Thursday, August 10, 2017

Why is a one pound coin worth more than four pennies?

The new 12-sided pound coin released earlier this year

The UK's recently-introduced one pound coin is made of 8.75 grams of metal, 76% of that copper and the remaining 24% a combination of zinc and nickel. At market prices, this amount of metal is worth around four pennies. So why do pounds trade for 100 pennies? Why are Brits passing these coins around as tokens—i.e. far above their metal content—rather than at their intrinsic melt value of four pennies each?

One answer is tradition. Brits accept that pound coins should trade at a 2000% premium to their metallic content because they've always done so. This isn't a very satisfactory answer. We need an explanation for why this tradition emerged in the first place.

It could be that the British government simply says that coins must be worth more than their metallic content, and Brits have fallen in line with this order. If they pass on these tokens at an illegal price, they'll be fined, or thrown in prison, or forced to drink tea without crumpets.

This too is an unsatisfactory explanation. Coin and banknote payments are highly decentralized—it's simply not possible to police against trades that deviate from the stipulated price. We have centuries of examples in which government proclamations about currency exchange rates have been ignored. Just today I can mention two. The Venezuelan government's official price for the bolivar is 2,870 to the dollar, but bolivars trade unofficially at 13,077, despite jail sentences to anyone caught trading in the black market. Zimbabwe's leaders say that their recently-printed issue of bond notes must trade at par to U.S. dollars, but in practice a 10-15% discount has emerged, one this will probably only widen over time.

So if governments can't will a monetary instrument like a coin to trade at a premium, where do these premia come from?

A bit of history about token coins—i.e. coins that carry a large premium—may help.

One strange feature about the world before the 1800s is that everyone—you, me, and our grandmas—had access to the mint. We could walk into the mint with a bag full of raw gold or silver and ask the mint master to have this material coined. Upon leaving we'd be provided with the same weight of metal (less a small fee for the mint), except that it had been transformed into coin form. This was called free minting: access was available to everyone.

Free minting meant that coins couldn't carry a premium over raw metal value, at least not for long. To see why, imagine a coin that contains one ounce of silver. When demand for that coin suddenly shoots up a shortage develops, the coin developing a 'fiat component'—it starts to trade at a large premium to its silver content, say one coin can buy two ounces of silver. At this point it has become a token. If I had one of these coins in my pocket, I'd sell it for two ounces of silver, take that silver to the mint, and get two coins in return. Voila, I've turned one coin into two coins! Because many people would conduct this same arbitrage, a slew of coins would enter into circulation. The shortage resolved, the market price of the coin would return to its intrinsic value. With the coin's fiat component gone, it has ceased to be a token.

If coins to are exist permanently as tokens, free minting needs to be halted. If people can't bring in silver to be minted, there is no way for the public to draw out a new supply of coins to remedy a shortage. It is then possible for a coin's value to have a permanent fiat component, or, put differently, for the coin's market price to forever above the intrinsic value of its metal content. 

As an economy grows, people need more coins to conduct transactions. With the mints being shut to the public, how would this supply be created? The answer is that government itself must introduce new coins into circulation by purchasing metal, bringing it to the mint to be coined, and issuing the coins into the economy. If it puts too many coins into circulation, the artificial scarcity that feeds the fiat component of a coin's value will cease to exist and the price of these tokens will fall to their intrinsic melt value. By carefully regulating this supply, coins should always contain a fiat component—their token nature continuing in perpetuity.

These were precisely the steps taken by the British authorities when they introduced their first official issue of silver token coins in 1817. In the centuries before, the British monetary authorities had always maintained a policy of free minting of silver, the Royal Mint—owned by the government—producing only full bodied silver coins, not mere tokens. In 1817, the era of free minting was suddenly brought to an end. The Mint would now only make new coins for the government's account, not for the public. At the same time a token coinage was introduced, the silver content of the new coins being set such that it was now significantly below the coin's face, or par, value. The crown in the picture below, which has the legend of Saint George and the Dragon engraved on it, is an example of one of these early tokens.

To maintain the premium on its tokens, the Mint began to carefully regulate the supply of new coins. Here is monetary historian Angela Redish:
The Mint bought silver at the prevailing market price in the quantity it thought necessary and believed that by limiting the quantity of silver coin supplied it could maintain the value of the coins above the value of their silver content; that is, the supply limitation would give value to the fiat component of the currency. (pdf)
While this worked at first, over the next decade the mechanism for maintaining an artificial shortage—and thus the fiat component of the government's new tokens—broke down. From Redish, we learn that throughout the 1820s the new tokens began to accumulate at the Bank of England, still then a private bank, which had a policy of accepting tokens at their official value from the public, providing gold in return. (The Mint itself had no conversion policy.) The Bank had effectively become the only redemption agent for government tokens. Without the Bank's sopping up the public's unwanted supply at par, the market value of silver tokens would have quickly become unhinged from the coin's face value, eventually falling in price to the market value of their metal content.

Having the Bank of England act as the lone redemption agent for the government's token coins wouldn't do, so in 1833 the government officially took on the task of maintaining the par value of tokens. The Bank of England still accepted all silver coins from the public at par, but now the Bank was allowed to return this stockpile to the Mint for redemption in gold at the coin's par value.

And that, ladies and gentleman, is why your new pound coins, despite containing just 4 pennies in metal content, are worth a full pound. Since 1833 the British Treasury has promised to act as a backstop for all its token coinage, buying them back at their full face value so as to prevent any decline in the fiat component of its coins. Put differently, your one pound coin is worth 2400% more then its metal content because the government promises to uphold that premium by using funds it has raised out of tax revenue.

Coins are thus very much a liability or IOU of the government. This IOU nature of coins tends to operate far in the background, but it becomes much more apparent when a denomination of coins is cancelled. Take for instance the 2013 termination of the Canadian cent, in which the Royal Canadian Mint began to withdraw the lowly penny, the nickel being given the duty of serving as our nation's smallest denomination coin. Ever since then Canadians have been dutifully bringing their hoard of pennies into the local bank in return for cash or a credit to their bank accounts, banks in return sending the coins onward to the government for redemption.

We know from its initial report that the government budgeted $53.3 million to pay the face value of pennies redeemed. Which means that it anticipated the return of 5.3 billion pennies. According to the Mint's 2016 Annual Report, some 6.3 billion pennies have been since brought in, a small amount compared to the roughly 35 billion produced since 1908 and presumably still languishing under mattresses and in dumps—but still above the budgeted amount. Which means a larger chunk of Canadian taxes will have to go to paying penny IOUs then originally expected.

So as you can see, it isn't by mere diktat or tradition that coins trade above their metal content. It's the government's promise to buy them back that provides coins with their fiat component. In the case of the UK's new one pound tokens, should Her Majesty's Treasury refuse to backstop them its quite probably they'd be worth, say, just 90 pence a few years from now; 50 pence a decade hence; and finally 4-5 pence much further down the road. The market value of the pound coins wouldn't fall below that. At 2 or 3 pence per coin, Brits would start withdrawing them from circulation and illegally melting them down for their metal value.

To write this post, I relied on these two fine sources:
1. Angela Redish, The Evolution of the Gold Standard in England, pdf
2. George Selgin, Good Money, link

I also got inspiration from the conversation with Dinero and Antti on this post

Tuesday, July 25, 2017

The gold trick

Now that the U.S. debt ceiling season is upon us again, I've been wondering if the U.S.'s official gold price is going to finally be revalued from $42.22. Why so?

Since March the U.S. Treasury has been legally prohibited from issuing new debt. Because the government needs to continue spending in order to keep the country running, and with debt financing no longer an option (at least until the ceiling is raised), Treasury Secretary Mnuchin has had no choice but to resort to a number of creative "extraordinary measures," or accounting tricks, to keep the doors open. Here is a list. They are the same tricks that Obama used in his brushes with the debt ceiling in 2011 and 2013.

The general gist of these measures goes something like this: a number of government trusts and savings plans invest in short term government securities, and these count against the debt limit. As these securities mature they are typically reinvested (i.e rolled over). The trick is to neither roll these securities over nor redeem them with cash. Instead, the assets are held in a limbo of sorts in which they don't collect interestand no longer count against the debt limit. This frees up a limited amount of headroom under the ceiling that the Treasury can fill with fresh debt in order to keep the government functioning.

These tricks provide around $250-300 billion of ammunition. Which sounds like a lot, but in the context of overall government spending of $3.7 trillion or so per year, it isn't. Most estimates have the extraordinary measures only lasting till September or October at which point a default event may occur, unless Congress raises the ceiling.

Not on the official list of measures for finessing the debt ceiling is a rarely-mentioned option that I like to call the gold trick. The U.S. government owns a lot of gold. Beware here, because a few commentators think that the idea behind the gold trick is to sell off some of this gold in order to fund the government. Nopenot an ounce of gold needs to be sold. The only thing that the Treasury need do is raise the U.S.'s official price for gold. By doing so, it automatically gets "free" funding from the Federal Reserve, funding which doesn't count against the debt ceiling.

We need a bit of history to understand the gold trick. Back in 1933 all U.S. citizens were required to sell their gold, gold certificates, and gold coins to the Fed at a rate of $20.67 per ounce. This is the famous gold confiscation that gold bugs like to talk about (see picture at top). The 195 million ounces that the Fed accumulated was subsequently sold to the Treasury. In return, the Treasury provided the Fed with gold certificates obliging the Treasury to pay them back. At the official price of $20.67, these certificates were held on the Fed's books at $4 billion.

The certificates the Fed received were a bit strange. A gold certificate usually provides its owner with a claim on a fixed quantity of gold, say one ounce, or 1/2 an ounce. In this case, the certificates provided a claim on a nominal, not fixed, amount of gold. If the Fed wanted to redeem all its certificates, it couldn't ask the Treasury for the 195 million ounces back. Rather, the certificates only entitled the Fed to redeem $4 billion worth of gold at the official price.

As long as the yellow metal's price stayed at $20.67, this wasn't a big deal. But it had important consequences when the official gold price was changed, which was exactly what happened in January 1934 when President Roosevelt increased the metal's price from $20.67 to $35. At this new price, the stash of gold held at the Treasury was now worth $6.8 billion, up from $4 billion. But thanks to their odd structure, the value of the Fed's gold certificates did not adjust in line with the revaluationafter all, they offered little more than a constant claim on $4 billion worth of gold. The remaining $2.8 billion worth of gold, which had been the Fed's just a month before, was now property of the Treasury.

Almost immediately the Treasury printed $2.8 billion worth of fresh gold certificates, shipped these certificates to the Fed, and had the Fed issue it $2.8 billion in new money. Voila, the Treasury had suddenly increased its bank account, and it didn't even have to issue new bonds, raise taxes, or reduce program spending. All it did was change the official gold price.

(If you want find this description confusing, I explained the gold trick slightly differently in 2012.)


Even when the U.S. eventually went off the gold standardunofficially in 1968 and officially in 1971it still maintained the practice of setting an official gold price. But by then the official price was no longer the axis around which the entire monetary system turned; it was little more than an accounting unit.

As gold's famous 1970s bull market started to ramp up, the authorities tried to keep pace by enacting changes to the official price. When gold hit $55 in May 1972, the official price was bumped up from $35 to $38. They ratcheted it up again in February 1973 to $42.22, although by then gold's market price had advanced to $75. Both of these revaluations resulted in the Fed providing new money to the Treasury, just like in 1934. Albert Berger, a Fed economist, has a good description of these two events:

After the 1973 revaluation the government stopped trying to keep up to gold's parabolic rise, and to this day the U.S. maintains an archaic price of $42.22, far below the actual price of $1250 or so.


Let's bring this back to the present. Come October, imagine that the U.S. Treasury has expended all of its conventional extraordinary measures and Congressdespite having a Republican majoritycan't decide on increasing the debt ceiling. Desperate for the cash required to keep basic service open, Treasury Secretary Mnuchin turns to an archaic, long forgotten lever, the official gold price. Maybe he decides to change it from $42.22 to, say, $50, or $100, or $1000whatever amount he needs in order to fund the government. The mechanics would work exactly like they did in 1934, 1972, and 1973. The capital gain arising from a rise in the accounting price would be credited to the Treasury in the form of new central bank deposits, and these could be immediately deployed to keep the government running.

Any change in the official price of gold needs to be authorized by Congress. Why would the same Congress that can't agree on adjusting the debt ceiling or repealing Obamacare agree to Mnuchin's request to change the price of gold? The Republican party has a long history of advocating for the gold standard; Ronald Reagan, for instance, was a supporter. President Trump himself likes the yellow metal. If you believe him, he once made a lot of money off of it:

As for the Republican's base, many of them are keen on ending the Fedanything that smells of a return to gold will make them happy. This seems to be a piece of legislation that pleases all factions.

The gold trick only works because the debt issued by the Fedreserves, or depositsis not included in the category of debts used to define the debt ceiling. By outsourcing the task of financing government services to the Fed via gold price increases, the Treasury can sneak around the ceiling. This is only cosmetic, of course, because a debt incurred by the Fed is just as real as a debt incurred by the Treasury, and so it should probably be included in the debt ceiling. After all, the taxpayer is ultimately on the hook for debt issued by both bodies.

An increase in the price of gold to its current market price of $1250 would only be a band-aid. While it would provide the Treasury with around $315 billion in new funds from the Fed, this would be enough to evade the debt ceiling for just a few months, maybe half a year. Sure, a few well-time Donald Trump tweets about the greatness of gold might push the price up by $50 to $1300, but even that would only buy the Treasury an extra $13 billion or so in central bank funds.


The Fed would hate the gold trick.

Much of Fed policy over the last few years has involved communicating with the public about the future size of the Fed balance sheet, which shot up over three rounds of quantitative easing. A sudden $315 billion increase in liabilities outstanding due to a revaluation of the official gold price to $1250 would throw a wrench in this strategy. To the public, it would look QE4-ish.   

QE is reversible. Unlike QE, the Fed would not be capable of reversing a balance sheet expansion caused by a gold revaluation, at least not without the Treasury's help. This would severely damage the Fed's independence. To see why, keep in mind that the Fed can only ever increase the money supply if it gets an asseta bond, mortgage backed securities, gold, etcin return. The advantage of having an actual asset in the vault is that it can be sold off in the future should a constriction in the money supply be necessary. Assets also generate income which can be used to pay the Fed's expenses like salaries or interest on reserves. With the gold trick, however, the Fed is being asked to increase the money supply without receiving a compensating asset. This means that, should it be necessary to drastically shrink the money supply in the future, it will only be able to do so by relying on goodwill of the Treasury. So much for being able to act independently of the President.

That the Fed probably prefers that the Treasury avoid a gold revaluation is one reason that it has never become one of the go-to extraordinary measures for finessing the debt ceiling. But I'm not sure that the current administration is one that cares very deeply about what the Fed thinks. If Congress greenlights the revaluation, there's really nothing that Fed Chair Yellen can do except enter-key new money for Mnuchin.


Earlier I mentioned that adjusting the official price to $1250 would only be a band-aid solution. Here's a bit of speculative fiction: imagine that come October the official price is adjusted up to something like $2000, or $5000, or $10,000. Granted, this would put it far above the market price of $1250--but the official price has been wrong for something like fifty years now; does anyone really care if the error is now to the upside rather than the downside? 

At an official price of $10,000, for instance, the Treasury would get some $2.6 trillion in spending power from the Fed, enough for it to avoid issuing new t-bills and bond in excess of the debt ceiling for several years. The Republicans would save face; they could tell their constituents that they held firm against an increase in the ceiling. When the Democrats--who are no friends of gold--inevitably come back to power, they could simply go back to the tradition of jacking up the debt ceiling.

This would certainly be a strange world. During Republican administrations, bond and bill issuance would slow dramatically, reserves at the Fed expanding in their place. Like the various QEs, there is no reason that these reserve expansion would cause inflation. The Fed would have to be careful that it pays enough interest on reserves that banks prefer to hoard their reserves rather than sell them. This increase in the Fed's interest burden would dramatically crimp its profits, which are paid out as a dividend to the Treasury each year. In fact, all the money the Treasury saved on not paying t-bill and bond interest would be almost precisely cancelled out by a shrinking Fed dividend. There is not much of a free lunch to be had. 

Investor who like to hold government debt in their portfolios would be in a bit of a jam. Everyone can buy a t-bill, but the ability to hold reserves is limited to banks. Unless the Fed were to allow wider access to their balance sheet, Republican administrations resorting to the gold trick would create broad safe asset shortages.

While a small increase in the official gold price may be part of Mnuchin's backup plan, a large increase to the official gold price is just speculative fiction. After all, a boost in the official price of gold to $10,000 would create an entirely different monetary system. Alternative systems are certainly worth exploring for what they teach us about are own system, but one would hope that the actual adoption of one would come after long debate and not as a result of opportunistic politics.

P.S. After writing this post, I stumbled on a paper by Fed economist Kenneth Garbade which describes how Eisenhower finessed the debt ceiling by using a version of the gold trick. Unlike 1972 and '73 the gold price was not increased. Instead, the Treasury was able to make use of unused space from the 1934 revaluation. A large portion of the gold the Treasury owned had not yet been monetized by writing up gold certificates and depositing them at the Fed. In late 1953, with the debt ceiling biting, around $500 million in gold certificates were exchanged with the Fed for deposits.

Friday, July 21, 2017

Dictionary money

Nick Rowe points out that if a central bank wants to control the economy's price level, it needn't issue any actual money—it can just edit the dictionary every morning, announcing the meaning of the word "dollar" or "yen" or "pound" to the public.

To a modern ear trained on a steady diet of central bank verbiage about interest rates, QE, and open market operations, the idea of conducting monetary policy by simply editing the meaning of a word seems odd. But I've got news for you: starting from Caesar's time and extending into the 1700s, the sort of dictionary money that Nick describes has been the dominant form of money in the West.

How has this system worked? People have historically advertised prices for wares using a word, or unit of account, the LSD unit being the most prevalent. In the case of Britain this meant pound/shilling/pence while in France it was livre/sous/denier, both of which come from the Latin librae/solidi/denarii. The monarch was responsible for declaring what these words meant. More specifically, the king or queen would post a sign in some central area saying something to the effect that a pound, or £, was worth, say, ten testoons, a type of silver coin. This definition was subject to change. The next day, for instance, an edict might be issued saying that a £ was now only worth nine testoons. Or, put differently, the £ now contained less silver. Just like that, prices had to rise 10% to account for the alteration made to the dictionary meaning of the word "pound."

Dictionary systems came to an end when the symbol for money was finally fused directly with the instrument itself. Remember, coins never used to have denominations, or units of account, on their face. Rather, they usually only had the monarch's head inscribed on them, maybe the name of the mint, and a few words about how awesome the monarch was. This lack of numbering was convenient. Since coins had no association with the unit of account, the quantity of coins (and thus silver) in the unit of account (i.e. the definition of the word) could be seamlessly changed by royal proclamation.

In the 1700s monarchs began to adopt the practice of inscribing the actual unit of account directly on the coin's face, i.e. coins began to be etched with 5¢ or £0.5.* Once this happened it became awkward to change the definition of the unit of account by editing the dictionary. Having permanently stamped the meaning of the word "dollar" or "pound" on millions of widely-circulating bits of stamped silver, changing that meaning by simply posting a sign on a popular street corner no longer did the trick. Every coin would have to be recalled and re-minted too!

Having long since put the definition of the word "dollar" or "yen" onto the actual instruments they issue, modern monetary authorities now have to do something to the instruments themselves if they want to conduct monetary policy. Maybe they issue a few more units of money or buy them back in order to alter their purchasing power. Maybe they jiggle the interest rate that those tokens throw off. Or they might raise or lower a currency's peg. Some sort of tangible action (or threat thereof) must be taken to change the economy-wide price level. Word updates won't do.

About the only place in the world that has dictionary money is Chile which, buffeted by high inflation, adopted a parallel unit of account called the Unidad de Fomento (UF) in the 1960s. (For more on the UF, see my old post here). Today, Chileans can choose to set prices in UF or in the Chilean peso. The latter is a conventional money, the word "peso" being defined as the 1 peso banknote issued by the nation's central bank. Unlike the peso, the UF lacks an underlying UF banknote. Rather, the Chilean government defines the word "Unidad de Fomento" to mean the number of Chilean pesos required to buy a fixed Chilean consumption basket. This definition changes every day and is posted here.

I think this is a pretty neat idea. As long as Chileans denominate their salary and other contracts using UFs rather than pesos, they are guaranteed to earn a steady stream of consumption, even if the Chilean peso hyperinflates.

These days inflation isn't really such a big deal, at least not in developed nations—central bankers seem to have mastered how to keep the purchasing power of the medium of exchange from getting out of hand. So adopting something like the UF might seem redundant. A dictionary money system is also unattractive because it imposes a calculational burden on citizens. People must be constantly doing conversions between an item's sticker price and whatever happens to be the medium of exchange necessary to complete the transaction. So if a book were to be priced at $5, you'd have to consult a government website to determine how many bitcoins, or dollar bills, or silver coins would be necessary to constitute a five dollar payment. The advantage of our current system is that because the word and the medium are unified, we don't have to do these conversions. A five dollar bill always suffices to cover a $5 sticker price. Simple.

On the other hand, dictionary money may have a role to play in our relatively recent deflationary age. Beginning with Japan back in the late 1990s, central bankers all over the world have been incapable of preventing deflation, or falling prices. Are their tools inadequate? Do they refuse to use these tools to their full extent? Do they not understand how to use them? With dictionary money, a central banker can't blame his or her tools for a miss, since all it takes to alter the price level is an update to the definition. A child could do it.

For instance, a nation like Japan could create dictionary money by removing the word "yen" on bills. It would do so by recalling all outstanding banknotes and replacing them with, say, Japanese pesos. Prices, however, would continue to be set in terms of the yen unit of account. Each morning the Bank of Japan would announce to the world how many Japanese pesos were in a yen. Say it starts with the yen being defined as ten pesos. To create some inflation, it would simply proclaim that the yen now contained just five pesos. Everyone with pesos in their pocket would suddenly be able to buy twice as much yen-denominated products as before. They would race out and spend. Shopkeepers who had previously been selling widgets for 1 yen, and getting ten Japanese pesos as payment, would quickly jack up prices to 2 yen in order to ensure that they still earn ten pesos per widget.

Voila, instant inflation.

* See Ernst Weber's "Pre-industrial Bimetallism: The Index Coin Hypothesis " [link]

Wednesday, July 12, 2017

Money in an economy without banks

by Alex Schaefer
Most of the world's money is currently in the form of deposits created by banks. After the 2008 credit crisis, which instilled a strong suspicion of banks among the public, it became fashionable to ask what money would look like in an economy without these organizations. Burn them to the ground or shutter them, what would take their place? One vision is to pursue pure centralization: have the state monopolize all money creation, say by providing universally-available accounts at the nation's central bank. Positive Money is an example of this. Another alternative, by way of Satoshi Nakamoto, is to pursue radical decentralization: replace bank IOUs with digital commodity money in the form of bitcoin and other private cryptocoins.

I'm going to provide a few historical examples that sketch out a third option for replacing banks; bills of exchange. A system underpinned by bills of exchange is capable of converting illiquid personal IOUs into money using a distributed method of credit verification, as opposed to a centralized method patched through a banking organization. Unlike bitcoin, however, these are IOUs, not mere bits of digital ledger-space. While few people these days are familiar with the bill of exchange, in its hey day this instrument was responsible for executing a large chunk of the Western world's transactions. 


The first story is of cheques, an instrument that while not precisely a bill of exchange gets pretty close. Last week in my homage to the cheque I brought up the Irish bank strike of 1970, described by Antoin Murphy (from whom I steal the title of this blog post). When the nation's banks shuttered their windows for half the year, Irish citizens re-purposed uncleared cheques as personal IOUs, these cheques circulating as a cash substitute. The system was decentralized in that banking institutions no longer served as creators of the medium for making payments; instead, everyone became their own unique money issuer. As Tim Harford recently wrote, pubs and corner shops were able to vouch for the creditworthiness (or not) of each cheque.

Irish cheque money only circulated for six months. After the banks reopened in November 1970, mounds of cheques were cleared & settled and the system returned to normal. Luckily, we have historical examples that lasted much longer than this.


Let's go back in time to Antwerp in the late 1400s. The institution of banking had been present in Europe for a few centuries, but according to Meir Kohn (who I get much of this material from) it began to go into decline at the end of the 15th century as waves of bank failures broke out across the continent, due in part to coin shortages. In Antwerp, the authorities went so far as to ban the practice of banking in 1489. In lieu of bank deposits, coins could of course be used to make payments, but this would have been a step backward since deposit banking had emerged, in part, to solve the problems related to coins, specifically the fact that they are expensive to store, awkward to transport, and heterogeneous, some coins containing more precious metals than others.

Similar to the Irish five hundred years later, Antwerp's financiers adapted to the death of bank money by innovating a decentralized alternative. Where the Irish chose cheques as their payments instrument, Antwerp settled on a related paper-based order called the bill of exchange. A bill of exchange was a popular way to remit money in medieval times. Say you were a citizen of Florence and you needed to get 20 gold coins to a relative in Venice. Rather than incur the cost and danger of transporting the coins yourself, you might try and strike a deal with a merchant who had offices—and gold—in both cities. By paying the merchant some gold in Florence, your home city, he would issue you a bill of exchange. This bill ordered his colleague in Venice to pay out 20 gold coins to whoever happened to be the bill bearer. You'd then send the bill to your relative in Venice, and he'd bring it into the office and collect the money. The merchant would earn a commission on the deal. No actual gold would travel between the two cities, just a secure and light paper instrument. It was a fantastic technology for saving on the costs of shipping and handling heavy coins.

While bills of exchange started out as remittance instruments, they were later used by merchants as a form of credit. A merchant might want to sell some wool to a manufacturer who in turn required three months to convert the wool into cloth and sell it. To finance the purchase of wool, the manufacturer could always turn to a banker. Absent a banker, the merchant himself might provide the manufacturer with a loan by drawing up a bill of exchange. On its face this bill contained written instructions ordering the manufacturer to pay x coins three months hence to the bearer of the bill. The merchant would keep it in his desk, and when the requisite amount of time had passed he would bring the bill to the manufacturer and collect on his debt, earning interest in the meantime.

The common denominator of a bill of exchange, whether used as a remittance or as credit, is that a private citizen has issued their own personal IOU, to be redeemed for cash after some time has passed. Then Antwerp happened.

In its original form, a bill of exchange could only be used by a small group of people, the initial drawer of the bill, the payor, and the payee. Antwerp's financiers took the bill of exchange and converted it into a fully transferable instrument, or money. They pried open the closed circuit so that if merchant A owned a bill of exchange that was to be paid out in coin by merchant B next month, merchant A could in the meantime transfer this IOU to merchant C as payment, and merchant C could transfer it to merchant D, and D to E etc. These transfers, or assignments, could occur without asking the original debtor, merchant B, for permission. This would have dramatically increased the liquidity of bills of exchange, allowing them to fill the vacuum left in Antwerp by the banning of bank deposits,

To further protect anyone who received a bill of exchange in payment, Kohn tells us that these instruments were granted currency status by Antwerp's merchants. As I wrote here, this meant that even if the bill of exchange had been stolen from merchant B and paid to merchant C (who had innocently accepted it), merchant B could not sue merchant C to get the bill back. This legal upgrade would have further promoted the liquidity of bills of exchange, since merchants needn't bother setting up burdensome verification processes to ensure that bills of exchange presented to them were not stolen. In the eyes of merchant law, all bills of exchange were considered "clean."

There was still one last barrier to creating a truly decentralized medium of exchange; how to overcome stranger danger. Say that you and I are acquaintances and I owe you $20. I tell you I'm going to settle my debt by giving you an IOU issued by another party. Banks are a great way to solve the stranger problem, since everyone will agree to settle debts using the IOUs of a well-known and trusted intermediary like a bank. But say instead I offer you a $20 bill of exchange that I've received from a friend. If you know that person you'll probably accept the deal, but in an economy like Antwerp's with thousands and thousands of actors, you might not know the name of the debtor written on the bill. And without enough knowledge to accept the credit, you'd have probably refused it.

According to Kohn, the final innovation developed in Antwerp solved the stranger problem—the ability to endorse a bill of exchange. I simply signed my name to the back of $20 bill of exchange, or endorsed it, and handed it to you. By signing it, I was agreeing to accept the debt as my own. So if the original debtor failed to pay you for the bill when it came due, you could flip the bill over and pursue the first name on the list of endorsees—me—for payment. And since you knew and trusted me, it was now possible for you to evaluate the credibility of a $20 bill of exchange that had originally been issued by a stranger. Bills could in turn be re-endorsed on by others, a long chain of transactions being made before the bill finally expired. Indeed, Henry Dunning Macleod once remarked that bills might sometimes have "150 indorsements on them before they became due."

From Antwerp, the practice of using negotiable bill of exchange would spread to the rest of Europe, in particular Britain. Below is an example of a bill of exchange from 1815 that ordered Pickford's, an English canal company, to pay £72  11s 1d to Richard Vann. You can see first hand how the stranger problem is solved. The bill has multiple endorsements on its reverse side (pictured below), including that of Richard Vann, William Alcock, T S Marriott, William Whittles, Jones & Mann, Thomas Whalley & Sons, James Mitchell and Richard Williams. To see the front side of the bill, click through to the original link:


Not only did this chain of cosigning individuals solve the stranger problem. It also created an incredibly safe instrument. Bills of exchange were effectively secured not only by the original person whose name was inscribed on the front, Vann, but by all the others who had cosigned the back; Alcock, Marriott, Whittles, etc. The odds of everyone on the list failing would have been quite low. It was an ingenious system.


Another interesting anecdote on bills of exchange comes from the county of Lancashire in north west England in the 1800s. By then, banknotes had long since been invented and were a popular payments medium in England. Typically issued by small private "country banks," banknotes were a centralized payments technology insofar as their value depended on the good credit of one issuer, the bank. Inhabitants of Lancashire were particularly suspicious of these instruments which explains why there were almost no note-issuing banks in the county. T.S. Ashton speculates that this wariness was due to the 1788 failure of Blackburn-based Livesay, Hargreaves and Co, a banknote issuer: "generations after, when proposals were made for local notes, men's minds turned back to the events of 1788."

In the absence of a system of banks providing transferable deposits or notes, bill of exchange circulated in Lancashire, even dominated, so much so that they were often "covered with endorsements" and become famous for their dirty appearance. Indeed as late as the 1820s, Ashton tells us that some "nine-tenths of the business of Manchester was done in bills, and only one-tenth in gold or Bank of England paper." Bills were used even in small denominations, say to pay piece workers. This is surprising because bills of exchange had typically been used by merchants and wholesalers, and therefore tended to be issued in large denominations.

Alas, according to Ashton the Lancashire bill of exchange was done in by the increase in stamp duties, which effectively made it more cost-effective to use bank-issued forms of payment that didn't require a stamp.


Just a few random thoughts in closing.

While Ireland, Lancashire, and Antwerp all provide a sketch of an alternative, distributed form of converting personal IOUs into money, do we really need a replacement for banks? While the U.S. banking system certainly had its difficulties in 2008, Canadian banks skated smoothly through the crisis. Maybe banks only need a face lift.

Even if we need to burn the suckers down, a paper-based backup like bills of exchange or cheque just won't cut it—we need digital money. But is it possible to digitally replicate the features of a bill of exchange? And even if an online bills of exchange system could be built, we live in an age where money transmitting is a highly regulated industry—how legal would it be for individuals to take over the role of money creator, transmitter, and verifier? (I once thought that Ripple was the answer to digitally replicating bills of exchange. But they decided to serve banks instead. Maybe Trustlines fits the *ahem* bill?)   

Tuesday, June 27, 2017

An homage to the cheque (or check)

The check used to buy Alaska (source)

I recently read an FP article about the odd persistence of the cheque as a way to make payments. According to the author, even though cheques are slow and cumbersome, people are willing to live with these drawbacks because they like the ability to write messages in the memo field. Competing electronic payments options (in Canada at least) don't have the ability to write memos.  

As someone pointed out to me on Twitter, in the U.S. the cheque's memo field is more than just a place for writing personal reminders. According to the law in certain states, when you disagree with your creditor about how much is owed—say the contractor who is building your deck has spent too much on materials—by writing out a cheque for less than the agreed amount and including "paid in full" in the memo line, the debt is extinguished the moment the contractor cashes it.  

What follows are some other neat things about cheques that don't get much attention.

People tend to think of cheques as a mere set of instructions issued to a banker on how to move bank deposits. To transfer deposits, we could always just walk into a bank and do this in person, but we prefer to save time and energy by issuing the instructions on paper.

But a cheque is more than just a substitute for a set of in-person verbal instruction. By inscribing these instructions onto a long-lived medium, we've created an entirely distinct financial instrument, something akin to a debt or a derivative. As long as a cheque exists, it derives its value from the underlying deposits that are expected to be delivered by the issuer.

Normally we take for granted that a $1000 cheque is worth $1000. But this isn't always the case. For instance, if the cheque writer decides to spend a $1000 cheque that has been post-dated for three months—i.e. the underlying cash can not be collected till then—the receiver will typically only accept said cheque at a discount to face value, say $960. After all, the receiver needs to be compensated for the interest they will have to forego in holding that cheque for the three months to encashment, not to mention incurring the risk that the cheque writer fails in the interim.

We don't normally think of cheques as a form of debt or financing, but after India's demonetization an interesting example of this practice was brought to light. This fascinating story describes how small-scale enterprises in Varinasi accept post-dated cheques as payment and then bring them to a battawala—or "one who deducts"—for discounting. The battawala sets his commission, or discount, based on the creditworthiness of the cheque issuer. The ability to sell post-dated cheques allows these businesses to finance expense such as salaries and inventories. A second article describes a battawala market that "opens from 3-7 p.m. every day at Chowk, the heart of the business district," where several thousand battawallas sit and trade post-dated bearer cheques for cash.

North America also has a post-dated cheque market of sorts. Payday lenders, which offer short-term lending to those who can't get it from banks, only issue loans on the provision of a post-dated cheque. They accept these cheques at large discount to face, so that a $350 cheque can only buy, say, a $300 loan.

In addition to being a form of debt, cheques are also a type of money. I don't mean in the sense that cheques allow for the transfer of underlying bank deposits; rather, an uncashed cheque can itself be transferred between many different parties as a medium of exchange. This is something that younger people who only use credit cards and P2P options may not know, but if the issuer of the cheque writes "to bearer" in the pay to field, then literally anyone who is 'bearing' or holding that cheque can bring it into the bank to be cashed. Given that it grants universal access to underlying cash, a $100 bearer cheque might be transferred three or four time over the course of a few days, resulting in $300 worth of transactions being consummated rather than just $100. In the first of the two articles I linked to above, for instance, the owner of a small sari business says that it isn't uncommon for a bearer cheque to change hands as many as five times. 

Just a head's up. Even if you indicate the name of the recipient in the pay to field of a cheque you've written, say to John Doe, he can still use it as a medium for paying someone else rather than cashing it... without you even knowing. By endorsing the back of the cheque with his signature, John Doe converts it into a bearer cheque. This is called blank endorsement. Anyone he gives it to can now either bring it in to be cashed or continue passing it off in a long chain of transactions. In the U.S., these sort of cheques are called third-party checks, although banks tend to be a little leery about accepting them these days.

The use of cheques-as-money is promoted by laws that, like banknotes, grant them currency status. I touched on this distinction last week, but here it is again. Say that person A is carrying some sort of financial instrument in their pocket and it is stolen. The thief uses it to buy something from person B, who accepts it without knowing it to be stolen property. If the financial instrument has not been granted currency status by the law, then person B will be liable to give it back to person A. If, however, the instrument is currency, then even if the police are able to locate the stolen instrument in person B's possession, person B does not have to give up the stolen cheque to person A. We call these special instruments negotiable instruments.

Instruments like cash and cheques that have been granted currency status, or are negotiable, have a big advantage over those that haven't. Because they won't be on the hook for returning stolen negotiable instruments, shopkeepers and others can accept these instruments without having to set up costly verification procedures. This means these instruments will tend to be more liquid than those that are non-negotiable.   

A neat result of the transferability of cheques is that cheque payment systems are incredibly robust in the face of disasters and banking system shutdowns. Any direct transfer a bank deposit, say using a debit card or some other form of electronic fund transfer, requires that the parties to a payment to establish a  communications channel with their respective banks. If there is a problem with either of the banks, the merchant, or the connection itself, then the transfer can't go through. With a cheque however, there is no need to communicate with one's banker. A cheque is created entirely without the bank's say-so. Anyone is allowed to receive that cheque, it being their choice to either cash it or pass it along. Which means that if the banking system is on the fritz, cheque payments can proceed.

The most famous example of this robustness is the Irish banking strike of 1970. With the entire banking system shut, for six months post-dated cheques circulated as the main form of money. In a well-known paper, Antoin Murphy recounts how pub owners acted as evaluators of the credit quality of each cheque, an episode I once wrote about here.

Another nice property of cheques is that, like cash, they can be used by the unbanked. If someone receives a cheque, they can go to the issuer's bank and cash it, even if they don't have a bank account. Alternatively, they can simply endorse the back of the cheque and spend it on as a medium of exchange.

This combination of negotiability, robustness, openness, and decentralization means that long before bitcoin and the cryptocoin revolution, we already had a decentralized payments system that allowed pretty much everyone to participate and, indeed, fabricate their own personal money instruments!

Was there ever a more versatile payments instrument than the cheque? Because you can write on them, a whole language of cheques has emerged, allowing for significant customization. By putting crossings on cheques, like this...

...the cheque writer is indicating that the only way to redeem it is by depositing it, not cashing it. This means that the final user of the cheque will be easy to trace, since they will be associated with a bank account. Affix the words non-negotiable within the cross on the front of the cheque and it loses its special status as currency. Should it be stolen and passed off to an innocent third-party, the victim can now directly pursue the third-party for restitution. To even further limit the power of subsequent users to use the cheque as money, the writer can indicate the account to which the cheque must be deposited.

This language of checks can be used not only by those that have originated the cheque, but also by those that receive it in payment. On the back of any check, any number of endorsements can be written, effectively allowing for the conversion of someone else's payment instructions into your own unique medium of exchange.    

In summary, while the popularity of the cheque has certainly been declining over the last few decade, it is still hanging in there—and that's because it seem to be providing some unique services that haven't yet been replicated by cheaper, digital alternatives. While those in the fintech space often smirk at cheques at as an outdated payments option inevitably doomed to extinction, they might be better served trying to replicate some of these features instead.

Tuesday, June 20, 2017

The road to sound digital money

No, I'm not talking about sound money in the sense of having a stable value. I'm talking about money that is sound because it can survive natural disasters, human error, terrorist attacks, and invasions.

Kermit Schoenholtz & Stephen Cecchetti, Tony Yates, and Michael Bordo & Andrew Levin (pdf) have all recently written about the idea of CBDC, or central bank digital currency, a new type of central bank-issued money for use by the public that may eventually displace banknotes and coin. Unlike private cryptocoins such as bitcoin, the value of CBDC would be fixed in nominal terms, so it would be very stable—much like a banknote.*

It's interesting to read how these macroeconomists envision the design of a potential CBDC. According to Schoenholtz & Cecchetti, central banks would provide "universal, unlimited access to deposit accounts." For Yates this means offering "existing digital account services to a wider group of entities." As for Levin and Bordo, they mention a similar format:
"Any individual, firm, or organization may hold funds electronically in a digital currency account at the central bank. This digital currency will be legal tender for all payment transactions, public and private. The central bank will process such payments by debiting the payer’s account and crediting the payee’s account; consequently, such payments can be practically instantaneous and costless as well as completely secure."
I don't want to pick on them too much, but all these authors are describing a particular implementation of central bank digital money: account-based digital money. There's an entirely different way to design a CBDC, as digital bearer tokens. My guess is that the authors omit this distinction because macroeconomists tend to abstract away from the differences between various types of money. Cash, coins, deposits, and cheques are all just a form of M in their equations. But if you get into the nitty gritty, bearer tokens and accounts two are very different beasts. Some thought needs to go into the relative merits and demerits of each implementation, especially if this new product is to replace banknotes at some hazy point in the future.

Let's first deal with account money. An owner of account-based money needs to establish a connection with the central issuer every time they want to make a payment. This connection allows vital information to flow, including instructions about how much money to transfer and to whom, confirmation that there is sufficient funds in the owner's account, and a password to confirm identity. Only then can the issuer dock the payor's account and credit the payee.

Bearer money, the best examples of which are banknotes and coins, never requires a connection between user and issuer. As I described in last week's post, courts have extended to banknotes the special status of having"currency." What this means is that if you are a shopkeeper, and someone uses stolen banknotes to buy something from you, even if the victim can prove the notes are stolen you do not have to give them back. The advantage of this is that there is never any need for a shopkeeper to call up the issuer in order to double check that the buyer is not a thief.** As for the issuer, say a central bank, they are not responsible for the debiting and crediting of banknote balances, effectively outsourcing this task to buyer and sellers who settle payments by moving banknotes from one person's hand to the other. The upshot of all this is that since users and issuers of bearer money don't need to exchange the sorts of information that are necessary for an account-based transaction to proceed, there is no need to ever link up.

This makes bearer money an incredibly robust form of money. If for any reason a connection can't be established between user and issuer, say because of a disaster or a malfunction, account-based money will be rendered useless. Examples of this include the recent two-day outage of Zimbabwe's account-based real-time gross settlement system due to excess usage, or the famous 2014 breakdown of the UK's CHAPS, its wholesale payments system, which limited the system to manual payments. M-Pesa, Kenya's mobile money service, has periodic outages, and last month my grocery store, Loblaw, suffered from a malfunction in its debit card system. Banknotes—which don't require constant communication with the mothership—worked fine throughout.

The private sector used to be heavily engaged in providing bearer money, both in the form of banknotes and bills of exchange. However, bills of exchange-as-money went extinct by the early 1900s. As for banknotes, the government thoroughly monopolized this activity by the mid-1900s. Which means the government has—perhaps inadvertently—taken on the mantle of being the sole issuer of stable, disaster-proof money. So any plan to slowly phase out government paper money is simultaneously a plan to phase out society's only truly robust payments option.

Going forward, it's always possible that governments once again allow the private sector to  issue bearer money. With the government's bearer money monopoly brought to an end, the public would be well-supplied with the stuff and central banks could safely exit the business of providing a robust payments option. But I can't see governments agreeing to relinquish this much control to private bankers. Which means that for society's sake, whatever digital replacement central banks choose to adopt in place of banknotes and coins should probably have bearer-like capabilities in order to replicate cash's robustness. Account-based money won't cut it. Nor will volatile private tokens like bitcoin.

One way to design a digital bearer money system is to have a central bank issue tokens onto a distributed ledger and peg their value, say like the Fedcoin idea. The task of verifying transactions and updating token balances would be outsourced to thousands of nodes located all over the world. So if all the nodes in the U.S. have been knocked out, there will still be nodes in Europe that can operate the payments system. This would restore a key feature of banknotes, that they have no central point of failure, thereby allowing central banks to get rid of cash. I'm sure there are other ways of creating robust money than using a distributed ledger, feel free to tell me about them in the comments section.

* CBDC would be redeemable on a 1:1 basis for traditional central bank money (and vice versa), so the two would have the same value and be interchangeable. Consumer prices, which are already expressed in terms of traditional central bank money, would now also be expressed in terms of CBDC. Since consumer prices tend to be sticky for around four months, CBDC holdings would have a long shelf-life. If CBDC was designed like bitcoin--i.e. its quantity was fixed and there was no peg to existing central bank money--then its value would diverge from traditional central bank money. Price would continue to be expressed in terms of traditional central bank money, and would be sticky, but there would be a distinct CBDC price that would no longer be sticky. So CBDC would no longer have a long-shelf life; indeed, CBDC prices could become quite volatile. See here.
** The caveat here is that while banknotes have long since been granted currency, CBDC—which does not exist—has not. Nor have cryptocurrencies like bitcoin been granted currency status. But if a central bank were to issue a bearer form of CBDC, it's hard to imagine the courts not declaring it to be currency fairly early on, unlike say bitcoin.

PS: I just stumbled on a 2006 paper from Charles Kahn and William Roberds which nicely captures these two types of money:

Saturday, June 17, 2017

On currency

David Birch recently grumbled about people's sloppy use of the term legal tender, and I agree with him. As Birch points out, what many of us don't realize is that shopkeepers have every right to refuse to accept legal tender such as coins and notes. This is because legal tender laws only apply to debts, not to day-to-day transactions. If someone has borrowed some money from you, for instance, then legal tender laws dictate a certain set of media that you cannot refuse to accept to settle that debt. These laws have been designed to protect your debtor from a situation in which you demand payment in a rare medium of exchange, say dinosaur bones, effectively driving them into bankruptcy.

Conversely, they also protect you the lender from being paid in an inconvenient settlement medium. In Canada, for instance, a five cent coin is legal tender, but only up to $5. If your debtor wants to pay off a $10,000 debt using a truckload of nickels, you can invoke legal tender laws and tell them to screw off—give me something more convenient.

Joining in with Birch in the grumbling, I'd argue that people make just as many errors with the term currency as they do with legal tender. When we use the word currency, we typically mean a grab bag of paper money, coins, deposits, and cryptocurrencies, or we use it to describe national units of account such as dollars, yen, pounds, pesos, ringgits, bitcoin, etc. But the word currency shouldn't be used so sloppily. 

Henry Dunning Macleod, a monetary theorist who wrote in the 1800s, has an interesting discussion of the etymology of the word. Macleod was a unique character in his own right. Trained as a commercial lawyer, he signed up as director of the Royal British Bank which failed in 1856 due to questionable loans and self dealing. Macleod went on to write a number of large tomes on monetary theory,  history, and law, including the Elements of Economic, on which I am drawing from for this post. Perhaps his main contribution to economics is the coining of the term Gresham's law, according to George Selgin.

From Macleod we learn that currency used to be used an adjective, not a noun. Certain types of goods or instruments were considered to be "current" in the eyes of the law and common business practice. They were said to have "currency," but were not themselves currency. Here is a clip from his book:
Let's break this down. Property that had been granted currency had a different legal status from property that didn't. Let's assume that a good has been stolen and sold by the thief to a third party, a shopkeeper, who innocently accepts it not knowing that it has been stolen. For most forms of property the original owner could sue the third party and get the stolen article back. But not if that good is one of the few to be considered by society to have currency, wrote Macleod. When an article is said to have currency, or to be current, the original owner cannot chase the third party to recover stolen property. So in our example, our shopkeeper gets to keep the stolen good, even if its stolen nature has been proven in court.

Coins had always been current according to mercantile practice, but if you read through Macleod you'll see that over the course of the 1700s, British common law jurists granted currency status to a series of new financial instruments, including banknotes, bills of exchange, stock certificates, exchequer bills, bonds, and more. (I went into this here.) What this illustrates is that an item didn't have to be money to have currency (e.g. bonds were considered to be current), nor did it have to be government-issued to be current (banknotes and bills of exchange were privately-issued).

Granting currency-status to a select group of instruments provided them with some useful mercantile properties. Consider first the converse: when the law did not grant currency to a certain good, any transfer of that good came with strings attached. For instance, if you tried to pawn off an expensive gold ring on a shopkeeper, the possession of that ring in your pocket would not be sufficient for the shopkeeper to establish title. If the ring had been stolen, and he/she accepted it, the shopkeeper might be forced to give it back to its original owner, leaving the shopkeeper out of pocket. So they would be wary at the outset about accepting the ring from you, perhaps requiring a time-consuming verification process before agreeing to the deal.

On the other hand, the shopkeeper would not hesitate to accept a gold coin. Because coins were current according to the law, anyone who received them in trade would not have had to worry about returning them to an angry victim down the line, and therefore could avoid the necessity of setting up a costly verification procedure. This would have encouraged trade in these instruments, rendering them much more liquid than items that weren't current.

According to Macleod, it was only after these early court cases that people started to directly refer to banknotes, coin, yen, dong, pounds, krona, and the like as currency-the-noun, a linguistic switch which Macleod angrily blamed on Yankee "barbarism":
"It is quite usual to say that such an opinion or such a report is Current: and we speak of the Currency of such an opinion or such a report... But who ever dreamt of calling the report or the opinion itself Currency?... To call Money itself Currency, because it is current, is as absurd as to call a wheel a rotation, because it rotates...Such as it is, however, this Yankeeim is far too firmly fixed in common use to be abolished."
It is interesting to note that while not all instruments that had currency were money (i.e. bonds), likewise not all money was granted currency status. According to Macleod, bank deposits did not have currency because, unlike banknotes and coins, deposits could not be dropped in the streets, stolen, lost or transferred to someone else by manual delivery. If you think about it, each movement of a bank deposit requires direct contact with the banking system in order to process the transfer. This effectively weeds out transfers of lost or stolen property, especially in Macleod's day where banking was conducted in person at a branch. Since anyone receiving bank deposits in payment needn't worry about a deposit being dubious, there was no need for the law to grant currency status to deposits.

All of this still has relevance today. Take the case of private cryptocurrencies, ICOs, and central bank digital currencies (CBDC). Because law makers have not been very clear about their legal status, bitcoin and other forms of crypto don't have currency, at least not in the Macleodian sense of the term. This means that a storekeeper who accepts bitcoin (or a future Fedcoin) may also be taking on the liability to give said coins back if they are proven to be stolen. And this lack of currency-status can only handicap a cyptocoin's ability to freely circulate.

If this post achieves anything, it's to illustrate that a special amnesty was once granted to a small set of financial instruments. This amnesty used to be referred to as currency. While we don't have to go back to the old practice of using of the word currency to refer to this special amnesty, we should at least be aware that this amnesty is still present and relevant.

Friday, June 9, 2017

The forking of the Indian rupee

This post is about the dismantling of the rupee-zone between 1947-49, an historical event that is especially topical in light of two modern monetary projects: Narendra Modi's poorly-executed 2016 demonetization and a potential eurozone breakup.

Thanks to a recommendation by Amol Agrawal, who blogs at the excellent Mostly Economics, I've been pecking away at the 900-page history of the Reserve Bank of India, although I have to confess that I've spent most of my time on the chapter on the partition period. For those who don't know, India and Pakistan weren't always independent countries. Up until partition in August 1947, each was part of British India, a British colony. The rupee, which was issued by the Reserve Bank of India (RBI), was the sole medium of exchange in British India. By mid-1949, less than two years after partition, usage of RBI-issued rupees had been successfully limited to the newly-created state of India. As for Pakistan, it had managed to erect its own central bank, the State Bank of Pakistan, as well as introduce a new currency, the Pakistani rupee.

At the time of partition, Pakistan's architects faced a daunting challenge; given that the Brits had announced in early 1947 that the partition of British India was to occur that August, there remained only a few months to create a central bank and issue a new currency. Because printing enough new currency for an entire nation would take far more than a few months to achieve, a temporary solution was arrived at: to use the RBI as an interim agent for issuing currency until the new Pakistani central bank had its own printing presses up and running.

This "bridge" involved using a combination of regular RBI-issued rupees circulating within Pakistan at the time and "overprinted" notes issued by the RBI. To ensure that the purchasing power of the two rupees stayed locked, the overprints were to be accepted by the RBI at par with regular notes. When enough Pakistani rupees had been printed by the newly-created State Bank of Pakistan, or the SBP, the mix of India rupees and overprinted notes was to be demonetized and replaced by Pakistani rupees on a 1:1 basis.

Here is what the Pakistani overprints looked like.

Note that they have the text "GOVERNMENT OF PAKISTAN" inscribed on them. Otherwise, overprints were just like regular rupees of the time.


Let's pause and bring this to the present. Like the rupee breakup of 1947-49, Modi's recent demonetization involved the cancellation of a large proportion of existing currency followed by an issue of new banknotes to replace them. (The 500 and 1000 rupee notes represented some 85% of India's paper money.) This is where the similarities between the two projects end. The architects of partition were wise enough to realize that they did not have enough time to print sufficient quantities of Pakistani rupees to replace Indian rupees, and so to avoid burdening the public with a shortage of cash they decided to use existing RBI-issued currency as a bridging mechanism.

Modi and his team of monetary architects evidently did not bother to familiarize themselves with RBI history. If they had, not only would they have realized what a huge task it is to replace the majority of a nation's currency, but they would also have learnt some tricks—like overprinting—to make the project easier. (Overstamping, a technique similar to overprinting, was successfully used in the break-up of the Austro Hungarian krona in 1991 as well as the Czechoslovak koruna in 1993.) This refusal to draw on the RBI's institutional memory means that some eight months after demonetization, Indians are still suffering from cash shortages.


Let's return back to the partition and explore the forking of the rupee more closely. The SBP, which was established July 1, 1948, formally took over the RBI-issued overprints as their liability that same day. As fresh Pakistan rupees came off the printing presses over the next months, SBP officials would steadily replace these overprints. That same day, the RBI subtracted the entire stock of overprinted notes from its total banknote liability. (The RBI had been issuing these notes since April.)

In taking over a large percent of the RBI's banknote liabilities, the SBP would need an equivalent set of assets to act as backing. These assets were to come from the RBI. More specifically, a fixed portion of the RBI's gold, coin, sterling-denominated securities, and rupee-denominated securities was to be transferred to the SBP, the rest remaining in India to serve a backing for RBI-issued rupee banknote.

To ensure fairness, a formula was settled on ahead of time to determine how the assets were to be apportioned. On a fixed date, the RBI would tally up how many notes were in circulation in Pakistan and how many in India, and divvy up the underlying assets according to the distribution of notes. That's fair way to do things, at least in theory. For the overprints, the RBI would record how many it had issued by July 1, 1948, and for each rupee overprint in existence it would transfer an equivalent quantity of assets to the SPB. When July 1 came, some 9.9% of the RBI's assets were dispatched to Pakistan. Thus one half of the mix of notes circulating in Pakistan, the overprints, had been demonetized.

There still remained the second half of the mix—regular Indian rupees. Dealing with these was more complicated. Unlike overprints, the RBI could have no firm measure for how many regular rupees were still being used in Pakistan, and thus had no way of knowing how many backing assets to transfer to the SBP. Intead, a mechanism for tallying up notes was established such that all Indian rupees circulating in Pakistan had to be brought to SBP offices for conversion into Pakistani rupees before July 1, 1949, one year after the central bank's founding. As Indian rupees flowed into the SBP over the course of the next twelve months, SBP officials remitted them to the RBI. The RBI then transferred an equivalent asset to the SBP for each Indian note it had received up until the expiry of the conversion period on July 1, 1949, after which the RBI ceased to accept remitted Indian rupees.

At this point, the RBI and the SBP were officially divorced. All liabilities and assets had been distributed to each respective party.


In a potential breakup of the euro, a formula like the one devised by the RBI will have to be used. The results, however, are likely to be messy. Because as I'll show, the divvying up of the RBI's assets wasn't without controversy.

If you look at the SBP's 2016 financial statements, you'll see an interesting line item called "Assets Held With the Reserve Bank of India":


Go to note 14, and you'll see that:
"These assets were allocated to the Government of Pakistan as its share of the assets of the Reserve Bank of India under the provisions of Pakistan (Monetary System and Reserve Bank) Order, 1947. The transfer of these assets to the Group is subject to final settlement between the Governments of Pakistan and India"

So it seem that Pakistan never received what it believes to be its fair portion of the RBI's assets. For almost 70-years now it has carried these IOUs on its balance sheet (see historical date here). That's a long time to hold an asset that is unlikely to be collected! The reason for this odd balance sheet item can be found on page 568 or the aforementioned 900-page RBI tome. Between the founding of the SBP in July 1948 and the July 1949 cutoff date for note remittances to the RBI, more Indian rupees had filtered over the border into Pakistan than expected. As such, Pakistan was able to stake a larger claim on the RBI's assets than initially estimated.

Indian officials, who were not happy with the amount of assets they were sending over to Pakistan, now claimed that only those notes already in circulation in Pakistan as of July 1948 could legitimately be remitted for underlying assets. Any notes that were imported into Pakistan from India after that date simply would not count to the final tally. Pakistani disagreed. In March 1949 the Indian government informed the bank that "pending negotiations with the Pakistan Government further releases to them should be withheld." This was unfortunate news for the SBP. It had effectively issued Pakistani rupees without a reciprocating asset to back them.* That's where the two parties stand to this day—the SBP grudgingly holds the RBI's IOU on its books as reminder that it never got its perceived fair share of the RBI's assets.

This sort of havoc is inevitable when a monetary union breaks up. If existing notes are to be converted into new national notes at a one-to-one basis over a fixed period of time, then everyone has an incentive to export their notes to the region that is expected to have the strongest national currency. I am speculating here, but in September 1949—just three months after the RBI had been successfully divided—India devalued its rupee by 30.5%. Pakistan didn't. So all thoe holding Pakistani rupees were suddenly 30.5% richer than those holding rupees. Maybe the mass banknote exodus into Pakistan during the conversion period was an attempt to avoid this impending devaluation.

This same sort of dynamic would surely characterize a euro break-up. If Europeans are given 6-months to convert their euros into new national currencies like the German mark or the Greek drachma, you can bet that everyone will ship their euros to Germany. Drachmas, like the Indian rupee, are sure to be devalued. And if the final distribution of banknotes is to serve as the marker for divvying up the European Central Bank's assets, then Germany would get most of them. Were it to be prevented from getting its share, then Germany would end up in the same situation as Pakistan, with a shortage of good assets to back up all the fresh marks it has issued.

*If you're interested in specific amounts owed, here's an old World Bank document on the issue.

Tuesday, May 30, 2017

Evaluating my bitcoin predictions

I wrote a bunch of posts on bitcoin between 2012-2015, but they tailed off a bit in late 2015 and 2016 as my attention turned to other subjects, namely old fashioned banknotes and cash, a terrifically fertile topic. Because my bitcoin posts tended to get a lot of comments at the time, I thought it would be worthwhile to go back and review some of the predictions I made, both for my sake and that of my readers.

My predictions tend to fall into three related buckets.
  1. Bitcoins will not become a generally-accepted medium of exchange
  2. Even mainstream organizations like the Fed might one day want to adopt bitcoin tech
  3. Bitcoin will fall to zero
On the first front, I've consistently written that bitcoin won't become a generally-accepted medium of exchange because of its volatility. And this prediction has panned out, so far at least. No, bitcoin has not destroyed VISA, nor has it driven the share prices of remittance providers like Western Union to zero, nor has it been adopted by unbanked Africans and Bangladeshis.

From a more anecdotal perspective, I live in what I like to think is a fairly vibrant part of Montreal filled with early adopters, but I never see shops or cafes that accept bitcoin. None of my circle of friends and family have ever tried the stuff, and when they ask me about it, it's always to gossip about the crazy high prices—not bitcoin-as-a-medium-of-exchange. Let's face it, bitcoin and other cryptocoins are great speculative vehicles, but they're flops as money.

On the second front, I've written about how the distributed ledger aspect of bitcoin could be split off from the token itself and used by financial institutions See here, for instance. This is the rough idea behind the "blockchain" movement that started up in 2015 or so. We'll see if it pans out. I also predicted that central banks would adopt bitcoin technology before banning it, perhaps in the form of a distributed currency, and have since wrote multiple posts on the Fedcoin idea. No central bank has quite got there yet, but they've all started talking about digital currency and have even been experimenting with it. So I think I've done alright on these predictions.

It's boring being right because you don't learn anything. My last prediction, that bitcoin will hit zero, is my most interesting one because I got it so wrong. In 2012, I wrote:
"My hunch is that bitcoin still has a positive value because proper competition will take a few years to truly develop. Let's see where we are in December 2013."
By December 2013, bitcoin had hit $800, not $0. Similarly, this:
"There is no way to arbitrage this premium away directly, but over time competitors will peck away at it, causing bitcoin's price to deteriorate back to its fundamental value, which I'd guess is <$1."
Or this from 2014:
"If I'm right, in the future bitcoin will be a smaller part of the cryptocoin world than it it now, whereas stable-value non-bootsrapped crypto assets, like Ripple IOUs, will be a larger part of that world."
To further illustrate how bad I got this one,I once owned 24 bitcoins. I bought them back in the fall of 2012 for around C$12 each (~US$10) for a total outlay of C$290. Thinking I was a genius, I sold out the next year when the price hit C$100, earning what thought to be a nice 700% return. Had I ignored my prediction and held, given today's bitcoin price of ~CAD$3000 my small stash would be worth a cool C$72,000. Ouch. That's not fun to read.

Given this incredibly wide miss, it's high time to re-evaluate my reasoning for a zero price of bitcoin. Do I turtle-in and keep my prediction or do I update it?


Here's how I've been thinking about the problem.

There are two types of assets in this world. Type A assets can only provide a return to their current holder if a stream of subsequent investors, buyers, or participants are recruited to provide that return. Examples include Ponzi schemes, chain letters, and pyramid schemes. Type B assets, on the other hand, can provide a return to their owner, even if no subsequent person ever steps forward to acquire that asset. Good examples of Type B assets are gold, land, stocks, and central bank-issued banknotes.

Say a buyer's strike suddenly hits the market for a Type B asset. Everyone decides to sell at the same moment so that the asset is offered at $0. An arbitrage opportunity presents itself. Since this asset will either yield a dividend (in the case of a stock), have some usage in decorating (like gold), or is destined to be repurchased by its issuer at some positive price (think central banks withdrawing banknotes by selling assets), anyone who buys it for $0 is getting something for nothing. As people compete to feast on this free lunch, prices will re-ratchet back up until the opportunity has disappeared. For this reason, Type B assets are characterized by price floors and buyers strikes are not crippling.

No equivalent arbitrage opportunity presents itself when a buyer's strike hits a Type A asset. Say Bernie Madoff issues a bunch of tickets, each providing its holder with a spot in a Ponzi scheme. A few days later, no one wants to purchase Madoff's tickets. Sure, you can now buy a ticket for $0, but because they have no intrinsic value the only way you'll be able to come out ahead is by selling it for more to another buyer, say for $1. This will require that you (or someone else) incur expenses on marketing the scheme i.e converting already angry sellers into buyers. This sounds like an awful lot of work, certainly too much to merit paying anything more than $0. Probably better to start an entirely new Type A asset than try to reboot the failed one. The upshot is that because Type A assets lack an arbitrage mechanism and marketing is costly, buyer's strikes quickly bring the game to an end. There is no floor.

Bitcoin is a Type A asset. It is unconsciously so, there being no Madoff-like evil genius at the centre of the scheme. It just sort of emerged spontaneously.

Like other Type A assets, bitcoin lacks a price floor. When a bitcoin buyer's strike hits, and bids across all the bitcoin exchanges evaporate, a bitcoin held in your wallet is worthless. There is no underlying business that can throw off dividends nor a central issuer that can cancel unwanted tokens. Sure, you can always purchase a bitcoin for $0, but in order to come out ahead you'll have to convince someone to buy it for $10. This means you'll have to regenerate the hype, excitement, and belief that initially spawned a positive bitcoin price. If you're not willing to spend time and money on these efforts, you better hope someone like Andreas Antonopoulos will. Whatever the case, any effort to push bitcoin back into positive territory will be costly.

Given that buyer's strikes are the death knell for Type A assets, it is vital to recruit a constant stream of new buyers to the cause. In bitcoin's case, recruitment has been easy. No Ponzi scheme ever boasted as engaging a mythology as bitcoin, starring the dashing and mysterious Satoshi Nakamoto, a radically decentralized digital currency poised to destroy the existing financial system, and "in math we trust". Because these ideas are so catchy, the mythology has pretty much sold itself—an incredibly cost-effective way of recruiting new participants. Every time bitcoin has experienced a lull in buying and its price has plunged, it has never quite fallen to zero. A batch of new converts, inspired by the latest Andreas Antonopoulos video on YouTube, has always emerged from the woodwork.

While the mythology is strong, it has long since spread into the easy cracks, i.e. libertarians and tech geeks. New target demographics, many of which do not agree with the core philosophy underlying the mythology, won't be so easily convinced to add their bids to the queue. As for Satoshi Nakamoto, he/she is almost ten years old now and getting stale. And one of the core promises of the mythology, the birth of a generally-accepted digital currency, has fallen flat. People are getting jaded.

Luckily, Bitcoin has always had a far more seductive recruiting tool, a rapidly rising price. While the technology and philosophy underlying bitcoin might motivate a few geeks, a 50% price jump is a universal intoxicant. Past returns bring the promise of future returns, waves of new buyers pushing the stuff ever higher. However, this process faces limits. The bigger bitcoin gets, the larger the stream of recruits needed to drive the price higher. At some point its market capitalization will get so large that the population of buyers necessary to keep the ball rolling will be exhausted. And when bitcoin can no longer demonstrate that it offers a superior return, a buyer's strike will hit as everyone rushes to sell at the same time, it's price falling to zero.  

So in the end, even though I've been terribly wrong I'm going to stick to my guns on this one. If I'm going to recant my bitcoin-to-zero views, you're going to have to convince me that a Type A asset can last indefinitely. I don't see how. Empirically, we know that Type A assets are precarious, short-lived things. There are no Ponzi or pyramid schemes still running from the 1800s, or the 1920s, or even from 2001. Bernie Madoff's Ponzi scheme, which popped in 2008, may have been the longest running Type A asset ever, it's alleged start date being the early 1970s. That's over thirty years. (Public run pension schemes don't count, since the government can coerce participation). If there is a reason that bitcoin can escape this fate, please explain in the comments section—maybe I'll see the light.