, the Federal Reserve, is up to. Canadians' lack of engagement sometimes worries me. To ensure that institutions like the Bank of Canada are serving Canadians, we need to be constantly auditing and debating everything that they do.

Let me offer an anecdote. During the 2007-08 credit crisis I was indirectly involved in the Bank of Canada Act being updated. To help cope with the credit crisis, it was deemed that the Bank of Canada needed to be able to buy a wider range of securities than the law permitted it to. Even though Canada had a minority government at the time, the requisite legislation was quickly shepherded through various committees and then onto the floor of Parliament. Voila, with almost no fuss the Bank of Canada Act was updated and the Bank could buy more assets. I recall press coverage being minimal.

The same process in the U.S. would have attracted massive amounts of press coverage. Think tanks from all parts of the spectrum would have chimed in. The political sniping between Republicans and Democrats would have been loud and vigorous.

If Americans hold a wide range of views on monetary issues, many of these views are anti-establishment. I'm thinking the End the Fed movement in particular. (There is no equivalent End the Bank of Canada movement.) We Canadians tend to be more trusting of our monetary institutions and the elites that run them.

But American skepticism about monetary institutions often slides into knee-jerk conspiracy theories. And that's where I prefer wishy-washy Canadians and their lack of engagement. Whereas there are umpteen U.S. monetary conspiracy theories, there are almost no Canadian ones.

For instance, American monetary conspiracy theorists are currently wildly excited about the national coin shortage. Due to a number of reasons (which I go into here, and Will Luther explores here) there are not enough coins to meet public demand. This shortage is temporary and unplanned. But American monetary conspiracy theorists have reworked this incident into some sort of coordinated effort by the powers-that-be to force Americans onto a cashless digital dollar and ultimately, into subservience to a one world government.

Here is Twitter:  

And here is Facebook:


Or here. I could provide many more examples. The coin shortage conspiracy theory has gone viral.

And so now I can finish off my theory. A society with a broad range of opinions about the monetary system (many of which are erroneous conspiracies and lies) is going to be much harder to change than a society that is neutral or uninterested about the monetary system. In the U.S., a fix as simple and smart as removing the penny will inevitably be misinterpreted (often willfully so) by crowds of monetary populists. And so any wise bureaucrat or legislator who wants to remove the penny will have to expend huge amounts of extra time combating misinformation. So maybe they won't bother.

And thus the state has failed Americans, and they are stuck with the penny. But we trusting (and perhaps naive) Canadians have been saved.

PS: In writing this I forgot to mention my last theory for the U.S. penny. American monetary experts tend to be inward-looking. Foreign monetary experts tend to be much more outward-looking. That is, an American analyst will generally know a lot about the Federal Reserve, but not much about the rest of the world's monetary institutions. But a foreign expert will generally be much more bilingual with respect to monetary systems. As a Canadian, for instance, I'm forced to know a lot about both my own monetary institutions and a list of American ones. A Swede monetary analyst is likely to be trilingual: comfortable with the Riksbank (Sweden's central bank), the European Central Bank, and the U.S. Federal Reserve. 

I worry that this inwardness leads to an incapacity on the part of the U.S. to learn from the successes of other monetary systems. The following nations have rid themselves of their lowest monetary unit: Canada, Australia, New Zealand, Switzerland, Singapore, Finland, Netherlands, Italy, Belgium, Ireland, Sweden, Norway, and more. That's a lot of playbooks to draw from. But many Americans won't know about this--they're too focused on themselves.

Friday, July 10, 2020

Bitcoin is more like ham radio than the early internet

People in the bitcoin community often make fun of me as a nocoiner. That is, I don't have any bitcoins and am vocal about that fact. (Neither of which is true, by the way).

The truth is that I have no problem with bitcoin. It is a solid protocol that has survived handily for eleven years. When I come off as being critical, it's usually because I'm attacking the various narratives, or fan fictions, that have sprung up around bitcoin. Don't get me wrong, all movements rely on some sort of internal mythology to help drive their progress. Bitcoin is no different in this respect. But there is a big difference between accurate self-perception and fantasy.

Bitcoin's wrongest narratives are its triumphal ones. Most of them paint bitcoin as some sort of heir apparent, waiting on the wings to inevitably replace regular money: Bitcoin is the internet in 1991, just on the cusp of mass adoption... Bitcoin is email... Hyperbitcoinization is one year away... Bitcoin as monetary revolution...etc. I'm sure you've run into these proclamations.

No, bitcoin isn't going to become a mainstream kind of money. It's too awkward for most people. Crazy price gyrations are far too wicked for the regular money-using public to tolerate.

Nor should bitcoiners want bitcoin to go mainstream.

If five years from now everyone in the world has become a bitcoin user, that could only be because something very very bad has happened to the regular monetary system. Perhaps hostile aliens have enslaved us and are using the payments system to control what we can buy, sort of like Margaret Atwood's Compucounts in her dystopic Handmaid's Tale. And so bitcoin has gone mainstream, but only because we have all been forced to become under-the-table bitcoin users in order to buy stuff we need.

Surely no bitcoiner would actually want such a dark future.

I think the ham radio community provides bitcoiners with fertile ground for cultural appropriation. As I suggest in my recent Coindesk article, Bitcoin and ham radio are quite similar. They are both clunky and old-fangled. Neither technology is particularly easy to use relative to more mainstream options: ham radio's user experience is trumped by Whatsapp's, and Zelle is smoother to use than bitcoin. Go to Youtube an you'll find thousands of videos explaining how each technology works.

The very feature that makes both ham and bitcoin so confusing is also its strength. They are both decentralized. That is, neither relies on a single omnipresent service provider. Rather, the actual user is 100% in charge of operating the tool. No account necessary. This lack of a gate keeper means that there is no one to soften the user experience. It also means that no one can be excluded from broadcasting a radio message, or transferring some bitcoins. That's a neat feature.

The ham radio community seems to be quite comfortable with its nicheness. Ham radio operators don't huddle together and talk about "overthrowing the totalitarian system of smart phones" or "displacing evil email." There is no ham radio fixes this meme on twitter.

And no wonder. If ham radio were to have gone mainstream by 2025, it would only be because some sort of massive natural disaster, say a meteor strike, has crippled all other forms of communication. No sane ham radio operator would wish this sort of doom scenario on the world.

When I was researching my Coindesk piece, I learned that there is a large community service element to ham radio. Hurricanes and other natural disaster often knock out cell phones and 911 call centres. As a robust decentralized communications network, independent ham radio operators become first responders. They locate desperate people and relay their needs on to emergency care providers. For instance, in the image below ham radio aficionado Josh Nass aka KI6NAZ is doing rounds of his neighborhood to see if any families have been knocked out by a (mock) disaster.

Source: Youtube

I really liked the ethos that Josh stands for. It's warm and cuddly and heroic. There also seems to be a good dose of humility among ham radio operators. The community thinks of itself as a group of civic-minded hobbyists, not revolutionaries on the cusp of tearing down the system.

Perhaps bitcoiners can learn from this. A hobbyist mentality is required to learn all the obscure things one must do with one's bitcoins: how to custody one's own keys, make bitcoin transactions, run a node, and set up Lightning. Between kids and jobs, most people won't have the time. Or maybe we're just lazy. When the regular monetary & payments system is compromised, say Visa or Zelle or Swish have gone down, perhaps these bitcoin hobbyists—like their ham radio cousins—can leap into action and help others by enabling them to route transactions around the blockages.

Better this sort of narrative than to be fooled by fantasies saying that bitcoin is destined to rule the world. In the long run, bad narratives lead to disillusionment, and disillusionment kills a movement.

To sum up, bitcoin isn't the next email. It seems more akin to ham radio, a civic-minded and wonkish hobby that comfortably exists alongside its more mainstream centralized cousins. When the regular payments system suffers from a rare interruption, that's bitcoin's turn in the spotlight. But when regular service is restored, it becomes a hobby again. And that's fine.

Monday, June 29, 2020

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

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

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

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

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

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

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

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

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

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

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

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

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

What about other developed nations?

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

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

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

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

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

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

Wednesday, June 24, 2020

Banks are slow to increase rates on savings accounts, but quick to reduce them

Chase Sunset & Vine, 2012. Painting by Alex Schaefer

There is a fundamental asymmetry to banking. Banks don't like to share higher interest rates with their customers who have checking and savings accounts. But they are quick to pass off lower interest rates to us.

This asymmetry is good for bank shareholders, but bad for customers.

To illustrate this asymmetry, I'll start by showing how banks modified interest rates on savings and checking accounts as the Federal Reserve, the U.S.'s central bank, went through a long period of hiking interest rates from 2015 to 2019.

The Federal Reserve's first rate increase (from 0.25% to 0.5%) was in December 2015. It increased rates once more in 2016 and three times in 2017. But the interest rate on the average U.S. savings account and interest checking account didn't start to rise till spring 2018, two and a half years after the Fed's first rate hike.

This irked me and I tweeted about it over a year ago:

If you're like me, you'd assume some sort of direct linkage between: 1) the interest rate that the Federal Reserve pays its customers (i.e. banks) and 2) the rate that these same banks pay their customers, you and me. Just like we have a checking account at a bank, banks maintain checking accounts at the Federal Reserve. They earn interest on balances held in those accounts. This rate is known as the Fed's interest rate on reserves, or IOR. As the Fed increases the interest rate that it pays on these checking accounts, the banks earn more from the Fed. But for some reason the banks are slow in passing these earnings on to the public.

Although the delay in pass-through irked me, I didn't take it too seriously, figuring it was due to some sort of institutional inertia. Banks are slow monolithic beasts. If they're slow to increase rates, at least they're slow to chop them, too, right? So on net, we customers aren't any worse off over the full economic cycle.
But if banks are slow to increase rates, is it indeed the case that they are also slow to reduce rates? Well, the results are in. The Fed began to cut rates in mid-2019, just around the time of my initial tweet. There were another few cuts in the latter half of 2019. Then COVID-19 hit in March, and the Fed rapidly ratcheted the rate it pay banks down from 1.6% to 0.1%. Banks went from earning around $38 billion in interest on their checking accounts at the Fed (in fiscal year 2018) to almost nothing.

If banks are generally lethargically about passing on rate changes to their customers, it should have taken them three or four years to reduce rates on savings and checking accounts back to where they had started. Nope. In just a month or two, the banks obliterated all the interest rate gains that customers with savings account had enjoyed since 2018:

So no, banks aren't lethargic beasts that are universally slow to change interest rates enjoyed by savers. They seem to have a strategy of increasing rates slowly, and then reducing them rapidly. Assholes.

Note that the savings rate I am using is from the Federal Deposit Insurance Corporation's website. FDIC takes the simple average of rates paid by all insured depository institutions and branches for which data are available.

By the way, this data probably doesn't represent the experience of the minority of financial sticklers who make an effort to locate high-interest rate savings accounts at online-only banks. JP Morgan's Goldman Sachs's Marcus currently offers 1.03%, much higher than the 0.10% that the Fed pays to Goldman JP Morgan. Ally offers 1.10%. But the average savings account holder doesn't bank at these institutions. They stick to Bank of America or Wells Fargo, which both offer a measly 0.01%.

This asymmetry is not a new phenomenon. In "Sticky Deposits", Federal Reserve economists John Driscoll & Ruth Judson found that rates are "downwards-flexible and upwards-sticky."

More specifically, the authors used proprietary data from 1997 to 2007 to show that interest rates on bank accounts and other retail deposits adjust about twice as frequently during periods of falling Fed interest rates as they do in rising ones. They estimate that this sluggish pass-through from rising Fed rates to customer rates costs American consumers around $100 billion per year!

My favorite chart from Driscoll & Judson is below:

Source: Judson & Driscoll

At left, we see the number of weeks it takes for banks to decrease the rate on interest checking accounts in response to a cut in the Fed's interest rate. At right we see the converse, how long it takes increase rates in response to higher Fed rates. Decreases tend to happen quickly (the purple bars in the left chart congregate closer to zero weeks) whereas increases are slow (the purple bars in the right chart congregate close to 100 weeks).

More specifically, during Fed easing cycles, checking deposit rates are updated on average every 22 weeks, but during tightening cycles it takes an average of 50 weeks.

So what explains this asymmetry? A lack of competition perhaps? If I had to guess, I'd say low financial education and dearth of customer attention. Banks can afford to be assholes because most customers either don't understand what is happening, or don't notice.

If the banks are taking advantage of their customers' ignorance and inattention to the tune of $100 billion per year, should something be done?

One option would be to provide a government savings option that 'corrects' for this asymmetry. Like digital savings bonds. Or maybe a government prepaid debit card with a built-in savings account. These cards would offer an interest rate that is linked to the Federal Reserve's interest rate, but only available to those below a certain income ceiling.

Or what about setting statutory minimum interest rates on savings accounts? In Brazil, for instance, banks are obligated to link the rate they pay on savings accounts to the central bank's interest rate:

Or maybe it starts with education. As part of its new financial literacy drive, Ontario will teach children how to identify Canadian coins and bills and compare their values in Grade 1, saving and spending from Grade 4, how to budget starting in Grade 5, and financial planning starting in Grade 6. If the result is a more savvy population, banks may face more pressure to pass on higher interest rates.

Or maybe nothing. In which case one hopes that over time the combination of better financial technology, branchless banking, and competition from Silicon Valley will eventually result in better pass-through and more symmetry in interest rates.

Friday, June 5, 2020

Want to open an account at the central bank? I'll pass, thanks

The only type of central bank-issued money that we hoi polloi can own are banknotes. But over the last few years, researchers at central banks have been increasingly toying with the idea of issuing digital money for public consumption. I count 380,000 search results on Google for the term "central bank digital currency," up from zero just a few years ago.

There are two types of proposed central bank digital currencies, or CBDCs. The first, Fedcoin, is implemented on a blockchain. I wrote about it here. But the odds of Fedcoin happening are minuscule. This post will be about the second type.

The second is a basic bank account, sort of like PayPal except run by a central bank like the Federal Reserve (or the European Central Bank or the Bank of England.) Just like you go to PayPal's website to register for an account, you'd head over to the Fed's website to open an account. A Fed version of PayPal would let you pay your friends, accept donations and business income, and buy stuff at stores. Except you'd be using Fed money, not PayPal money.

I'm not philosophically or ideologically opposed to the idea of a Fed PayPal. If the Fed (or any other central bank) wants to get into providing payments services to regular folks, fine. The same goes for Walmart. If it wants to start providing retail bank accounts, great. Ditto for Facebook. I think Libra is an admirable project. Oh, and I also want more co-operative banks and credit unions. What about community currencies? By all means, let's get more alternative systems like Ithaca Hours and the Bristol Pound up and running. And while were at it, commercial banks, credit unions, and municipalities should be allowed to issue banknotes. Heck, why not a Nike banknote?

In short, the more payments options people have, the better. (My one caveat: If a central bank is going to introduce a central bank version of PayPal, it should be obligated to recover its costs. FedPal shouldn't have an advantage over regular PayPal, the Michigan First Credit Union, or a commercial bank like Wells Fargo.*)

All that being said, I'm not terribly optimistic about the prospects for a central bank version of PayPal.

With paper money, central banks already have an incredibly popular product. Banknotes are anonymous. People can use them for activities that might be frowned on, and this is a pretty big market. Bills have another nice property; they are ungated. Anyone can accept a dollar without needing to open an account. This accessibility has made paper dollars, which can move fluidly across borders, wildly popular in nations with poorly functioning banking and monetary systems. Most importantly, central banks have a monopoly on the business of issuing cash. So they don't have to worry about competition.

But the success of central banks' cash line of business won't translate into success for a central bank version of PayPal. Given the current state of anti-money laundering regulations, we probably wouldn't be able to open a Fed PayPal account anonymously. Furthermore, it's unlikely that the Fed, or any other central bank for that matter, would open up eligibility to non-citizens living in foreign countries.

So forget about catering to the huge market of anonymity seekers and foreigners who would love to hold a U.S. dollar account directly at the Fed. FedPal would probably be a US-only product. (Likewise, the Riksbank's e-krona would be a Sweden-only product).

But this is a crowded field. Whereas cash is a government-run monopoly, thousands of competitors offer digital payments accounts. Can the central bank differentiate itself from a slew of other digital account options? I'm skeptical.

1. Features?

You've gotta keep in mind that CBDC is a brainchild of macroeconomic theoreticians, not product designers. Macroeconomists don't have any expertise in designing retail banking products. And so I'm not terribly bullish on the Fed or the Bank of England coming up with new features that would differentiate a central bank account from any other payments accounts.

2. Safety?

Not really. In the U.S. (as in most developed countries), bank accounts and prepaid debit cards are already insured up to $250,000. For most regular folks, dollars held at the Fed won't be any safer than those held in banks.

3. Fees?

The Fed might try to offer a low-fee option, perhaps to the unbanked or the underbanked. But in the U.S., this is getting to be a crowded field. Chime, Varo, Ally, and Simple offer no-monthly fee accounts. There are plenty of no-fee prepaid debit cards out there, too. Just last week, I spotlighted the PODERcard, which is marketed to unbanked immigrants.

The public sector is already active in this field, too. The Federal government already offers a no-fee prepaid debit card, the Direct Express card, to over 60 million Americans who receive Federal benefits. And state governments often provide no-fee debit cards for tax refunds, unemployment, and other state benefits. It's hard to see what a CBDC can bring to the table.

4. Higher interest rates?

Might a CBDC be able to offer higher interest rates than the competition? A few commentators have suggested that a Fed version of PayPal offer regular Americans the same interest rate that the Fed pays large banks that keep accounts at the Fed. Banks maintain accounts at the Fed so that they can make interbank payments and meet reserve requirements.

In the chart below, the Fed pays banks the blue line, interest rate on reserves. This rate has historically been far higher than the two red lines in the chart: the average rate that banks pay customers on a checking or savings account. (For its part, PayPal pays its customers 0%).

Were the Fed to pay FedPal account holders the blue line, i.e. the same interest rate it pays banks, this would effectively convert a FedPal account into an incredibly high-yield checking account. No doubt it would become a wildly popular product.

But serving millions of retail customers is a lot more expensive than serving a couple of hundred banks. Think customer help lines, fraud prevention, advertising, paper check processing, ATM network fees, and more. As I stipulated at the outset, FedPal shouldn't be allowed to operate at a loss. This would be unfair to the thousands of community banks, credit unions, fintechs, and commercial banks that are trying their hardest to provide payment services to the public.

To recover its costs of serving a retail customer base, the Fed would have no choice but reduce the interest rate it offers. How low would it go? As a monopoly, the Fed is unused to the rigors of competition. I wouldn't expect it to be able to run a tight enough ship that it could afford to pay customers an especially high interest rate.

5. Speed?

Nope. With the introduction of Zelle, it's possible for Americans to make free instant payments, 24/7. Many other nations (like Sweden) also have real-time payments. We've got it here in Canada, too.


So central bank version of PayPal would be just another middling bank account. Sure, roll it out. But don't expect it to change the world. 

Funny enough, central bank macroeconomists are worried about the opposite: that CBDC could change everything. In the papers they write on the topic, macroeconomists fret that any CBDC they introduce will be so attractive that consumers will rapidly desert their regular bank and open an account at the central bank. This would cause the whole banking system to implode.Without a stable base of deposits, banks would be unable do any lending.

In my view, the real threat is the opposite. Given the institutional constraints I listed above, a central bank version of PayPal is destined to be a middling payments product. But it gets worse. Because central bankers are so worried about the macroeconomic effects that a FedPal will have on the economy, they will inevitably underdesign these accounts, turning a middling product into a crappy one. Adoption will never occur, and so FedPal will be wound down. This failure will go on to undermine the reputations of central banks.

The lesson is, either do a stellar job designing these things... or don't do it at all.

* If the U.S. government is going to get more actively involved in offering low cost payments services to the public, there's a better way to get there than starting up a new CBDC-based system from scratch. Just offer government-sponsored prepaid debit cards. 
The neat thing is, it already does this. Millions of Americans who receive Federal benefit payments like social security already use the Direct Express card, a no-fee debit card issued by the government in partnership with Comerica. And to help disburse coronavirus relief payments, the government recently issued millions of EIP card, a no-fee prepaid debit card in partnership with Metabank. As I suggested here, why not make these cards better by letting card owners send/receive real-time payments via Zelle, attaching a savings account to the card, and giving users the in-app option of buying Treasury savings bonds.

In a recent article for the Sound Money Project, I suggested that the IRS start issuing debit cards too.

Saturday, May 30, 2020

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.

Tuesday, May 19, 2020

One country, two monetary systems

I often write about odd monetary phenomena on this blog. Here's a new contender, Yemen's dual banknote system.

Yemen uses the Yemeni rial as a unit of account. As one of the poorest countries in the world, Yemen still relies mostly on banknotes to make transactions, which are issued by the Central Bank of Yemen, or CBY.

One of the convenient features of banknotes is their fungibility. This means that one banknote is perfectly interchangeable with another. For a few months now, something strange has happened to Yemen's banknotes. Old rials and new rials have ceased to be fungible. Any rial note that was printed prior to 2016 is now worth around 10% more than newer rial notes.

More generally, the entire Yemeni monetary system has split on the basis of banknote age. From a Western perspective, it would be as if every single U.S. banknote issued with a Steve Mnuchin signature on it, the current Treasury Secretary, were worth 10% less than bills signed five years ago by his predecessor Jack Lew.

Conflicts are always complicated. What follows is a short but drastically simplified explanation of how Yemen's banknote problem began.


In 2014, the northwestern part of Yemen was taken over by rebel Houthis. They also managed to capture the capital, Sana'a. Meanwhile, an internationally-recognized government occupies the south, the port city of Aden being its capital. Very few people live in eastern Yemen.

Source: Aljazeera

The Central Bank of Yemen has always been located in the capital, Sana'a. It tried to be a neutral party between the two warring sides. This sounds like it must have been a very awkward role to play.

For instance, before the war started the central bank was responsible for paying government salaries, including the army. When the war kicked off some soldiers supported the rebels in the north while others joined the internationally-recognized government in the south. According to Mansour Rageh & coauthors, this meant that the central bank was simultaneously paying the salaries of both sides of the conflict. That's touchy.

This balancing act eventually broke down in 2016 when the internationally-recognized government forced the central bank to move to Aden. Rageh et al explain how this happened. In short, the government convinced the international community to block the Sana'a branch's access to foreign reserves. It also prevented the branch from getting new banknotes printed.
So by late 2016 we've got two different branches of the central bank, one controlled by the rebels and the other by the internationally-recognized government. The latter controls most monetary functions.

With the stage set, we can now start to get into the meat of why old rial notes are worth more than new ones. After the Aden branch of the CBY had established itself in 2016, one of the first things it did was order a bunch of new banknotes to be printed up by Russian note printer Goznak. These arrived in Aden in early 2017. They looked like this:

Source: Banknote News

You can see that there are some differences between the new 1000 rial note and the old one, pictured below:

Source: Banknote News

The rebels were not happy with the new notes. It's easy to guess why. Fresh money could be used to pay government fighters, not rebel fighters. This "blood money" would then cheekily flow north via trade. Since anyone who holds a banknote is by definition funding the government that issues it with a no-interest loan, the rebel north was financing its own enemies. (The technical term for this sort of financing is seigniorage).

In 2017, the rebels began to limit the ability of northern civilians to use the newly issued banknotes. This mostly affected banks and other large businesses in the northern Yemen, which were now required to avoid dealing in the new notes. Anthony Biswell of the Sana'a Center for Strategic Studies has a much weightier explanation of this transition. Do read his article if you want to learn more about this topic.

Anyways, on December 18, 2019 the rial spat crescendoed into a full out ban. The rebel government announced that everyone in the north had thirty days to turn over new notes at any of 300 agents located across the region. In return they would get an equivalent amount of old banknotes, if available, up to 100,000 rials per person. That's around US$170.

Anything above this 100,000 rial limit would have to be converted into a digital rials. These would be supplied by one of three privately provided electronic wallets. Unfortunately, Yemen has almost no digital payments infrastructure, so these balances wouldn't be of much use.

Thanks to the December 2019 ban, the price of old and new rial banknotes has completely diverged. Below is a chart from the World Bank.

Source: World Bank

We can surmise why a big gap has developed between the two types of notes. The stock of old pre-2016 banknotes is fixed. It can't grow. But the supply of new banknotes is not fixed. The Aden branch of the CBY can get Goznik to print as many notes as it wants. So the rare rials, the old ones, are worth more.

I'd expect Gresham's law to kick in, too. Gresham's law says that if a government stipulates that two payment instruments are to circulate at the same rate, but one is worth fundamentally more than the other, then the "bad" one drives out the "good". More specifically, the undervalued money will be hoarded (or exported), leaving only the overvalued one in circulation.

In Aden's case this is likely to translate into "bad" rials (the post-2016 ones) driving "good" rials (the pre-2016 notes) out of circulation. Since the Aden government treats both old and new banknotes as interchangeable, but old ones are worth more, the old ones will all be exported to the north.


Where might all this lead? With the Sana'a branch having declared war on new notes, the Aden branch may do the opposite and try to hurt the old ones. This would involve orphaning all of its pre-2016 banknotes. That is to say, the Aden branch will demonetize them; cease accepting old notes as its liability or obligation.

But even if they were to be demonetized, orphaned rials would still circulate.

The topic of "orphaned" currency has popped up before on this blog. The Somalian central bank ceased to exist in 1991. Yet even though the Somali shilling now lacked a central bank sponsor, they continued to be used in Somalia as a medium of exchange, as recounted by Will Luther here.

A new Somali central bank has stated that it will re-adopt these old shillings and replace them with new currency. To date, this hasn't happened.

Along these same lines, even though Saddam Hussein disowned Iraqi dinars that had been printed in Switzerland, these so-called "Swiss Dinars" continued to circulate in northern Iraq. After Saddam was deposed by the Americans in 2003, the new central bank re-adopted all of the orphaned Swiss dinars.

If the Aden government is going to disown old Yemeni rials, I wouldn't expect them to remain orphaned for long. The Sana'a branch of the Central Bank of Yemen would quickly adopt them as their own obligation. At which point Yemen's unofficial two-currency system would become official. The Sana'a branch might even try to get its own version of the rial printed up. If so, it would have to rely on printers other than Goznak.


Yemenis already face so many difficulties. The sudden emergence of a dual-currency regime only compounds their plight. Prices are a language. We become fluent in this language as we engage in our commercial habits of buying, selling, and appraising. The sudden rial split forces Yemenis to start "speaking" in two different price arrays (three if the U.S. dollar is included). It's terribly inconvenient.

There are also costs to renegotiating rial-denominated debts. If one Yemeni owes the other, are they to pay in old rials or new ones? Debtors will always prefer the debased currency, new rials, but creditors will ask for the stronger one, old rials. Somehow a decision will have to be made.

Finally, a dual currency regime means that Yemenis will be forced to convert from one type of currency to another to make payments. That means incurring fees, hassles, and waiting time.

In the west, we take fungibility for granted. To achieve monetary standardization, a big investment in technology and coordination is required. The fact that a dollar is worth the same in Los Angeles as it is in New York, or Vancouver as it is in Halifax, is worth celebrating.

P.S. Yemen's old rials are really old. See image below. Dilapidated banknotes are a major problem. They make trade harder and allow for easier counterfeiting.