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.

Thursday, January 3, 2019

Should we have to line up for money or not?

I finally had some time to read George Selgin's excellent Floored! over the Christmas holiday.

Some family members saw me reading the book and asked me what it was about. The subject that George is tackling—two types of central bank operating systems—is quite technical, so I wasn't sure how to break it down for them. But in hindsight, here's how I would go about it. I'm going to explain what the issues are in terms of an instrument we all use and understand: good ol' fashioned banknotes. 


Imagine that when you go to your bank this morning to withdraw $200 in cash, you can only get $100 out of the ATM. The bank manager says that it is expecting another shipment of cash later in the day, so come back then. But be early, he warns, since a lineup is sure to develop.

What explains this odd situation? The central bank has started to ration the amount of banknotes it issues. For instance, the Bank of Canada currently supplies Canadians with $85 billion in banknotes. But say it has decided to only provide half that, $45 billion.

A world in which banknotes are rationed would be very different from our actual world. When we march up to an ATM, we are accustomed to getting as much cash as we want. If everyone in my neighbourhood were to suddenly decide that they wanted to cash out their bank accounts, the Bank of Canada will print whatever amount of currency is necessary to meet that demand. Central bank don't keep cash scarce, they keep it plentiful.

Strange things happen in a world with rationed cash. Imagine that everyone wants to hold $200 in banknotes in their wallet but can only get $100 from the ATM. Further, assume that people need to hold a bit of cash because certain transactions can only be consummated with banknotes. To cope with this chronic cash shortage, a spare-cash market will emerge. For a fee, those who have a bit of extra cash on hand will lend to those who are short.

The spare-cash market would look a bit like this. To top her existing cash balance of $100 up to her desired $200, Jill makes a deal with Joe to lend her $100 in cash. She provides security for the loan by transferring $100 from her bank account to Joe's bank account. A day later Jill repays Joe with $100 in banknotes, and he returns her $100 security deposit, less a $1 fee. Jill has effectively paid $101 to get $100. Or put differently, she has paid Joe 1% in interest to get $100 in cash for a day.

We could even imagine informal person-to-person trading posts springing up outside of popular ATMs where those who are short of cash meet up with lenders like Joe who specialize in locating and lending spare cash. An Uber-style app would be created where the credit history of borrowers are documented, reducing the risk to lenders. People might be able to order up cash from home, delivered by bike courier.

The spare-cash market that I've just described is not a market we are accustomed to. As I said earlier, central banks keep cash plentiful. But it's similar to another market we are all familiar with: the secondary market for concert tickets. Tickets are necessarily rationed because there are only so many seats in a concert venue. Professional ticket scalpers line up ahead of time and buy these tickets so they can on-sell them at a premium.

Like the scalped ticket market, the spare-cash market is a natural response to scarcity. Those who can't spare enough time to stand in an ATM queue but need banknotes, like Jill, can pay those with spare time to stand in line, like Joe. Both are made better of. Joe's lot has improved because he earns more standing in ATM lines and lending cash than he did in his previous occupation. Jill is better off because she attains her desired amount of cash.

Once cash stops being a free good, cash payment delays emerge. Say that Jill prefers to go shopping in the morning for groceries and other necessities, before her hair dressing salon opens. But because acquiring cash is costly, she sometimes delays her shopping trip till later in the day, in the hope that someone might walk into her salon and pay with cash. That way she can avoid paying interest to Joe. 

However, if over the course of the day no one pays Jill with banknotes, she will have to borrow in the spare-cash market at the last minute. If everyone is following the same strategy as Jill, there will be an end-of-day spike in cash demand. Joe may run out of cash to provide his customers, and so Jill may have to go without food that night.

So now that we've outlined the contours of a world where cash is rationed and ATM lineups develop, would it be preferable to a world in which cash is plentiful and there are no lineups?


Let me start by arguing why an alternative world in which cash is rationed might be more desirable than our current world with plentiful cash.

Thanks to cash rationing, Joe and Jill are forced to transact with each other. Perhaps a 'citizen-lender' like Joe can get additional incites insights into Jill's capacity to bear credit, the sorts of incites insights that a banker cannot. This extra bit of person-to-person monitoring may prevent folks like Jill from over- or underborrowing. 

This oversight function that Joe fulfills never emerges in the plentiful cash world since the two aren't forced into an economic relationship. And thus the credit market in a plentiful cash world may be less efficient than it would be if cash were rationed.

Now let me argue the opposite, why the world of plentiful cash may be superior.

There is an underlying logic to rationing concert tickets. A venue has just x seats, and so only x tickets can be sold. But there is no equivalent reason for a central bank to limit the size of its banknote issue. It does not face a capacity restraint, and the extra cost involved in printing new banknotes is tiny. And so any decision to ration cash is a purely arbitrary one.

Under rationing, citizens are forced to engage in a host of time-consuming activities that they wouldn't otherwise have to engage in, including locating a reliable cash lender, providing personal and potentially intrusive credit data to this lender, and then setting up an appointment to settle the debt at a later date. To avoid the hassles and expenses of dealing in the spare-cash market, folks like Jill may try to avoid making cash trades until later in the day, but that means she can't follow her preferred shopping schedule. 

If cash were plentiful, the millions of citizen-hours spent in coping with these annoyances would be freed up for alternative uses. Jill might be able to enjoy the extra minutes she now has with her children, or work on upgrading her salon. Instead of paying for Joe to stand in an ATM line-up, she can hire him to help in the construction, surely a much more socially useful activity than lining up.   

So which world do you prefer? Joe's extra credit monitoring is certainly beneficial. But does it outweigh all of the costs and nuisances that a cash shortage imposes on people's lives? This is a tough calculation to make. If you support cash rationing because you like the fact that it leads to a secondary market in cash loans (and thus more credit monitoring), why not create shortages in other financial markets, say by forcing banks to also ration deposits?


Let's wrap this all up. We've explored the difference between a world in which cash is rationed and one in which it is plentiful.

But George's book isn't about cash, it's about another instrument issued by central banks: reserves. Unlike cash, reserves are an exclusive financial instrument. Only banks can hold them. Since reserves aren't part of our day-to-day experience, I've tried to explain things in terms of banknotes, a far more mundane central bank-issued instrument. 

George argues in his book for rationing reserves. It would be as-if he were arguing for the rationing of cash in the scenario I sketched out above. Note that I am not saying that George wants cash to be rationed (as a free banker he would probably be against it), but I am saying that many of his arguments in favor of reserve rationing can be recast in terms of a banknote rationing.

In particular, George speaks favorably of the secondary market in reserves that springs up thanks to rationing. In the U.S., this is usually referred to as the fed funds market, but more generally it is known as the interbank market. The interbank market is exactly like the spare-cash market that I've described above. Just as Joe lends to Jill in the spare-cash market, banks lend reserves to each other in the interbank market. George provides much evidence that the self-monitoring that banks engage in by transacting in the interbank market is a valuable function. 

What George doesn't touch on is that this increase in the amount of credit monitoring, far from being free, comes at the cost. Like Jill, banks must spend time and resources coping with a perpetual reserve scarcity. If this artificial shortage was removed, banks could stop allocating internal resources to this coping effort and deploy it instead to other uses. In the same way that plentiful money meant that Jill could hire Joe to upgrade her salon rather than paying him to stand in line, a bank can move employees from its defunct fed funds department to bolster its lending department, or customer service, or technology effort.

The question shouldn't be: do we want interbank peer monitoring? Rather, do we want interbank peer monitoring at all costs? I think this makes the calculation much more difficult.

Thursday, December 27, 2018

Swedish betrayal

I recently wrote two posts for the Sound Money Project about Swedish monetary innovation. The first is about an effort by the Swedish central bank—the Riksbank—to force retailers to accept cash, and the other is about the e-Krona, a potential Riksbank-issued digital currency.

This post covers a third topic. For many years now those of us who are interested in cash, privacy, and payments have had our eye on Swedish banknote demand. The amount of paper kronor in circulation has been declining at a rapid pace. Many commentators are convinced that this is due to the rise of digital payments. Since Sweden is at the vanguard of this trend, it is believed that other nation's will eventually experience similar declines in cash demand too.

But I disagree. While digital payments share some of the blame for the obsolescence of paper kronor, the Riksbank is also responsible. The Riksbank betrayed the Swedish cash-using public this decade by embarking on an aggressive note switch.  Had it chosen a more customer friendly approach, Swedes would be holding a much larger stock of banknotes than they are now. As long as other countries don't enact the same policies as Sweden, they needn't worry about precipitous declines in cash demand.

Banknotes are dead, long live banknotes

Across the globe, an odd pattern has played out over the last decade. The proportion of payments that are being made with cash has been rapidly declining thanks to the popularity of card payments. Sweden is no different in this respect, although it may be further along than most:

Source: Reserve Bank of Australia

Oddly, even as developed countries are seeing fewer transactions completed using cash, the quantity of banknotes outstanding has jumped. This increase in cash outstanding, which generally exceeds GDP growth, is mostly due to an increase in demand for large-value denominations, as the chart below illustrates:

Source: Bank for International Settlements

The BIS has a good explanation for this seemingly contradictory pattern. The demand for cash can be split into two buckets: means-of-payment and store-of-value. Banknotes earmarked as a means of payment are generally spent over the next few days. Demand for this type of cash is stagnating thanks to increased card usage. Not so the former. The demand to store $100 bills under mattresses and in safety deposit boxes in anticipation of some sort of disaster is booming. According to the BIS, this is due in part to low interest rates, which makes banknotes more attractive relative to a bank deposit or government bond.

The number of banknotes held as a store-of-value demand accounts for quite a large proportion of total cash in circulation. In a recent paper, Reserve Bank of Australia researchers estimated that 50% to 75% of Australian banknotes are hoarded as a store of value. Keep in mind that these sorts of calculations are subject to all sorts of assumptions. Australia's experience with cash probably applies to most other developed nations.

Sweden, a sign of what's to come?

Which gets us back to Sweden. Sweden differs from all other nations because of what is happening with its banknote count. The quantity of paper kronor outstanding has been consistently plummeting for a decade now, and currently clocks in at just half its 2008 tally:

Even Norway, which has probably proceeded further along the path of digital payments than Sweden, has experienced only a small decline in notes outstanding, nothing akin to Sweden's white-knuckled collapse. The key question is this: why have most developed nations experienced digital payments renaissances along with stability in cash demand, whereas Sweden's own renaissance has been twinned with a seismic drop in cash demand?

The answer to the question is important. Many commentators (including Ken Rogoff) are convinced that the rest of the world's nations will eventually find themselves in the same situation as Sweden. The allure of digital payments will inevitably lead to an all-out Swedish-style desertion of cash.

I'm not convinced. As I mentioned at the outset of this post, the Riksbank shot itself in the foot by carrying out an aggressive currency swap between 2012-2017. This swap did incredible damage to the paper kronor "user experience", or UX. In response, discouraged Swedes fled from cash and substituted into less awkward alternatives like bank deposits. Let's take a closer look at Sweden's 'great note switch'.

The 'great' note switch

Every decade or two central banks will roll out new banknotes with updated designs and anti-counterfeiting measures. This is good policy since it cuts down on fake notes. These switches are generally carried out in a way that ensures that the public's user experience with cash remains a good one throughout. The best way to maintain cash's UX during a changeover period is to allow for long, or indefinite periods of concurrent circulation between old and new notes. Concurrent circulation cuts down on confusion and hassle endured by note users.

Let me explain with an example. Up here in Canada, the Bank of Canada introduced polymer banknotes between 2011 and 2013. But no time frame was placed on the demonetization, or cancellation, of previous paper $5, $10, $20, $50, and $100 notes. Since we all knew from the get-go that we would be free to spend or deposit old Canadian banknotes whenever we got around to it, we didn't have to go through the hassle of rounding up old notes stored under our mattresses and bringing them in for new ones. Apart from the novelty of polymer notes, we hardly noticed the switch to polymer.

Not so with Sweden's rollout of new banknotes. Rather than allowing for a long period of concurrent circulation between old and new notes, the Riksbank announced a shot-gun one-year conversion window for legacy notes. After that point, all old notes would be declared invalid.

For instance, the new 20, 50, and 1000-krona notes were all introduced on October 1, 2015. Swedes had until June 30, 2016—a mere 273 days later—to spend the old notes at retail outlets, after which it was prohibited for retailers accept old notes. If they had missed that window, the Swedish public then had another 62 days—till August 31—to deposit them in banks. After that, all old 20, 50, and 1000 notes would invalid. Owners of invalid banknotes could bring them to the Riksbank, fill out a form explaining why the due date had been ignored, and for a fee get valid ones.

The same shot-gun approach characterized the rollout of the new 100 and 500 the following year. Swedes had 273-days to spend old 100 and 500-krona notes, and another 365 days to deposit them at banks.

I've pasted the time frame for the entire conversion below:

Source: Riksbank

The October 2015 and 2016 switches were preceded by a preparatory demonetization in 2012. At the time, Sweden had two types of 1000-krona note in circulation. The version that had been introduced in 2006 had a special foil strip to combat counterfeiters, but the 1989 version did not. In November 2012 the Riksbank announced that Swedes would have 418 days—till Dec 31, 2013—to use old 1000 notes without foil strips. After that date the notes would be invalid.  

That outlines Sweden's hectic changeover timeline. Now, let's go back to 2012 and put ourselves in the shoes of Hakan, a Swede who has stashed a few 1000-krona banknotes in anticipation of emergencies or other exigencies. In 2012, Hakan would have learnt that all of his 1000-krona notes without foil strips would have to be replaced or declared invalid.

How to deal with this annoyance? Hakan could have replaced them with 1000-krona notes with foil strips, but the Riksbank had also communicated that notes with strips were to be invalidated by 2016. Replacing them with 500 notes would be equally inconvenient, since these were scheduled to be replaced in 2017. Rather than committing himself to a string of inconvenient switches, Hakan may have simply given up and deposited his notes in a bank.

Below I've charted the evolution of Sweden's notes-in-circulation by denomination:

Note the massive 50% decline in 1000-krona notes outstanding between the end of 2012 and 2013. Granted, the 1000-krona was already in decline prior to then. But without the aggressive 2012-13 demonetization, this decline would have been much less precipitous.

Even more glaring is the drop in the number of 500-krona notes beginning in 2015 as the conversion period approached. Rather than swapping old 500-krona notes for new ones, or 1000-krona notes, Swedes instead choose to deposit them in the bank. After enduring a stream of inconvenient note exchanges, were cash users like Hakan simply sick of their product expiring on them? 

A natural experiment: Norway v Sweden

Neighbouring Norway serves as a good control or benchmark for studying Sweden. Both nations have similar tastes for digital payments and cash, identical banknote denomination structures, and their currencies trade close to par. But unlike Sweden, Norway did not implement a massive note replacement effort. This gives us some clues into how Sweden's switch may have affected demand for the paper kronor.

Below I've separately charted the evolution in the value of each nation's stock of 500 and 1000 notes, and the combined large denomination note stock (1000s + 500s).

During the 2015-2017 changeover period, demand for Sweden's 500-krona note plummeted, but uptake of the Norway's 500-krone note continued to grow nicely (first chart). The aggressive demonetization of 2012-13 coincided with a big drop in the quantity of Swedish 1000-krona notes. Meanwhile, the rate of decline in the quantity of Norwegian 1000-krone notes continued as before (second chart). What message do I take from these two charts? Given two otherwise equal nations, the one that subjects its citizens to an aggressive note swap will experience a large decline in the popularity of the targeted note.

As for the last chart, the total value of Swedish high denomination banknotes was once twice that of Norway's count. But it is now equal to that of Norway, despite the fact that Sweden has twice the population. My guess is that if the Riksbank hadn't inflicted a series of aggressive demonetizations on Swedes, folks like Hakan could have blissfully ignored the entire changeover, and Sweden would still have a much bigger note count than Norway. The black dotted line gives a hint of where Sweden might be now if the pre-changeover trend in kronor banknote demand had continued.

Why did the Riksbank betray the Swedish public?

Why didn't the Riksbank adopt the same policy as the Bank of Canada during its own massive note switch? In the charts above its quite easy to point out when the 500-krona and 1000-krona notes were replaced. But try spotting when Canada switched from paper to polymer banknotes:

You can't, because it was a gentle switch, one that didn't hurt cash's UX.

Patriotic Swedes might counter that Sweden isn't Canada, it has its own way of doing things. But during previous Swedish note introductions, long windows of concurrent circulation were the standard. For instance, when the 1000-krona note that was printed from 1952-1973 was replaced by a new 1000 note in 1976, the legacy note remained valid for more than ten years after that, until Dec 31, 1987. And when the next series of 1000-krona notes was rolled out in 1989, the legacy note was accepted until December 1998. Long windows, not short ones, is the Swedish tradition.

A March 2018 report from the Riksbank entitled Banknote and coin changeover in Sweden: Summary and evaluation gives some insights into why a shot-gun switch was chosen instead of a user-friendly approach. Very early on the process, the Riksbank began to consult with firms involved in the movement of cash including the BDB Bankernas Depå AB (a bank-owned cash depot operator), the Swedish Bankers’ Association, the larger banks, ATM operators, and others. One of the questions that was discussed was how long the old banknotes should remain valid. In April 2012, these market participants submitted their preferred timetable for the changeover. One of their preferences was for:
"...the old banknotes and coins to become invalid after a relatively short period so that they could avoid having to manage double versions of the banknotes and coins for an extended period."
These same market participants also requested that the Riksbank demonetize the old 1000-krona notes without foil strips. Removal of this older series meant one less version to manage once the new 1000-krona note was debuted in 2015. Market participants also hoped that the old banknotes wouldn't be exchanged for new ones, thus reducing the total amount in circulation. If you are wondering why bankers might want fewer banknotes outstanding, go read my 'conflict of interest' section a few paragraphs below. 

The timetable that ended up being adopted by the Riksbank in May 2012 was basically the same one proposed by industry. So there you go. The Riksbank introduced a shot-gun approach because that's what Swedish bankers wanted. But in designing the changeover to be convenient for banks, the Riksbank threw the Swedish public under the bus. Nor was it unaware of the inconvenience it was imposing on Swedes. According to the March 2018 report:
"The Riksbank was aware that the timetable would lead to complications for the general public in that there would be a number of different dates to keep track of. The need for information activities would be increased. However, the Riksbank considered that the interests of the cash market were more important..."
Now, if the Riksbank had justified the shot-gun switch as a way to flush tax cheats out, I might be more sympathetic. At least an argument could be made that the public's welfare was being served by imposing a series of inconveniences on them. But as the above quote indicates, the motivations for quickly invalidating old notes was much less nuanced than this. The Riksbank deemed that the 'complications' that the general public had to endure simply weren't as important as the 'interests' of the banks. Full stop.

There is a huge conflict of interest involved in consulting with banks about cash's future. Sweden's bankers would have been quite pleased to provide the most awkward timetable imaginable. After all, they would have been the main beneficiaries. The more Swedes who forsake cash to pay with cards, the more fees banks earn. Furthermore, each kronor that is held in the form of cash is a kronor that isn't held at a bank in the form of a deposit. Banks lust after consumer deposits because they are a low-cost source of funding. One wonders if the Riksbank fully understood this conflict of interest.

Notes for the future

The decline in the kronor count has finally been reversed. In the tweet I embedded above, the amount of paper kronor in circulation rose in 2018, the first increase in many years. The impositions on the the kronor's UX over the last five years are finally drawing to a close. Now that they no longer have to worry about timetables and expiry dates, are Swedes like Hakan finally returning to the market?

The great irony is that the Riksbank, having caused a big chunk of the decline in 1000 and 500-krona note usage, is suddenly getting quite worried about this trend. Earlier this year, Riksbank governor Stefan Ingves lamented that
"There are those who think we have nothing to fear in a world where public means of payment have been replaced completely by private alternatives. They are wrong, in my opinion. In times of crisis, the general public has always sought refuge in risk-free assets, such as cash, that are guaranteed by the state. The idea of commercial agents shouldering the responsibility to satisfy public demand for safe payments at all times is unlikely."
The Riksbank may even roll out an e-Krona, a digital currency designed to meet Swede's desire for "continued access to a means of payment that is risk-free and guaranteed by the state." Odd that Ingves is now so concerned about Swedish access to a risk-free payments medium when he was so willing to ignore the interests of Swedish cash owners just a few years before.

Sweden will probably have to go through another note switch sometime in the late 2020s. I hope that when it comes, Swedish bankers will get a little bit less representation at the table and the Swedish public a bit more.

As for concerned citizens and central bankers in other countries that are planning to introduce new notes, we can all learn some lessons from Sweden's 2012-2017 changeover. Aggressive note switches may be good for private bankers, but they hurt cash-using citizens.  The long-window approach to note switches, not Sweden's shot-gun method, is the customer-friendly approach.

Dedicated to my favorite Swedish hockey player:

Sunday, December 23, 2018

Christmas and cash

Merry Christmas and Happy New Year to all my readers. And to everyone who left a comment this year, thank you. It's always fun to debate things over in the comments section and I feel it makes the blogs themselves stronger. Don't forget to check out the discussion board where we had a number of interesting discussions in 2018.

The last time I published my Christmas cash usage chart was in 2015. I figured it was high time to update it:

The annual Christmas spike in U.S. banknote demand is getting harder and harder to pick out in the chart. So are the monthly upticks coinciding with payrolls. Most people are getting pretty comfortable buying stuff with cards. And so they are less likely to take cash out of an ATM before the holiday chaos or withdraw grocery money after a paycheck has been deposited.

Even though transactional demand for dollars is on the downswing, the stock of Federal Reserve banknotes continues to grow at a healthy pace. The slope of the black line (i.e. its growth rate) may not be as steep as it was in the 1970s, 80s, or 90s, but it is certainly steeper than it was in the 2000s. It is typical to divide cash demand into two buckets. Cash held for transactional purposes gets folded into a wallet. Cash held for store-of-value purposes gets buried in back yards or hidden under mattresses. Continued growth in the demand for U.S. dollars is mostly due to the latter, not only in the U.S. but all over the world. 

Here is the same chart for Canada:

Both the Christmas bump and the sawtooth pattern arising from monthly payrolls are less noticeable than previous years. But these patterns remain more apparent for Canadian dollars than U.S. dollars. Not because Canadians like cash more than Americans. We don't, and are probably further along the path towards digital payments then they are. Rather, the percentage of U.S. dollars held overseas is much larger than Canadian dollars, so domestic usage of U.S. cash for transactions purposes gets blurred by all its other uses.

Like the demand for U.S. dollars, the demand for Canadian dollars is growing at a healthy rate. So far the slope of the black line (2016-2018) is a bit steeper (i.e. its growth rate is higherr) than all other periods except for the earliest one, 1987-1987. Paper Canadian dollars aren't going away anytime soon.

These were my top posts of 2018 by order of popularity:

Two notions of fungibility
Did Brexit break the banknote?
The €300 million cash withdrawal
"The Narrow Bank"

Bitcoin and the bubble theory of money

Two older posts got a lot of visitors too.

Ghost Money: Chile's Unidad de Fomento (2013)
Fedcoin (2014)

Who knew that Chile's strange indexed unit of account, the Unidad de Fomento, would be a draw?

My favorite post of the year was Paying interest on cash. I like this policy. It helps the lower-income and unbanked earn interest. It also provides a means for central bankers to promote cash usage, which in turn helps keep financial privacy alive. And economists should like it, since it fulfills the Friedman rule.  

For those of you who don't know, I've also been doing much more paid writing in 2018. Prior to that, blogging was more of a hobby. Here are the venues I've been writing for: Breaker, Bullionstar, and the Sound Money project. If you don't have much time to check out my articles, here are my favorites from each:

Bitcoin Is Perfect for Cross Border Payments (Except for One Big Problem) - Why I don't use bitcoin for getting paid.
The future of cash: Iceland vs Sweden - We always assume that Scandinavians are moving away from cash, but Iceland shows that this isn't the case.
Pricing the anonymity of banknotes - Should financial anonymity be provided in abundance, banned, or should we pay for it?

Lastly, R3 just published my paper on a central bank digital currency for Brazil.
Many of the points I make apply just as well to any other country.

Wednesday, December 12, 2018

Can lottery tickets become money?

Say that the local lottery system has decided to innovate. Lottery tickets can now be used as money. A ticket with a face value of $x can be used to buy $x worth of stuff at any checkout counter in the country. Or they can be held in digital form and transferred instantaneously across the lottery's new payments system to friends, the utility company, or the government tax department.

With the payments infrastructure in place, will people actually use lottery tickets to pay their bills, transact with friends, or settle their taxes? Can lottery tickets become money-like?

I'm skeptical. Here's my thinking. Say that Jane has just bought $10 worth of digital lottery tickets. At the same time she's chosen to leave $10 in her bank account (she likes the fact that they aren't risky). She spies a coffee stand and suddenly has an urge to buy a $2 coffee. When she arrives at the till, how will she decide to pay? With lottery tickets or deposits?

By paying for the $2 coffee with a bit of both—$1 in lottery tickets and $1 worth of bank deposits—she could end up with $9 of each, re-attaining her pre-coffee 50/50 allocation. But let's assume that every transaction is a bit costly to make, both in terms of time to completion and the small fixed fee associated with each payments network. So paying with both will be too expensive. She'll have to choose one or the other.

A lottery ticket is more than just a bet. Jane is investing in a fantasy in which she is fabulously rich. So from Jane's perspective, swapping her lottery ticket for a mere cup of coffee would be silly. Once she owns it, her ticket is worth more than hundreds of cups of coffee. A form of Gresham's law kicks in. Given that the coffee seller accepts both lottery tickets and deposits at their face value, Jane will only spend her deposits, which she perceives as being overvalued, while hoarding the lottery ticket, which she thinks are being undervalued by the coffee seller. If every lottery player is like Jane, than 'undervalued' lottery tickets will never circulate as money.

Jane could of course consider buying the coffee with lottery tickets only to purchase replacement tickets in time for the draw. But there's always a risk that she'll forget, or not have enough time because something unforeseen suddenly intervenes. By paying with a boring deposit, she doesn't have to fear missing out on a jackpot.

If it seems unlikely that Jane will want to purchase the coffee with a lottery ticket, what about Jim, who owns the coffee stand? Would he prefer to receive lottery tickets or bank deposits?

Again, a mix of the two instruments would be costly for him to accept given a doubling up of payments processing fees. In the unlikely event that Jim is also a lottery player and hasn't yet bought his tickets yet, then he may prefer that Jane buys a coffee with lottery tickets.

Consider that Jim has a constant stream of business expenses ahead of him, but rarely knows precisely when he'll have to make a purchase. Because the lottery tickets will most likely expire worthless in the future, they don't provide him with a suitable means of solving for his future uncertainty. Deposits, on the other hand, will always retain their value. As long as he keeps them on hand, he knows that he can meet his bills. So I think that Jim will probably prefer that Jane pays with deposits. (See more here).

In the unlikely event that Jane insists on paying with lottery tickets, Jim will probably acquiesce—the customer is always right. Since he doesn't want to be exposed to the uncertainty of lottery tickets, he will probably try to exchange them as quickly as possible for deposits, but this will be subject to a conversion fee. Anticipating this expense, Jim could very well decide at the outset to incentivize Jane to pay with deposits. He might place a small surcharge on lottery ticket payments, or offer a small discount if customers pay with deposits. Jim might even pretend that his lottery payments terminal is broken.


The combination of Jane's reticence to pay with lottery tickets, a form of Gresham's law, and Jim's preference to avoid them will doom lottery tickets as money. Even though the infrastructure is in place for lottery tickets to be transported instantaneously from one person to the other, the incentives just aren't present. Investing in the infrastructure turned out to be a waste of money.

I think this setup also explains why bitcoin has never been adopted as a form of money. Like Jane's lottery ticket, a bitcoin owner's bitcoins aren't just bitcoins, they are a dream, a lambo, a ticket out of drudgery. Spending them at a retailer at mere market value would be a waste given their 'destiny' is to hit the moon. Sure, a bitcoiner can always spend a few precious bitcoins on a coffee, only to replenish his stock later in the day. But this would be dangerous, since bitcoin's price could spike at any moment. Far safer to spend one's deposits and hoard one's bitcoins.

Even when they claim to be accepting bitcoins, retailers like Jim actually rely on intermediaries like BitPay to step in and purchase the bitcoins while relaying dollars to the retailer. For instance, see last month's post on Ohio tax payments.

I also wonder how well my story fits with other examples of volatile media being used as money. For instance, John Cochrane has blogged about a world where one might trade an "S&P500 index share for a candy bar." If lottery ticket buyers and bitcoin owners are consuming a dream, then perhaps an  owner of an equity ETF is doing the same. In which case, no one would bother buying candy bars with stocks, and so building out the payments infrastructure necessary to facilitate this would be pointless.

Wednesday, November 28, 2018

No, Ohio isn't accepting bitcoin tax payments

Anthony Pompliano, or Pomp, is at it again. Some of you may recall his odd claims about bitcoin adoption in Argentina, which I took apart here. Well, the following tweet wandered onto my twitter stream a couple of days ago.

For more, here is the Wall Street Journal.

So let's get this straight. The Ohio state government is not accepting bitcoin as payment for taxes. Rather, it is sponsoring a gateway that allows business owners to offload their bitcoins on the market in the moments prior to tax settlement. Now that actual dollars having been obtained, the tax obligation can now be settled. Take a look at the FAQ at
"At no point will the Treasurer’s office hold cryptocurrency. Payments made on, through our third party cryptocurrency payment processor partner BitPay, are immediately converted to USD before being deposited into a state account."
Here's an example of how this might work. Let's say an Ohio business owner has to pay $10,000 in taxes. By logging into, she can sell $10,000 worth of bitcoins to a payments processor called BitPay. BitPay in turn quickly sells those bitcoins for the requisite amount of dollars on a bitcoin exchange like Coinbase, and then forwards the $10,000 (in fiat) to the State of Ohio. Dollars, not bitcoins, are being accepted for taxes.

Ohio's announcement is not a big deal, certainly not one deserving of a WHOA. In addition to bitcoin, there are all sorts of assets that we taxpayers can offload in the moments before settling our tax bill. Once we know how much we owe, we can sell an appropriate amount of Tesla shares, then forward the dollar proceeds to the state. This sort of at-the-last-second sale is exactly what is happening with, except an intermediary—BitPay—has been introduced to expedite the final step. We can do the same with gold, or silver, or property. Heck, using Pomp's definition we can even pay our taxes with an old IKEA sofa. Quickly sell the sofa at a low price on kijiji, deposit the cash, then settle the tax bill with an ACH payment to the government. The whole process won't take longer than 45 minutes.We don't even need to pay an intermediary like BitPay to process it.

The sad thing is that is a big waste of taxpayer funds. Only a handful of businesses are ever going to use it. Say that our Ohio business owner has some dollars in her bank account as well as some bitcoin. She owes the state $10,000. According to the FAQ, the fee for going the Bitcoin route is 1%, which means she'll pay a fee of $100. Meanwhile, an ACH payment is free. Unless she has some sort of soft spot for paying with bitcoin, a quick and simple calculation means the she will never opt to use, preferring to use old-fashioned but free ACH.

I'm being generous with my example. I've assumed that our business owner already happens to have enough bitcoin on hand to send her payment to But if she doesn't (which is likely to be the case), then that only multiplies the unlikelihood of her ever going via Ohio's new bitcoin route. To fund her $10,000 payment to, she'll first have to endure the hassle and expense of acquiring enough bitcoins ahead of time. Given that she must still incur BitPay's 1% fee to settle her taxes, its hard to imagine her ever bothering to embark on such a costly chain of transactions.

Don't blame BitPay for the high fee. It charges 1% because dealing in bitcoin is a nuisance. Not only must BitPay recoup the trading costs that it incurs by selling our business women's $10,000 worth of bitcoins (both commission and slippage), but in the time between accepting her submission and making the trade it must cope with bitcoin's volatility. BitPay is just trying to get by.

Why is Ohio going through with this project? Ohio Treasurer Josh Mandel, who is behind the effort, has this to say: "Around 2014, I developed an interest in crypto and now I consider myself a crypto enthusiast." Right. This project seems more to me like a fanboy's devotion to the cause than a genuine attempt to help the Ohioan taxpayer.

Back to Pomp. To end his tweet, he proclaims that the "virus is spreading." Not at all. A well-designed payment option will literally drag people in because it is so incredibly useful. This ain't it, Pomp. Not only is Ohio not accepting bitcoins (no doubt they are too volatile), but it is unlikely that Ohio businesses will adopt Ten years into Satoshi Nakamoto's payments experiment, it still hasn't succeeded in pulling in mainstream payees and payors. Let's face it. Bitcoin is just not that great of a payments system.

...which isn't to say that bitcoin hasn't been successful. What Nakamoto didn't realize at the time is that he wasn't creating decentralized cash. Rather, he was creating what would eventually become one of the world's most popular decentralized financial games. Bitcoin is in the same category as the lottery or poker, not Visa or cash. If you think about bitcoin this way, you'll see why it is silly to set up payments gateways like If you were to offer someone the opportunity to buy $1 worth of goods with a $1 lottery ticket, they'd laugh at you. To a lottery player, their lottery ticket is their potential salvation, their route to becoming a millionaire. To use it to buy stuff would be sacrilegious. The same goes for bitcoin. People don't want to waste their prized bitcoins on buying stuff or making tax payments. No, their bitcoins are their ticket to riches.

Tuesday, November 13, 2018

The demonetization gap

Two years ago, Indian PM Narendra Modi suddenly demonetized all of the nation's 1000 and 500 banknotes. His stated goal was to exact justice on all those holding large amount of dubiously-earned cash. But since these two denominations constituted around 85% of India's currency supply, the demonetization immediately threw the entire nation into chaos.

After suffering from a nine-month note shortage, enough new notes were printed to meet India's demand for cash. But in the interim, what had happened to Indians' demand for cash? Did their experience with demonetization lead them to hold less cash than before, or did they simply revert to their pre-demonetization habits and patterns? I wrote an article in September 2017 dealing with these questions. With another year having passed we now have more data—so I'm going to provide quick update.

My claim is that a demonetization gap continues to exists. This gap is evidence that the cancellation of 1000 and 500s has had an enduring effect on Indians' behaviour surrounding cash.

To measure the gap, we need to compare the evolution of India's cash supply to the path it would have taken in a world in which Modi's demonetization never occurred. We know that the supply of rupee banknotes grew at an average rate of around 12.3% from 2011 to 2016, and on the eve of demonetization there were around 17.5 trillion in banknotes and coins in circulation. Taking these numbers and extrapolating forward, November 2018's cash-in-circulation count would have clocked in at around 21.5 trillion rupees had the demonetization not occurred. But in our actual world, the one where demonetization occurred, India's cash count registers at just 19.5 trillion rupees.

So thanks to demonetization, Indians are holding around 2 trillion fewer paper rupees than they otherwise would have. I've illustrated the demonetization gap below:

What sort of assumptions do we need to make in order for the demonetization gap to be zero? Let's say that demonetization had never occurred. To get from a currency stock of 17.5 trillion in November 2016 to 19.5 trillion by November 2018, we need to assume an absurdly low 6% growth rate for the stock of currency stock. I doubt India has ever experienced such a slow growth rate in cash-in-circulation. So while you can quibble with the size of the gap, I think it's undeniable that some sort of gap exists i.e. demonetization has had long lasting effects on cash holdings.

There are two potential explanations for why a demonetization gap exists. My guess is that both are to some extent true, although as time passes the influence of the second will tend to disappear:

1. Demonetization might have had a permanent effect on Indians' taste for cash. Prior to demonetization, a money launderer might typically have built up an inventory of 100 lakh (US$135,0000) worth of banknotes before laundering them. But the demonetization frightened him, so now he launders his ill-gotten gains whenever he holds just 50 lakh worth of notes.

Or maybe a family that typically conducted most of their day-to-day transactions in cash opened a bank account during demonetization so that they could deposit their notes. And now they've fallen into the habit of paying for half their family expenses with cash, and the other half with debit cards.

These sorts of changes to transactions preferences would get expressed in the nation's overall stock of notes by a reduction relative to trend.

2. Demonetization might have caused large and lasting damage to the informal sector of the Indian economy. With 85% of the nation's money stuck suddenly came unusable, and so many businesses dependent on cash, these businesses may have been forced to go under. With informal production cratering, fewer banknotes would be required for transactions purpose than would otherwise be the case. Over the long term, however, one would expect these sectors to rebuild, any drag they had once placed on cash demand being removed.

If Indian's taste for cash changed, how might these new tastes have manifested themselves? Did Indians swap cash for deposits in the regulated banking system or did they simply swap one form of anonymous "black money" for another (i.e. cash for gold, diamonds, real estate)? In my post from last September I found some interesting charts. I'm going to update them below.

As the chart above illustrates, the number of point-of-sale (POS) terminals installed has experienced a one-time shot to the arm after the November 2016 demonetization announcement.

The second chart shows that the value of POS transactions using debit and credit cards moved to a new and higher plateau.

The last chart shows the growth in value transacted using mobile wallets. Demonetization gave mobile wallet usage a quick shot to the arm, but it is difficult to determine if growth stayed above trend in 2017-18 or below. Given that mobile wallets are recent and started from a very low base, usage had already been growing very fast before demonetization.

In any case, I think the charts provide at least some evidence that the shift out of cash has been captured by digital finance.


The existence of a demonetization gap does not mean that Modi's effort was a success. If someone comes up with a great monetary innovation, expect it to be quickly copied. Polymer banknotes, real-time gross settlement systems, and inflation targeting are all examples of monetary technologies that have spread from their original adopter to the rest of the world. But not a single nation has copied India's demonetization. I would be surprised if any ever do. The costs imposed by the event—lost labour time, foregone transactions, chaos—were all too apparent, and its benefits dubious.

That being said, I sympathize with the intuition that was at the core of Modi's demonetization. Let's face it, plenty of people use cash as a way to avoid taxes. These cheats force everyone else to pay more than their fair share for shared infrastructure. It would be nice if there was a way to rebalance the load by taking back resources lost to the cheats. A classic way to fix this problem is to have the tax department hire more inspectors. An alternative is to design the nation's cash system in a way that corrects for any unfairness. Modi's demonetization is an example of the second approach, a massive cash dragnet designed to flush out cheats.

But it was an incredibly clumsy effort. The tricky thing with cash is that it is simultaneously a vessel for tax evasion for a few cheats and also a vital monetary fluid for the many. Punishing the first group means that the second will also be hurt. If the costs incurred by the second group are too high, then the calculus behind the whole effort fails.

Modi's demonetization tried to lessen the blast radius by targeting users of large denomination 500 and 1000 notes while leaving users of the 10, 20, 50, 100, and 200 untouched. The motivation behind this was that presumably large tax cheats will concentrate their cash holdings in higher denomination notes, while regular note users will tend to concentrate in the lower denominations. But even with this filter in place, the 500 and 1000 were so widely held by Indians that the demonetization of these denominations forced a large proportion of the population to endure massive lineups for weeks. Retail trade ground to a halt.

Over the last two years I suggested a few ideas that would have improved the effectiveness of Modi's demonetization. Instead of targeting all 500s and 1000 notes, demonetizing notes by serial number would have resulted in a much smaller blast radius. Rather than withdrawing 500s and 1000s, it would have been easier to overstamp them with stickers, and then slowly withdraw these overstamped notes over time. This would have helped prevent massive cash shortages.

But even after these modifications, demonetization is too blunt of a tool to effectively solve the complicated inequities arising from cash-based tax evasion. So should Indians (and the rest of us too) simply live with these imperfections, accepting unfairness as an acceptable cost of maintaining cash systems?

Maybe not. In his paper Taxing Cash, Ilan Benshalom has suggested a less invasive technique for reclaiming resources from cash-using tax evaders. Rather than demonetizing all 500 and 1000s, Modi could have introduced a recurring withdrawal fee of 10 for each 500 note and a 20 rupee fee on each 1000 note.

Imagine that Rohit needs to pay Indira 10 lakh. The two can avoid taxes if they agree to transact using cash rather than making a digital payment. So Rohit withdraws one thousand 1000 bills from his bank. He incurs a fee of 20,000 (20 for each note), the bank forwarding the full amount to the government. Rohit might consider avoiding the withdrawal tax by withdrawing 50s and 100s (which don't incur fees), but he is unlikely to go this route since 10 lakh in small denomination notes would be terribly awkward.

The upshot is that Indian tax payers would get 20,000 in compensation for Rohit and Indira's evasion of taxes. Compared to Modi's demonetization, the blast radius of a large denomination withdrawal tax is much smaller. Regular Indians could have easily continued about their business using untaxed 100s or migrating to digital payments. It sounds promising, but after Modi's explosive demonetization, Indians are probably much less open to new monetary experiments, and who can blame them.

There are several other ways to visualize Indian demand for cash over time. For instance, here is the cash-to-GDP ratio:

The idea here is that for each unit of GDP, some amount of cash is used as means of circulating production. (Note: While the cash-in-circulation numbers are current, 2018 Q2 nominal GDP has still not been published. I estimated it by assuming 11.5% nominal growth, the average growth rate over the last few years.)

Vivek Dehejia and Rupa Subramanya measure the ratio of cash-in-circulation to the total money stock, or M3. They find little evidence of a reduced reliance on cash. For the chart below, I've used M4 which includes not only chequing and savings deposits held at banks but also total postal office deposits:

The cash-to-M4 ratio is a bit lower than it was on the eve of demonetization. For each ₹100 held in accounts, Indians now only hold ₹14.9 in banknotes and coins, down from ₹16 in October 2016. Be careful with using the cash-to-M4 ratio as a measure of preferences for banknotes. If Indians want to hold fewer deposits and more government bonds, M4 declines, and so the cash-to-M4 ratio will rise. But preferences for cash haven't changed at all.