Small steps, not a large leap, towards less black money & more digital money

 We are more than thirty days into Narendra Modi's demonetization campaign, and while many of the commentators I follow say that it is admirable of Modi to try to reduce the role of black money (wealth held by tax-evaders and criminals) and increase digital money adoption, most say that demonetization is not the way to go about it.

In short, the idea behind Modi's demonetization is to require everyone who owns old 1000 and 500 rupee notes to bring them to a bank before year-end for conversion into new banknotes or to be deposited into an account. By forcing Indians to re-familiarize themselves with dormant accounts, or open new ones, the architects of the plan hope that India's reliance on cash as a medium of exchange will be reduced. Any amounts above the ceiling require proper documentation. Those who own large amounts of cash for undocumented reasons, either because they are evading taxes or engaging in criminal behaviour, will therefore be unable to make the switch, their money expiring worthless by year's end. Having been taught a lesson, they may choose to permanently move some of their operations into the official sector.

Kaushik Basu, World Bank chief economist from 2012-2016, is particularly pessimistic about the policy, noting that while he agrees with the Reserve Bank of India's estimate that the economy will probably grow at 7.1% in 2016-17, from 7.6% estimated earlier, he expects a "huge drop" in the economy next year. "Money works like blood," says Basu, invoking one of the Physiocrat's classic analogies of the economy to the human body.

I certainly agree with Basu's use of the money-as-blood analogy, but my hunch is that temporary media of exchange will spring up to take the at least some of the space heretofore occupied by Modi's demonetized banknotes. My mental model for understanding demonetization is the Irish bank strike of 1970. For six months banks were shuttered, Irish citizens entirely cut off from their bank accounts. Cheques could not be deposited, nor could the central bank use the branch banking system as a means to get paper money into the economy.

India can cope without cash for a few days. In 1970, Irish banks closed for six month: the economy did just fine. https://t.co/TB8n53wqal pic.twitter.com/qXcw3EEc9v

— JP Koning (@jp_koning) November 14, 2016

Rather than suffering a huge blow, the Irish economy continued to function as it did before. Into the void vacated by banks and cash, post-dated cheques emerged as a the economy's blood, its circulating medium of exchange, with pub owners acting as informal credit evaluators.

Like Ireland in 1970, India suddenly finds itself deprived of a large portion of its money. In the place of 1000 and 500 rupee notes I expect informal credit to take some of its place, the effects on the economy therefore not being as devastating as Basu hints. See for instance this:

While many commentators are already declaring the demonetization to be a success or a failure, we won't have a good sense of this for several years. What sort of data should we be evaluating along the way? One of the effects we'd expect to see in a successful policy is a long-term reduction in the usage of cash, both as licit users of banknotes are diverted into the banking system and illicit users, burned by the forced switch out of old 1000 and 500 rupee notes, migrate out of the underground economy into the official economy. This should be reflected in data on India's currency in circulation, an attractive indicator in that is simple, accurate, not subject to revision, and comes out on a weekly basis. You can download the data here under the section 'Reserve money'.

The chart below shows the number of rupee banknotes outstanding going back to 2001. Prior to the demonetization, cash had been growing at a rate of 14-15% per year, as illustrated by the blue trend line. Since then you can see that there has been a huge collapse in quantity outstanding as Indians queue to deposit their cash in the banking system. At the same time, the Reserve Bank of India (RBI) hasn't printed enough new 500 and 2000 rupee notes to meet demand.

Cash in circulation will inevitably rebound in 2017 as the RBI catches up to demand by printing new rupees. If cash in circulation jumps back to the pre-demonetization level of ~18 trillion rupees and proceeds to readopt its growth path of 14-15%, than the demonetization will have failed to generate the desired effect. Despite suffering through queues and a relatively sluggish period of aggregate demand, Indians will have returned to their old habits, the whole demonetization campaign being a waste of time and effort.

But if cash in circulation only retraces part of the rebound, say rising to 16 trillion rupees by mid- 2017 (it is currently at ~10 trillion), and then sets out on a new and lower growth path (say 12-13%), then it will have achieved at least some of the desired effect. A new growth path starting from a lower level would imply that the demonetization has been successful in modifying the behaviour of licit cash users (i.e. converted them into digital money users) while driving illicit users of cash into the official economy.

My hunch is that of these two possibilities, the second is more likely: India will see a reduction in the growth path of rupee banknotes starting from a lower plateau. That being said, I find myself sharing many of the worries that Basu and other commentators have. Such a large and aggressive demonetization is a risky way to achieve the twin goals of broadening India's official economy and increase electronic money use. In order to catch people by surprise, much collateral damage must be inflicted, including time wasted in lineups and trades that go unconsummated due to a lack of cash (informal credit as in the case of Ireland not being able to completely fill the void). Suyash Rai makes a convincing argument that a demonetization of this size intrudes on property rights and rule of law.

Despite the chaos it has created, I still feel that the demonetization will make India at least a bit better off than before. However, other nations with large underground economies and low digital money uptake should be wary of copying India's example, waiting at least three or four years to gauge the final outcome. Rather than Modi's risky shock-and-awe approach, a better way to solve the problem is through a series of small and gradual measures. One of these steps might include implementing the approach Kaushik Basu writes about in his 2011 paper Why, for a Class of Bribes, the Act of Giving a Bribe should be Treated as Legal. See my post here for a full explanation.

Here's another incremental maneuver. Instead of imposing a short period of time for switching out of a limited quantity of 1000 and 500 rupee notes, why not allow three or four years for unlimited amounts of notes to be converted—but design the new notes to be 40% larger than the demonetized ones, as Peter Garber suggests, thus making it harder for Indians to store and handle cash?

Another step would be to copy Sweden which, thanks to several policies enacted over the last decade or so, is the only nation in the world with declining cash in circulation. One reason: retailers are required to use certified cash registers that prevent cash-induced tax gas. The Swedes have also adopted tax policies that encourage reporting of activities that typically remain in the unofficial economy, as I explain here. I also recently learnt from Miles Kimball that the Riksbank, Sweden's central bank, privatized the banknote distribution system in the 2000s, the effect being to end the subsidization of note transportation. If banks must bear the true (and higher) cost of moving notes around India, then this will be passed onto their customers, who in turn will react by switching into cheaper digital alternatives. I plan to write about this next week.

The advantage of many incremental steps towards increased digital money usage and a smaller underground economy is that should one step go bad, the blast radius will be small. One large Modi-style step might get you there faster, but if it goes awry, it risks upending the entire effort.

Should we legalize the act of paying a bribe?

From the website IPaidaBribe.com

A few months ago  I stumbled on Kaushik Basu's fascinating and readable 2011 paper Why, for a Class of Bribes, the Act of Giving a Bribe should be Treated as Legal. In the context of Narendra Modi's massive demonetization campaign, which has as one of its goals a reduction in corruption, I thought it was a timely moment to shine the spotlight on Basu's idea.

To reduce bribery, the act of giving a bribe should be legalized, suggests World Bank Chief Economist @kaushikcbasu https://t.co/xORxMAjcNq pic.twitter.com/bqOI0uOI36

— JP Koning (@jp_koning) September 25, 2016

One reason that bribery often goes undetected by authorities is that the bribe giver and the bribe taker are incentivized to cooperate with each other in order to keep a bribe secret. After all, the law typically treats both parties as equally guilty—work together and no one gets in trouble. Basu's idea is to upend this symmetry by having the bribe giver face a different set of consequences than the taker should the bribe be made public. Once they face different fates, the motivation that the giver and taker have to cooperate will disappear, or at least be diminished, making it easier for the authorities to cut down on bribery.

In the case of a specific kind of bribery, harassment bribes, Basu proposes completely legalizing the act of giving a bribe while maintaining the prohibition against the taking of a bribe. Harassment bribes are amounts that must be paid to get government services to which one is legally entitled to, say like an official who requires a 'gift' before stamping a document or a teacher who won't correct his/her students' final exams without passing around a hat.

In addition to granting the bribe giver full immunity, Basu also wants to implement a requirement that the taker, once convicted, pay the giver back. So if they successfully offer a bribe and then report it, not only does the bribe giver get the required service that the official had been withholding—they also get the full amount of the bribe returned to them. Knowing that he/she can no longer count on a giver's cooperation post-bribe, the bribe taker will now suspect that all bribes offered and solicited will be made public after the fact by the giver, leading to prosecution. Far safer for the taker to simply stop asking for or accepting bribes.

What about other types of bribes, say like a bribe paid to win a government contract? Here Basu suggests that while the giving of this sort of bribe should not be legalized, the giver should face a more lenient penalty than the taker so as to reduce their motivation to collude.

A policy of allowing bribe givers to tell on bribe takers can backfire, as Basu points out in a more formal paper. Say that a government legalizes the act of giving a bribe, but that the probability of a bribe-giver's information being acted upon by the government is low (perhaps a very high bar for conviction has been set or the department for registering cases of bribery is not sufficiently responsive). In this case, the expected penalty for bribe-taking remains small enough that bribery will not be abolished. Rather, average bribe sizes will rise since government officials will require more compensation to make up for the odds of being detected. Since the same nations that suffer from bribery may be the same ones that fail to run effective departments for taking complaints about bribery and verifying them, the odds of policy failure are not small.

Another problem with this scheme is that it might encourage citizens to blackmail government officials. After all, once a bribe-giver has lured an official into accepting a bribe, he/she can now turn around and tell the official that without some form of compensation, the bribe will be revealed. In response to this, Basu notes wryly that "there is nothing fool-proof in economic policy design," but also suggests increasing the punishment for blackmail.

If the idea of legalizing bribe-giving seems odd on first pass, just think of it as a whistle blowing rule, say like the one recently implemented by the SEC. Whistle-blowing laws are designed to break the psychological incentive for employers to go along with their rule-breaking employees. After all, deviating from an employer-enforced consensus can cause a lot of stress. An offer of financial aid may go some distance to alleviating what is sure to be a difficult experience. In the same way that Basu's legalizing of bribe-giving deputizes bribe givers to come forth and help the authorities pinpoint fraud by government officials, compensation for employees deputizes them to pinpoint corporate fraud.

As I pointed out in this post, Modi's demonetization is a gamble. Sure, it could work out magnificently. But at what cost? With no academic literature documenting the effect of aggressive demonetizations on black market activity, it's hard to know what to expect. While my sense is that the demonetization will probably enjoy some degree of success, a series of incremental changes—including a legalization of bribe-giving (for which their exists a growing body of empirical literature)— would be a far more certain, albeit less dashing, strategy for encouraging growth in the official sectors of developing nations.

A 21st century U.S. trade dollar

"America's only unwanted, unhonoured coin." 

- John Willem on the silver trade dollar.

The inspiration for this post comes from the old trade dollar, a U.S. silver coin that was minted in the 1870s and 1880s for the sole purpose of circulating in China. Taking the trade dollar as a model, I'm going to discuss the idea of converting the U.S. $100 bill into a trade bill; i.e. to limit it to foreign and not domestic usage.

Why bother modifying the $100 in this way? While not entirely convinced, I do lean towards Ken Rogoff's idea of getting rid of high denomination banknotes like the Canadian $100, the Swiss 1000 franc, and the Europe's €500. These bills are used primarily by criminals and tax evaders; their removal will make these activities more costly. The public's licit demand for a private means of payment can be met by low denomination notes, as can the necessity for a convenient physical payments medium on the part of the unbanked.

But as I wrote here, the Federal Reserve's $100 is categorically different from the above banknotes. The dollar plays a special role as the world's backup medium of exchange and unit of account. Abolish the $100 and not only will those dollarized countries already using U.S. banknotes (many of them poor) be hurt, but so will the desperate citizens of foreign countries who might try to flee to the dollar in the future due to the awful monetary policies of their leaders, usually dictators.*

By converting the $100 into a trade bill, everyone can have their cake and eat it too. Like the old silver trade dollar, the $100 trade bill will be barred from playing a role in the U.S. economy, thus doing damage to the domestic underground economy. But it will be free to be used in places like Venezuela which, thanks to misgovernance, are in urgent need of a better monetary standard.

To help determine the structure of a modern $100 trade bill, let's explore the design of the 19th century silver trade dollar. China had a long history of using silver as money, and as trade with the west grew the Spanish silver dollar—minted in Mexico—had become quite popular with Chinese merchants. U.S. traders were penalized as they had to acquire Mexican dollars at a premium to the coin's intrinsic silver value in order to do business with China. Enter the trade dollar. The idea was to introduce a U.S. equivalent to the Mexican dollar in order to help out U.S. merchants, who would no longer have to pay a premium. The trade dollar would also provide domestic silver producers, an important political constituency, with an outlet for their production.

While U.S. legislators liked the idea of having U.S. silver coins circulate overseas, they did not want the trade dollar to be used in the U.S. After all, the U.S. was in the midst of giving up the old bimetallic standard (silver and gold) in favour of a gold standard, and a new silver coin might interfere with this process.

Thus, we arrive at the Coinage Act of 1873, which simultaneously took the U.S. off of silver (by ending the free coinage of silver) while also introducing the trade dollar. To ensure that the trade dollar would not be "made a part of or be in any way confounded with our monetary system," its legal tender status was limited to $5 i.e. no domestic debt could be extinguished with more than $5 in trade dollars (for a review of legal tender, go here). To further hurt its domestic usefulness, this legal tender status would be completely revoked in 1876.

While the trade dollar was well-received in China (most of them were chopped), it wasn't entirely successful in staying out of domestic U.S. circulation. According to Garnett, of the $35.9 million in trade dollars coined, $29.4 million were exported. Of this amount, $2.1 million returned to the U.S., joining the $6.6 million that had never left the country.

It's important to understand why trade dollars sometimes stayed in the U.S.—after all, the idea of a trade bill simply won't work if $100 notes continue circulating in the U.S. There seems to be two reasons for this. From 1873 until 1876, trade coins still had a limited value as legal tender. At first, this wasn't an issue. Since the intrinsic value of the coins' silver content exceeded their official legal tender value, it made little sense for Americans to use them to settle local debts—debtors would be effectively overpaying if they did so. However, as silver prices fell through the 1870s the official legal tender value of trade dollars began to exceed their intrinsic value, at which point it was profitable for debtors to pay off their bills in overvalued silver trade dollars. This would have diverted trade dollars from China in order to meet local demand.

Secondly, speculators began to buy trade dollars in China and bring them back home on the expectation that the U.S. government would eventually redeem them at their original value of $1, even as they traded at around 80 cents on the dollar. This belief was eventually realized in 1887 when Congress compelled the government to redeem all trade dollars at par.

So with these design flaws in mind, let's design our $100 trade bill. To begin with, on January 1, 2017 the U.S. government will announce  its intention to rescind the legal tender status of $100 bills. That means the $100 can no longer be used by a debtor to discharge any U.S. debt. Legal tender status must be entirely rescinded to avoid the mistakes of the trade dollar.

Next, the Federal Reserve announces that after a certain date (say January 1, 2019), all domestic deposits and withdrawals of $100 notes will be illegal. Until then, the public enjoys a two-year window for bringing bills into banks or Federal Reserve branches for conversion into $20 bills or deposits. To prevent local hoarding of $100 bills, the domestic closure of the "$100 window" must be perceived to be permanent. Remember that trade dollar inconvertibility was perceived to be temporary, thus encouraging domestic demand. Likewise, if they anticipate a re-opening of the "$100 window," Americans will simply keep their $100s at home.

Banning local redemption will likely force all local retailers, wholesalers, and other businesses to stop accepting $100 bills. A retailer like Walmart that receives a $100 bill during the course of business will have to ship it overseas to be spent or deposited, and that would be quite expensive. Likewise, licit person-to-person exchanges of $100s will be crimped. Lacking domestic acceptance by banks and retailers, the $100 will have no liquidity, and regular people will no longer be willing to accept them.

For these same reasons, illicit domestic usage of $100s will suffer. Since no legitimate businesses will accept them, criminals won't be able to spend $100 notes into the local economy. To launder $100 bills, it will now be necessary to send them overseas for deposit into foreign banks. This will impose significant handling costs on money launderers, especially if the government institutes laws that limit large cash exports. These handling costs will  probably be high enough to force domestic illegal currency users to migrate to $20 bills as their preferred medium.

While domestic usage of $100s will rapidly decline, foreign-based banks will be completely free to allow deposits and withdrawals of $100 banknotes, much as they do now. To get $100 notes shipped from the U.S., foreign banks will have to put in orders with a Federal Reserve bank (they tend to prefer the New York Fed's cash office and, in the West, the San Francisco Fed's Los Angeles cash office). To redeposit $100 bills, they will have to send them by plane back to New York.

This setup should be sufficient to flush most $100 bills out of domestic circulation, forcing U.S.-based criminals and tax evaders to fall back on less convenient $20s. And just as the trade dollar successfully met Chinese demand for silver money, the $100 trade bill will meet Panamanian, Zimbabwean, and other foreign demand for U.S. high denomination cash.

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*Rogoff believes that a policy of removing high denomination notes should only be enacted by developed nations. But since so many undeveloped nations use the dollar, Rogoff is being inconsistent in calling for an end to the $100.

To read more about U.S. trade dollars, here are some good sources:
A Trade Dollar Song and Chorus, 1883 (link)
Collecting Trade Dollars (link)
The History of the Trade Dollar (link)

The British (link), Japanese (link), and French (link) also issued trade dollars

Milton Friedman wrote an excellent account of the switch from bimetallism to the gold standard (pdf).

A modern example of Gresham's Law

Sir Thomas Gresham

Anyone who makes an effort to study monetary economics quickly encounters the concept of Gresham's law, or the idea that bad money can often chase out good. Gresham's law is usually used to explain the failures of bygone monetary systems like bimetallic and coin standards. But the phenomenon isn't confined to ancient times. I'd argue that a modern incarnation of Gresham's law is occurring right now in Zimbabwe.

Zimbabwe's stock market has blown away all other stock markets by rising 30% in the last month-and-a-half. The chart below compares the Zimbabwe Industrial index to the U.S. S&P 500, both of which are denominated in U.S. dollars. I'd argue that the extraordinary performance of Zimbabwean stock is an instance of Gresham's law. With the imminent arrival of newly printed Zimbabwean paper money, known as bond notes, "bad" paper money is poised to chase out "good" money, stocks being one of the few places where Zimbabweans can protect their savings.

What follows is a quick summary of bond notes (alternatively, read my two earlier posts). The Mugabe government, which began discussing the idea of a new paper currency earlier this year, says that it will issue low denomination bond notes into circulation before the end of the November. Recall that Zimbabwe has been using U.S. dollars since 2008 after a brutal hyperinflation destroyed the value of the local currency. The regime claims that a $1 bond note will be worth the same as a regular $1 Federal Reserve note. It says it has received a U.S. dollar line of credit from the African Export-Import Bank that will guarantee the peg.

Enter Gresham's law, which says that if two different media circulate, and the government dictates that citizens are to accept the two instruments at a fixed ratio—say via legal tender laws—then the undervalued medium will disappear leaving only the overvalued one to circulate. So called bad money drives out good.

Medieval coinage systems were often crippled by Gresham's law. For instance, say a new debased silver penny was introduced into circulation along with existing pennies. Because it contained a smaller amount of silver, the new penny was worth less than the old. However, legal tender laws required that all pennies be accepted without discrimination in the settlement of debts. Medieval debtors would thus always prefer to discharge debts with new pennies rather than old ones since they would be giving up less silver. The result was that only "bad money," or debased coinage, circulated. Because "good money," or undebased coinage, was undervalued, people either hoarded it, sent it overseas, exchanged it on the black market at its true value, or melted it down.

The same conditions that created Gresham effects in medieval times are emerging in modern day Zimbabwe. Rather than two different medieval coins, we've got two different types of dollars; bond notes and regular U.S. cash. The next ingredient for Gresham's law is a decree that dictates the rate at which people are to accept the two instruments. In Zimbabwe's case, the government has already declared that bond notes (once they appear) are to be legal tender along with U.S. Federal Reserve notes, which means that Zimbabwean creditors will have to accept bond notes at par as a means of discharging all debts, even if they'd prefer the genuine thing.

Since a chequing deposit is a debt incurred by a bank to a depositor, this means that Zimbabwean banks can—in theory at least—meet depositors' demands for redemption by providing bond notes. So a Zimbabwean bank deposit is no longer just a claim on actual dollars, but a claim on some mysterious as-yet unissued Zimbabwean government liability.

The last ingredient for Gresham's law is an overvaluation of one of the two media. In Zimbabwe, this will most likely occur as the market value of bond notes falls below that of genuine U.S. dollars. While many countries maintain successful currency pegs to the U.S. dollar, they have the resources to do so. I'm skeptical that the isolated and corrupt Mugabe regime has the resources to pull a peg off.

Bond notes have yet to be issued, but because existing bank deposits—or electronic dollars—are likely to be payable in this new paper currency, we can think of deposits as a surrogate for the bond note. The first bit of evidence that Zimbabwe has run into Gresham's law is that physical U.S. dollars are beginning to disappear from circulation, replaced entirely by electronic dollars. Why might this be happening? Start with the assumption that Zimbabwean bank deposits have become "bad," meaning they are worth less than actual physical dollars. If a Zimbabwean citizen needs to buy $100 in groceries, and the grocer is required by law to accept deposits and cash at the same rate, our citizen will naturally spend only overvalued deposits and hoard "good" and undervalued cash.

In fact, we have direct evidence that deposits have become "bad". In the black market, dealers will only sell physical cash at a premium. I've seen anywhere from 5% to 20% mentioned.

More evidence is provided from the stock market. The shares of Old Mutual, a global financial company, trade on both the Zimbabwe Stock Exchange (ZSE) and the London Stock Exchange (LSE). Because investors have the ability to deregister their shares from one exchange and transfer them for re-registration on the other, arbitrage should keep the prices of each listing in line. After all, if the price in London is too high, then investors need only buy the shares in Zimbabwe, transfer them to London, sell, and repurchase in Zimbabwe, earning risk-free profits. If the price in Zimbabwe is too high, just do the reverse

Oddly, Old Mutual trades in London for around $2.30 per share (after converting into US dollars) whereas it is valued at $3.20 in Zimbabwe. Here's the article that first tipped me off to this. As the chart below shows, this rather large gap has progressively emerged as the introduction of bond notes becomes more likely. Why is no one arbitraging the difference by purchasing Old Mutual in London for $2.30, then transferring it to Zimbabwe to be sold for $3.20? The large discrepancy likely reflects the growing risk that any dollar sent to Zimbabwe is likely to be trapped and re-denominated into a bond note.

The ratio of the two Old Mutual listings implies that the exchange rate between genuine U.S. dollars and dollars held in Zimbabwe is around 0.72:1, i.e. one Zimbabwean U.S. dollar deposit is only worth 72 cents in genuine U.S. dollars. While transaction costs and other frictions may explain part of the gap, this is still an incredibly wide discount.

Those with long memories will remember that during Zimbabwe's last hyperinflation, the cross-rate between Old Mutual listings was a popular way to measure the true exchange rate between the hyperinflating Zimbabwe dollar and the U.S. dollar. The official rate maintained by the Reserve Bank of Zimbabwe was not the true rate as it dramatically overvalued the Zimbabwe dollar. In the chart below of the hyperinflation, pinched from a paper by Steve Hanke, the Old Mutual Implied Rate—or OMIR—appears along with the black market rate for U.S. dollars. (I once discussed the OMIR here. The same trick was used in Venezuela using ADRs.)

From Hanke and Kwok

Once all the ingredients for Gresham's law are in place, inflation is never far behind. Because U.S. dollars are being undervalued, Zimbabweans will refuse to buy stuff with anything other than overvalued deposits. If they don't update their sticker prices, retailers will soon discover that they are receiving fewer real dollars than before. To maintain the real value of their revenues, they will have to mark up their prices, thus compensating for the fact that only "bad" money is flowing into their tills.

While retail prices are usually sticky, financial prices are not. And that may be why we've seen such a huge jump in Zimbabwean stock prices but little movement in Zimbabwean consumer price inflation. With Gresham's law beginning to push good money out of circulation, nimble owners of Zimbabwean shares are demanding a higher share price from potential share buyers in order to compensate for the risk of holding soon-to-be issued bond notes. Less nimble retailers have yet to demand this same compensation from their customers. Don't expect this to last; consumer price inflation can't be too far behind asset price inflation.

Modi's demonetization: chaos is a feature, not a bug

Prime Minister Narendra Modi's aggressive demonetization of the 500 and 1000 rupee note is causing plenty of chaos in India. A general shortage of money has emerged, massive lineups have formed at banks, and cash-based business has come to a standstill. All this would seem to indicate that the process has been ineptly carried out. But I'd argue that the problems listed above are exactly what one should expect of a well-designed aggressive demonetization. Chaos is a feature, not a bug.

As I mentioned in my previous post, a regular demonetization isn't meant to harm anyone. To ensure that no one is left behind, legacy note are gradually replaced with new ones, a process that often takes decades to carry out. See for instance the below pamphlet published by the Bangko Sentral ng Pilipinas (BSP), the Philippines central bank. It shows a slow and staged approach to replacing old peso notes with new ones. The goal of an aggressive demonetization like Modi's is exactly opposite: to leave people behind. To get this effect, the demonetization has to begin suddenly and end quickly.

Why didn't Modi make more preparations for the retirement of the Rs 500 and 1000 note? For instance, to reduce lineups at banks and ATMs the Reserve Bank of India could have begun supplying banks with extra 100 rupee notes several weeks ago in order to ensure that there was sufficient supply come November 8. And maybe the RBI could have nudged banks to purchase more safety deposit boxes to hold cash and hire extra staff to handle the rush.

Or take ATMs. One reason for lineups is that with the demise of the 500 and 1000 note, ATMs are running at a fraction of their capacity.  Indian ATMs have four "cassettes", each holding around 2000 notes. Two cassettes are typically configured for the old 500 rupee note, one for the legacy 1000, and one for the still-existing 100. They typically do not dispense 50s. Thus the maximum an Indian ATM can provide in a post-demonetized India is one cassette worth of 100s, or 200,000 rupees (US$3,000). If everyone in the lineup removes 2000 rupees, the daily limit, that means just 100 people can be served. That's peanuts.

To get ATMs up to full capacity, all four cassettes need to be dispensing some combination of new 500 notes, 2000 notes, and/or existing 50 and 100 notes. The problem is that each ATM cassette need to be re-calibrated to hold a certain denomination since notes are not uniformly shaped. With every single ATM in the country needing to be modified, and only so much staff trained to do so, it's taking a lot of time.

So why didn't the government begin working with ATM companies a few months ago to make all the modifications in time for November 8? This would have surely reduced the awful indignities that regular Indians must undergo as they wait for hours to withdraw cash.

Unfortunately, any attempt to modify ATMs ahead of time would have caused Modi's aggressive demonetization to fail. In order to inflict maximum damage on those who depend on "black money" (i.e. income obtained illegally or not declared for tax purposes),  an aggressive demonetization needs to be executed suddenly. If rumour gets out that a demonetization is about to occur, the element of surprise will be lost. Those working in the underground economy will simply switch their high value banknotes into low ones ahead of the demonetization, thereby avoiding being damaged. And of course it is the rich, not the poor, who have the best networks for gleaning information. To reduce the potential for information leaks, the number of people 'in the know' needs to be kept to a minimum, and this means that all large-scale preparation—including a huge reconfiguration of the ATM network—must be avoided.

So if you support the idea of a demonetization—specifically one that is designed to hurt the underground economy and, in so doing, draw people into the taxed economy--then you should just accept that this was always going to be a messy affair. If it had been a smooth one, then that would have been a sign that it wasn't being effective.
  
Once the dust is settled, India will be made better off by the demonetization. While many Indians in the underground sector will grudgingly comply and deposit their funds in an account only to withdraw that same amount in new notes later, others will keep their funds in the banking system. To change, people sometimes need to be prodded. This should be a shift in the right direction given that a banked economy is stronger than an unbanked one.

My back of the envelope calculation tells me that the demonetization will generate real pain on the underground economy. Consider that there are Rs 12.2 trillion worth of 1000 and 500 notes in circulation, or US$181 billion (source). Assume that 40% of these notes, or Rs 4.9 trillion (US$72.7 billion) circulate in the dark economy and lack a paper trail. Further assume that thanks to Indian ingenuity, or jugaad, half of the black money will sneak through the demonetization. That still leaves the remaining Rs 2.4 trillion, or US$36 billion, stranded. That's a painful writeoff!

To build and effectively run a nation, a government needs to be able to efficiently collect taxes. Many will shrug off the immense losses caused by the demonetization and go back to using cash as a way to evade to avoid the tax man, especially now that the government has (somewhat puzzlingly) introduced a new 2000 rupee banknote. But a large enough contingent will migrate to the tax-paying economy for good. Once bitten, twice shy.

Aggressive demonetizations

Prime Minister Narendra Modi surprised Indians today by announcing that India's highest denomination notes, the 500 and 1000 rupee, will cease to be legal tender. On first blush, India seems to be enacting Ken Rogoff's idea of cutting down on criminality and tax evasion by phasing out high-denomination notes, which I recently discussed here.

But this isn't the case. Rather than removing the Rs. 500, the Reserve Bank of India is replacing it with a new bill. Furthermore, it will also be issuing a Rs. 2000 note, a new highest denomination note. What India is doing is enacting what I'll call an aggressive demonetization. I'd argue that this is an alternative (though not mutually exclusive) idea to Rogoff's. Both schemes are intended to create a logistical nightmare for money launderers; but whereas Rogoff's entails altering the denomination structure of banknotes to get this effect, Modi's aggressive demonetization keeps that structure intact while using note redemption and re-issuance as its lever.

Demonetizations are usually non-aggressive drawn-out affairs. For instance, when Canada announced that it would withdraw its $1000 note, it gave Canadians an eternal window to bring them in for redemption. The $1000 remains legal tender in Canada, meaning that it can be used to discharge any debt. As another example, take the euro. The introduction of the euro meant an end to all the national European currencies. While each of these currencies lost legal tender status in 2002, many enjoy an unlimited time frame for conversion into euros, including the Deutsche mark and Belgian franc. See below:

India's demonetization is an aggressive one because legal tender status is to be removed immediately and the time limit for redemption is incredibly tight and scripted. Here is Modi's announcement:

All details on the announcements made today can be found here. https://t.co/UoiCjCyupV #IndiaFightsCorruption pic.twitter.com/WKpgsdTcjg

— Narendra Modi (@narendramodi) November 8, 2016

To summarize, Indians have just a few weeks to exchange old notes for new ones at banks or post offices. Proof of ID is required and switches are limited to Rs 4000, around US$60. There is no size limit for directly depositing old notes in bank of post office accounts. But of course, this means that the depositor's identity will be known by the bank and transactions will be traceable. Deposits can be made at banks until the end of the year. After that date, the central bank will exchange old notes until March 31, 2017, although this will require some sort of declaration of origin.

The point of all this is to suss out anyone with large amounts of cash that has been earned from dubious sources. Say you've got one million paper rupees, worth around US$15,000. If you've got the receipts to show why you have that much cash, then you can safely bring it to the bank. But if you don't, you'll have to get rid of it as quick as you can by spending it, say on gold (or any other good). However, this will be an incredibly difficult task given the fact that there will be many other Indians trying to spend their undocumented Rs. 1000 and Rs. 500 notes on gold at that very same time, and only a limited number of gold dealers willing to accept them. After all, any gold dealer who accepts notes now inherits the same problem: what to do with newly-demonetized banknotes. Any gold dealer who starts to bring in larger-than-normal amounts of paper money to their bank for redemption will surely face questions. To compensate for this risk, gold dealers will either impose a large penalty on cash payments or they'll stop accepting cash altogether.

Some undocumented rupees will no doubt be successful in evading Modi's aggressive demonetization, but large quantities will be left stranded. Significant damage will have been dealt to anyone working in the underground economy.

As Tony Yates points out, the most aggressive demonetization in history was probably Saddam Hussein's recall of the Swiss dinar in 1993. Swiss dinars were Iraqi banknotes printed on high quality paper whereas dinars printed after the 1992 U.S. invasion were issued on shoddy and easily counterfeitable material. On May 5, Saddam announced that all Swiss dinars had to be turned into the central bank for an equivalent amount of post-war currency over a tiny six day exchange period. He then proceeded to close the border, preventing Kurds and other foreigners from making the switch. Huge amounts of currency was left stranded, although unlike the Indian situation it was foreigners, not criminals/tax evaders, who were the target. (I went into the Iraq story here. The Burmese kyat and North Korean won demonetizations of 1985 and 1999 were also quite awful, see here.)

If you think Modi's strategy is new, or confined to developing nations, think again. A few years ago, Sweden carried out out a (somewhat less) aggressive demonetization in order to catch illicit cash users. In 2012, the Riksbank announced that all  1000 krona banknotes without foil strips were to be declared invalid by the end of 2013 (each 1000 krona note is worth around $110). Until December 31, 2013, Swedes were permitted to get rid of 1000 krona notes by either using them to buy stuff or depositing them at a bank. To tighten the noose, no anonymous conversions of old notes into existing notes were permitted. Swedes had to have bank accounts, and therefore had to forgo their anonymity, in order to rid themselves of old currency.

Anyone who's seen Breaking Bad knows that laundering money takes time and patience. A Swedish criminal with ten million dollars worth of high denomination krona was suddenly faced with a significant problem; how to get this stash back into the legitimate economy within 400 or so days.

How tough was this challenge? We know that at the start of 2013 there were fourteen million 1,000 krona notes in circulation (worth 14 billion SEK, or US$1.6 billion). After the expiry date, the Riksbank noted that there were still some three million 1,000 krona notes that had not been redeemed, worth around $330 million. This gives a rough indication of the value of banknotes left stranded by criminals and tax evaders, around 25% of all notes outstanding.

After the December 31, 2013 deadline, the Riksbank itself offered to redeem invalid banknotes (it still does), albeit for a 100 krona fee. However, criminal and tax evaders have no doubt steered clear of this offer as the declaration form includes the following question:

Sweden is the only country in the world in which cash holdings are in decline. Might this have had something to do with the damage inflicted by the Riksbank's 2013 demonetization on the psyche of participants in the underground economy?

So let's compare the advantages of Modi's aggressive demonetization to Rogoff's abolition of high denomination notes. If an aggressive demonetization is chosen, then a central bank gets to enjoy high profits, or seigniorage, since it continues to issue an extended range of banknotes, unlike Rogoff's abolition. The more float, or 0% cash liabilities that remain outstanding, the more interest the central bank will earn on its bond portfolio. The central bank also earns significant earnings from 'breakage.' All illegitimate banknotes that never get redeemed are recognized as a one-time unusual gain on the central bank's statement of income. Finally, people engaging in legal activities who enjoy the anonymity afforded by high denomination notes still get to use them; they don't under Rogoff's abolition.

Unfortunately, an aggressive demonetization can only be effective for a little while. It's hard to see why people won't quickly re-adopt the highest denomination note as a medium for evading taxes and engaging in illicit activity. In response, the central bank will have to enact an followup demonetizations every few years, but of course the underground economy will do its best to anticipate these by moving into low-denomination notes or foreign paper whenever it suspects something is afoot.

To create a logistical nightmare for money launderers, maybe Peter Garber's idea beats Rogoff's abolition and Modi's demonetization?:

"Why not simply increase the physical dimensions of high-denomination notes without jumping through the flaming hoop of elimination? Before 1929, U.S. currency was 40 percent physically larger than it is now. Restoring that size or making it even larger would instantly work the wonders of decades of inflation. The iron law for subverting illicit economies: a percentage increase in physical note size is equivalent to the same percentage increase in the price level."

Thoughts on Rogoff's 'Curse of Cash'

The US$5000 banknote, destroyed in 1969 along with the $10,000, $1000, and $500 notes

With the publication of his new book The Curse of Cash, economist Ken Rogoff has ignited a big debate over the future of paper money. Both the book, which is packed with information and accessible to a mainstream audience, and Rogoff's series of blog posts are well worth reading, even if you already disagree with his premise that the way the world currently handles cash needs to be modified.

The key observation motivating Rogoff's book is this one: with $1.3 trillion worth of U.S. currency in existence, a back-of-the-envelope calculation says that the average four person family should be holding around $16,800 in cash. However, this simply doesn't reflect the personal experience of most Americans. Indeed, 2012 survey data shows that consumers generally report holding just $56 per person, leaving the majority of cash unaccounted for. Nor is this anomaly confined to the U.S. Given $78 billion in Canadian currency outstanding, a four person family in Canada should hold around $6,000. Instead, survey data shows the average person only holds a median $38 in their wallets. The same pattern occurs in Europe, Japan, Australia, and elsewhere.

According to Rogoff, much of the unaccounted cash is being held by those who participate in the underground economy, both by those engaged in criminal activity and those employed in legal activity (dentists, contractors, retailers, etc) who use cash as a way to avoid taxes. Rogoff's premise is that if we can alter the institution of cash, then maybe we can flush some of these people out of the underground economy and back into the legal, tax-paying economy.

The denomination structure of cash

Having read through many of the criticisms that Rogoff has received over the last few months, I've noticed that there is a tendency on the part of his opponents to frame this debate as an either/or one. Either keep cash and the personal liberty it provides—anonymity and uncensored access to the payments system—or sacrifice cash and in the process throw out that liberty.

This mischaracterizes the debate. Rogoff isn't advocating an end to cash or the liberties that go with it. Rather, he wants a modification of the existing denomination structure of banknotes such that the $100, $50, and $20 are removed while the $1, $2, $5 and $10 are left in circulation. Over the long-term, he proposes replacing these small bills with heavy coins. The set of personal liberties afforded by cash will be allowed to live on, albeit through the reduced convenience of small banknotes like the $10.

The term denomination structure refers to the top and bottom-most denominations issued by the monetary authority, the spacing between denominations, and the point at which the transition between coins to notes begins. As per Tyler Cowen's second law ("There is a literature on everything"), academics have been writing on the topic of optimal denomination structure for a few decades. The goal of this literature is to find the range and spacing of notes/coins that reduces the amount of monetary work that all participants in a currency system must engage in. By monetary work, I mean the effort that goes into printing money, carrying it, storing it, counting it, making calculations with it, paying with it, and breaking it into smaller amounts. If a denomination structure can be found that allows everyone do a little bit less work, society is much better off.

Rogoff takes the opposite approach. His abolition of large denomination banknotes is designed to increase rather than reduce the amount of monetary work that users of cash must engage in. After all, ten thousand dollars worth of Rogoff's preferred highest value note—the $10 bill—requires far more effort to count, store, and lug around than a hundred $100 bills.

Rogoff believes that the increase in monetary work brought about by a reduction in the purchasing power of the highest value note can be a useful filtering mechanism for improving societal welfare. Assume that there are "bad" and "good" users of cash, the former being criminals and tax evaders and the latter being regular people who want to enjoy the speed, anonymity, and convenience of paper money. "Good" cash users only need small quantities of notes from time to time and therefore will only be slightly inconvenienced by the increase in monetary work caused by a constriction in the purchasing power of the highest denomination note. "Bad" users tend to make regular use of large amounts of cash, and will therefore be severely affected by a constriction.

While Rogoff's abolition won't stop crime or tax evasion, it will surely make these activities trickier. This should in turn push activity out of the non-taxed underground economy into the legal economy.

Burdening cash is the status quo policy  

These ideas aren't entirely novel. In fact, I'd argue that since the 1800s, the U.S. has been implicitly adopting Rogoff's strategy of increasing the amount of monetary work involved in using cash. The chart below illustrates both the nominal and real value (in 2015 dollars) of the U.S.'s highest denomination banknote going back to 1871.

In general, the purchasing power of the highest denomination note has been gradually declining. This has been mostly due to the fact that even as inflation erodes the dollar's value, American monetary authorities have chosen to avoid introducing new higher value notes. Nor is the U.S. unique in this respect. Correct me if I'm wrong, but I can't think of a single developed nation that has introduced a higher denomination note over the last fifty years.

In the U.S.'s case, the decline in the purchasing power of the highest denomination note hasn't been entirely due to the combination of inflation and a lack of new large value U.S. notes. Take a look at what happened in 1969. Throughout the 19th century the U.S. Treasury was an issuer of $10,000 certificates, a practice the Federal Reserve would continue after its founding in 1913. However, on July 14, 1969 the Fed announced that it would put an end to this tradition by destroying all $10,000, $5000, $1000, and $500 denominations, leaving the $100 as the U.S.'s largest denomination. It did so on the very same day that Richard Nixon launched his famous war on drugs. Although the Fed claimed that its decision was motivated by the declining usage of large value banknotes over the previous two decades (PDF pg 624), the timing indicates that Nixon's crime push must have been a big reason.

So largely through a policy of benign neglect (i.e. by passively allowing inflation to eat away at its purchasing power), the U.S. along with most developed nations have been gradually increasing the workload involved in using the highest value note. Assuming inflation of 2%, by 2095 or so the US$100 will buy as much as the $20 does today. By 2130, it will buy as much as the $10 does today.

Rogoff isn't content with the gradual approach to increasing monetary work. He wants to add a one-time increase in the level of monetary work involved in using cash. This would involve a quick Nixon-style "tightening" of the filter, removing in one fell swoop all denominations above the $10 bill. Put differently, rather than waiting till 2130 for the $100 bill to be worth $10, he wants this event to happen now. Once a Rogoff-style high denomination notes abolition has been carried out, inflation will once again determine the rate of increase in the monetary work involved in cash usage.

So ultimately, the great cash debate isn't about cash vs. cashlessness. For decades developed nations have been gradually increasing the burden of using banknotes. Should we stick with the status quo or speed things up a little?

The case of Sweden

Rogoff makes one mistake in his book. As many people may know, Sweden is the only nation in which cash usage is in decline, a precedent Rogoff wants other nations to emulate. Several times in his book, Rogoff mentions that the Swedes have removed their highest denomination note, the 1,000 kronor, and that this removal helps to explain the nation's dramatic drop in cash usage. But this isn't the case. All that the Riksbank did was replace the old 1,000 kroner note in 2013 (which had Gustav Vasa on it) with a new Dag Hammarskjöld version. The 1,000 is still alive and kicking.

This puts Rogoff in a somewhat uncomfortable position. Some other policy than the one he prefers is at work in the very country he puts forth as an example for all to follow. I think I might know what this policy is. As discussed in this excellent post by Martin Enlund, the Swedes implemented a tax deduction in 2007 for the purchase of household-related services such as the hiring of gardeners, nannies, cooks, and cleaners. This initial deduction, called RUT-avdrag, was extended in 2008 to include labour costs for repairing and expanding homes and apartments, this second deduction called ROT-avdrag.

Enlund's chart shows how the decline in krona outstanding closely coincides with the timing of the introduction of RUT and ROT:

Prior to the enactment of the RUT and ROT deductions, a large share of Swedish home-related purchases would have been conducted in cash in order to avoid taxes, but with households anxious to claim their tax credits, many of these transactions would have been pulled into the open. Note the rise in RUT and ROT payments on Enlund's chart, for instance. Calleman reports that  the number of customers using registered domestic service companies rose from 92,000 in 2008 to 537,600 in 2013. Since the implementation of RUT and ROT, Swedish opinions on paying for undeclared work have changed dramatically. In 2006, 17% said it was completely wrong to to hire undeclared labour. In 2012, 47% felt it was completely wrong.

Using data from a survey of the general public conducted by the Swedish tax authority, the charts below show how much knowledge Swedes have about those around them engaged in tax evasion. In the bottom chart, the number of Swedes who are aware of businesses that are evading taxes has fallen from 27% in 2007 to just 9% in 2013. That is an especially large and fast decline. As the tax authority points out, RUT and ROT is the likely explanation.

Rogoff himself maintains in The Curse of Cash that the largest holdings of cash in the underground economy are due not to criminals but those engaged in legal work (like contractors) who are avoiding taxes. By cutting down dramatically on tax evasion among those engaged in household services and repairs, the RUT and ROT deductions may explain a significant chunk of the decline in Swedish currency in circulation.

This post has gone long enough, so let me get to my final point. I agree with Rogoff's general point that it makes sense to burden cash users with ever more work since this burden disproportionately falls on heavy users like criminals. But Rogoff hasn't yet convinced me that the status quo policy of gradually increasing the workload involved in cash usage (via inflation) needs to be sped up by a sudden removal of every bill above the $10. After all, the Swedes are setting an example of how a policy of gradualism can be twinned with tax policy in order to get some of the very effects that Rogoff advocates, namely pulling people out of the underground economy into the legal economy.

Is the Swede's approach better than Rogoff's high denomination note abolition? I'm not sure, I don't know enough about the economics of tax policy to arrive at a firm conclusion. But it seems to me that a more complete analysis of the real reasons for Sweden's cash miracle needs to be conducted before we go about killing the $20, $50, and $100.

How anonymous is cash?

Dutch 10 guilder note. Holland and Lebanon are the only countries to have issued banknotes with bar codes.

One of the interesting things that we've all learnt about Bitcoin is that it isn't actually anonymous, it's pseudo-anonymous. While anyone can deal in bitcoins without providing personal information like a phone number or photo ID, all bitcoin transactions are broadcast to the public. By analyzing these transaction patterns, it may be possible to flush a user's true identity out into the open.

Bitcoin is an attempt to digitally replicate many of the features of the old fashioned banknote, but even banknotes are to some degree pseudo-anonymous. Each banknote has a unique serial number on it. By tracking serial numbers, it may be possible to connect a note to a noteholder and thereby destroy their anonymity. The process of unveiling note users occurs most often in kidnapping cases. When their young son was kidnapped in 1932, the Lindbergh family paid a $50,000 ransom in non-sequential banknotes. In an effort to identify the kidnapper, a list of the serial numbers of notes used to pay the ransom was published in the New York Times and circulated in pamphlet form to banks all over the New York area. Anyone who found the note was to immediately alert the authorities, this information being potentially useful in helping to triangulate the guilty party:

Published list of banknotes the Lindbergh's used to pay the ransom

Kidnappers prefer to be payed in non-sequential numbered bills. The Lindbergh kidnapper is no exception, writing in one of several ransom notes: "Don't mark any bills or take them from one serial nomer [sic]." The reason for this is that it's easy for a bank teller to cross reference incoming notes against a list that contains an easy-to-remember range of sequential numbers. When serial numbers are randomized, the list becomes much harder for the human eye to parse; just try to work through the above example. The non-sequential nature of the ransom payment probably explains why only a few of the Lindbergh blacklisted notes were found...

...at least at first. The final pinpointing of the Lindbergh kidnapper really only became possible when Franklin D. Roosevelt decided to temporarily take the U.S. off the gold standard in 1933. Somewhat serendipitously, the authorities who were helping the Lindbergh family had decided to pay the 1932 ransom in gold certificates, a Treasury-issued instrument that was redeemable in a fixed quantity of gold. At the time, gold certificates circulated along with a motley crew of other private and government-issued note types including Federal Reserve notes, U.S. Notes, Federal Reserve Bank Notes, silver certificates, and National Bank Notes (see here).

As part of the process of going off the gold standard, Roosevelt issued Executive Order 6102 requiring all Americans to bring in their gold, gold coins, and gold certificates to be exchanged for Federal Reserve notes. The Lindbergh kidnapper would only tender a few of his gold certificates in 1933, perhaps worrying that bringing in all $50,000 at once would attract attention.

Subsequent to Roosevelt's Executive Order, gold hoarding became an illegal act. So when the kidnapper bought gas with a $10 gold certificate in September 1934, the gas station attendant—probably worried that he might not be able to deposit it—wrote the license plate of the car on the note. Three days later the station managed to deposit the note at its bank where it was successfully cross-referenced against the black list, a much easier process now that the population of gold certificates was so small. Bruno Richard Hauptmann, the kidnapper, had been unveiled.

Using serial numbers to unveil identity requires the cooperation of private banks as well as some luck, in the Lindbergh's case the coincidental alteration of the monetary standard. However, there is no reason that central banks themselves can't be aggressive in monitoring serial numbers. In 1973 the Dutch central bank, the De Nederlandsche Bank (DNB), set up the first real-time database of banknotes in circulation. All banknote serial numbers are registered in the database. As used banknotes are brought into DNB processing points each day, machines read their serial numbers and update the database to indicate that these notes are no longer in circulation. When these same notes are paid out to banks the next day, the system once again updates its database to indicate that they have re-entered circulation. Over time, the system gleans information about the paths taken by each individual note, including how long it stays in circulation and its geographical exit point. It also provides excellent protection against counterfeits. If the DNB detects two banknotes entering its system with identical serial numbers on the same day, then one of them is by definition a fake.

While many central banks were "intrigued" by the Dutch registration system none of them actually implemented the concept (see page 263 of pdf). As of 2012, the DNB  remains the only central bank to register banknotes on a daily basis, a fact which I find kind of shocking. Why have serial numbers if not for tracking? Decoration?

The upshot is that if you had to choose a place to be kidnapped, Holland would probably be it. As long as the serial numbers are recorded by the authorities before the ransom is paid, then the DNB's registration system can be mobilized to catch kidnappers. For instance, the DNB claims it was instrumental in catching the kidnapper of Gerrit Jan Heijn, an heir to the Albert Heijn supermarket empire, in 1987. When the kidnapper spent NLG 250 to buy groceries, the note was soon deposited at the DNB and read into the database, at which point authorities had enough information to trace it back to the commercial bank and then the supermarket.

Interestingly, there are a number of private banknote trackers on the internet, the most well known of which is Where's George. A user logs into the website and registers a U.S. banknote by entering its serial number. When someone else subsequently registers the same banknote, the ‘route’ of the bill is displayed. Where's George tracks around 266 million bills. EuroBillTracker, the equivalent for the euro, tracks around 160 million notes. Below is a map showing the "hits," or connections it has established over the last week:

Hits registered by EuroBillTracker

So cash is somewhat less than anonymous, or anonymous-ish, since behind the curtain an organization like the DNB may be recording serial numbers, and this data might be useful in learning about users' real life identities. By tracking serial numbers more robustly, the anonymity of cash can be further eroded. Imagine a Where's George world where each time a bills is used, the receiver is required to submit the serial number to a government-run central registry. If so, the banknote system would have attained the same level of pseudo-anonymity as bitcoin, where anyone is free to transact using banknotes but transaction chains are fully public.

We could go further and imagine a world where a central bank like the DNB requires that the circulation of high denomination banknotes, say the €200 note, be confined to 'legitimate' channels only. Cash is perpetually being withdrawn from the central bank, used in payments, and then redeposited at the central bank. To confine €200s to legitimate channels, the DNB would simply announce that it intends to limit redeposits to those notes that have fully verified transactions histories. Verification means that when someone receives a €200 note, they must register it by submitting its serial number to the central bank via an app along with some sort of proof of identity.

When someone fails to either register a note or provide adequate identification, that note effectively falls out of the system. After all, because the DNB won't allow a note with an incomplete chain of verified transactions to be redeposited, banks will refuse to accept any note that hasn't been registered by its current owner. And knowing that banks won't accept them, neither will retailers. Bills that have fallen through the cracks will only have value in an alternative black market where they'd likely trade at a large discount to legitimate notes. Incidentally, establishing a verification system for €200s is very similar to Ken Rogoff's idea of abolishing high denomination notes, except instead of withdrawing €200s, they'd be allowed to stay in circulation in 'cleansed' form.

Thanks to a distinctive earmark—their serial number—the anonymity of banknotes is never fully assured. While serial numbers are rarely used these days for tracing, who knows what might happen in the future. Privacy advocates can take some comfort in the fact that, unlike paper money, coins have no distinctive markings and are therefore capable of serving as a purely anonymous exchange medium. Unfortunately coins have a low value to weight ratio so lugging the stuff around is a pain. The Swiss and Japanese stand out here for issuing the highest value coins, the five franc coin and 500 yen coin respectively, each worth around US$5.

As for cryptocoin fans, tomorrow Zcash will be launching. Whereas the entire history of bitcoin transactions is public, Zcash succeeds in hiding everything about the transaction. That's true anonymity.

The strange mania for Swiss National Bank shares

The shares of the Swiss National Bank (SNB), Switzerland's central bank, have almost doubled since July, despite there being no real news. Yep, you read that right, the SNB is listed on the stock market. There are four other central banks with listed shares: Belgium, Japan, Greece, and South Africa. I discussed this odd group back in 2013.

Why are SNB shares catapulting higher? This is a staid central bank, after all, not a penny stock.

Let's look at the fine print. Swiss National Bank shares aren't regular shares. To begin with, the dividend is capped at 6% of the company's share capital. The SNB was originally capitalized back in 1907 with 25 million Swiss francs, an amount that hasn't changed in 109 years. Which means that the dividend is, and always has been, limited in aggregate to a minuscule 1.5 million francs per year (about US$1.5 million). Because this amount must be divvied among the 100,000 shares, each share gets just 15 francs per year.

The SNB has faithfully paid this 15 franc dividend since its founding (apart from 2013, when it was omitted due to massive capital loss on its gold holdings). For instance, here it is paying the dividend throughout the 1980s:

Once the 1.5 million franc dividend is paid, Swiss law dictates that all remaining profits get sent to the Swiss central government and the cantonal governments. It further stipulates that if the SNB is to be liquidated, shareholders will only receive a cash payment equal to the nominal value of their shares. This means that if shares are trading for 1025 Fr, but there is residual firm value (after paying debtors) of 10,000 francs per share, well too bad—shareholders only get 1025 Fr.

Given these peculiar details, an SNB share isn't really equity; it's best thought of as a perpetual government bond with a 6% coupon, sometimes known as a consol. It throws off 15 francs per year for the rest of time. With the SNB as issuer, these securities are pretty much risk-free.

The math behind SNB shares is straightforward. Just use the Finance 101 formula for a perpetual bond, PV=c/r, or present value (PV) equals yearly cash flow (c) divided by yield (r). With annual interest payments of 15 francs and SNB shares trading at 2000 Fr, the yield comes out to 0.75%.

Here's what I think explains the rise in SNB shares. In July, an odd thing happened. The yield on the Swiss 50-year bond, the closest instrument in Switzerland to a perpetual government bond, fell below 0%. SNB shares (i.e. perpetual bonds) were themselves trading at around 1000 francs at that point for a yield of 1.5%. A few large investors probably began to ask themselves: Why the devil are we accepting a negative nominal return on our ultra long-term government bond portfolio if these other government bonds, which happen to be issued by the central bank and masquerade as shares, still have a positive yield? And so they started to buy SNB shares in quantity, driving the price up and the yield down.

This sort of thinking explains why SNB shares have risen, but not necessarily the explosive nature of the move. The shares haven't just risen by a few bucks, after all. They've almost doubled!

Let's take a closer look at the perpetual bond formula. If nominal interest rates fall from 1.5% to 0.5%, a fifty-year bond with a par value of 1000 francs and a 15 franc yearly coupon will rise from 1000 to 1,441 francs. Not bad, but compare that to a perpetual. For the same decline in rates, SNB shares will double in value from 1000 to 2000 francs. As rates continue to fall towards zero percent, the price of a perpetual goes parabolic. At 0.25%, the perpetual will be worth 6000 Fr, at 0.1% it trades at 15,000 Fr, and at 0.01% it sells for 150,000 francs. At 0.001%, they'd be valued at 1,500,000 francs each!

In the table below, I've illustrated the relative dynamic of a 50-year bond and a perpetual as rates fall to zero.

Price of a 50-year bond and perpetual at various interest rates

At the limit of 0%, SNB shares will have an infinite price. If all existing and yet-to-be-issued government fixed term bonds are guaranteed to lose money over the course of their existence, but there exists a government security that is guaranteed to perpetually offer a positive cash flow, then an investor will pay *any* amount of money to own those cash flows. There is no price to which SNB perpetual bond can rise that chokes off their demand.

The behavior of perpetual bonds at low interest rates *might* explain why SNB shares have gone hyperbolic. It also means that if Swiss rates continue to fall, the shares could have another double or two in the tank. So much for staid Swiss central banking.

---

Hat tip to Leon Oudejans for alerting me to the recent rise in SNB shares.

P.S. Does anyone know how rare perpetuals are, specifically perpetuals like SNB shares that don't provide the issuer with the option to call it? My understanding is that this sort of security just isn't issued anymore, at least not since British consols.

What the difference between an SNB share and a 1000 Swiss banknote? Not much, right? They're both perpetual bonds, one paying 15 francs a year, the other paying zero francs per year. If you were to write the number 1000 on an SNB bearer share, and 500 on a half share, and 100 on a fifth share, etc you'd have the entire series of Swiss banknotes. Cut the dividend on shares to zero, and won't banknotes and shares be exactly the same?

Here's a chart of the Bank of Japan, which is also a perpetual bond underneath the hood.