Wednesday, January 15, 2020

Flooding or marijuana? Two theories for falling cash demand


When Canada legalized marijuana in October 2018, the amount of banknotes in circulation took a sudden plunge.

In a 2019 paper available here, economists Charles Goodhart & Jonathan Ashworth theorized that because the marijuana trade has always been conducted using anonymity-providing cash, legalization meant that Canadians could now buy pot with debit and credit cards. Thus the big drop in cash held that October.

Here is one of the charts that the pair used:

Source: Goodhart & Ashworth

Goodhart & Ashworth went on to suggest that October's $1.5 billion decline in cash outstanding (1.4% of all banknotes!) provided early evidence that Canadian Prime Minister Trudeau’s 2015 promise to keep "profits out of the hands of criminals" had been successful.

Hold on! said Bank of Canada researchers Engert, Fung, Molnar, & Nicholls. In a paper published at the end of 2019, Engert et al confirmed that there had been a huge decline in notes outstanding in October 2018. (In fact, it was the biggest October decline since the Bank of Canada, our central bank, was founded in 1935.)

But unlike Goodhard & Ashworth, who could only rely on public national data on banknote usage, Engert et al had access to non-public information. The Bank of Canada economists disclosed that when huge amounts of rain inundated the city of Toronto in August 2018, two of Canada's big banks lost access to their regional note distribution centres.

Regional distribution centres are where banks bring excess banknotes collected from their customers. The centres are equipped with machines for sorting notes for quality. Good notes can be recycled back into the economy. Bad ones get sent back to the Bank of Canada. Distribution centres are also used to receive new notes from the Bank of Canada to stock bank ATMs. 

Perhaps the two banks couldn't get physical access to their Toronto centres because the vault doors were blocked by water? Were the sorting machines damaged? Maybe the notes were water-logged and had to go through the Bank of Canada's lengthy mutilated banknote redemption process? 

Whatever the case, the banks could no longer bring excess notes to their Toronto distribution centre for sorting and eventual return to the Bank of Canada, or to recycle back into the economy. Furthermore, to keep their customers happy with fresh bills, the two banks had to get extra "contingency" banknotes from the Bank of Canada. This clogging up of the system translated into far more banknotes in existence than normal. When the two banks finally "regained access" to their "quarantined" notes in October, they sent the entire surplus back to the Bank of Canada.

Using data from the Bank of Canada's proprietary Bank Note Distribution System (BNDS), which breaks down the banknote statistics for each of the Bank of Canada's 10 regional distribution points across the country, Engert et al produce the following chart for the Toronto area.

Source: Engert et al

August 2018 had a big jump in "net withdrawals" (presumably as the two banks asked the Bank of Canada for contingency banknotes and hoarded customers' unwanted and unsorted notes) followed by the huge compensating decline in October as they returned their excess note supplies.

Since Toronto is Canada's biggest city by a long shot, it biased the national statistics observed by Goodhart & Ashworth. By contrast, proprietary BNDS data shows that Montreal, Vancouver, Calgary, and other distribution points (which did not have flooding) did not show any decline in cash circulation during the October legalization of marijuana. But Montrealers smoke plenty of pot. If Goodhart & Ashworth's theory is right, we would have expected to see a big drop in Montreal regional net withdrawals of cash too.

It's not that Goodhart & Ashworth's theory about a general linkage between marijuana and cash usage is wrong. It's probably true that legalization of marijuana could get reflected in national banknote stocks.

But in Canada's case, the rollout of legalization hasn't gone smoothly. According to a recent Statscan report, only 28% of cannabis users reported obtaining all of the cannabis they consumed from a legal source. Much of this is due to the fact that prices are much higher at official stores Crowd-sourced data from Statscan shows that whereas it costs $10.23 per gram in a store, illegal pot goes for just $5.59.

Be careful of patterns in the data. They're not always what they seem.

Sunday, January 5, 2020

Cryptocurrency in a land of strict gambling laws

Kim Jin-Woo, K-pop star jailed for online gambling [source]

I recently read that South Korea will not be taxing capital gains on cryptocurrencies next year. Young Koreans who became paper multi-millionaires when XRP or some other cryptocurrency skyrocketed from 0.1 cents to 25 cents have reason to celebrate. They can sell without having to give up a single won of their winnings to the Korean tax authority.

Letting off the crypto-rich may sound like a bad tax policy. In this post I'll make the argument for why it isn't. Cryptocurrency gains enjoyed by a retail clientele probably shouldn't be taxed (nor should a big loss on their cryptocurrency holdings allow them to reduce their taxable income.)

Few nations have taken to cryptocurrency with as much gusto as South Korea. In a study from earlier this year, Larry Cermak found that on a per capita basis, South Koreans generate more visits to cryptocurrency exchanges than any other nation except for Singapore.

Why do South Koreans like crypto so much?

Korea's gambling industry may give us some insights. While gambling has been slowly liberalized in many parts of the world, South Korea's gambling rules are positively draconian.

To begin with, casino gambling is illegal in Korea. Not only that, but under the Habitual Overseas Gambler law Korean citizens are prohibited from gambling in other countries too. Earlier this year K-pop star Seungri was accused of gambling in Vegas while Shoo, another star, was convicted for visiting Macau's casinos.

Oddly, there are 23 casinos in Korea. The catch? Only foreigners can visit them. Just one of these casinos is open to South Koreans, the Kwangon Land Casino. But it is located in a coal mining area far from any big city. Given huge demand and restricted supply, gamblers who visit Kwangon must "reserve seats for blackjack and baccarat and, while waiting, wade into thick crowds to place a bet on other players’ hands."

Some Koreans try to evade harsh gambling rules by frequenting foreign gambling websites. But this requires a degree of tech savvy. Foreign currency must be snuck onto an online wallet like Skrill, and a VPN will probably be necessary since foreign casino sites are often blocked by the Korean government, redirecting to to warning.or.kr.



This roundabout route to betting isn't without danger. K-pop star Jung Jin Woo was recently imprisoned for online gambling (see image at top).

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Enter cryptocurrencies, a new type of gambling technology. People who buy cryptocurrencies such as bitcoin, litecoin, and XRP are making a bet on what they think a subsequent round of players will pay for the tokens, the second round's expectation in turn a function of what they believe the third wave of players will pay. If they get this guessing game right, the earliest players win at the expense of the late ones.

The prices generated by these 24/7 mind-games are incredibly volatile. But that's part of the excitement. Bet correctly and one's entire financial life can be upgraded. With so few opportunities for wagering, no wonder that Koreans have flocked to these new financial games.

If cryptocurrencies are just another form of gambling, why hasn't the Korean government blocked them? I can think of two reasons. First, since cryptocurrencies are decentralized bearer instruments, it is difficult to screen them out. Sure, centralized exchanges can be shut down. But the stuff will squeak through informally anyways. Secondly, cryptocurrencies have been mis-marketed as a monetary technology rather than a gambling technology. The term cryptocurrency, for instance, misappropriates the word currency while bitcoin co-opts coin. Tricked into thinking that these new tokens are a form of money or currency, the Korean government has allowed them to slip through its gambling dragnet.

[Yes, there are a few niche cases in which cryptocurrency does serve as a genuine monetary technology. For instance, Matt Ahlborg has a great article chronicling how Nigerian remitters are using a combination of gift cards (iTunes, Steam, Best Buy, etc) and bitcoin to evade Nigeria's capital controls. But the majority of cryptocurrency activity is still generated by gamblers in rich developed nation, the few developing nation monetary use-cases piggy-backing on top.]

Which finally gets me back to the topic of taxing cryptocurrency winnings. In most nations, gambling winnings are not subject to capital gains taxes. (Nor can losses be used to reduce taxes). If you win $10,000 in roulette up here in Canada, you don't have to worry about the tax harvesters at Revenue Canada taking any of it. Lose $10,000, however, and the opposite applies. You can't deduct that $10,000 loss from your taxable income. The US is an exception. It is one of few nations to tax gambling gains.

There are decent reasons for eschewing a tax on gambling winning (and its converse, a tax rebate on gambling losses). Tim Worstall had a good post about this a few years back. "The point about betting of all types," says Worstall, "is that the winning of some people are, and must be, entirely offset by the losses of others." Gambling, in other words, is a zero-sum game. So if a government taxes winning roulette players and offers a tax rebate to losing roulette players, the two flows cancel each other out. On net, no taxes on roulette will be collected.

That seems like a pretty dumb tax. It has all the administrative hassles of a regular tax without generating any of the tax income.

Cryptocurrencies, like other gambles, don't generate any real wealth. Everything that a winning cryptocurrency player earns is necessarily paid by an eventual loser. Since winnings are equivalent to losses over the life-time of a cryptocurrency game, any tax income that a government collects on crypto winnings will eventually be offset by the rebate that it disburses on crypto losses. Like the roulette tax of the previous paragraph, there doesn't seem much point in bothering.

(There are some complications here. All cryptocurrencies are international gambling games--they are played across many national borders. Citizens of certain nations may have gotten into the game earlier than others. Assuming that the average Korean punter bought into bitcoin and XRP later than Americans and Europeans, a Korean capital gains tax may actually generate large losses to the Korean government. This is because the Korean government will end up paying out far more in tax rebates to losers than the taxes it collects from winners.)

By comparison, the tax situation with stocks is entirely different. A tax on stock market capital gains  and associated tax deductability of capital losses don't precisely offset each other. This is because companies like Microsoft or Exxon are not zero-sum games. The underlying businesses generate consistent income that accrues to investors. And so the revenues that the government enjoys from taxing winning stock owners far exceeds the government's payouts to losing stock owners.

So in sum, there are good reasons not to implement a gains/losses tax on betting games like roulette, poker, or cryptocurrency. Interestingly, a decision to avoid taxing cryptocurrency gains may actually help promote their usage as monetary instruments. Calculating how much tax one owes after each purchase made with cryptocurrency is a pain. Remove that headache and people may be more willing to spend them.