Friday, March 2, 2018

The odd relationship between gangster and central banker

In my recent post for the Sound Money Project, I touched on the odd relationship between central banker and gangster. I want to focus a bit more on this relationship.

An awkward truth of central banking is that one of the central bank's most important lines of business—the business of providing cash, specifically high denomination banknotes—primarily serves hoodlums, gangsters, tax evaders, and the mafia. Yes, non-criminals certainly make some use of high denomination banknotes, say a few notes hidden in the cookie jar in case the electricity goes down. But the largest base of users is comprised of folks who hold notes—not in cookie jars—but by the suitcase full; criminals. Banknotes are anonymous after all, so they are an excellent way for criminal organizations to make large-scale transactions without being traced.

Providing criminals with high-denomination banknotes is a lucrative line of business. For each $100 note put into circulation, a central bank holds $100 worth of interest earning assets in its vaults. Since note holders don't have the right to receive any interest, the central banks gets to keep all this interest income for itself.

For instance, by the end of 2016 the Bank of Canada had placed $80.5 billion worth of banknotes into circulation. Large denomination banknotes—the $50, $100 and $1000 notes—accounted for $58.4 billion of this, or around 72% of all banknotes. The assets standing behind all outstanding banknotes allowed the Bank of Canada to earn $1.53 billion in interest in 2016. Of this amount, around $1.1 billion (72% of $1.53 billion) can be attributed to high denomination banknotes, the majority of which comes courtesy of the largest holders of high denomination notes: gangsters.

So you can begin to see why the Bank of Canada might not want to get out of the business of producing $50, $100, and $1000 notes. $1.1 billion is a lot of profit! Of course, were the Bank to get out of producing high denomination notes altogether, it wouldn't forgo the entire $1.1 billion in yearly income. Criminals might choose to use $10 and $20 notes in the place of the demonetized high denomination notes. However, $10s and $20s are a bulky way to store value. They surely wouldn't be capable of recapturing all of the criminal wealth formerly held in the form of $50, $100, and $1000 notes. Which means that the total amount of banknotes outstanding would fall and Bank of Canada profits would shrink.

Why might central bankers care about their profits? As I wrote here, any government bureaucrat who can provide their master with an ongoing revenue stream will always have more say in their department's fate than a bureaucrat who has to ask for funding each year. And of all government bureaucrats, none is more jealous of their independence than the central banker. The process of ratcheting the interest rate lever higher or lower requires a complete absence of political meddling, so say central bankers. One might imagine that this autonomy is worth so much to central bankers that it justifies taking on a clientele dominated by gangsters.

There is a better reason for why it might be in the public interest for central bankers to continue serving criminals with high denomination banknotes. Consider the fact that if high denomination notes were to be rescinded, criminals would simply use other forms of payment in their place. If the substitute payments medium that criminals select places a new and extremely onerous set of burdens on society, then maybe the public provision of high denomination notes should not be discontinued.

What alternative payments media might criminals use in the place of $100 and $50 notes? In his screed against high denomination banknotes, Ken Rogoff suggests that gold, uncut diamonds, and bitcoin might become popular as a criminal payments media. The fact that these instruments are cumbersome relative to cash would make criminals easier to catch, and Rogoff claims that the crime rate might even drop.

In a provocative article, James McAndrews counters that rather than turning to commodities, criminals will instead select private debts as their preferred payments medium. A thief who sells stolen goods to a fence would accept some sort of IOU as payment rather than cash or diamonds. This IOU wouldn't be anonymous. Like any debt, the debtor and creditor would be a matter of record. But as long as the system of debts is secret—i.e. only criminal participants can see the record—then the users can't be tracked by the authorities, like cash.

When an IOU defaults, the traditional legal system provides a means for sorting things out. But this system would be out of bounds to criminals trafficking in IOUs. What is required is some sort of underground administrator or third-party to act as arbiter. According to McAndrews, the party that is likely to emerge as enforcer of criminal debts is organized crime: the mafia. 

In addition to enforcing IOUs, the mafia would also be in a position to fabricate new IOUs for use in the criminal monetary system. McAndrews uses the example of inflated invoices. The mafia would coerce legitimate businesses into writing IOUs, or invoices, for goods they never bought, or bought  at inflated prices. These invoices would circulate among criminals as money. To assure that the police ignored their extortion of legitimate business, the mafia would resort to stepped up bribery of the police.

All of this changes the calculus of a central bank withdrawal from the business of providing criminals with banknotes. Sure, a demonetization of high denomination notes might lead some gangsters to go legit because the lack of $100 and $50 notes makes their business too expensive to operate. But a whole new range of crimes could emerge. Violence could grow as the mafia executes defaulters in order to maintain the sanctity of the new IOU payments system that has taken the place of high denomination banknotes. Legitimate businesses could get blackmailed into feeding the criminal monetary system, those run by immigrants likely being the most vulnerable. And police departments will be corrupted.

McAndrews uses the public provision of free condoms and clean needles as an analogy. Restrict free condoms and it is possible that the rate of sexual intercourse goes down. But surely there will be an increase in unsafe sex, unplanned pregnancy, and sexually transmitted diseases. As for the provision of clean needles, restrict it and heroin use might fall. However, the prevalence of HIV will rise. Both unsafe sex and dirty needle usage impose costs not only on those directly afflicted but also indirectly on us—i.e. taxpayers who pay increased health care expenditures.

Likewise with cash. A restriction of $50 and $100 notes could very well lead to attrition in the ranks of existing criminals, as Ken Rogoff reasons. However, this could be twinned with an increase in mafia activity and the potential subordination of us—i.e. legitimate business—to the needs of the underground payments system. Keeping high value banknotes may thus be the wise decision, in the same way that choosing to keep free condom and clean needle programs going makes everyone's lives better off.


  1. "The process of ratcheting the interest rate lever higher or lower requires a complete absence of political meddling"
    How about a nice currency board instead? Perhaps targeted at some ghost money, with the virtual exchange rate crawling up or down as deemed necessary by the central banker. And let the interest rates wander as determined by market conditions.

    "Bitcoin" -- In addition to the inelastic supply of BTC, there is a hard maximum of 1MB of transactions/block (and one block is created in ~10 minutes). As such, there is a limit on the number of transactions that can happen, which is why transaction fees have gone through the roof (on the order of $100/transaction). This fee is flat, not a fraction of the transaction's value, too.

    Mr. McAndrew's scenario: watch for the conjunction fallacy. Several steps have to go "just right" (or wrong) for the described scenario to happen. Notably, "independent" gangs have to know where/how to find the "alternative judicial system" to enforce the IOUs. This both erodes their independence/profits and exposes the "courts" to being found by the police.

    Furthermore, the scenario has a sort of "complementary goods problem" in that the IOUs are very risky investments in the absence of a "court" system to enforce them, and the "courts" are unduly expensive (visible to authorities) to maintain unless there is a large flow of IOUs to be handled. As such, a system of this kind is unlikely to arise without significant coordination.

    My guess is that (looking at the Store of value post) drugs e.g. cocaine are a fairly good substitute. They have approximately the same value density as $50 bills, and they are already being traded by the gangs.

    1. Thanks for stopping by. For the sake of argument I'll take McAndrews side.

      "Several steps have to go "just right" (or wrong) for the described scenario to happen."

      We know that when traditional monetary instruments are suddenly taken away, in their place people use basic forms of credit rather than barter. During India's recent demonetization, informal credit systems sprung up to take the place of suddenly useless ₹2000 and ₹1000 notes. And when the Irish banking system went on strike in 1970, IOUs in the form of uncleared cheques circulated. So there is something natural about debt emerging as money when a vacuum is created.

      "My guess is that (looking at the Store of value post) drugs e.g. cocaine are a fairly good substitute."

      The big advantage of IOUs over barter is that IOUs are denominated in the numeraire currency. This is convenient because payments would be made in the same unit that prices are set. Gold or cocaine could become the preferred medium for payment for criminals, as you suggest, but if so it is likely that the dollar would remain the unit of account given the volatility in these commodities' prices. So there would be an inconvenient splitting of the unit of account and medium of exchange function. And this inconvenience would militate against the emergence of gold or cocaine as a payments medium in the first place.