Pricing the anonymity of banknotes

Banknotes are useful. Not only do they provide their owner with a standard set of payments services, they also offer financial anonymity. This post introduces the idea of trying to price the anonymity component. 

To help think about why we might want to price anonymous banknote usage, I’m going to make an analogy. Imagine Walmart sells special suits that allow people to become invisible. While most Walmart customers always pay for the goods they find in the aisles, a few try these invisible suits on, grab a bunch of stuff, and sneak out without paying. The product is weaponized and turned against its provider.

This same sort of weaponization characterizes the modern provision of banknotes. The government, like Walmart, provides citizens with a privacy-enhancing product: cash. Because its coins and banknotes don’t leave a paper trail, they act as a financial cloak. In the same way that an invisible suit can be used to evade Walmart’s checkout counter, a government-issued banknote can be turned against its provider by allowing users to avoid paying for the government services they have consumed. 

Walmart may wish to do something about the weaponization of invisible suits, especially if the costs imposed by abusers of suits begin to exceed the amount of income the company gets from buyers of invisible suits. One option Walmart has is to stop selling the product. No one would fault them for putting an end to an unprofitable business line. Invisible-suit aficionados could just shop elsewhere. 

But what if Walmart is society’s only provider of invisibility? This complicates things. While a few bad apples regularly abuse Walmart’s invisible suits by using them to steal, many others use the suits in legitimate ways. So while a decision to stop selling invisible suits might improve Walmart’s finances, it might also make society worse off. 

This same tension crops up in the debate over the future of cash. A ban on cash would help reduce tax evasion and improve government finances. But since banknotes are the only anonymous financial product, and no other entity is permitted to provide banknotes, a ban would put an immediate end to financial privacy. Because privacy is something that regular folks value for licit reasons, their welfare would be reduced.

Say Walmart does the noble thing. It continues to stock invisible suits to meet the public’s demand for privacy. But the company still has costs it must meet, including wages, inventories, and rent, and with a steady loss of payments facilitated by the weaponization of invisible suits, that hurdle becomes much harder to clear. To plug deficits, Walmart may have to ask all its rule-abiding customers to pay a little bit more for their purchases by raising all of prices by a little bit. 

But an across-the-board price increase hardly seems fair. Those abiding by Walmart’s rules are being asked to make up for a shortfall that is entirely the fault of suit-stealing rule breakers. Honest shoppers who don’t generally like to use invisible suits will be particularly furious — and who can blame them? They are being asked to pay more for the goods they hold dear in order to support the use of a single product they never cared for much anyway. 

This same lack of fairness plagues modern tax systems. The government needs to fund (via taxes) the services it provides, but the presence of cash is weaponized against the system by tax cheats. The funding gap that emerges must be made up for by all of the remaining citizens — the non-cheaters. So taxes, or the price of government services, will be higher in the presence of cash than in a world without cash. Non-cheaters, particularly those who don’t use cash, will feel betrayed because they must pay higher taxes to support the ongoing provision of a product they don’t necessarily value. 

Walmart may have a better option. Instead of increasing the price of all goods to make up for the behavior of a few invisible-suit users, it can just raise the price of suits high enough to make up for the shortfall. So customers who like invisibility end up bearing the costs imposed by thieves who weaponize suits. This targeted approach seems like a fairer path for Walmart to take. It releases a large chunk of its customer base from the obligation of offsetting the invisibility-induced shortfall while still giving those who value the privacy provided by invisible suits the option of buying them.

If setting a higher price for invisibility is the best option for Walmart, what about modern banknote-providing governments? In the same way that Walmart increases the price of invisible suits to offset the shortfall created by those who weaponize them, a government can introduce a levy on cash users. Rather than placing this levy on all banknote denominations, it might target high-denomination banknotes instead. The idea is that bulky $1s and €5s may be less useful in large-scale tax evasion than $100s and €200s. 

By setting a levy or negative interest rate of 5 to 10 percent per year on high-denomination notes (there are various ways to do this), the government would be able to earn a large-enough stream of revenue to help offset the shortfall created by cash-using tax evaders. The effect would be a lower tax bill for all non-cheaters, both for those who generally do not use cash and those who use only small-denomination notes ($1 and €5s). In effect, the anonymity provided by $100s and €200s would now be directly paid for by the users of those $100s and €200s. Unlike an all-out ban on banknotes, financial anonymity would still be provided. 

I think it makes sense for the Walmart in our thought experiment to give anonymity pricing a shot. Maybe governments should entertain the idea, too.

[This post was originally published at the Sound Money Project. I've modified it slightly for clarity.]

Setelinleikkaus: When Finns snipped their cash in half to curb inflation

On the last day of 1945, with World War II finally behind it, Finland's government announced a new and very strange policy.

All Finns were required to take out a pair of scissors and snip their banknotes in half. This was known in Finland as setelinleikkaus, or banknote cutting. Anyone who owned any of the three largest denomination Finnish banknotes — the 5000 markka note, the 1000, or the 500 — was required to perform this operation immediately. The left side of the note could still be used to buy things, but at only half its value. So if a Finn had a 1000 markka note in their wallet, henceforth he or she could now only buy 500 markka worth of items at stores. As for the right side, it could no longer be spent and effectively became a bond (more on this later).

Source: Hallitus kansan kukkarolla, by Antti Heinonen

Setelinleikkaus was Finland's particular response to the post-War European problem of "monetary overhang," described in a 1990 paper by economists Rudi Dornbusch and Holger Wolf. After many years of war production, price controls, and rationing, European citizens had built-up a substantial chest of forced savings, or involuntary postponed consumption, as Dornbusch & Wolf refer to it. With WWII now over, Europeans would soon want to begin living as they had before, spending the balances they had accumulated on goods and services. Alas, with most factories having been configured to military purposes or having been bombed into dust, there wasn't nearly enough consumption items to make everyone happy.

It was plain to governments all across Europe what this sudden making-up of postponed consumption in a war-focused economy would lead to: a big one time jump in prices.

This may sound familiar to the modern day reader, since we just went through our own wartime economy of sorts: the 2020-21 battle against COVID and subsequent return to a peacetime economy. The supply chain problem caused by the COVID shutdowns combined with the big jump in spending as lockdowns expired, spurred on by a big overhang of unspent COVID support cheques, led to the steepest inflation in decades. 

According to Dornbusch and Wolf, European authorities fretted that the post-WWII jump in prices could very well spiral into something worse: all-out hyperinflation, as had happened after the first World War. Currencies were no longer linked to gold, after all, having lost that tether when the war started, or earlier, in response to the Great Depression. 

To prevent what they saw as imminent hyperinflation, almost all European countries began to enact monetary reforms. Finland's own unique reform — obliging their citizens to cut their stash of banknotes in two — would reduce the economy's stock of banknotes to just "lefts," thereby halving spending power and muting the wave of post-wartime spending. After February 16, 1946 the halves would be demonetized, but until then the Finns could continue to make purchases with them or bring them to the nearest bank to be converted into a new edition of the currency.

As for the right halves, they were to be transformed into a long-term investment. Finns were obligated to bring each right half in to be registered, upon which it would be converted into a Finnish government bond that paid 2% interest per year, to be repaid four years later, in 1949. It was illegal to try and spend right halves or transfer their ownership to anyone else (although it's not apparent how this was enforced).

In theory, turning right halves into bonds would shift a large part of the Finnish public's post-war consumption intentions forward to 1949, when the bonds could finally be cashed. By then, the economy would have fully transitioned back to a civilian one and would be capable of accepting everyone's desired consumption spending without hyperinflation occurring.

To our modern sensibilities, this is a wildly invasive policy. Had setelinleikkaus been proposed in 2022-23 as a way to dampen the inflationary effects of the reopening of COVID-wracked economies, and we all had to cut our dollar bills or yen or euros in half, there probably would have been a revolt.

With the benefit of hindsight, we know that setelinleikkaus didn't work very well. Finland continued to suffer from high inflation in the years after the war, much more so than most European countries did.

Why the failure? As Finish economist Matti Viren has pointed out, the reform only affected banknotes, not bank deposits. This stock of notes only comprised 8% of the total Finnish money supply, (Finns being  uncommonly comfortable with banks) so a major chunk of the monetary overhang was left in place.

Another glitch appears to have been the public's anticipation of setelinleikkaus. According to
former central banker Antti Heinonen, who wrote an entire book on the subject, banks began to advertise their services as a way to avoid the dangers of the upcoming monetary reform (see images below). So Finns deposited their cash prior to the final date, the monetary overhang to some degree evading the blockade.

Finnish bank advertisements warning of the upcoming note cutting
Left: "Bank accounts are fully secured in the banknote exchange."
Right: "Depositors are protected."
Source: Hallitus kansan kukkarolla, by Antti Heinonen (Translations via Google Translate)

If the Finnish experiment was a dud, other European responses to the post WWII overhang — either  redenominations, temporarily blocking of funds, or all-out write offs of bank accounts — were more successful. Germany's monetary reform of 1948, which introduced the Deutschmark and was later dubbed the "German economic miracle", is the one that captures the most attention, but here I want to focus on a lesser known reform.

Belgium's Operation Gutt, named after Belgium's Minister of Finance, Camille Gutt, was the earliest and perhaps the most dramatic of the post-war monetary operations. Taking place over four days in October 1944, Belgium contracted its entire money supply, both banknotes and deposits, from 165 billion to 57.5 billion francs. That's a two-thirds decline! You can see it illustrated in the chart below, along with the monetary reform enacted by the Dutch the following year, inspired by the Belgians.

A chart showing the incredible contraction of Belgium's money supply in 1944
Source: Federal Reserve Bulletin, October 1946 (red arrow is my emphasis)

It's not just the size of Operation Gutt that is striking to the modern eye. It's also the oddity of the tool being used. Today, we control inflation with changes in interest rates, not changes in the quantity of money. To soften the effect of the global COVID monetary overhang, for instance, central banks in the U.S., Canada, and Europe began to raise rates in 2022 from around 0% to 4-5% in 2024. 

By making it more lucrative for everyone to save and less attractive to borrow, central bankers were trying to reduce our propensity to spend our COVID support payments, and with less spending, prices wouldn't get pushed up as fast. This reliance on interest rates as our main tool of monetary policy is a relatively new phenomenon. In times past, central banks tended to lean heavily on changes in the supply of money, which may explain why in 1945, their main response — in Europe at least —  was to obliterate the public's money balances rather than to jack up interest rates to 25% or 50%.   

It's worth exploring in some more detail how Operation Gutt was designed. On October 9, 1944, Belgian bank depositors had 90% of the money held in their accounts frozen, leaving just 10% in spendable form.

As for holders of banknotes, there was no Finnish-style cutting. Rather, Belgians had four days, beginning October 9, to bring all their banknotes to the nearest bank, only the first 2,000 francs qualifying for conversion to newly printed versions. All notes above that ceiling got blocked in a separate account (along with excess deposits), some of which would be released slowly over the next few years—while the rest would remain frozen forever, subject to whether the owner was deemed to have been a collaborator who got rich during the occupation. (Finland's setelinleikkaus also had this same "cleansing" motivation.)

In 1944, a line forms at the National Bank of Belgium to exchange notes.
Source: National Bank of Belgium on Flickr

In this sense, the post-WWII European monetary reforms were not only designed to reduce inflation, but also had a moral basis. Think of them as progenitors to India's 2016 demonetization, which was designed to catch so-called "black money," although it failed to do so.

Did Operation Gutt work? Incredibly, the decimation of two-thirds of the money supply in just a few days did not cause an immediate fall in Belgian prices. According to Belgian economic historians Monique Verbreyt and Herman Van der Wee, the Belgian retail price index stood at 260 the month of the reform, but had risen to 387 by September 1945. So it would seem that the whole operation failed. This surely draws into question the quantity theory of money, one of the basic tenets of monetary economics. A decline in the money supply, all things staying the same, is supposed to cause a fall in prices. Here is a glaring case in which it didn't.

However, the National Bank of Belgium (NBB), the country's central bank, strikes a more constructive tone. In a recent retrospective on Operation Gutt, the NBB describes the reform as a gamble that paid off over time, eventually inspiring the "Belgian Economic Miracle", a period of low inflation and fast growth lasting from 1946-1949. By contrast, France did not embark on its own monetary reforms, the NBB takes pains to point out, and it thereby "paid the consequences of post-World War II inflation well into the 1960s." Belgium's inflation rate was also much lower than Finland's in the four or five years after the war. 

Which gets us back to Finland. Unlike the Belgian central bank, Finland's central bank — Suomen Pankki — notably avoids almost all mention of its post-war reform on its website. According to Matti Viren, setelinleikkaus led to "distrust towards the authorities and economic policy for decades," so there may be some sheepish reticence on the part of the central bank to draw attention to it.

But setelinleikkaus and Operation Gutt aren't just archaic monetary policy dead-ends. One day I suspect they'll be back. Not just as a special tool for responding to emergencies, but as a day-to-day policy wrench, albeit in a new and refined form. 

Cash, which is awkward to immobilize for policy reasons, will be gone in a decade or two, leaving the public entirely dependent on bank deposits and fintech balances which, thanks to digitization and automation, can be easily controlled by the authorities. To rein in a jump in inflation, central bankers will require commercial banks and companies like PayPal to impose temporary quantitative freezing on their clients'  accounts, but unlike Finland's 1945 blockade, the authorities will be able to rapidly and precisely define the criteria, say by allowing for spending on necessities — food, electricity, and gas— while embargoing purchases of luxury cars and real estate.

The future version of setelinleikkaus won't be clumsy, it'll be a precise and surgical inflation-fighting tool, albeit a controversial one.