The dematerialization of cash

"One dollar bill," watercolour by Adam Lister (source)

R3, a company specializing in distributed ledger technology, has just posted a paper I wrote for them entitled Fedcoin: A Central Bank-issued Cryptocurrency. And here is a nice write-up on the Fedcoin idea in American Banker, which unfortunately is behind their paywall.

The paper is pretty wide-ranging, but one thing that's worth focusing on is the ability of Fedcoin to provide some of the same features as banknotes, in particular anonymity and censorship resistance. That a Fedcoin system can be designed to provide the same degree of privacy as cash runs counter to some of its early critics, who see in Fedcoin a coming financial panopticon.

One really neat things about good ol' cash is that, like bitcoin, it is a decentralized network. The opposite of this is a centralized network, say something like the deposit banking system. In the banking system, storage of value is handled by the issuing bank through accounts hosted on the bank's database. Conversely, in a banknote system, the issuing central bank offloads the task of storing value onto us. We the public—think of us as nodes in a decentralized network—are responsible for choosing how and where to keep our cash, say in a wallet, or under our bed, or in a safety deposit box, as well as bearing those storage costs. The central bank doesn't care how we manage this task, though they'd prefer that we don't mangle the notes too much.

Or take the process of securely transferring value. Centralized actors like banks handle all the stages of moving deposits from a buyer to a seller, including verifying identities, ensuring adequate account balances, updating ledger entries etc. But in a transfer of banknotes, the transaction process is entirely devolved to the buyer and seller, who must physically move the cash to the right location, count out by hand the necessary quantity of banknotes, and then come to a consensus that the transaction has been settled. As for the central bank's ledger of notes, there is nothing that needs updating. Unlike private bankers, central bankers don't care who owns their circulating liabilities.

The task of screening for counterfeit notes is also outsourced to the public. Each time a shopper accepts a banknote, say as change, they'll give it a once-over to verify that it hasn't been run off by a teenager using an inkjet printer. Retailers deal in cash all day and are familiar with banknote anti-counterfeiting devices, and thus can exercise more judgement in checking for fakes. And banks, the recipient of notes from retailers at the end of the day, will catch many of the counterfeits that have slipped through the system.

Banknote systems aren't entirely decentralized, of course. The central bank has the final say on whether a note is counterfeit or not. It also regulates the purchasing power of those banknotes, either by toggling interest rates higher or lower, repurchasing money using its portfolio of assets, or issuing more money in return for assets.

Because they are at least partly decentralized, banknote systems inherit two nice features: anonymity and censorship resistance. The first feature is self-explanatory: the central issuer makes no effort to determine the identity of a banknote owner. Proceeding from this, the issuer lacks enough information to censor, or prevent any particular party, from using the banknote network. These are completely open systems. By contrast, centralized systems like banks can easily censor members of the public from making payments. Take the Huntingdon Live Sciences episode in 2001, for instance, in which a UK-based company involved in drug-testing was cut off by British banks in response to pressure from animal rights activists. Other examples of censorship by banks include the blockade of Wikileaks and the monetary embargo of Iran.

Now in theory a banknote system could be modified by introducing more centralization, thus removing anonymity and introducing censorship. Each banknote has a unique serial number. The central bank could set a rule that for every cash transaction, the buyer and seller are obligated to log in to a government-provided account where they register the note's serial number into a tracking database. To get these accounts, users would be required to submit documents and ID. This would destroy the anonymity of cash users and open the door for censorship. In practice, though, the guardians of banknote systems have chosen to preserve anonymity by ignoring serial numbers.

One of the major trends over the last decades has been dematerialization, the replacement of paper by bits and bytes as a medium for holding data. This saves on costs like printing, storage, and distribution; improves speed; and reduces waste. We saw it with stock & bond certificates a few decades ago, books, newspapers, music, record keeping, bills. And one day we may see it with cash. The question is: how to allow for the dematerialization of cash without losing its useful features like anonymity and censorship resistance?.

Bitcoin is one answer. But Bitcoin only goes half-way to solving the problem since it does not recreate one of cash's other key features, its stability. A nation's prices are conveniently denominated in terms of its paper money (i.e. U.S. retailers set prices in dollars, Japanese retailers in yen), and since prices tend to stay sticky for 4.3 months or so on average, the public has a huge degree of certainty over the medium-term purchasing power of the money in their wallets. This is a very nice feature. Bitcoin prices? Not so stable.

Fedcoin may be able to recreate this stability while still providing anonymity and censorship resistance. A government copies the source code of a proven cryptocoin (maybe bitcoin, maybe zcash, maybe ethereum), boots the system up, and promises to peg the price of each coin to its existing banknotes, say 1 coin = $1 banknote.

As with bitcoins, anyone would be able to hold Fedcoins without the necessity of providing identification. And like Bitcoin, Fedcoin could be designed in such a way that a distributed collection of Fedcoin nodes (or miners) validate transactions by referring to the system's shared history. Remember how the Fed allows banknote users to anonymously come to a consensus about the validity of a banknote transactions i.e. they do not have to log in to an account to register note serial numbers? Likewise, Fedcoin could be designed in a way that nodes have the ability to remain anonymous. This would preserve a degree of censorship resistance and openness. After all, if validators must unveil themselves, governments and other powerful actors might compel those nodes to censor transactions.

This is just one way of setting up anonymous central bank money. I'm sure there are many others. There are also ways to set up non-anonymous central bank money, but these are less interesting to me, a point I made here. As I point out in the R3 paper, I think my preferred set-up would be to allow individuals a rationed amount of anonymity, targeting some sort of “sweet spot” such that there is enough anonymity-providing exchange media for regular consumers but not enough for criminals. But I can't wrap my head around how to design something like this. Anyways, go read the paper, there's plenty more.

---

PS: I also recently had an article on bitcoin published in the Common Reader, a publication of Washington University in St. Louis.

And since we're on the theme, I should link to some other public appearances by yours truly, including recent-ish podcasts with David Beckworth and Alex Millar.

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.

In praise of anonymous money

A while back I was paying for gas at a nearby gas station when the clerk fumbled my credit card. When he bent down to pick it up he momentarily disappeared behind the counter. Because credit card transactions are always such repetitive affairs, this slight break from routine raised my hackles. Might the clerk have done something with my card while out of sight, perhaps taken a quick photo of it?

Credit and debit payments require the relay of personal information. But this information-richness is also their weakness, since valuable data can be "skimmed" and used to attack the payer later on. That's why an anonymous payments medium is so important; it provides buyers with a shield from everyone else involved in a transaction. The next time I payed for gas at the nearby station, I bought myself some peace of mind by handing the clerk a few $20 notes instead.

Like banknotes, bitcoin is a (near) anonymous payments medium. My gas station doesn't accept bitcoin, however, nor would I be able to pay for a tank of gas with bitcoin since I'm wary of holding more than a few dollars of the volatile stuff. There is no inherent reason that an anonymous digital money must be volatile. David Chaum's eCash, first proposed in the 1990s, was a monetary product that, unlike bitcoin, offered stability while still allowing for anonymity.

Here's a broad-brush description of how eCash worked. A customer would kick the process off by creating $x worth of digital coins, each with a unique serial number. The bank would in turn sign the coins and debit the customer's bank account for that amount. Thanks to Chaum's invention of blind signatures, the bank would not be able to see the serial numbers of the coins it had signed, and thus could not match those coins to a specific person. This 'blinding' provided a measure of anonymity.

What about the double spending problem that bedevils digital cash? Because digital coins can be copied ad infinitum, a mechanism must be introduced to prevent a dishonest actor from buying up the entire world. Chaum solved this by having the bank rig up a database of already-spent coins. When the customer spent $x at a merchant, the merchant would call up the bank and provide it with each coin's unique serial number. The bank would check the number against its database to ensure that the coins had not been spent. If they hadn't, the transaction was free to proceed. The merchant in turn had to return the $x to the bank to be redeemed.

Bitcoin's creator(s) Satoshi Nakamoto doesn't seem to have been a fan of Chaum's eCash. In his famous white paper, Nakamoto says (not referring to eCash in particular) that the "problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them, just like a bank." Later on in a forum post Nakamoto talks about the "old Chaumian central mint stuff," noting that:

a lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990s. I hope it's obvious that it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we're trying a decentralized, non-trust-based system.

Nakamoto thus designed Bitcoin so that it had no central points of control. There is no third party database to record serial numbers; instead, the task of validating transactions is outsourced to a distributed network of anonymous miners and nodes. As for the money supply, there is no "Chaumian central mint" that issues and redeems tokens; rather, the evolution of bitcoin supply is set ahead of time by the Bitcoin protocol.

By sacrificing this last central point of control, Nakamoto condemned bitcoin to being a permanently volatile instrument. Unlike eCash, which is stable because the issuing bank pegs its price to that of bank deposits at a 1:1 rate, bitcoin's purchasing power is left entirely to the whims of market demand. Should market demand suddenly rise, bitcoin can double in price. Should it collapse, bitcoin will be worth $0.  

Sacrificing the Chaumian issuer/redeemer leads to another, more nuanced, trade-off. Because bitcoin is not pegged to the dollar, retail prices will always be expressed in dollars with the bitcoin equivalent bobbing up and down every few seconds or so. Put differently, bitcoin users must get accustomed to the unit of account and medium of exchange being divorced from each other.

Contrast this to eCash. Thanks to the peg, the two functions of money—unit of account and medium of exchange—are married. Anyone who owns eCash can relax knowing that they possess the same exact unit that all other economic actors are using to express prices. This provides eCash users with a degree of certainty. As a service to their customers, retailers tend to keep prices sticky in terms of the unit of account for days, even months. So if carrots are going for $2 today, an eCash owner knows that they'll be going for that same amount next week. This fixity makes planning one's life a much easier affair. Those who own bitcoins enjoy no such certainty. Carrots that cost 0.005 bitcoins today may cost 0.01 next week.

So these two monetary products provide users with a degree of anonymity while asking them to make very different sacrifices. Bitcoin foregoes both stability and the convenient marriage of unit of account and medium of exchange. Chaum's eCash retains both stability and a marriage but introduces several central points of control that might render it subject to attack. Pick your poison. My gut feeling, however, is that over the long term, the public will prefer to stomach some degree of centralization in return for a stable anonymity product that doesn't suffer from medium of exchange/unit of account divergence. But I could be wrong.

Kocherlakota on cash

Narayana Kocherlakota, formerly the head of the Federal Reserve Bank of Minneapolis and now a prolific economics blogger, penned a recent article on the abolition of cash. Kocherlakota makes the point that if you don't like government meddling in the proper functioning of free markets, then you shouldn't be a big fan of central bank-issued banknotes. For markets to clear, it may be occasionally necessary for nominal interest rates to fall well below zero. Cash sets a lower limit to interest rates, thus preventing this rebalancing from happening.

I pretty much agree with Kocherlakota's framing of the point. In fact, it's an angle I've taken before, both here and in A Libertarian Case for Abolishing Cash. Yes, my libertarian and other free-marketer readers, you didn't misread that. There is a decent case for removing banknotes that is entirely consistent with libertarian principles. If you think usury laws are distortionary because they impose a ceiling on interest rates—and there are some famous libertarians who have railed against usury—then an appeal to symmetry says that you should be equally furious about the artificial, and damaging, interest rate floor set by cash.

Scott Sumner steps up to the plate and defends cash here. He brings up some good points, but I'm going to focus on his last one. Scott says that a cashless economy would create a "giant panopticon" where the state knows everything about you. I quite like Nick Rowe's response in which he welcomes Scott to the Margaret Atwood Club for the Preservation of Currency. In Atwood's dystopian Handmaid's Tale, a theocratic government named the Republic of Gilead has taken away many of the rights that women currently enjoy. One of the tools the Republic uses to control women is a ban on cash, all transactions now being routed digitally through something called the Compubank:

I agree that we don't want to abolish cash if it is only going to lead to Atwood's Compubank. But Scott misses the fact that even though Kocherlakota wants the government to exit the cash business, he simultaneously wants fintech companies to take up the mantle of anonymity services provider. Like Sumner, Kocherlakota doesn't seem to want a Compubank.

For instance, in a recent presentation entitled The Zero Lower Bound and Anonymity: A Monetary Mystery Tour, Kocherlakota highlights the potential for cryptocoins Zcash and Monero to substitute for central bank cash. Unlike bitcoin, these cryptocoins provide full anonymity rather than just pseudonymity. If you want to learn more about Zcash, I just listened to a great podcast with Zcash's Zooko Wilcox-O'Hearn here. As for Monero, Bloomberg recently covered its spectacular rise in price.

As Monero illustrates, cryptocoins are incredibly volatile. Is anonymity too important of a good to be outsourced to assets that behave like penny stocks? I'm not sure. And as Nick Rowe points out, the concurrent circulation of deposits (pegged to central bank money) and anonymity-providing cryptocoins would create havoc with the traditional way of accounting for prices. Retailers would probably still set prices in terms of central bank money but anyone wanting to purchase something anonymously would have to engage in an inconvenient ritual of exchange rate conversion prior to consummating the deal. Perhaps these are simply the true costs of enjoying anonymity?

Kocherlakota doesn't mention it explicitly, but should cash be abolished in order to remove the lower bound to interest rates, a potential replacement would be a new central bank-issued emoney, either Fedcoin or what Dave Birch has dubbed FedPesa. A good example of a Fedcoin-in-the-works comes from the People's Bank of China, which vice governor Fan Yifei expects to "gradually replace paper money." As for Birch's FedPesa, a real life example of this is provided by Ecuador's Dinero electrónico, a mobile money scheme maintained by the Central Bank of Ecuador (CBE) for use by the public.

Should a government decide to abolish cash and implement a central bank emoney scheme in its place, it would be possible to set negative interest rates on these tokens while at the same time promising to provide both stability and anonymity. One wonders how credible the latter promise would be. The CBE requires that citizens provide national identity card before opening accounts. And consider that the PBoC's potential cyptocoin will be designed to provide "controlled anonymity," whatever that means. Unless significant safeguards are set, it's hard not to worry that a potential Atwood-style Compubank is waiting in the wings.

An alternative way to coordinate a smooth government exit from the cash business is Bill Woolsey's idea of allowing private banks to step into the role of providing banknotes. In this scenario, the likes of HSBC, Bank of America, Wells Fargo, Deutsche Bank, and Royal Bank of Canada would become sole providers of circulating banknotes. Wouldn't this simply re-establish the zero lower bound? Not necessarily. As I wrote back in 2013, the moment a central bank sets deeply negative interest rates, private banks will face huge incentives to either 1. get out of the business of cash or 2. stay in the game while modifying arrangements, the effect being that the zero lower bound is quickly ripped apart.

The provision of anonymity services via the issuance of private banknotes has some advantages over cryptocoins like Zcash. Since they'd be pegged to central bank money, private banknotes would provide 'fixed-price' anonymity. Nor would the public have to constantly do exchange rate conversions between one currency type or the other. On the other hand, Zcash payments can be made instantaneously over long distances; you just can't do that with banknotes. And of course, there's also the stablecoin dream, i.e. the possibility that private cryptocoins like Zcash might themselves be stabilized by pegging them to central bank cash, as Will Luther describes here (for a more skeptical take, read R3's Kathleen B here)

Because of what he calls "over-issue" problems, Kocherlakota is more confident in the prospects for cryptocoins than private banknotes. I'm not so worried. The voluminous free-banking literature developed by people like George Selgin, Larry White, and Kevin Dowd teaches us that as long as silly regulations are avoided, the promise to redeem notes at par in a competitive environment will ensure that the quantity of private banknotes supplied never exceeds the quantity demanded. Don't look to the so-called U.S. Wildcat banking era for proof. During that era, note-issuing banks were too encumbered by strict laws against branch banking and cumbersome backing rules to effectively supply notes, as Selgin points out here. Rather, the Scottish and Canadian banking systems of the 1800s provide evidence that banks can responsibly issue paper money.

Wouldn't the private provision of banknotes require the passing of new laws? Funny enough, U.S. commercial banks can already issue their own banknotes. In a fascinating 2001 article, Kurt Schuler points out that federally-chartered banks have been free to issue notes since 1994 when restrictions on note issuance by national banks was repealed as obsolete by the Community Development Banking and Financial Institutions Act. So the floodgates are open, in the U.S. at least, although as of yet no bank has taken the lead.

If governments are going to remove the zero lower bound by getting out of the business of providing anonymous payments, I say let a thousand flowers bloom. If the void is to be filled, don't put up any impediments to the creation of anonymity-providing fintech options like Zcash, but likewise don't prevent old fashioned banks from getting into the now-vacated banknote game either. Let the market decide which anonymity product they prefer... and celebrate the fact that the government's artificial floor to interest rates has been dismantled.

---

P.S. It would be remiss of me to omit pointing out that there are sound ways to dismantle the zero lower bound without removing cash, Miles Kimball's plan being one of them.

What makes money special, the lawyer's edition (with a guest appearance by bitcoin)

Juan Galt recently introduced me to one of bitcoin's biggest problems. Bitcoin is not money, at least not according to the law.

Economists like to say that money is unique because it is a medium of exchange, store of value, and unit of account. Lawyers and judges have a different story to tell about money's uniqueness. Unlike goods, money can't be 'followed.' When a good is exchanged, its entire history goes with it. This history may be checkered. Say that a car has been stolen at some point in its past and then sold, and the police discover this fact. The current owner—though having purchased the car innocently—is required to return it to its rightful owner. The law 'follows' goods.

With money things are different. Each time a monetary instrument is transferred, its history is wiped clean. As long as the recipient accepts the money in good faith, the original owner of stolen dollars cannot make a claim for those dollars.

This peculiar legal treatment of money, dubbed money's liability limitation by Steve Randy Waldman, ensures fungibility. When all members of a population can be perfectly substituted for each other, than we say that they are fungible. If each monetary unit's unique history becomes a datum that merchants must take into account before selling a good, then fungibility no longer prevails. One unit may be worth more than another because its history is more pristine.

Fungibility is important because it promotes the smooth functioning of a monetary system. If merchants have to analyze each piece of money they are offered to ascertain its legitimacy, long lineups will develop. Exchange grinds to a halt.

So why not extend the status enjoyed by current forms of money to bitcoin? What follows is a quick tour through the history of how jurists have rationalized the legal treatment of other forms of money, including coins, banknotes, and bills of exchange. This should provide us with enough grist to analyze bitcoin's current legal status.

---  

Let's start with coins. The basic principle of nemo dat quod non habet governs property; no one can give away that which they do not have. According to early common law jurists, coins were exempt from nemo dat because they couldn't be followed. The inability to follow coins arose from the fact that they were homogeneous. In the words of the jurists of the day, 'money has no earmark.' Whereas one pig could be differentiated from another thanks to the practice of earmarking—cutting out a distinct piece from a pig's ear—coins could not be earmarked, and therefore could not be differentiated.

Thus there was no way for a victim to lay claim to lost or stolen coins. With no way to prove that the coins in the accused's pockets had not already been there, mixed coins could not be sufficiently distinguished to establish title. James Fox, for instance, cites a 1614 case in which a gambler, Warde, "thrusts" his coins into the stack of another gambler, Aeyre, perhaps hoping to get a tell from of his opponent. Aeyre refuses to give the coins back. The judge upholds Aeyre's rights to the entire stash since money has no earmark, and therefore nemo dat does not apply. Once mixed, who ever possesses the pile of coins has the best title.

Interestingly, the only way to preserve ownership of coins in the medieval era was to keep them in a bag. Since they could now be identified by the distinctiveness of their container, like any other good they were subject to nemo dat. Had Aeyre's coins been bagged, he could have easily mixed them with Warde's without losing title to them.

The fact that coins had no earmark meant that each piece's distinct past was irrelevant. While this was awkward for poor Aeyre, society was made better off by this decision. Coins became much more fungible than they otherwise would have been, and this would have dramatically promoted their use in trade, greasing the wheels of commerce in general.

---

Let's move on to paper credit, namely bills of exchange and banknotes. While bills of exchange developed in the 12th or 13th century, the first notes would not have appeared in England until the 17th century. Though English common law was useful for land disputes, it had not yet developed the expertise to deal with commercial disputes. Indeed, common lawyers' expertise with commercial matters was so limited that Josiah Child, an English trader, complained that he could only make his lawyers understand "one half of our case, we being amongst them as in a Foreign Country."

Rather than resorting to common law, problems arising from the usage of negotiable instruments like bills were governed by lex mercatoria, or merchant's law, a private form of commercial law or custom that had been developed by European merchants over the preceding centuries. Market courts, operated by the merchants themselves, guaranteed a decision the day after a complaint, a necessity given the mobile nature of commercial life.

According to Lowry, the close-knitted nature of the merchant class began to unravel by the end of the seventeenth century, making merchant law less enforceable. As commercial cases were increasingly brought to common law courts, jurists had to decide how to treat these new financial innovations.

Lex mercatoria had always accepted the principle that, as in the case of coins, bills of exchange could not be followed. Since those who accepted bills of exchange didn't have worry about whether they had been stolen or not, this would have made trade in bills of exchange extremely fluid. However, the stance taken by lex mercatoria was an anathema to common law logic. Unlike coins, which couldn't be followed due to their lack of earmark, both bills of exchange and banknotes did have earmarks. Whereas coins were issued in uniform denominations, bills of exchange were usually made out in non-standard ones, say $101.50, making for easy identification. Bills were also signed by a unique debtor and a range of consignees. As for banknotes, these had serial numbers on them. Without the homogeneity of coins, there seemed to be no way to save the these relatively new financial instruments from the harsh strictures of common law nemo dat. Goods they were to be, not money.

It was Lord Mansfield, an English jurist, who took on the task of incorporating lex mercatoria into English common law (Adam Back notes a similar case in Scotland). Take Miller v Race, Mansfield's definitive ruling on banknotes in 1758. The note in question had been issued by the Bank of England "to William Finney or bearer on demand" and subsequently mailed to a third party by Finney. Along the way it was stolen and used to buy room and board at an inn, the innkeeper Miller innocently accepting the note. Finney, upon learning of the robbery, asked Race, an employee at the Bank of England, to stop payment of the note, upon which Miller the innkeeper sued Race. If the bill was treated as a regular good, then Finney would have prevailed. However, Mansfield ruled that despite the note having been stolen, Miller had the best title and was allowed to keep it.

In justifying his ruling, Mansfield dismissed as "quaint" the old earmark principle for not following money. Instead, he appealed to the common mercantile practice of the day. Banknotes, wrote Mansfield, are:

not goods, nor securities, nor documents for debts, nor are so esteemed; but are treated as money, as cash, in the ordinary course and transactions of business, by the general consent of mankind, which gives them the credit and currency of money to all intents and purposes. The are as much money as guineas themselves are, or any other current coins that is used in common payment as money or cash. 

The true reason that money cannot be followed, said Mansfield, is upon "the currency of it; it can not be recovered after it has passed in currency." Thus had Finney sued the robber before he had spent the stolen note, he would have succeeded in claiming title since the note had not yet passed into currency. But once Miller accepted it, the note was "in currency" and thus out of nemo dat's reach. In subsequent rulings, Mansfield extended this same protection to bills of exchange, cheques, bonds, and exchequer bills. Any contrary decision would "incommode" trade and commerce, wrote Mansfield. Thus the customs of merchants were transcribed into common law.

---

So both lex mercatoria and the common law tradition that superseded it accepted the principle that in order to protect commerce, highly liquid instruments should not be subject to nemo dat.  Given this precedent, why not extend this same broad amnesty to modern monetary innovations like bitcoin, Fedcoin, or other digital bearer tokens?

One reason could be that bitcoin hasn't proven itself yet. Whereas bills of exchange and banknotes had been widely accepted for decades, even centuries prior to Mansfield's ruling, bitcoin is less than a decade old. It fails the my-grandmother-uses-it-test or, in Mansfield's words, lacks the "general consent of mankind." People seem more intent on hoarding the stuff than trading it around in the "ordinary course of business." Unfortunately there is a chicken-and-egg dynamic at play here; how can bitcoin gain enough consent to be granted amnesty by the law if it needs amnesty to gain consent in the first place?

Lacking common law amnesty from nemo dat, an alternative would be to modify bitcoin so that it is completely anonymous. Although it is true that the real world identity of a bitcoin owner remains unknown, the blockchain itself is a publicly-distributed ledger that reveals the history of every single bitcoin. Removing the ability to see the ledger's history would restore true anonymity. In the same way that coins were originally exempt from nemo dat because they were physically impossible to follow, modern law would not be able to trace any given bitcoin because there would be no means to do so. Anonymity in turn guarantees fungibility, without which mass market adoption might never happen. My understanding is that extensions such as Zerocoin or Zerocash would be able to achieve this sort of true anonymity.

The third route is to roll with the punches and accept non-fungibility. If merchants must search each bitcoin's past, they will innovate solutions to cope. One innovation would be to set up a system for grading bitcoin so as to save on transaction time. Tokens that pass a test of authenticity would be accepted at par whereas low grade bitcoin, that which has a soiled history, would pass at a large discount to pure bitcoin. I believe that a few bitcoin grading services have emerged, including Mint Exchange, which sells freshly-mined bitcoin (which are unburdened by a history) at a premium to regular bitcoin.

---

Let's explore the third route a bit more. There is precedent for non-fungible monetary systems. During the so-called Wildcat banking era in the early to mid 1800s, U.S. privately-issued banknotes of the same denomination (say $1) were often  accepted at varying discounts to par. A $10 note from a the Bank of Talahassee might only be worth 98% that of a $10 note from the Bank of Fargo.

While banking regulations prevented note-issuing banks from establishing branches beyond state borders, nothing kept their notes from circulating outside of their home state. However, for notes to be settled in gold, they had to be returned to the issuing bank. Given the large distances involved and lack of transportation infrastructure, this could be an expensive process. To recoup this cost a merchant would typically accept local notes at par while applying discounts to non-local notes. The discount acted as a fee that covered the merchant's transportation costs. And since each bank's brand of notes involved different transportation costs, there were a bewildering number of discounts.

To solve the non-fungibility problem, a new profession emerged, that of a banknote analyst. In addition to providing merchants with information on how to spot counterfeit bank notes, an analyst would publish a weekly banknote reporter that advertised the market price of each banknote that circulated in a particular city, say Philadelphia. Gary Gorton provides a visual feel for what one looks like. Philadelphian merchants who subscribed would, upon being proffered a particular note by a customer, consult their reporter and apply the proper discount. I've explained in more depth how this process worked here and here.

While a Wildcat-era sorting mechanism for bitcoins would help merchants cope with the fungibility problem, any sort of grading process would also impose an extra set of costs on the bitcoin system, making it less competitive with banknotes and deposits. The lack of uniformity of U.S. banknotes was recognized to be enough of a problem that the 1864 National Banking Acts required all banks to accept notes at par (it would have been better to allow banks to establish branches across state lines, of course. See George Selgin here).

Uniformity would certainly be the most efficient solution for bitcoin, but lacking a central authority that can enforce par acceptance, bitcoin may have to endure a period of non-fungibility before the law deems the cryptocurrency popular enough to earn amnesty from nemo dat. That's a low bar to set, but if bitcoin is as good as its proponents say, it should be a bar that can be limbo-ed.


Sources:

S. Todd Lowry: "Lord Mansfield and the Law Merchant: Law and Economics in the Eighteenth Century" (1973) [link]
Benjamin Geva: "The Payment Order of Antiquity and the Middle Ages" (2011)
Kenneth Reid: "Banknotes and their Vindication in Eighteenth-Century Scotland" (2013) [link]
David Fox: "Banks v Whetston" in Landmark Cases in Property Law (2015)
Tim Swanson: Unable to dynamically match supply with demand (2015)
Nick Szabo: From Contracts to Money (2006)

A libertarian case for abolishing cash

Last week Citi's Willem Buiter published a note on the three ways to get rid of the effective lower bound to nominal interest rates, one of which is to abolish cash. He goes on to say that

politically, the abolition of currency would run into opposition from some of the legitimately cash-dependent poor and elderly, from those for whom the anonymity of cash is desired because they are engaged in illegal activities and from libertarians. The first constituency can be helped, the second can be ignored and the third one should take one for the team.

I think that Buiter is wrong to characterize libertarians as necessarily opposed to the abolition of cash. Their take on cash is probably (or at least should be) a bit more nuanced. Since libertarians generally advocate government withdrawal from lines of business like health care or liquor retailing, an exit of central banks from the cash business should be a desirable outcome.

What Buiter is advocating is a bit more extreme than just government exit, however. An across-the-board banning of cash would not only take the government out of the cash business but also prevent individuals and businesses from entering the product niche. The participation of the private sector in the provision of cash isn't just science fiction. Historically, commercial banks were intimately involved in the production of paper currency. In modern times, the majority of banknotes that circulate in Scotland are issued by three private banks—the Bank of Scotland, the Royal Bank of Scotland, and the Clydesdale Bank, while in Hong Kong, the major commercial banks are charged with issuing currency.

Buiter would probably object to private banknotes. After all, if private banks are able to issue negotiable bearer instrument that pay a zero nominal interest rate, a central banker will continue to be plagued by the problem that he/she can't reduce interest rates below zero—instead of fleeing into 0% government paper, the public will hide in private banknotes. It's the same liquidity trap as before, with private currency in the place of central bank currency.

However, there would be one key difference. Private banks must abide by the Darwinian calculus of profit and losses, central banks don't have to. Take a world with privatized cash. A recession hits and the rate of return on capital falls plummets. At the same time, the central bank drops its deposit rate deep into negative territory. As a private bank tries to match with deposit rate reductions of its own, say to -2%, customers will convert negative yielding deposits into the bank's higher-yielding 0% bank notes. The bank, whose survival depends on a healthy spread between the rates on borrowing and lending, faces a sudden spike in borrowing costs to 0%, the rate on their cash base. Spreads will shrink, even invert. Bankruptcy looms.

In order to avert this disaster, private issuers will quickly institute limits on their cash business. This could involve adopting any one of Buiter's three remedies: 1) cancel their note issue; 2) impose a fee on cash, or; 3) remove the fixed exchange rate between deposits and cash. Thus,the lower bound probably wouldn't be a problem in a banking system characterized by privatized paper issuance. The necessity of maintaining a spread would force private banks to rapidly innovate any one of these three escapes come recession and negative nominal rates. Upon recovery, they can remove these limitations and continue with their regular cash business.

Imagine that private banks all choose the first option when nominal rates fall below zero, cancellation. With cash no longer in existence, banks will have succeeded in restoring their margins to health. The population, however, will have effectively lost their ability to make anonymous transactions. This puts a libertarian in a tough philosophical position. On the one hand, a cashless world poses a serious threat to personal liberty. John Cochrane calls it an "Orwellian nightmare," and Chris Dillow has referred to banning cash as "a grossly illiberal measure - the banning of capitalist acts between consenting adults."

On the other hand, if cash threatens a bank's existence, no libertarian would advocate the use of force to prevent said bank from exiting the business of cash provision. Capitalistic acts cannot be forced upon non-consenting adults, or, put differently, Jack's desire for anonymity-providing products doesn't justify Jill being put into chains in order to provide those products. Therefore, a withdrawal of cash by banks as nominal rates fall below zero, and the loss of anonymity that comes with it, is consistent with libertarianism.

So oddly, Buiter's proposed end point—a cancellation of cash in order to rid the world of the lower bound—is very similar to what a libertarian end point could look like. Both institutions will elect to withdraw cash from circulation because it interferes with their institutional prerogatives. For a central bank, this mission boils down to the targeting of some nominal variable like inflation while in the case of a private bank it is its ability to earn a competitive return. That's not to say that a libertarian ought to support Buiter's abolition, only that the subject is more nuanced than it might seem upon a superficial reading.  

As a postscript, it's worth noting that neither Buiter's central banker nor a libertarian's private banker need go as far as abolishing cash in order to remove the effective lower bound. Buiter provides two other options, the best of which (in my opinion) is removing the fixed exchange rate between cash and deposits. Miles Kimball has gone through this option exhaustively. I've outlined some even less invasive, though not as effective, options here.

---

Related links: 

Does the zero lower bound exist thanks to the government's paper currency monopoly? (link)
Is legal tender an imposition on free markets or a free market institution? (link)
Bill Woolsey on how the private sector would withdraw cash at negative rates (link | link )
FTAlphaville: Buiter on the death of cash ( link )

Note: I changed some wording on September 26, 2015. The message remains the same.

Cracks in the zero-lower bound

Shibboleth, by Doris Scalcedo

John Cochrane writes an interesting post that makes the case that removing or penalizing cash would not remove an economy's 0% lower bound. Briefly, the zero lower bound problem arises when a central bank tries to reduce the interest rate on central bank deposits below zero. Because cash always yields a superior 0% yield, everyone will race to convert their deposits into cash, thus preventing a negative interest rate from ever emerging. By removing cash, this escape route is plugged and a central bank can safely guide rates to -4 or -5%.

Cochrane's point is that even if cash is removed, there are a number of alternative 0% yielding 'exits' to which people will flee, the effect being that rates will be inhibited from falling much below 0%. The examples he provides includes prepayment of taxes, bills, and mortgage payments, and the hoarding of gift cars or stored value cards like subway passes. In a follow-up post, he mentions a strategy of rolling over cheques.

There are two points I want to make:

1. Even with alternatives, a central bank can still create inflation

Scott Sumner points out that even in a cashless world at the zero lower bound, the existence of these alternatives cannot impede a central bank from driving up inflation. This is because the other alternative assets that Cochrane discusses are not media of account. To be a medium of account is to be that good which defines the $ unit that appears on a retailer's website and their aisles. What this means is that the the sorts of dollars that a retailer has in mind when setting sticker prices are those issued by the nation's central bank (in a cashless world, this would be central bank deposits). Retailers aren't using gift card dollars or stored value card dollars as the 'reference dollar' for their sticker prices.

Keep in mind that the use of central bank deposits as the medium of account does not preclude retailers from accepting gift cards in payment at the till. However, if they accept them, they'll probably apply some sort of reduction/addition to a good's advertised sticker price. If we assume that gift cards have become quite liquid in the absence of cash, I think it's conceivable that retailers would offer a reduction (ie. take gift cards at a premium) since gift cards would be a better asset than a deposit; in addition to being useful as media of exchange, they yield 0% rather than negative yielding deposits. We could imagine a range of different gift card premia developing based on their perceived quality, with cashiers consulting some sort of electronic guide to calculate the final bill.

In any case, Sumner's point is that as the central bank reduces rates into negative territory, sticker prices will all rise, despite the fact that alternative media exist that can be used to make payments. I think he's dead right.

2. Alternative escape routes will be resolved by simple product alterations, not a legal revolution

Cochrane's posts emphasize that in a negative rate world, all sorts of odd financial loop holes will be exploited in order to earn superior 0% returns. I think he's right on this. However, Cochrane seems to believe that that the government will have to upend 'centuries of law' in order to plug these alternative 0% instruments. I am more sanguine than him. If someone is exploiting a loophole in order to earn a superior 0% return, someone else is bearing that negative return. Institutions forced to bear the negative impacts of these loopholes will have an incentive to quickly evolve simple strategies to plug them, thus precluding any need for either Cochrane's rather dramatic 'legal revolution' or the heavy hand of the government.

Take Cochrane's first 'escape', gift cards. Consider a retailer that issues 0% gift cards in various denominations like $50s and $100s. Assume that in a world without cash, these cards have become relatively liquid. The central bank suddenly pushes rates to -5%. People who own negative yielding bank deposits will flock to buy the retailer's gift cards (assume that both instruments are equally risky) with the goal of immediately improving their expected return from -5% to 0%. The retailer, however, is left holding a -5% asset while owing a 0% liability, an awful position to be in. To remove the burden of this negative spread, our retailer need only reduce the return on newly-issued gift cards to -5%, say be introducing a redemption fee of 5%. A gift card worth $100, when redeemed, now only buys you $95 worth of stuff. Either that or just stop issuing the things. The loophole is closed and the problem solved.

The same goes for Cochrane's other 0% exit, prepayment if bills. A firm that allows for prepayments is accepting a 0% liability on itself; it effectively owes x dollars worth of some service or item. So we are back to our gift card example above, since gift cards are basically prepayments. Impose an appropriately sized fee on those who want to prepay and the problem is solved. Banks have always charged prepayment penalties on mortgages, car loans, and business loans, so this is nothing revolutionary in turning to this solution.

The next of Cochrane's 0% exits is a string of constantly renewed personal cheques. Rather than cashing a personal check, a cheque holder waits for that cheque to go 'stale', usually after 6-months, and then asks the issuer to issue a new one, rinsing and repeating as often as necessary. As physical bearer instruments, cheques (much like cash) cannot be made to pay negative interest, which allows the holder of a cheque to earn a perpetual 0% return. The unfortunate issuer of the cheque is left bearing a 0% liability in a world where their assets are yielding just -5%. This problem will quickly be resolved by people no longer writing checks. There is a less extreme alternative. Banks, unwilling to lose revenues from their cheques businesses, will simply increase cheque cancellation fees. Before a stale check is re-issued, it must be canceled, which traditionally incurs a cancellation fee. If the person running the scheme is required to pay an appropriately sized fee to carry over the cheque, the scheme can be rendered no more profitable than owning a -5% deposit.

Cochrane also points to Kenneth Garbade and Jamie McAndrews's scheme whereby depositors can purchase certified cheques from banks and thereby evade negative rates. According to Garbade and McAndrews, commercial banks "might find their liabilities shifting from deposits (on which they charge interest) to certified cheques outstanding," with this shift imposing significant costs on banks since certified cheques are less stable than deposits. If such a shift were to occur, banks would find themselves bearing a negative spread (liabilities yielding 0% while assets yielding -5%), a position they would be quick to remedy. One option would be to cease the issuance of certified cheques altogether. Alternatively, banks have always charged a fee for certified cheques. They could simply increase this fee to the point that the cost of holding a certified cheque is brought in line with the negative deposit rate. Once again, problem solved.

This fee strategy shouldn't be unfamiliar. It is the mirror image of the strategy adopted by U.S. commercial banks when interest rates were capped during the inflationary 1960s and 70s. Unable to reward depositors with sufficiently high interest rates, banks evaded the ceilings by offering implicit interest in the form of under-priced banking services, say by reducing fees on certified cheques. In our modern era in which deflation is pushing rates towards an equally artificial 0% barrier (in this case arising from the circulation of personal and certified cheques rather than a government imposed cap), all those services that a bank had been underpricing or pricing at market will now be adjusted upwards so that they are overpriced.

In sum, no revolutions here, just markets adaptation via boring old fee changes.

In closing, Cochrane has much more legitimate worries about two other problems: Big Brother and the disproportionate effect on the poor if cash is removed. Agreed, these are big issues. Now it could be that the emergence of cryptocurrencies such as bitcoin solves the Big Brother problem so that there is no role left for cash in preserving anonymity. Let's put bitcoin aside though. The simple answer to both of Cochrane's concerns is that we don't need an outright ban on cash to remove the 0% lower bound. Just adopt Miles Kimball's proposal for a crawling peg between cash and deposits. Kimball's peg is designed in a way that it would impose the same penalty on cash as that incurred by deposits. This would allow central banks to push rates to zero without mass flight into cash, all the while preserving the institution of cash for the poor and those requiring anonymity. (I've written in support of Kimball's plan here and here)

There is also my lazy man's route toward getting below the lower bound (here, here, here). I call it lazy since it's not nearly as complete as Kimball's solution, nor as complicated. Simply withdraw high denominations of bills like $100s, $50s, and $20s. When a central bank sends rates to -3% or -4%, people will balk at fleeing from deposits into $1s, $5s, and $10s since low denominations are very inconvenient to store. That way the poor still get to use cash and the zero lower bound can be breached.

Fedcoin

Recent posts by Adrian Hope Baille and Sina Motamedi have got me thinking again about the idea of the Federal Reserve (or any other central bank for that matter) adopting bitcoin technology. Here's an older post of mine on the idea, although this post will take a different tack.

The bitcoin ethos enshrines the idea of a world free from the totalitarian control of central banks. So in exploring the idea of Fed-run bitcoin-style ledger, I realize that I run the risk of being cast as Darth Vader (or even *yikes* the Emperor) by bitcoin true believers. So be it. While I do empathize with the bitcoin ideal—I support freedom in banking—I rank the importance of bitcoin-as-product above bitcoin-as-philosophy. And at the moment, bitcoin is not a great product. While bitcoin has many useful features, these are all overshadowed by the fact that its price is too damn volatile for it to be be taken seriously as an exchange medium. This volatility arises because bitcoin lacks a fundamental value, or anchor, a point that I've written about many times in the past. However, there is one way to fix the crypto volatility problem...

Enter Fedcoin

Setting up the apparatus would be very simple. The Fed would create a new blockchain called Fedcoin. Or it might create a Ripple style ledger by the same name. It doesn't matter which. There would be an important difference between Fedcoin and more traditional cryptoledgers. One user—the Fed—would get special authority to create and destroy ledger entries, or Fedcoin. (Sina Motamedi gives a more technical explanation for how this would work in the case of a blockchain-style ledger)

The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types—paper money and electronic reserves—and Fedcoin at a rate of 1:1. The outcome of this rule would be that Fedcoin could only be created at the same time that an equivalent reserve or paper note was destroyed and, vice versa, Fedcoin could only be destroyed upon the creation of a new paper note or reserve entry.

So unlike bitcoin, the price of Fedcoin would be anchored. Should Fedcoin trade at a discount to dollar notes and reserves, people would convert Fedcoin into these alternatives until the arbitrage opportunity disappears, and vice versa if Fedcoin should trade at a premium.

As for the supply of Fedcoin, it would effectively be left free to vary endogenously, much like how the Fed currently let's the market determine the supply of Fed paper money. This flexibility stands in contrast to the fixed supply of bitcoin and other cryptocoins. The mechanism would work something like this. Should the public demand Fedcoin, they would have to bring paper dollars to the Fed to be converted into an equivalent number of new Fedcoin ledger entries, the notes officially removed from circulation and shredded. As for banks, if they wanted to accumulate an inventory of Fedcoin, they would exchange reserves for Fedcoin at a rate of 1:1, those reserves being deleted from Fed computers and the coins added to the Fedcoin ledger.

Symmetrically, unwanted Fedcoin would reflux to the central bank in return for either newly-created cash (in the case of the public) or reserves (in the case of banks), upon which the Fed would erase those coins from the ledger. The upshot is that the Fed would have no control over the quantity of Fedcoin—it would only passively create new coin according to the demands of the public.

Apart from that, Fedcoin would be similar in nature to most other cryptoledgers. All Fedcoin transactions would be announced to a distributed network of listening nodes for processing and verification. In other words, these nodes, and not the Fed, would be responsible for maintaining the integrity of the Fedcoin ledger.

Why implement Fedcoin?

The main reasons that the Fed would implement Fedcoin would be to provide the public with an innovative and cheap payments option, and to provide the taxpayer with tax savings.

The public would enjoy all the benefits of bitcoin including fast transaction speeds, cheap transaction costs, and the ability to transact almost anywhere and with almost anyone as long as all parties to a transaction had a smartphone and the right software. At the same time Fedcoin's stability would immediately differentiate it from bitcoin. No longer would users have to fear losing 50% of their purchasing power prior to making a transaction.

Fedcoin's distributed architecture would be both complementary and in many ways superior to Fedwire, a centralized system which currently provides for the transferal of Fed electronic reserves among banks. I won't bother getting into the specifics: see this old post.

By introducing Fedcoin, the Fed would also lower its costs. While I haven't done the calculations, I have little doubt that running a distributed cryptoledger is far cheaper than maintaining billions of paper notes in circulation. Paper currency involves all sorts of outlays including designing and printing notes, collecting, processing and storing them, as well as constantly defending the note issue against counterfeiters. A distributed ledger does all this at a fraction of the cost. As Fedcoin begins to displace cash, and I think that this would steadily happen over time due to its superiority over paper, the Fed's costs would fall and its profits rise to the benefit of the taxpayer.

Fedcoin would have no impact on monetary policy

Fed officials might balk at giving the idea a shot if they feared that adopting a Fed cryptoledger would impede the smooth functioning of Fed monetary policy. They needn't worry.

The Fed currently exercises control over the price level by varying the quantity of reserves and/or the interest paid on reserves. The existence of cash doesn't get in the way of this process, nor has it ever gotten in the way. Bringing in a third liability type, Fedcoin, the quantity of which is designed to fluctuate in the same way as cash, would likewise have no impact on monetary policy. The Fed would continue to lever the return on reserves in order to get a bite on prices while allowing the market to independently choose the quantity of Fedcoin and cash it wished to hold.

Well, almost none: Interest on Fedcoin and the zero lower bound

Ok, I sort of lied in the last paragraph. While it happens only rarely, there are times when cash does get in the way of monetary policy, and so would Fedcoin if it were implemented. If the Fed needs to reduce rates on reserves to negative levels in order to hit its price and employment targets, the existence of cash impedes the smooth slide below zero. With reserves yielding -2% and paper notes yielding 0%, reserves would quickly be converted en masse into cash until only the latter remains. At that point the Fed would have lost its ability to alter rates—cash doesn't pay interest nor can it be penalized—and would no longer be capable of exercising monetary policy. This is called the zero-lower bound, and it terrifies central bankers.

Fedcoin has the potential to alleviate the zero lower bound problem. Here's how.

As Fedcoin adoption grows among the public, cash would steadily be withdrawn. And while it might not shrink to nothing—the public might still choose to use some cash—at least the Fed would have a good case for entirely canceling larger denominations like the $100 and $50.

Consider also that it would be possible for interest to be paid on each Fedcoin  (unlike bitcoin and cash), the rate to be determined by the Fed. And just as Fedcoin could earn positive interest, the Fed could also impose a negative rate penalty on Fedcoin. This would effectively solve the Fed's zero lower bound problem. After all, if the Fed wished to reduce the rate on reserves to -2 or -3% in order to deal with a crisis, and reserve owners began to bolt into Fedcoin so as to avoid the penalty, the Fed would be able to forestall this run by simultaneously reducing the interest rate on Fedcoin to -2 or -3%. Nor could reserve owners race into cash, with only low denomination and expensive-to-store $5s and $10s available.

So by implementing something like Fedcoin, the Fed could safely implement a negative interest rate monetary policy.

(Lastly, monetary policy nerds will notice that the displacement of non-interest yielding cash with interest-yielding Fedcoin is a tidy way to arrive at Milton Friedman's optimum quantity of money, or the Friedman rule.)

The big losers: banks

Fedcoin has the potential to tear down the private banking system. Interest yielding Fedcoin would be able to do everything a bank deposit could do and more, and all this at a fraction of the cost. As the public shifted out of private bank deposits and into Fedcoin, banks would have to sell off their loan portfolios, the entire banking industry shrinking into irrelevance.

One way to prevent this from happening would be for the Fed to make an explicit announcement that any bank could be free to create its own competing copy of Fedcoin, say WellsFargoCoin. Like the Fed, Wells Fargo would promise to offer two-way convertibility between its deposits/cash/Fedcoin and WellsFargoCoin at a rate of 1:1 to ensure that the price of its new ledger entries were well-anchored. The bank could then implement features to compete with Fedcoin such as higher interest rates or complimentary financial services. Even as Wells Fargo's deposit base steadily shrunk due to technological obsolescence, its base of WellsFargoCoin liabilities would rise in a compensatory manner.

The resulting lattice network of competing private bank crypto ledgers built on top of the Fedcoin ledger would work in a similar fashion to the current banking system. Wells Fargo would make loans in WellsFargoCoin and take deposits of FedCoin as well as competing bankcoins, say CitiCoin or BankofAmericaCoin. Intra-bank cryptocoin payments would be cleared on the books of the Federal Reserve with reserves transfers over the Fedwire funds system, although Fedcoin might eventually take the place of Fedwire. A change in the value of Fedcoin or reserves due to a shift in monetary policy would be transmitted immediately into a change in the value of all private bankcoins by virtue of  the convertibility of the latter into the former.

Nor would it be necessary to start with Fedcoin and then introduce bankcoins. Why not begin with the latter and skip Fedcoin altogether? Why aren't private banks at this very moment switching out deposits and replacing them with cryptoledgers?

KYC: Know your customer

'Know your customer' regulations would make implementation difficult, but not impossible.

With bitcoin, the location of a coin (its address) is public but the identity of the owner is not. However, laws require banks to gather information on their customers to protect against money laundering. As these laws are unlikely to change with the advent of new technology, banks would probably require anyone wanting to use bank cryptoledgers to have an account with a regulated bank. This would not be too onerous given that most Americans already have bank accounts.  However, it compromises anonymity, one of the key ideals of bitcoin, since each coin would be traceable by the authorities to a real person.

Perhaps there is still a way to preserve some degree of anonymity. Historically the Fed has always been spared from KYC rules since it has never had to document who uses cash. By grandfathering KYC exemption to Fedcoin, any user who wanted to preserve their anonymity could use Fedcoin rather than any of the multiple bankcoin ledgers, just like today they prefer to use anonymous Fed cash rather than bank accounts to transact.

In summary

So that's a rough sketch of Fedcoin—a decentralized, flexible, and well-backed payments system that grants one user, the Fed, a set of special privileges and responsibilities. Feel free to modify the idea in the comments section.

And just so we are keeping tabs, these are the institutions that Fedcoin could eventually make obsolete: bank deposits, banks (unless the latter are allowed to innovate their own bankcoins), the credit card networks Visa and Mastercard, bank notes, Fedwire, and even bitcoin itself, which would be unable to compete with a stable-value copy of itself.

Bitcoin true believers may not like this post, but perhaps they can take something constructive from it. Fedcoin is one of the potential competitors in the distant horizon. Now is the time for the rebels to figure out how to create a stable-price version of bitcoin, before Darth Vader does it himself. Otherwise they may someday find themselves closing down their bitcoin startups in order to write code for the Empire.

---

Note: My apologies to readers for my having succumbed to the constant temptation to adorn all blog posts with Star Wars references.