Friday, May 10, 2019

Kyle Bass's big nickel bet

In 2011, hedge fund manager Kyle Bass reportedly bought $1 million worth of nickels. Why on earth would anyone want to own 20 million nickels? Let's work out the underlying logic of this trade.

A nickel weighs five grams, 75% of which is copper and the rest is nickel. At the time that Bass bought his nickels, the actual metal content of each coin was worth around 6.8 cents. So Bass was buying 6.8 cents for 5 cents, or $1.36 million worth of base metals for just $1 million.

To realize this 6.8 cents, Bass would have to sell the copper and nickel as metal, not coin. But liberating the actual metal from each token isn't so easy. Since 2006 it's been illegal to melt pennies and nickels down. As a regulated hedge fund manager, Bass probably isn't willing to break the law. Which means he'd only be able to realize the metal content of nickels indirectly, by on-selling them to a buyer who is willing take on the risks of melting nickels. That wouldn't be me, mind you. Five years in jail sounds like a long time.

At the right price, would-be smelterers will surely emerge out of the woodwork to buy Bass's stash. Say the prices of nickel and copper explode such that a nickel now contains 20 cents worth of metal. Bass should have no problems finding someone who'd pay him 12-15 cents for each of his nickels. Bass wouldn't be doing anything illegal, he'd just be selling nickels on to a stranger at a premium. And given that he only paid face value for each nickel, he'd be more than doubling his bet. 

So Bass has upside exposure to the next bull market in copper and nickel prices. The neat part of this trade is that he has no downside exposure. That's because a nickel can never be worth less than its face value of five cents. For example, consider that the price of base metals has fallen by quite a bit since Bass bought his stash of nickels. And so the melt value of a nickel has tumbled too, currently registering at around 4 cents, or 41% less than when he bought them. But Bass needn't worry. His nickels can still be taken to the Federal Reserve where they can be exchanged for twenty to the dollar, or five cents each.

Huge upside and no downside—why isn't everyone doing this trade? There's a catch. Carrying costs. Bass's trade has yet to pay off. A bull market in commodities hasn't developed. Which means that Bass has had to store 20 million nickels for eight years. But storing stuff isn't free. What follows is an estimate of the cost of doing so.


The first big cost that Bass faces is storage. His nickels take up a lot of space. Stacked one on top of the other, would twenty million nickels fit into a standard 20 foot freight container? Given that a container measures 8 x 8.5 x 20 ft, it has enough space to fit around 32,700 nickels per layer, 1,328 nickels high. That's room for 43,480,000 nickels—more than enough for Bass's hoard.

Stacking individual coins on top of each other isn't a realistic storage technique. Imagine the amount of time this would take. The industry standard for storing and handling large amounts of coins is using certified bags. According to the Fed, the standard bag size for nickels is $200, or 4,000 nickels per bag. In addition to bags, it also typical for banks to sell customers boxes filled with $100 worth of rolled-up nickels. Either bagged or boxed, there will be plenty of 'honeycombing,' or gaps between coins and packaging material.

Bass's hoard would be extremely heavy, far exceeding the capacity of a lone shipping container. Twenty million nickels weighs 100,000 kg, or 220,462 pounds. But a 20' container is only rated to hold 25,000 kg (55,120 lbs). Both the weight of the coins and the honeycombing effect mean that it could take as much as four freight containers to handle $1 million worth of nickels.

Bass could find a farmer who would be willing to store four freight containers in his field for a few hundred bucks a year. But he probably wants something more formal than that. One option is a warehouse. Warehouses charge by the pallet. A pallet can hold up to 4,600 lbs worth of goods, which works out to around 417,000 nickels, or 104 bags per pallet. Which means Bass will have to store 48 pallets of nickels. 

I searched around a bit and found that warehouses generally charge a monthly fee of anywhere from $5 to $20 per pallet. There are a lot of variables that can affect this amount. If the pallets are stackable, and thus take up less floor area, then the monthly fee will be less. Location of the warehouse is another factor. Securing space in the vicinity of New York costs more than Des Moines.

Coins on a pallet at the Federal Reserve (source)

Given that Bass has the flexibility to choose an out-of-the way warehouse (he doesn't need to access his inventory every few days), he should be able to get a cheap deal. Let's assume $5/month per pallet. With 48 pallets of nickels, that works out to around $2875 per year, or 0.29% of the total value of his $1 million stash.

Over eight years, that works out to $23,000. So after storage costs, Bass's $1 million in nickels has dwindled to just $977,000.

Bass probably wants to insure his nickels for theft and damage as well. Commercial property insurance seems to cost around $750 per year for each million dollars insured. Over eight years, that's $6000, which brings Bass's stash of nickels down to $971,000.

The last major cost is foregone interest. Instead of investing his $1 million in Treasury bills, Bass is keeping his wealth inert in warehoused nickels. Interest rates have been pretty low for the last decade, which means that Bass has only given up around 0.1 to 0.15% per year in interest income, or $1500. So for the period between 2011 and 2016, he would have given up about $9,000 in interest. That brings the value of his nickles down to $962,000.

But in 2017, Treasury bill rates began to rise, hitting 1%. At today's t-bill rate of around 2%, Bass is giving up $20,000 per year to invest in 0%-yielding nickels. Ouch. Interest costs from 2017 and 2018 mean that Bass's nickel stash has effectively dwindled to around $930,000.

So as you can see, even though Bass doesn't have to worry about taking a capital loss on his stash of nickels, the ongoing grind of carrying costs means that it's been a pricey trade. In eight years he's down by around $70,000, or 7%. In the end it could still all be worth it. If base metal prices triple, he'll still be able to make a lot of money on his initial investment. And I'm sure they will triple... at some point.


I've described the nickel trade from Kyle Bass's perspective. But let's view it from the perspective of the taxpayer. The U.S. Mint and the Federal Reserve (and therefore the taxpayer) are providing Bass with the opportunity to win big while offering him protection him from capital losses. In options lingo, they've sold him a put option. Is this a smart thing to do? Bass's isn't an isolated trade. For every Kyle Bass there are probably dozens of others trying the same thing. So the stakes aren't small.

The taxpayer is not providing this put option for free. There is at least some quid pro quo. In choosing to hold $1 million in nickles, Bass is effectively loaning money to the government at an interest rate of zero. If Bass had chosen to hold $1 million in Treasury bills instead of coins, the government would have to pay him 2% a year in interest, or $20,000. Coins don't yield interest, so the government needn't pay Bass a cent for his loan. We can think of the $20,000 in interest as the fee or compensation that tax payers get for providing Bass with downside protection on his speculative bet on metals prices.

But is the government extracting enough out of Bass for the trade? When interest rates were still at 0.1% a few years back, and Bass's yearly interest costs were a mere $1,000, Bass was probably getting the better end of the deal. But with rates at 2%, it's not so obvious who is coming out ahead. Whatever the case, should the government even be in the business of providing principle-protected commodity bets to citizens? Aren't exotic financial bets more Goldman Sach's game? 

One way for the government to extract itself from these bets would be to reduce the commodity value of the nickel. Put differently, it can debase the coinage. The last time the U.S. debased the nickel was in 1965 when it stopped minting them with silver.

The U.S. Mint could carry out a debasement by switching to steel, which is cheaper than copper/nickel. With a lower metal value, the nickel would be much less inviting for Bass and other speculators. He'd need a much bigger bull market in metals prices before he'd be able to break even.

Or maybe the U.S. could adopt plastic nickels, like Transnistria.

Whether steel or plastic, the key is to avoid an possibility of being Bass's dupe.

An even better way to avoid being the dupe? The nickel is monetary pollution. Let's just get rid of it. It made sense to have a five-cent coin back in the 1950s. A five cent coin back in the 1950s would have been worth about as much as a fifty cents, and fifty cents is a meaningful amount of money. You can buy stuff for fifty cents, say a cheap drink. But go to a grocery store today and try to see what you can buy for a nickel. Nothing.

Most nickels are used just once. Cashiers pays them out as change to customers, and from there they go straight into people's cupboards where they are forgotten. Or they get thrown in the trash. Or they're hoovered up by speculators like Kyle Bass. All of this is socially wasteful behaviour. Bass's speculation is no exception: the resources he consumes storing nickels could be put to far better use. Let's put an end to all this waste by ceasing to produce five-cent coins.

Monday, April 29, 2019

The difference between two colourful bits of rectangular paper

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Alpha leaders vs beta followers

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

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

This means that the purchasing power of the bond is subservient to that of the banknote. Or as Nick Rowe tweets, "currency is alpha leader, bonds are beta follower."
This has much larger implications for the macroeconomy. In the long-run, the US's price level is set by the alpha leader, the Federal Reserve, not by the beta follower, the Treasury.

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

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

In conclusion...

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

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

Wednesday, April 17, 2019


The U.S. $10,000 was available till Nixon nixed it in 1969

For the last few years the conversation about cash has been dominated by Ken Rogoff's proposal to remove high-denomination banknotes. In an effort to broaden the discussion, last year I wrote an essay for Cato Unbound about introducing a new U.S. supernote. The value of the current highest denomination note--the $100 bill--has deteriorated over the decades thanks to inflation. Is it time to restore the purchasing power of U.S. cash by bringing out a $1,000 note?

In the same essay I also floated the idea of taxing the supernote. Why a tax? A new $1,000 bill could be used for both good and nefarious purposes. Given that nefarious supernote usage (tax evasion and crime) could impose costs on society, a tax would make up for this by transferring wealth from note users to the rest of us. (I also blogged about the idea of taxing cash here and here). 

Josh Hendrickson, Will Luther, and Jamie McAndrews all had responses. Do read them, as they give a good sense of all the various nuances and complications involved in issuing a supernote and taxing it.


Say we introduce a new supernote worth $1,000. What would Walter, a seasoned drug dealer, think about this new policy? Let's walk through the day-to-day costs that Walter absorbs as an illicit cash user.

Walter makes large value payments using banknotes. He also stores plenty of the stuff. A million dollars worth of $100 notes (i.e. 10,000 notes) takes up a lot of space. But one thousand $1000 bills can be packed into a container a tenth the size. This will make Walter's business much easier to expedite. His costs of counting, transporting, storing, and sorting notes will all drop significantly.

The risk of detection will also be much lower with supernotes. Hiding twenty supernotes in a car is a lot easier than hiding two-hundred $100 notes. Detection by authorities imposes costs on Walter and his associates. Banknotes can be seized under civil asset forfeiture laws. In many cases the police can seize cash on mere suspicion of wrongdoing--they don't even have to charge the owner with a crime.

Example of an asset forfeiture case involving cash [source]

These seizures can be contested by Walter and his associates, but this will involve significant time and legal expenses. There are also non-pecuniary losses associated with detection. If Walter or one of his associates is pulled over for speeding and the cops find a bag full of $100 notes in his car trunk, that may provide law enforcement with information and insight into his network.

Finally, Walter also incurs a "tax" on his cash holdings. Specifically, his cash does not earn interest. If Walter regularly stores $100,000 in cash, and the interest rate is 3%, he is effectively forfeiting around $3,000/year. This loss is the same whether Walter holds his stash in $100 notes or supernotes. Walter's $3000/year loss goes directly to the public. He is providing the rest of us with an interest-free loan, or a subsidy.

Weaving this all together, from Walter's perspective the new supernote is a great product. It reduces his storage & handling costs (S) as well as any costs arising from detection (D), and does so without increasing his taxes (T).

Civil society isn't quite as well off with a supernote. We've provided Walter with a superior means of avoiding detection. Not only does this mean that we've increased the odds of Walter staying out of jail. We've also reduced asset forfeiture revenues. Since law enforcement agencies uses forfeitures to fund their operations, any diminution in this flow means that the rest of us will have to pay higher taxes to compensate.


Why don't we strike a deal with Walter? If supernotes allow him to enjoy lower S and D, why don't we ask for higher T in compensation? Setting a higher T involves an increase in the tax rate on supernotes relative to $100 notes.

One way to do this is to make the supernote depreciate a bit each day. The central bank will buy the note back today for $1000, but tomorrow it will only buy it back at $999.95. This constitutes a 5¢/day transfer from Walter to the public. At a yearly interest rate of 3%, he also loses around 5¢/day in forgone interest. This combination of a capital loss and forgone interest comprise the supernote tax.

Now when Walter and his colleagues switch from using the $100 bill to the supernote, society's decline in forfeiture income is compensated by higher tax income. Even with the higher tax, Walter prefers the supernote to the $100 because he saves enough on S and D to make it worth his while. So everyone wins if we issue a supernote.

Or as Hendrikson says in his response essay:
"the introduction of the supernote is in this instance welfare-improving (given the premise that illegal trade creates a social cost) because it allows policymakers to engineer a transfer from criminals to law-abiding citizens that would not be available otherwise."

There may be some additional improvements in efficiency to be gained by replacing a bad tax--asset forfeiture--with a good one. Having the police directly raise funds by confiscating people's property is ripe for abuse.
By contrast, a supernote tax is automatic, predictable, transparent, and easier to collect.


A supernote would provide at least some benefit to non-criminals. Say that Sarah wants to sell her car for $8000. She may be wary of accepting a check from the buyer, Todd, who she doesn't know. If she provides the car to Todd but his check bounces, then she's out of hand. Cash is a simple way to solve this problem. The moment that cash passes hands from Todd to Sarah, the payment is 100% certain.

Without a supernote, Todd will have to pay for the $8000 car with eighty $100s. Wouldn't it be more cost effective for him to make the payment with just eight $1000s? Less counting is required and the bills easily slip into a wallet. So S is reduced. (Detection, or D, is not a cost that licit users need worry about.)

Unfortunately the imposition of a tax will reduce the supernote's potential for improving the lives of non-criminals like Sarah and Todd. Since the tax raises the cost of the supernote relative to alternatives like the $100 note, many people who would otherwise have consumed the supernote just won't bother. Put differently, the  consumer surplus (for licit users) that is created by the introduction of a taxed supernote will be small than if the supernote was untaxed.

If the tax is set quite high, then usage of supernotes may be entirely confined to criminals. This the sort of monetary future that David Birch would probably say was first described by novelist William Gibson in Count Zero. Cash still exists, but it will have disappeared from polite society.


A taxed supernote is a neat idea, but does it qualify as a "fancy monetary standard" i.e too abstract and academic to inspire confidence? "Fancy" is the word that Irving Fisher's critics used to denigrate his early ideas about price targeting.

Admittedly a taxed supernote doesn't present a very clean user interface. Having a round face value is one of the conveniences of a note. This feature ensures that it can be easily divided into smaller amounts. But the supernote tax means that the face value of the note will very quickly fall to some inconvenient number like $999.33. As McAndrews points out
"...the differential rates of exchange among the different denominations of notes is an inconvenience. The cost of all those calculations required to make change and set different prices based on which note a customer offers must be counted against whatever benefit a tax might achieve."
It might be possible to avoid the rounding problem by finding a different means for assessing the tax. In his paper Taxing Cash, Ilan Benshalom describes a withdrawal tax. This tax would be assessed whenever money is taken out of an ATM or bank teller. However, supernotes will probably circulate for long periods of time without every being deposited, which means the withdrawal tax will rarely be activated.

For now, taxed supernotes are science fiction. But who knows? Irving Fisher's fancy monetary standard was science fiction for decades, but it has slowly become the standard way of doing monetary policy these days.

Wednesday, April 3, 2019

Banknotes in bottles in coal mines

[This is a guest post by Mike Sproul. Mike has posted a few times before to the Moneyess blog.]

“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well tried principles of Laissez Faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

-J.M. Keynes, The General Theory.

Keynes’ ruminations about bank notes and coal mines are a good place to draw a dividing line between classical economists and Keynesians.  In contrast to Keynesian optimism about the coal mine scheme, classical economists tell us that the newly dug-up bank notes will only succeed in causing inflation, while wasting the labor of those who dig up the notes.

Surprisingly, there is some middle ground about burying bank notes. Economists of both stripes generally agree that money shortages cause recessions. If there is not enough money for people to conduct business conveniently, then people are forced to revert to barter or other less efficient means of trade. Trade slows, and productivity suffers.  Some economists will call it a “money shortage”. Others will say “liquidity crisis”, “credit crunch”, “tight money”, “failure of aggregate demand”, and so on. Whatever the terminology, economists have been saying for centuries that money shortages cause recessions.
In the year 1722-3, the Governor and Assembly…thought themselves obliged to take into their serious consideration the distressed circumstances and sufferings of the people, through the extreme want of some kind of currency…These bills being emitted, their effect very sensibly appeared, in giving new life to business, and raising the country in some measure, from its languishing state. (Pennsylvania Assembly to the Board of Trade, 1726. Cited in Brock, 1941, p. 76)
Now we begin to see the middle ground. Both Keynesians and Classicals agree that the coal mine scheme could potentially provide badly needed liquidity and thus end a recession. Once this is agreed, the rest is just dickering over the size of various forces. A Keynesian might think that the misallocation of labor spent digging up bank notes might drag down national production by 5%, but that the notes dug up might lubricate trade enough to boost production by 20%.  A Classical might put the figures at 10% drag and 15% boost.

The backing theory of money gives us a way to clear up some confusion between these two views, and provides a liquidity-based theory of recessions that both Keynesians and Classicals can live with.

The backing theory is summed up in figure 1:

In line (1), the bank (which may be a central bank or a private bank) receives 100 ounces of silver on deposit, and issues $100 of bank notes in exchange. Each dollar note is worth 1 ounce of silver.

In line (2) the bank issues another $200 in exchange for 200 ounces worth (or dollars’ worth) of bonds. The backing theory view is that even though the bank tripled the money supply, the bank also tripled the assets backing that money, so it remains true that $1=1 ounce.

Now suppose that the $300 in circulation is 10% less than the “ideal” quantity of money, and that the economy is therefore in recession. A well-functioning bank would respond to the money shortage by issuing another $30 of bank notes, while getting 30 ounces (or $30) of bonds or other assets in exchange. This open-market purchase of bonds would relieve the money shortage, end the recession, and leave the value of the dollar at $1=1 ounce. The open-market purchase method gives excellent results. Keynesians would not be surprised at this, but Classicals might be surprised that the money injection caused no inflation.

Next, let’s try the bottles-in-coal-mines method. The bank prints $30 of bank notes, places them in bottles, and buries them in coal mines. Workers will waste (at most) $30 worth of labor digging up the notes. The bank gets no new assets as it issues the $30 of bank notes, so the value of the dollar falls by about 10% relative to silver. While there are 10% more dollars in circulation, each dollar is worth 10% less silver. The real value of the aggregate circulating cash is thus unchanged. There is no relief of the money shortage, and so the recession continues. The bottles-in-coal-mines method gives terrible results, just as Classicals would expect. Keynesians might be surprised to see that even in a recession, the money injection still causes inflation and fails to stimulate production.

We can improve on the bottles-in-coal-mines method by following Keynes’ suggestion and issuing bank notes in exchange for houses and such. The bank prints $30 of bank notes and spends them acquiring 30 ounces (or $30) worth of houses. The bank’s assets (including houses) rise in step with its money-issue, so the value of the dollar remains at $1=1 ounce. This method relieves the money shortage, ends the recession, and causes no inflation. Excellent results, and not especially surprising to either Keynesians or Classicals. The problem is that it is not always easy for the bank’s assets to keep up with its money-issue. If the bank had spent its $30 of new notes on houses that were only worth 29 ounces, then money-issue would outrun the bank’s assets, and inflation would result. Overall, it’s safer for the bank to spend its $30 buying bonds than buying houses.

There are many more methods of issuing banknotes, but I’ll mention just one: Print $30 of bank notes and give them away to passers-by outside the bank. Then have the government give $30 of bonds to the bank. The bank’s assets will rise in step with its note issue, so there is no inflation. At the same time, the real money supply rises by 10%, so the money shortage is relieved and the recession ends. Excellent results once again. The only problem is that the government will eventually run out of wealth, and will be unable to help the money-issuing bank’s assets keep up with its money issue.

1) Money shortages cause recessions, and the solution is to issue more money.
2) Issuing new money won’t cause inflation, as long as the new money is adequately backed.
3) It is best to issue new money via conventional open-market purchases of bonds. Failing that, it’s ok to issue new money for houses, or even to give it away, provided the government can cover the give-away. But whatever you do, don’t bury the money in coal mines.

Sunday, March 31, 2019

Prepaid debit cards. The other anonymous payments method

When it comes to financial privacy, good old fashioned banknotes and privacy cryptocurrencies like Zcash & Monero get all the attention. But as I recently wrote for the Sound Money Project, let's not forget about prepaid debit cards.

Having written a bunch of posts over the last two years about financial privacy, I recently decided that it was time to step up my own personal financial privacy game. A few months ago I walked into my local pharmacy and bought my first non-reloadable prepaid debit card (i.e. gift card), a Vanilla card.

You've probably seen the rack of prepaid cards near the front of pharmacies and department stores. Some of them are closed-loop cards. They can only be used to buy things at the issuer, say Tim Horton's or Starbucks. But some of them, like my new Vanilla Prepaid card, are open-loop cards. That means they can be used wherever Visa or MasterCard are accepted. In Canada, Vanilla cards are sold in denominations from $25 to $250.

The Vanilla card that I bought doesn't have my name on it, nor did I have to show any ID to buy it. I paid for it in cash. This means that whenever I use my card, my identity won't be associated with the purchase. My card is backed by dollars held in a pooled account at Peoples Trust Company, a Canadian bank. It gives me the right to anonymously route my portion of the pooled funds along the MasterCard network to a retailer who operates a MasterCard terminal.

Given that authorities and banks have spend decades constructing a vast financial surveillance apparatus (the Bank Secrecy Act, FATF, AML, CFT, suspicious transaction reporting etc), it seems odd that this small window for accessing the digital payments system anonymously would have remained intact. To comply with Canadian anti-money laundering requirements, card-issuing banks require that the prepaid card seller (my pharmacy) collect the buyer's personal information if the face value of the card exceeds $1000. For amounts below that, due diligence is waived. The same practice is followed in the U.S. This regulatory exemption is why I didn't have to give up my anonymity when I bought my card.

The idea motivating the sub-$1000 exemption is that small amounts of anonymity can't easily facilitate criminal activity, but larger amounts can. (Note that I can convert my non-reloadable Vanilla card into reloadable format—i.e. a card that I'll be able to add money after the first batch is used up—but I'll have to register and forfeit my information. Only non-reloadable cards below the $1000 cap are exempt from due diligence.)

I'm not obsessed with privacy. I still use my information-laden credit card for a big chunk of my day-to-day purchases. But from time-to-time I want to have the option of shielding my data from outside observers. Cash is good for that. I already use banknotes and coins to pay for about half of my face-to-face purchases. This is usually for the sake of convenience, but sometimes it's because I'd prefer not to give up too many of my personal details to the retailer (especially small shops I've never been to before).

By adding a non-reloadable prepaid debit card to my wallet, I've gained an extra degree of protection. Say that I've used up all of the cash in my wallet, or I need to make a purchase in a place that doesn't accept cash, or I want to buy something online—well, a prepaid gift card offers me a way to make a transaction while still protecting my data.   

Law abiding citizens who are conscious of their financial privacy are a pretty small demographic. Sellers of non-reloadable prepaid cards have much larger markets in mind, specifically: 1) people looking to buy convenient gifts for friends and family or; 2) the unbanked and underbanked, i.e. those who don't have bank accounts or have them but don't use them. By allowing people to buy prepaid cards without identification, those without formal credentials such as driver's licenses, social insurance numbers, or credit scores can still make digital payments. Think the homeless, children and teenagers, immigrants, and refugees.

The post-9/11 brigade of security-at-all-costs zealots would love for regulators to shut the prepaid anonymity window. They worry that terrorists and money launderers will abuse prepaid cards. The anonymous prepaid window has only stayed open because these zealots have been countered by a collection of banking lobbyists who want to keep doing business with the unbanked and politicians who care about the disadvantaged.

I'm neither unbanked nor underbanked. I've got several bank accounts that I often use. Nor am I buying these cards as gifts. So I'm not really the target market for non-reloadable debit cards. My ability to get anonymous access the digital payments system is really just a by-product of the wider effort to make it easy for the unbanked to plug in. This is a precarious position for a privacy-conscious individual to be. In the U.S., where only ~93% of the population is banked, the constituency for anonymous prepaid access is relatively large. But in places where the banked population is approaching 100% (Canada, Finland, Germany, Netherlands, Denmark, Belgium, Sweden, UK), there is probably diminishing political support for providing anonymous access to the banking system.

In Europe, for instance, the window for anonymous access to digital payments seems to be closing. When the EU's 4th Anti-money laundering directive was passed in 2015, up to €250 in electronic money (the EU's term for prepaid instruments that reside on a device, say a card or a phone) could be bought without being asked to give up personal information. With the passage of the 5th Anti-money laundering directive in 2018, this amount has been reduced to just €150. And a new ceiling on online purchases of €50 was introduced. As I wrote in my recent Breakermag article, such a tiny amount of anonymity just isn't that useful.

One thing I've noticed about prepaid financial anonymity is that it is expensive. My first Vanilla card had a face value of $25. But I had to pay an onerous $3.95 to activate it. Buying higher value cards defrays this expense, but it still costs $7.50 to activate a card with a face value of $250. That's a 3% levy. Keep in mind that when I use an anonymous prepaid card not only am I paying the activation fee, I am also forgoing 2% cash back that my not-so anonymous credit card would otherwise provide me with.

Think about it this way. Let's say I decide to buy my groceries anonymously using a prepaid card. My $250 only gets me $242.50 worth of goods ($250 less the $7.50 activation fee). With my credit card, I can get $255 worth of food ($250 plus $5 cash back). That's an extra $12.50 in spending power if I decide to go the non-anonymous route. Sure, by using a prepaid card I've prevented my grocery store from being able to collect information about my eating habits. But is the $12.50 I've given up worth it? (Incidentally, this calculation also indicates how costly it is to be unbanked!)

While prepaid anonymity is handicapped by a low ceiling and high fees, the drawbacks don't stop there. Non-reloadable prepaid debit cards are great for buyers who want small amounts of privacy, but they don't help out retailers who want to shield themselves. In a recent article, privacy advocate Timothy May made a great distinction between buyer privacy and seller privacy:    

If someone is selling a controversial product (May uses birth control information as an example), they must always be wary of snitches who make a purchase only to "out" the seller, either by reporting the transaction to the authorities or posting it to social media. Controversy-wary payments providers will quickly cut the seller off. To protect themselves, sellers need a payments method that doesn't leave a paper trail. They also need a payments system from which they can't be censored. Cash is a good example—it doesn't leave a paper trail and is censorship resistant. So are privacy-friendly cryptocurrencies. But prepaid cards don't cut it. The seller can easily be reported to the network and banished.

The last drawback of non-reloadable prepaid debit cards is that they can't be used to make anonymous person-to-person payments. As far as I know, there is no technical reason that I shouldn't be able to use my Vanilla debit card to anonymously send $100 to anyone else with a Visa card, just by inputting their card number and clicking send on a website. In theory, this payment should get pushed across the Visa network.

But there are regulatory reasons that I can't do so. In the U.S., the Financial Crimes Enforcement Network (FinCEN) prohibits anonymous debit cards from offering person-to-person capabilities, and I believe the same rule applies in Canada. Meanwhile, cash and privacy-friendly cryptocurrencies do allow for anonymous person-to-person payments.

In sum, non-reloadable prepaid debit cards allow for a small extension of one's financial privacy. But in an age where the ability to make payments without someone snooping is getting increasingly rare, I suppose we have to take whatever crumbs we can get.

Thursday, March 28, 2019

Should governments finance themselves through their central bank?

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

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

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

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

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

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

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

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

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


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

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


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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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


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

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

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

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

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

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

Monday, March 4, 2019

Swish > cash and bitcoin

Ok, another Sweden post. I keep returning to Sweden because no country has gone further down the road to being cash-free. Since all of us seem to be following the same trajectory, we should probably be paying attention.

Lucky for us, every two years the Riksbank—Sweden's central bank—-carries out a payments survey and puts the data up on its website. One of the most interesting questions that is asked is "which of the following payments methods have you used in the last month?"

I plotted out some of the data and tweeted the result:

What follows are a few observations.

Swish beats cash

Only 61% of Swedes used cash in the last month, down from 94% just eight years ago. But 62% now use a service called Swish. Swish is a mobile payments app that Swedes use to pay each other in real-time and on the weekend. Think Venmo or Zelle in the US, or Interac e-Transfer in Canada. These sort of payments options are not really used much at the point-of-sale. They're a person-to-person (P2P) payments technology.

Swish was developed by Sweden's banks, not by an upstart tech company. Incidentally, both Zelle and Interac e-Transfer are also owned by banks. (Venmo is owned by PayPal, a fintech). Which goes to show that banks aren't always the slow moving monoliths that a lot of people make them out to be. They'll protect their turf.

Swish was introduced in 2012, around the time that Sweden's legacy banknotes were all being scheduled to be replaced by a new issue of notes. By any measure, the timetable that the Riksbank selected for the switch over was inconvenient for cash-users. Rather than allowing for permanent note switches (like we do in Canada and the US) or a long window (like Sweden did in the 1980s and 1990s), the Riksbank gave Swedes only a year or two to make the swap. In the case of the 1000 kroner note, they'd have to do two swaps in five years. Due to the inconvenience of the changeover, many more Swedes chose to go cashless than would otherwise have been the case. I make this point in an earlier post which I called Swedish betrayal.

The Riksbank chose this timetable because it was recommended to them in 2012 by a collection of private financial institutions including Sweden's big banks. This was at the same time that the banks were introducing Swish. Since Swish and banknotes are direct competitors in the P2P payments space, an inconvenient note switch would have given banks quite the helpful tail-wind.

So Swish's success (at the expense of cash) probably isn't solely a function of enlightened consumer choice--it also benefited from a gentle nudge from the Riksbank (and the private sector, who advised the central bank). 

Debit card way more popular than credit cards

Canada is the land of credit cards. According to a recent Bank of Canada survey, around 39% of all retail payments are made with credit, or 56% of all value spent. Debit is a distant 26%. While debit is more popular in the U.S., credit cards aren't far behind.

So why is debit card usage so popular in Sweden? I'd guess low interchange fees. An interchange fee is how much a retailer must pay for each transaction that a customer makes using a card. In Sweden, interchange fees for credit cards are set at 0.3% while debit is 0.2%. In Canada, credit card interchange fees vary between 1%-2.5% compared. For debit, they are set at 0.25%.

Canadian banks can use the income from credit card interchange fees to fund handsome reward programs and 2% cash back. Swedish banks can't because credit card interchange fees are so low. So from a Canadian shopper's perspective, why use you debit card to buy $100 in groceries when you can use you credit card to get the same groceries and also get $2 cash back? Swedes don't face this same payments calculus—low mandated interchange fees mean that credit card can't come equipped with massive amounts of rewards. So buying 1000 kronor worth of groceries with a credit card doesn't provide any advantages to a debit card.

What happened to the bitcoin payments revolution?

If you want an example of a payments revolution, Swish is it—not bitcoin. Only six out of 2011 Swedes surveyed by the Riksbank used bitcoin to make a payment over the course of the month. That's an adoption rate of just 0.3%.

That being said, it's not as if bitcoin is unpopular in Sweden. Stockholm's Nasdaq/OMX exchange has the distinction of listing Bitcoin Tracker One, the world's first (and one of its only) exchange-traded bitcoin financial products. Bitcoin Tracker One is one of the exchange's most active tracking certificates. At the peak of the bitcoin bull market in December 2017, assets under management ballooned to $600 million.

These statistics illustrate the odd nature of bitcoin's success. Bitcoin was supposed to be a payments, or monetary technology. But this vision has never panned out. Rather, bitcoin has taken off as a great way for Swedes (and everyone else) to gamble. I took up this theme in a recent article for the Sound Money Project:
"Forget online payments; Bitcoin has become the most successful gambling technology to be invented since Henry Orenstein introduced the poker pocket cam in 1999. The pocket cam allowed viewers to see players' cards, revolutionizing the way people watched the game of poker and launching the 2000s poker frenzy.

In what sense did Bitcoin succeed as a gambling technology? At its core, Bitcoin is a pure Keynesian beauty contest. People try to guess what other people guess other people guess Bitcoin's value will be. The price that results from this contest is incredibly unsteady. But these explosive rises and stunning falls provide a fun, challenging, and addictive bet for casual gamblers and deep-pocketed professional speculators alike."
With bitcoin's first and primary function being gambling, a small minority of Swedes (six out of 2011) have been able to piggy back off it and use it for payments. An analogy can be made to other products that have alternative uses, say like how tooth paste's primary use case is to clean teeth, but a few people might use it to remove carpet stains.

The problem is that the very feature that makes bitcoin such a great gamble—its beauty contest nature—interferes with its serviceability as a payments system. I don't think this problem is solvable. Which is unfortunate because in theory at least, bitcoin seemed to have several features that would have made it a decent replacement for cash. 

Wednesday, February 20, 2019

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.

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.

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.

Tuesday, January 29, 2019

The Haitian dollar

Haiti is home to a strange monetary phenomenon. Shopkeepers and merchants set prices in the Haitian dollar, but there is no actual thing as the Haitian dollar.

I've written before about an exotic type of unit-of-account known as an abstract unit of account. A nation's unit of account is the symbol used by its citizens and businesses to advertise and record prices. Here in Canada we use the $ while in a country like Japan people use the ¥. The national unit of account almost always corresponds to the national medium-of-exchange. In both Canada and Japan, the $ and the ¥ amounts advertised in shop aisles are embodied by physical dollar and yen banknotes and coins.

Abstract units of account, on the other hand, don't correspond to anything that exists. In the UK, for instance, race horse auctions are priced in guineas, a gold coin that hasn't been minted in over two centuries. The guinea is a ghost money, an accounting unit that according to John Munro is "calculated according to the precious metal content of some famous, once highly favoured coin of the past than no longer circulates."

Other examples of abstract units of account include include Chile's Unidad de Fomento, or UF, (which I wrote about here) and Angolan macutes (see here).

Like the guinea, the Haitian dollar is an abstract unit of account. I should warn you that I've never been to Haiti--all of this comes from what I've read in tourist guides, newspapers, Haitian blogs, and an academic paper on the topic from Federico Neiburg. But from what I understand, it is quite common for prices in Haiti to be set in a unit referred to as the 'Haitian dollar.' However, there is no corresponding Haitian dollar banknotes or coins. The U.S. dollar and the Haitian gourde, a currency managed by Haiti's central bank, circulate in Haiti and are used to consummate all payments. But the Haitian gourde is not the same as the Haitian dollar.

How does this work in practice? Say that a restaurant is selling sandwiches for fifteen Haitian dollars. Paying with Haitian dollars is impossible--they don't exist--so some other route must be taken to complete the deal. Haitians have spontaneously adopted a rule of thumb that the Haitian dollar is equal to five Haitian gourdes. So to pay for the sandwich, it will be necessary to hand over 75 gourdes (H$15 x 5$H/HG).

Here is a sign showing both Haitian dollar and Haitian gourde (HTG) prices. Source: Pawol Mwen blog

A certain degree of mental gymnastics is thus required of Haitians, since sticker prices must always be multiplied by five (to arrive at the gourde amount) and banknotes held in a wallet divided by five (to arrive at the Haitian dollar amount). For foreigners, this can be confusing, but for Haitians the motley of U.S. dollars, gourdes, and the Haitian dollar unit of account has become second nature. Says Nieburg:
"The adjective Haitian (aysien), as in dolà aysien, is only used when one of the participants in a transaction is foreign. Among Haitians, when people say dolà they always mean dolà aysien."
Nieburg provides some more colour by describing the monetary demographics of Port-au-Prince, Haiti's capital:
" the urban islands of foreigners scattered across various regions of the city, the US dollar predominates as a unit of account and means of payment in sectors such as the housing market, as well as in restaurants, hotels, night clubs, and supermarkets (which used to double as currency exchange bureaus) that cater for upper-class Haitians and the legion of ex-pats, relief workers, and consultants. As we move down the social scale, the US dollar begins to be used as a means of payment for transactions calculated in Haitian dollars. Lower down—where the majority of transactions are to be found—people calculate in Haitian dollars and pay in gourdes."
Where does the practice of using the Haitian dollar come from? I wasn't aware of this, but during WWI the U.S. invaded Haiti, occupying it till 1934. There was a strong German mercantile presence in Haiti and apparently the U.S. authorities feared that Germany might take over.

By 1918 the government's gourdes had become "so worn and torn" that a shortage of banknotes arose. As part of a 1919 U.S.-initiated monetary reform, all previous issues of gourdes were to be replaced by a new issue by the Banque Nationale de la Republique d'Haiti, which by then was owned and controlled by New York-based City Bank (and would eventually become Citigroup). The BNRH was granted a monopoly on banknote issuance, which meant that the Haitian government could no longer print its own currency.

The new banknotes were to be convertible into U.S. dollars at a rate of five gourdes to the dollar, a promise that the BNRH printed on the face of each bill, as the images below illustrate.

1919 one gourde note (source)
"This bill issued by the National Bank of the Republic of Haiti, under its concession contract and conforming with the agreement of May 2, 1919, is payable to the holder in legal money of the United States at the rate of five gourdes to the dollar upon presentation to the bank's office in Port-au-Prince or, after a delay, at its provincial branches."

Even after the U.S. occupation ended and City Bank sold the BNRH back to the Haitian government, the promise to redeem gourdes with U.S. dollars continued. This peg stretched right through the rule of "Papa Doc" Duvalier until the gourde was finally untethered from the dollar in the late 1980s.

So several generations of Haitians had become used to a five-to-one ratio between U.S. dollars and gourdes. Dividing a price by five in order to get the U.S. dollar price may have become such a standard piece of mental arithmetic that the practice continued into the 1990s and 21st century, even after the calculation's answer no longer corresponded to the correct U.S. dollar amount. The Haitian dollar may simply have been a placeholder that was invented in order to provide continuity for the age-old custom of dividing by five.

Since it was unpegged, the Haitian gourde has fallen consistently against the U.S. dollar, possibly contributing to the tradition of using the Haitian dollar unit. Quoting prices in Haitian dollars could be a non-violent way for Haitians to show their dissatisfaction with their government's finances. Or perhaps it is a marketing trick that Haitian merchants use to make their wares seem less cheap, sort of like how shopkeepers here in Canada often set prices at $4.99 instead of $5.00.   

According to Nieburg, the government has even tried to ban the practice of pricing in Haitian dollars. Intellectuals who support the measure have condemned the abstract unit as just "another sign of the country’s backwardness." But the attempt failed. Units of account are just a part of language. And language is very difficult to control.

The Haitian dollar is probably the best (and simplest) modern example I've ever run into of an abstract unit of account. For monetary enthusiasts like myself, it provides a great illustration of the many different functions packaged into the thing we call "money." These functions needn't be unified into one object or instrument. They can be split up, so that the instruments that we pass from hand to hand (or from phone to phone), the so-called medium-of-exchange, no longer correspond to the symbol used for pricing, the unit-of-account.

Nobel Prize winning economist Robert Shiller has written enthusiastically about so-called monetary separation. William Stanley Jevons's tabular standard, which was never implemented but has been considered by some to be the ideal monetary system, relies on a split between the medium-of-exchange and unit-of-account. Rather than being backwards, the sort of Haitian dollar standard that we see in modern Haiti could one day become the guiding principle of the monetary systems of the future.