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.

Fire hydrant ruptured in the storm tonight and I basically had to swim home at King/Atlantic. Streetcar is stuck in over a foot of water! #toronto @CityNews @CP24 @blogto pic.twitter.com/qLluipWDA6

— Victoria Pike 🎄 (@victoria_pike) August 8, 2018

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.