Can a central bank eliminate its highest value banknote?

Singapore's $10,000 bill, worth around US$7500, shares title to world's largest value banknote with Brunei's $10,000

Peter Sands has adeptly made the case for eliminating high denomination banknotes. The rough idea is that if all central banks were to eliminate their highest value banknotes, then criminals would have to fall back on smaller denominations or more volatile media of exchange like gold. Since both of these options are more cumbersome than large denomination notes, storage and handling expenses will grow. This means the costs of running a criminal enterprise increases as does the odds of being apprehended.

Elimination of cash is a polarizing topic. For now I'm going to sidestep that debate because I think there's a more interesting topic to chew on: might a central bank be unsuccessful in its attempt to withdraw its own high denomination notes? Put differently, what happens if everyone just ignores a central banker's demands to retire the biggest bill?

Take the most popular high denomination banknote in the world, the US$100 bill. According to the Federal Reserve, there are 10.8 billion of these in circulation, or around $1 trillion in nominal value terms. Popular not only with criminals, the $100 bill circulates in many dollarized or semi-dollarized nations as a legitimate means of exchange in the absence of decent local alternatives. Say that the Federal Reserves wants to hobble criminals by cancelling all 10.8 billion notes. It announces that everyone holding $100s has until January 1, 2018 to trade them in for two $50s (or five $20s). After that date any $100 notes that remain in circulation will no longer be considered money. Specifically, they will cease to be recognized by the Fed as a liability.

Will this demonetization work? Consider what happens if everyone simply ignores the proclamation and continues to use $100s in trade. Say that by the January 1, 2018 expiry date, only $300 billion of the $1 trillion in $100 bills in circulation have been tendered leaving the remaining $700 billion (or 7 billion individual notes) in peoples' pockets.

So much for hurting criminals by removing the $100, right? We'd say that the central bank's demonetization campaign has failed. But not so fast.

Even though 7 billion $100 bills remain in circulation, the nature of $100 bill will have changed. Prior to January 1, 2018, the Fed maintained a peg between the $100 bill and all other denomination ($50, $20, $10, $5, and $1). This peg was enforced by the Fed's promise to convert any quantity of $100 bills into lower denominated notes and vice versa. After the expiry date, the Fed will no longer include the $100 in these pegging arrangements.

In addition to maintaining a fixed rate between the various denomination, the Fed also promises to peg the value of a dollar to a slowly-declining bundle of consumer goods (put differently, it set a 3% 2% inflation target). It does so by injecting an appropriate quantity of new currency into the economy via open market purchases or withdrawing sufficient currency by selling assets. When the Fed demonetizes the $100 note, it ceases to include the $100 in its consumer goods peg. This means it will no longer dedicate any of its assets to protecting the purchasing power of the $100 bill.

Given this new setup, as demand for $100 bills varies their value will float relative to both Fed dollars and the slowly declining consumer good bundle. Like bitcoin, which also has a fixed supply, fluctuations in the purchasing power of the $100 could be quite volatile. One day the $100 might be worth $110, the next it could be worth just $90. So even if the Fed has failed in withdrawing the $100, it will still have succeeded in imposing purchasing power volatility on criminals and other users of the $100. Volatile assets make for unpleasant and costly media of exchange and criminals will not be happy with these change.

By forswearing the $100, the Fed also ceases to act as a guardian of the quality of its issue of $100 bills against counterfeiters. The abdication of this function is especially important given that the marginal cost of printing a decent knock off of the $100 is probably just a few cents. Absent the threat of imprisonment, entrepreneurs will swarm to duplicate the $100, spending counterfeits into circulation and steadily reducing the purchasing power of the $100. After a few years of constant counterfeiting the $100 bill won't be worth much more than a few cents or so; the marginal cost of paper, ink, and printing. This hyperinflation will bring the nominal value of the original 7 billion in notes to just $700 million, down from $1 trillion.

Highest denomination note in various counties, sorted by US$ equivalent

Incidentally, we know this is a likely situation because of what has happened in Somalia. When Somalia's central bank was dismantled in the early 1990s, Somali shillings continued to circulate (see my blog post here). Over the next few years, warlords issued their own counterfeits which eventually drove the value of the shilling down to the cost of paper and transportation. William Luther has described this process here.

Along the way to hitting a terminal value of just a few cents, the $100 will lose any advantage it had previously enjoyed in terms of storage costs and handling. The moment a $100 falls to $49, the Fed's own $50 note becomes a cheaper note for criminals to use. And as the hyperinflation continues and the $100 falls to $19, the Fed's own $20 note will become preferred. The upshot is this: even if the Fed's January 1, 2018 expiry date fails to attract any $100s for redemption, competitive counterfeiting means that the $100 will inevitably cease to be used as the criminal economy's preferred medium of exchange.

Since criminals are rational and can anticipate that this sort of hyperinflation will ensue, they are more likely to tender their notes for cancellation prior to the original January 1, 2018 deadline. Better to get full restitution rather than lose all one's wealth.

Could criminals somehow police against hyperinflation by rejecting counterfeits? Militating against this would be the constant degradation of the note issue's quality due to normal passage of paper from hand to hand. In normal times, the Fed works behind the scenes to keep its note issue up to snuff, replacing worn out specimens with fresh new greenbacks. Once the Fed abdicates this role, $100 bills will quickly start to deteriorate. Picking the counterfeits out from a stack of bills will become more difficult, only making the job of counterfeiting easier.

In the face of this deterioration the mass of $100 bills may begin to fragment and lose fungibility. Fungibility is the idea that all members of a population are perfect substitutes. Well-preserved $100s that are easily identifiable as non-counterfeits may pass at a higher value than a slightly worn out $100, with well-worn and less identifiable $100 bills trading at an even larger discount. Without fungibility, it becomes far more difficult for a medium of exchange to do its job. Where a transaction with fungible $100 notes might be consummated in a few moments, it may take hours to grade a small stack of heterogeneous bills. The costs arising from non-fungibility may be so high that criminals will prefer to use relatively bulky $50 bills which, though possessing higher storage costs, will not be plagued by the requirement that each note be closely analyzed for quality.

So in the end, even if criminals ignore a central bank's deadline to tender notes for cancellation, they will eventually cease using the highest denomination notes through a more roundabout route. A central bank's renouncement of both its role as enforcer of the largest denomination's peg to other notes as well as its commitment to tend to that note's quality will set off forces that drive the purchasing power of those notes down to the cost of paper and ink, at which point they will be as good as demonetized.

Having settled whether a central bank can demonetize its highest value note, should it? That's an entirely different post. Or we can hash it out in the comments.

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PS. An alternative story to a Somali-style hyperinflation is an Iraqi-style deflation. See Tony Yates on Twitter. I've written about the odd case of the Iraqi Swiss dinar here. How likely is an Iraqi scenario? Criminals would have to assume that a future monetary authority, maybe even the Fed itself, reverts its decision and undertakes to adopt orphan $100 bills as a liability at a price consistent with their previous purchasing power. This would give $100 bills a fixed value in the present.

PPS. On the topic of altering the relationship between high denomination notes and other notes, see my posts on high value note embargoes.