Demonetization by serial number

This continues a series of posts (1, 2, 3) I've been writing that tries to improve on Indian PM Narendra Modi's clumsy demonetization, or what I prefer to call a policy of surprise note swaps.

The main goal of Modi's demonetization (i.e. note swapping) is to attack holdings of so-called "black money," or unaccounted cash. The problem here is that to have a genuine long-run effect on the behavior of illicit cash users, a policy of demonetization needs to be more than a one-off game. It needs to be a repeatable one. A credible threat of a repeat swap a few months down the road ensures that stocks of licit money don't get rebuilt after the most recent swap. If that threat isn't credible, then people will simply go back to old patterns of cash usage.

It's worth pointing out that the idea of behind demonetization precedes Modi by many decades. In a 1976 article entitled Calling in the Big Bills and a 1980 a follow-up How to Make the Mob Miserable, James S. Henry, who is on Twitter, described what he called "surprise currency recalls."

In 1976, @submergingmkt wrote the original call for an aggressive demonetization: https://t.co/tDro2hnvAZ Does he approve of Modi's effort? pic.twitter.com/wM2EzLjkWB

— JP Koning (@jp_koning) January 10, 2017

Specifically, Henry advocated a sudden cancellation and reissuance of all US$50 and $100 notes as a way to hurt "tax cheats, Mafiosi, and other pillars of the criminal community." Rather than a one-shot action, which would only annoy criminals, the idea was that "the recalls could be repeated, at random, every few years or so, raising the 'transaction costs' of doing illegal business."

In order to credibly threaten a series of repeat note swaps, I'd argue that the quantity of notes recalled in each demonetization must be small. Small batches of notes can be quickly cancelled and replaced without disturbing people's lives. This keeps the economic and political costs of withdrawing demonetized cash (lineups, cash shortages, etc) manageable. If these costs are too high, the threat of repeats isn't credible.

Instead of going small, Narendra Modi decided to go big by having the Reserve Bank of India demonetize both of India's highest value banknotes, the ₹500 and ₹1000 note, which together comprised some 86% of India's cash. This has caused all sorts of problems. For instance, almost four months after the November 8 announcement the amount of cash in circulation is still far below the required levels of ₹17-19 trillion, the RBI unable to run its printing presses fast enough to keep up. The RBI's inability to fill the vacuum left by demonetized notes has been ably explained by James Wilson and is illustrated in the chart below:

Because of the enormous disruption it has caused, Modi's massive demonetization departs from Henry's script—it cannot be repeated, not for decades (a point that Russell A. Green makes here as well). Were Modi to begin discussing another demonetization, say for 2018, Indians would probably rise up in anger at the possibility of more lineups, empty ATMs, and hurdles to making basic purchases. Which means that post-Modi demonetization, it's entirely safe for India's illicit users of cash to wade back into the waters. If cash usage patterns return to normal, it seems to me that the entire demonetization project was an exercise in futility.

In India's case, demonetizing entire note denominations is too powerful a tool to ensure repeatability. Even if Modi had demonetized the ₹1000 note and not the ₹500, for instance, the exercise would still have involved some 30-40% of the nation's cash supply. This would have been an arduous affair for all involved, certainly not one that could be repeated for many years.

Weeding out rupee banknotes according to serial number rather than denomination would have allowed for a more refined policy along the lines advocated by Henry. Here's how it would work. The government begins by declaring that all ₹1000 notes ending with the number 9 are henceforth illegal. Anyone owning an offending note can bring it to a bank to be swapped for a legitimate ₹1000 note (one that doesn't end in 9). However, the government sets a limit on the number of demonetized notes that can be exchanged directly for legitimate notes, say no more than three. Anything above that can only be exchanged in person at a bank teller for deposits, which requires that they have an account (i.e. their anonymity will be lifted). Once an individual has deposited five notes in their account, all subsequent deposits of demonetized notes would require a good explanation for the notes' provenance. Should the requisite paper trail be missing, the depositor gives up the entire amount.

The process begins anew a few months hence, the specific timing and banknote target being randomly chosen. So maybe thirteen months after the first swap, the government demonetizes all ₹500 notes ending in 6. Randomness prevents people from anticipating the move and hiding their illicit wealth in a different high denomination note. 

Too understand how this affects black money owners, consider someone who owns a large quantity of illicit ₹1000 banknotes, say ₹70 million (US$1 million, or 70,000 banknotes). This person faces the threat of losing 10% to the note swap. After all, when the 9s are called, odds are that he or she will have around 7,000 of them, of which only eight can be returned without requiring a paper trail. The owner can simply accept a continuing string of 10% losses each year as a cost of doing business.

Alternatively, they might protect themselves ahead of time by converting their hoard into a competing store of value, say gold, bitcoin or low denomination rupee notes like ₹100s (which are not subject to the policy of ongoing swaps). If they flee high denomination notes to avoid subsequent demonetizations, illicit cash users in a worse position than before the adoption of the policy of note swapping. Gold and small denomination notes have far higher storage and handling costs than ₹1000 banknote. And unlike gold and bitcoin, a banknote is both supremely liquid and stable. So even if large-scale owners of banknotes manage to avoid painful note swaps, they still endure higher costs.

As for licit users of high denomination notes, the fact that the 10% clawback would not apply to them means they needn't change their behavior. Nor would the poor--who are unlikely to be able to provide a paper trail--have to worry about the policy. Demonetizations would only occur in high denominations, in India's case ₹500 and 1000s, and the poor are less likely to own these in quantities above the three note limit.

Incidentally, readers may recognize a policy of repeat demonetizations as akin to a Gesell stamp tax, named after Silvio Gesell, who in 1916 proposed the idea of taxing currency holdings in order to increase the velocity of circulation. Greg Mankiw famously updated Gesell's idea during the 2008 credit crisis to remove the zero lower bound. He did so by using serial numbers as the device for imposing a negative return rather than stamps. This post updates Mankiw's idea, except rather than applying the tax to all cash it strikes only at illicit cash holdings, and does so in the name of an entirely different policy goal—attacking the underground economy, not removal of the zero lower bound.

A series of small serial number-based swaps seems like a better policy than Modi's ham-handed demonetization of all ₹1000 and ₹500s. It would certainly do a better job of promoting a long-term decline in undocumented cash holdings and would do so by imposing a much smaller blast radius on the Indian public. There would be no currency shortages, huge lineups at banks, empty ATMs, or trades going unconsummated due to lack of paper money.

 That being said, while superior to Modi's shock & awe approach, a policy of repeat note swaps certainly has its flaws. In principle, the idea of surprising citizens every few months—i.e. forcing them to keep on guessing—does not seem entirely consistent with the rule of law. Another problem is that once the policy has been ongoing for several years, the list of demonetized serial numbers will be quite long. The process of buying stuff with notes will become evermore difficult given the necessity that the merchant consult this list prior to each deal to ensure that bad notes aren't being fobbed off. Finally, commenting recently on Henry's plan, Ken Rogoff notes that "there is a fine line between a snap currency exchange and a debt default, especially for a highly developed economy in peacetime." Since debt defaults hurt a countries credit standing, serial demonetizations might lead the investment community to be more leery about the nation's other liabilities, say its bonds.

Italian exit and the problem of lira shortages

The topic of euro breakup has slowly been trickling back in the news, especially with the potential for Italy leaving the currency union, a so-called Italexit. In this post I want to explore one of the major conundrums that would-be exiteers must face; the problem of banknotes.

Almost all euro exit scenarios begin with the departing country announcing a shot-gun redenomination of bank deposits into a new currency, in Italy's case the lira. The effort must be sudden—if redenomination is anticipated ahead of time, depositors will preemptively withdraw funds from the exiting country's banking system, say Italy, and put them in the banking systems of the remaining members, say Germany, doing irreparable damage to Italian banks. After all, why risk holding soon-to-be lira when they are likely to be worth far less than euros?

Once the surprise redenomination has been carried out, the next step is to quickly introduce new lira banknotes into the economy. Lira deposits, after all, should probably be convertible into lira cash. This is much tougher than it sounds. Consider the recent Indian debacle. On November 8, 2016 Indian PM Narendra Modi demonetized around 85% of India's banknotes. Ever since then the Reserve Bank of India, the nation's central bank, has been furiously trying to replace the legacy issue with new currency. Because a nation's printing presses will typically only have the capacity to augment the stock of already-existing currency by a few percent each year, a rapid replacement of the entire stock simply isn't possible. India, which has been plagued with a chronic shortage of banknotes since the November announcement, is unlikely to meet its citizens' demand for cash until well into 2017. This in turn has hurt the Indian economy.

Like India, any Italian effort to print enough new lira paper to meet domestic demand could take months to complete. Without sufficient paper lira, existing euro banknotes would have to meet Italians' demand for paper money. Under this scenario, Italians would have to endure a messy mixture of electronic lira circulating with paper euros, reminiscent of the old bimetallic, or silver & gold standards, of yore. I say messy because everything in Italy would have two prices, a lira price and a euro price. In some ways this would be similar to the euro changeover period in 2002 when European shops displayed both euro and legacy currency prices on their shelves (lira, deutschemarks, francs, etc). The difference is that in the 2002 changeover the exchange rate was fixed, so the amount of mental arithmetic devoted to calculating exchange rates was minimal. In the case of Italexit and a new lira, the price of the lira would likely float relative to the euro, so the mental gymnastics required of Italians would be much more onerous.

If the Italian government were to attempt to fix this messiness by forcing retailers to accept euros and lira at a fixed rate, then Gresham's law would probably kick in. Because the government's chosen ratio is likely to overvalue the lira and undervalue the euro, Italians would hoard their paper euros (preferring to use them in Germany and elsewhere) while relying solely on electronic lira to buy things. This hoarding of paper euros, and the ongoing lack of paper lira, would likely lead to a severe banknote shortage, much like the shortages that India and Zimbabwe are currently enduring.

Some readers are probably wondering why Italy wouldn't try printing new banknotes ahead of the redenomination date. That way it could engineer a rapid lira changeover rather than a slow one. The problem here is that if Italian authorities take a preemptive approach, odds are that word will leak out that new lira are being printed, and depositors—spotting an impending redenomination coming down the road—will flee the Italian banking system en masse. So we are right back where we started. A successful Italexit requires that new lira banknotes be printed only after the redenomination has been announced, not before.

One technique that Italy might try in order to get lira paper into circulation as rapidly as possible is to use overstamping (described here). Once redenomination had been announced, Italian authorities quickly produce a large quantity of special stickers or stamps. They would then require Italians to bring in their euro banknotes to banks in order to be stamped, upon which those overstamped euros would no longer be recognized as euros, but lira. The window for getting euros stamped would last a week or two, after which the Italian government would declare that all remaining euro notes are no longer fit to circulate in Italy. Stamped notes would function as Italy's paper currency until the nation's printing presses have had the time to print genuine lira paper currency, at which point Italians would be required to bring stamped notes in for final conversion.

But even here Italy runs into a problem. An Italian with a stash of euro banknotes can either bring this stash in to be overstamped, and eventually converted into lira, or they can break the law and hoard said euros under their mattress. Hoarded euro note will still be valuable because they can be used to buy stuff in Germany, France, and in other remaining eurozone members. An overstamped euro, however, which has effectively been rebranded as lira, will be worth much less than before. Many Italians will therefore avoid getting their money stamped, preferring to get more value for their euro banknotes than less. And this means that Italy is likely to suffer a severe cash crunch, with euros being hoarded and new lira unable to fill the void fast enough, yet another manifestation of Gresham's law.

So any would-be euro exiteer faces several ugly possibilities, including a messy period of multiple prices to massive cash crunches.

It is because of these difficulties (and others) that I see euro exit as an incredibly unlikely proposition. The euro isn't a glove, it's a Chinese finger trap—once you've got it on, it's almost impossible to get out.

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If there is to be an exit, the most likely one will be the euros without the Eurozone approach. Rather than announcing a new lira, Italy simply says that it will officially leave the Eurozone while continuing to use the euro unofficially. This means that Italian banks would continue to denominate deposits in euros and keep euro banknotes in reserve to meet redemption requests. The euro would still be used by Italian merchants to price goods, and euro banknotes would continue circulating across the nation. The difference now would be that the Bank of Italy would no longer have the authority to print euro banknotes. Instead, Italy would have to import banknotes from the rest of Europe, much like how Panama—a dollarized nation—imports U.S. banknotes from the U.S., as do Zimbabwe and Ecuador. By employing this sort of strategy, all the hassles I wrote about in this post (multiple prices & cash crunches) are cleanly avoided while at the same time an exit of sorts is achieved.

The shrinking rupee

Earlier this month I criticized the architects of India's recent note demonetization for not using the traditional overstamping technique for replacing large quantities of banknotes.

This week I want to examine another feature of Modi's demonetization: the concurrent change in note sizing. The new series of ₹500 and ₹2000 notes are smaller in size than the ₹500 and ₹1000 series that they have since replaced. This has caused huge logistical problems. Since each cartridge in an ATM must be manually configured to handle a certain note size, ATMs were not equipped hold the newly issued ₹500s, ₹2000s, or additional ₹100s for that matter. Instead, they were forced to operate at a fraction of their capacity. Indians, desperate to replace their demonetized notes with good cash, were left on the lurch.

Let's explore the reduction in banknotes size. I'd argue that independent of the decision to crack down on black money, the decision to go smaller makes a lot of sense. But twinning a banknote size reduction with a demonetization was a recipe for disaster.

Consider that the length of the current issue of rupee banknotes grows as the denomination increases, like this:

Denomination: width x length

₹100: 73mm x 157mm

₹500: 73mm x 167mm

₹1000: 73mm x 177mm

To Americans and Canadians, this may seem odd since all our money is the same size. However, a pattern of progressively longer notes is quite common in other countries. Euro banknotes, for instance, also increase in size as denomination rises as do Swiss francs and Japanese yen. Presumably this format is chosen to to make manual sorting easier.

Now if the Reserve Bank of India, the nation's central bank, had continued to follow its traditional size progression, the newly issued 2000 rupee note would have had these measurements:

₹2000: 73mm x 187 mm

This would have been an awfully big note, one of the largest in the world by surface area. It would have clocked in 32% larger than a US$20 bill, for instance, and 43% larger than a 20 euro note. Not only would a note of this size have been expensive to print, but the combined costs of storage and handling incurred by hundreds of millions of Indians over time would have been quite large. Reducing the size would cut down on both expenses.*

The trend among central banks is to reduce the dimensions of banknotes. For instance, euro banknotes are quite a bit smaller than the francs, deutschmarks, and other notes that they replaced. The five euro note is one of the smallest notes in the world (see this pdf). When the Swiss began to introduce the ninth generation of Swiss banknotes in 2016, they lopped around 11 mm off the length of the 50 franc note and 4mm off its height (it now clocks in at 70 x 137 mm, down from 74 x 148).  By doing so, the Swiss National Bank will be lowering manufacturing and handling costs of the currency. In the chart below, you can see the evolution of the dimensions of Swiss cash over time.

Data source: Wikipedia

So India's decision to reduce the size of the new notes is very much modern practice. 17mm has been removed from the length of the ₹500 note; it measures 150 mm rather than 167mm. As for its height, it has gone from 73mm to 66mm. The new ₹2000 note measures 66mm x166mm, a 20% reduction from what it would have measured had the RBI continued with its old progression. Presumably the RBI will eventually do the same with the smaller denomination like the ₹100 as well.

While a note size reduction makes sense, twinning it with an aggressive demonetization was a bad decision. To reduce the odds of damaging the economy, the void left by demonetized notes must be filled as rapidly as possible. In India's case, the discontinuity in banknote size interfered with this re-cashification process. The authorities should have split the two policies apart, say by enacting a gentle two or three-year conversion of existing notes to a new and smaller series, and only announcing a surprise aggressive demonetization of the two highest denomination notes four or five years from now, say in 2021.

Alternatively, the authorities could have proceeded with their November 8 aggressive demonetization, but without enacting a note size reduction. The RBI should have taken incoming demonetized 500 and 1000 rupee notes and stamped them for re-circulation to ensure the banknote supply was sufficient, as I went into here. By using existing banknotes, ATMs cartridges would not have required adjustment. As for the new ₹500 note, it should have been the same size as the old series to ensure that cash distribution worked smoothly. Then—say five years from now—the Reserve Bank of India could have gradually phased in reduced note sizes for the entire range of denominations from the ₹10 to the ₹2000. This would have cut down on the chaos of the last few months.

The RBI seems not have been involved much in the planning stage of demonetization. According to recent press reports, the Board was "asked" to consider the demonetization just a day before it was enacted and had not discussed the matter before then. This is a shame. While an aggressive demonetization needs to be planned in secret, as I pointed out here, having at least a few closed-mouth central bank types involved from the outset seems like a basic requirement. They might have been able to fix the mistake of combining a demonetization with a note reduction.

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*On the other hand, there are arguments for increasing note size too. See Garber.

Modi and the overstamping of demonetized currency

1913 Austro-Hungarian banknote with 1919 Czechoslovak overstamp

When Indian PM Narendra Modi and his small group of would-be monetary architects were putting together their plan to suddenly demonetize the 500 and 1000 rupee note and replace them with new notes (including a new 2000 rupee note), they must have been missing a monetary historian. That's because there is a long history of nations suddenly demonetizing the entire circulating paper issue and introducing a new paper currency. These rapid switches have tended to follow a well-trodden script, one that Modi did not follow. Had he chosen to adopt it, the last two months might have been less chaotic.

One challenge faced by any prospective note switcher is to print the new currency fast enough to replace the legacy notes. When the switch is a slow one that is planned long beforehand, like the euro introduction, this is not an issue. In the case of a rapid switch that cannot be prepared for, however, the printing challenge is overwhelming. In India's case, pre-printing notes was not the answer. Because its goal was to surprise a large number of cash-users with undeclared cash, the rupee switch had to be sudden—printing large batches of notes ahead of time might have tipped off the prey. Without enough currency, however, an economy undergoing a switch is cursed to endure a temporary cash crunch, much like the one India has experienced. To cope with the period between the demonetization of the old notes and the issuance of new ones, nations have resorted to an old monetary trick called overstamping.

The 1993 conversion of old Czechoslovak koruna into new Czech and Slovak money is the best modern example of a successful rapid currency switch, thanks in no small part to its use of the overstamping technique. With the January 1993 dissolution of Czechoslovakia into Slovakia and the Czech Republic, the public also anticipated an ensuing breakup of the still-circulating Czechoslovak koruna into two national currencies. Since Czech was expected to be the more economically robust of the two nations, depositors began to move their paper money and bank accounts to the Czech side of the border to ensure their savings would be held in the stronger of the two soon-to-be currencies.

Anxious to put an end to capital flight before it crippled the monetary systems of the fledgling nations, the Czechs and Slovaks were forced to introduce new monetary units ahead of schedule. Unfortunately, the banknotes hadn't been printed yet. As a temporary expedient, the monetary authorities decided to affix different coloured stickers, or stamps, to existing Czechoslovak banknotes in order to demarcate them as either new Czech koruna or new Slovak koruna.

In executing a currency switch, affixing stamps on existing legacy notes has several advantages over relying entirely on new banknotes. Stamps take far less time to design and print than banknotes, they can be rapidly distributed thanks to their small size, and they are cheaper to store. In the case of Czechoslovakia, for six days in February 1993 all koruna banknotes were brought in so as to have the proper Czech or Slovak stamp affixed to them (below is a legacy koruna note with a Czech stamp on it). After the six day period passed, any unstamped currency was declared worthless. Cross border movements of cash between Czech and Slovakia were made illegal for that period and cash withdrawals from banks suspended.

1985 Czechoslovak koruna with yellow overstamp (top left)

Once the new notes had been printed up, Czechs and Slovaks could bring their stamped legacy notes to the bank to get new ones. All in all, it was a relatively smooth currency switch.

As I said at the outset, there is a long history to currency swaps. In 1919, the existing Austro-Hungarian krona was dismembered, with each of Czechoslovakia, Serbia, Hungary, Austria, and Romania printing unique stamps to be affixed to the krona circulating in their jurisdiction. Once new notes had been printed, stamped krona could be brought in for redemption. Peter Garber and Michael Spencer go into some detail on this episode here. As for the general practice of affixing stamps to money, I'd suggest Arnold Keller and John Sandrock here.

Zooming forward in time, to fill the void vacated by demonetized banknotes Modi's planning team decided to rely entirely on the ability of the Reserve Bank of India (RBI) to print new currency. And that's where its problems began; with 24 billion pieces needing to be printed, there simply wasn't enough time.  Blogger James Wilson calculates the replacement effort might not be completed till as late as September 2017:

Long lineups developed at banks and, without enough cash to go around, trade has been impaired. Had it borrowed from the above precedents, Modi's demonetization team might have been able to avoid at least some of this mess by procuring a supply of several billion worth of stickers or stamps. Some of these could have been printed and hoarded by the government in the months prior to November 8, the rest could have been printed on demand after the announcement date. The trick would be to ensure that the stamps had enough special security features so that, once issued, they succeeded in throwing off counterfeiters, who would have a strong incentive to make fakes for sale to those who had large amounts of undocumented cash.

Under a stamp scheme, come the November 8 demonetization announcement the RBI would have distributed the stamps to banks. Members of the public could then bring their demonetized notes to their local bank in order to have them stamped, up to a certain quota. These stamped notes would quickly reenter circulation, helping close the void left by the sudden demonetization of 80% of India's money supply and the slow trickle of newly-issued 500 and 2000 rupee notes entering the economy. Once the RBI had managed to print enough 500 and 2000 notes, it would set some fixed conversion period for turning in stamped 500 notes and 1000s for new notes.

It could be that Modi's team considered a stamping mechanism and decided against it for some justifiable reason that I'm not aware of. Or perhaps they simply didn't do their homework. If they didn't, overstamping could very well have diminished the shock faced by the Indian economy over the last few weeks. Countries that decide to follow India's path in the future would do well to include it in their plans.

Small steps, not a large leap, towards less black money & more digital money

 We are more than thirty days into Narendra Modi's demonetization campaign, and while many of the commentators I follow say that it is admirable of Modi to try to reduce the role of black money (wealth held by tax-evaders and criminals) and increase digital money adoption, most say that demonetization is not the way to go about it.

In short, the idea behind Modi's demonetization is to require everyone who owns old 1000 and 500 rupee notes to bring them to a bank before year-end for conversion into new banknotes or to be deposited into an account. By forcing Indians to re-familiarize themselves with dormant accounts, or open new ones, the architects of the plan hope that India's reliance on cash as a medium of exchange will be reduced. Any amounts above the ceiling require proper documentation. Those who own large amounts of cash for undocumented reasons, either because they are evading taxes or engaging in criminal behaviour, will therefore be unable to make the switch, their money expiring worthless by year's end. Having been taught a lesson, they may choose to permanently move some of their operations into the official sector.

Kaushik Basu, World Bank chief economist from 2012-2016, is particularly pessimistic about the policy, noting that while he agrees with the Reserve Bank of India's estimate that the economy will probably grow at 7.1% in 2016-17, from 7.6% estimated earlier, he expects a "huge drop" in the economy next year. "Money works like blood," says Basu, invoking one of the Physiocrat's classic analogies of the economy to the human body.

I certainly agree with Basu's use of the money-as-blood analogy, but my hunch is that temporary media of exchange will spring up to take the at least some of the space heretofore occupied by Modi's demonetized banknotes. My mental model for understanding demonetization is the Irish bank strike of 1970. For six months banks were shuttered, Irish citizens entirely cut off from their bank accounts. Cheques could not be deposited, nor could the central bank use the branch banking system as a means to get paper money into the economy.

India can cope without cash for a few days. In 1970, Irish banks closed for six month: the economy did just fine. https://t.co/TB8n53wqal pic.twitter.com/qXcw3EEc9v

— JP Koning (@jp_koning) November 14, 2016

Rather than suffering a huge blow, the Irish economy continued to function as it did before. Into the void vacated by banks and cash, post-dated cheques emerged as a the economy's blood, its circulating medium of exchange, with pub owners acting as informal credit evaluators.

Like Ireland in 1970, India suddenly finds itself deprived of a large portion of its money. In the place of 1000 and 500 rupee notes I expect informal credit to take some of its place, the effects on the economy therefore not being as devastating as Basu hints. See for instance this:

While many commentators are already declaring the demonetization to be a success or a failure, we won't have a good sense of this for several years. What sort of data should we be evaluating along the way? One of the effects we'd expect to see in a successful policy is a long-term reduction in the usage of cash, both as licit users of banknotes are diverted into the banking system and illicit users, burned by the forced switch out of old 1000 and 500 rupee notes, migrate out of the underground economy into the official economy. This should be reflected in data on India's currency in circulation, an attractive indicator in that is simple, accurate, not subject to revision, and comes out on a weekly basis. You can download the data here under the section 'Reserve money'.

The chart below shows the number of rupee banknotes outstanding going back to 2001. Prior to the demonetization, cash had been growing at a rate of 14-15% per year, as illustrated by the blue trend line. Since then you can see that there has been a huge collapse in quantity outstanding as Indians queue to deposit their cash in the banking system. At the same time, the Reserve Bank of India (RBI) hasn't printed enough new 500 and 2000 rupee notes to meet demand.

Cash in circulation will inevitably rebound in 2017 as the RBI catches up to demand by printing new rupees. If cash in circulation jumps back to the pre-demonetization level of ~18 trillion rupees and proceeds to readopt its growth path of 14-15%, than the demonetization will have failed to generate the desired effect. Despite suffering through queues and a relatively sluggish period of aggregate demand, Indians will have returned to their old habits, the whole demonetization campaign being a waste of time and effort.

But if cash in circulation only retraces part of the rebound, say rising to 16 trillion rupees by mid- 2017 (it is currently at ~10 trillion), and then sets out on a new and lower growth path (say 12-13%), then it will have achieved at least some of the desired effect. A new growth path starting from a lower level would imply that the demonetization has been successful in modifying the behaviour of licit cash users (i.e. converted them into digital money users) while driving illicit users of cash into the official economy.

My hunch is that of these two possibilities, the second is more likely: India will see a reduction in the growth path of rupee banknotes starting from a lower plateau. That being said, I find myself sharing many of the worries that Basu and other commentators have. Such a large and aggressive demonetization is a risky way to achieve the twin goals of broadening India's official economy and increase electronic money use. In order to catch people by surprise, much collateral damage must be inflicted, including time wasted in lineups and trades that go unconsummated due to a lack of cash (informal credit as in the case of Ireland not being able to completely fill the void). Suyash Rai makes a convincing argument that a demonetization of this size intrudes on property rights and rule of law.

Despite the chaos it has created, I still feel that the demonetization will make India at least a bit better off than before. However, other nations with large underground economies and low digital money uptake should be wary of copying India's example, waiting at least three or four years to gauge the final outcome. Rather than Modi's risky shock-and-awe approach, a better way to solve the problem is through a series of small and gradual measures. One of these steps might include implementing the approach Kaushik Basu writes about in his 2011 paper Why, for a Class of Bribes, the Act of Giving a Bribe should be Treated as Legal. See my post here for a full explanation.

Here's another incremental maneuver. Instead of imposing a short period of time for switching out of a limited quantity of 1000 and 500 rupee notes, why not allow three or four years for unlimited amounts of notes to be converted—but design the new notes to be 40% larger than the demonetized ones, as Peter Garber suggests, thus making it harder for Indians to store and handle cash?

Another step would be to copy Sweden which, thanks to several policies enacted over the last decade or so, is the only nation in the world with declining cash in circulation. One reason: retailers are required to use certified cash registers that prevent cash-induced tax gas. The Swedes have also adopted tax policies that encourage reporting of activities that typically remain in the unofficial economy, as I explain here. I also recently learnt from Miles Kimball that the Riksbank, Sweden's central bank, privatized the banknote distribution system in the 2000s, the effect being to end the subsidization of note transportation. If banks must bear the true (and higher) cost of moving notes around India, then this will be passed onto their customers, who in turn will react by switching into cheaper digital alternatives. I plan to write about this next week.

The advantage of many incremental steps towards increased digital money usage and a smaller underground economy is that should one step go bad, the blast radius will be small. One large Modi-style step might get you there faster, but if it goes awry, it risks upending the entire effort.

Modi's demonetization: chaos is a feature, not a bug

Prime Minister Narendra Modi's aggressive demonetization of the 500 and 1000 rupee note is causing plenty of chaos in India. A general shortage of money has emerged, massive lineups have formed at banks, and cash-based business has come to a standstill. All this would seem to indicate that the process has been ineptly carried out. But I'd argue that the problems listed above are exactly what one should expect of a well-designed aggressive demonetization. Chaos is a feature, not a bug.

As I mentioned in my previous post, a regular demonetization isn't meant to harm anyone. To ensure that no one is left behind, legacy note are gradually replaced with new ones, a process that often takes decades to carry out. See for instance the below pamphlet published by the Bangko Sentral ng Pilipinas (BSP), the Philippines central bank. It shows a slow and staged approach to replacing old peso notes with new ones. The goal of an aggressive demonetization like Modi's is exactly opposite: to leave people behind. To get this effect, the demonetization has to begin suddenly and end quickly.

Why didn't Modi make more preparations for the retirement of the Rs 500 and 1000 note? For instance, to reduce lineups at banks and ATMs the Reserve Bank of India could have begun supplying banks with extra 100 rupee notes several weeks ago in order to ensure that there was sufficient supply come November 8. And maybe the RBI could have nudged banks to purchase more safety deposit boxes to hold cash and hire extra staff to handle the rush.

Or take ATMs. One reason for lineups is that with the demise of the 500 and 1000 note, ATMs are running at a fraction of their capacity.  Indian ATMs have four "cassettes", each holding around 2000 notes. Two cassettes are typically configured for the old 500 rupee note, one for the legacy 1000, and one for the still-existing 100. They typically do not dispense 50s. Thus the maximum an Indian ATM can provide in a post-demonetized India is one cassette worth of 100s, or 200,000 rupees (US$3,000). If everyone in the lineup removes 2000 rupees, the daily limit, that means just 100 people can be served. That's peanuts.

To get ATMs up to full capacity, all four cassettes need to be dispensing some combination of new 500 notes, 2000 notes, and/or existing 50 and 100 notes. The problem is that each ATM cassette need to be re-calibrated to hold a certain denomination since notes are not uniformly shaped. With every single ATM in the country needing to be modified, and only so much staff trained to do so, it's taking a lot of time.

So why didn't the government begin working with ATM companies a few months ago to make all the modifications in time for November 8? This would have surely reduced the awful indignities that regular Indians must undergo as they wait for hours to withdraw cash.

Unfortunately, any attempt to modify ATMs ahead of time would have caused Modi's aggressive demonetization to fail. In order to inflict maximum damage on those who depend on "black money" (i.e. income obtained illegally or not declared for tax purposes),  an aggressive demonetization needs to be executed suddenly. If rumour gets out that a demonetization is about to occur, the element of surprise will be lost. Those working in the underground economy will simply switch their high value banknotes into low ones ahead of the demonetization, thereby avoiding being damaged. And of course it is the rich, not the poor, who have the best networks for gleaning information. To reduce the potential for information leaks, the number of people 'in the know' needs to be kept to a minimum, and this means that all large-scale preparation—including a huge reconfiguration of the ATM network—must be avoided.

So if you support the idea of a demonetization—specifically one that is designed to hurt the underground economy and, in so doing, draw people into the taxed economy--then you should just accept that this was always going to be a messy affair. If it had been a smooth one, then that would have been a sign that it wasn't being effective.
  
Once the dust is settled, India will be made better off by the demonetization. While many Indians in the underground sector will grudgingly comply and deposit their funds in an account only to withdraw that same amount in new notes later, others will keep their funds in the banking system. To change, people sometimes need to be prodded. This should be a shift in the right direction given that a banked economy is stronger than an unbanked one.

My back of the envelope calculation tells me that the demonetization will generate real pain on the underground economy. Consider that there are Rs 12.2 trillion worth of 1000 and 500 notes in circulation, or US$181 billion (source). Assume that 40% of these notes, or Rs 4.9 trillion (US$72.7 billion) circulate in the dark economy and lack a paper trail. Further assume that thanks to Indian ingenuity, or jugaad, half of the black money will sneak through the demonetization. That still leaves the remaining Rs 2.4 trillion, or US$36 billion, stranded. That's a painful writeoff!

To build and effectively run a nation, a government needs to be able to efficiently collect taxes. Many will shrug off the immense losses caused by the demonetization and go back to using cash as a way to evade to avoid the tax man, especially now that the government has (somewhat puzzlingly) introduced a new 2000 rupee banknote. But a large enough contingent will migrate to the tax-paying economy for good. Once bitten, twice shy.

Aggressive demonetizations

Prime Minister Narendra Modi surprised Indians today by announcing that India's highest denomination notes, the 500 and 1000 rupee, will cease to be legal tender. On first blush, India seems to be enacting Ken Rogoff's idea of cutting down on criminality and tax evasion by phasing out high-denomination notes, which I recently discussed here.

But this isn't the case. Rather than removing the Rs. 500, the Reserve Bank of India is replacing it with a new bill. Furthermore, it will also be issuing a Rs. 2000 note, a new highest denomination note. What India is doing is enacting what I'll call an aggressive demonetization. I'd argue that this is an alternative (though not mutually exclusive) idea to Rogoff's. Both schemes are intended to create a logistical nightmare for money launderers; but whereas Rogoff's entails altering the denomination structure of banknotes to get this effect, Modi's aggressive demonetization keeps that structure intact while using note redemption and re-issuance as its lever.

Demonetizations are usually non-aggressive drawn-out affairs. For instance, when Canada announced that it would withdraw its $1000 note, it gave Canadians an eternal window to bring them in for redemption. The $1000 remains legal tender in Canada, meaning that it can be used to discharge any debt. As another example, take the euro. The introduction of the euro meant an end to all the national European currencies. While each of these currencies lost legal tender status in 2002, many enjoy an unlimited time frame for conversion into euros, including the Deutsche mark and Belgian franc. See below:

India's demonetization is an aggressive one because legal tender status is to be removed immediately and the time limit for redemption is incredibly tight and scripted. Here is Modi's announcement:

All details on the announcements made today can be found here. https://t.co/UoiCjCyupV #IndiaFightsCorruption pic.twitter.com/WKpgsdTcjg

— Narendra Modi (@narendramodi) November 8, 2016

To summarize, Indians have just a few weeks to exchange old notes for new ones at banks or post offices. Proof of ID is required and switches are limited to Rs 4000, around US$60. There is no size limit for directly depositing old notes in bank of post office accounts. But of course, this means that the depositor's identity will be known by the bank and transactions will be traceable. Deposits can be made at banks until the end of the year. After that date, the central bank will exchange old notes until March 31, 2017, although this will require some sort of declaration of origin.

The point of all this is to suss out anyone with large amounts of cash that has been earned from dubious sources. Say you've got one million paper rupees, worth around US$15,000. If you've got the receipts to show why you have that much cash, then you can safely bring it to the bank. But if you don't, you'll have to get rid of it as quick as you can by spending it, say on gold (or any other good). However, this will be an incredibly difficult task given the fact that there will be many other Indians trying to spend their undocumented Rs. 1000 and Rs. 500 notes on gold at that very same time, and only a limited number of gold dealers willing to accept them. After all, any gold dealer who accepts notes now inherits the same problem: what to do with newly-demonetized banknotes. Any gold dealer who starts to bring in larger-than-normal amounts of paper money to their bank for redemption will surely face questions. To compensate for this risk, gold dealers will either impose a large penalty on cash payments or they'll stop accepting cash altogether.

Some undocumented rupees will no doubt be successful in evading Modi's aggressive demonetization, but large quantities will be left stranded. Significant damage will have been dealt to anyone working in the underground economy.

As Tony Yates points out, the most aggressive demonetization in history was probably Saddam Hussein's recall of the Swiss dinar in 1993. Swiss dinars were Iraqi banknotes printed on high quality paper whereas dinars printed after the 1992 U.S. invasion were issued on shoddy and easily counterfeitable material. On May 5, Saddam announced that all Swiss dinars had to be turned into the central bank for an equivalent amount of post-war currency over a tiny six day exchange period. He then proceeded to close the border, preventing Kurds and other foreigners from making the switch. Huge amounts of currency was left stranded, although unlike the Indian situation it was foreigners, not criminals/tax evaders, who were the target. (I went into the Iraq story here. The Burmese kyat and North Korean won demonetizations of 1985 and 1999 were also quite awful, see here.)

If you think Modi's strategy is new, or confined to developing nations, think again. A few years ago, Sweden carried out out a (somewhat less) aggressive demonetization in order to catch illicit cash users. In 2012, the Riksbank announced that all  1000 krona banknotes without foil strips were to be declared invalid by the end of 2013 (each 1000 krona note is worth around $110). Until December 31, 2013, Swedes were permitted to get rid of 1000 krona notes by either using them to buy stuff or depositing them at a bank. To tighten the noose, no anonymous conversions of old notes into existing notes were permitted. Swedes had to have bank accounts, and therefore had to forgo their anonymity, in order to rid themselves of old currency.

Anyone who's seen Breaking Bad knows that laundering money takes time and patience. A Swedish criminal with ten million dollars worth of high denomination krona was suddenly faced with a significant problem; how to get this stash back into the legitimate economy within 400 or so days.

How tough was this challenge? We know that at the start of 2013 there were fourteen million 1,000 krona notes in circulation (worth 14 billion SEK, or US$1.6 billion). After the expiry date, the Riksbank noted that there were still some three million 1,000 krona notes that had not been redeemed, worth around $330 million. This gives a rough indication of the value of banknotes left stranded by criminals and tax evaders, around 25% of all notes outstanding.

After the December 31, 2013 deadline, the Riksbank itself offered to redeem invalid banknotes (it still does), albeit for a 100 krona fee. However, criminal and tax evaders have no doubt steered clear of this offer as the declaration form includes the following question:

Sweden is the only country in the world in which cash holdings are in decline. Might this have had something to do with the damage inflicted by the Riksbank's 2013 demonetization on the psyche of participants in the underground economy?

So let's compare the advantages of Modi's aggressive demonetization to Rogoff's abolition of high denomination notes. If an aggressive demonetization is chosen, then a central bank gets to enjoy high profits, or seigniorage, since it continues to issue an extended range of banknotes, unlike Rogoff's abolition. The more float, or 0% cash liabilities that remain outstanding, the more interest the central bank will earn on its bond portfolio. The central bank also earns significant earnings from 'breakage.' All illegitimate banknotes that never get redeemed are recognized as a one-time unusual gain on the central bank's statement of income. Finally, people engaging in legal activities who enjoy the anonymity afforded by high denomination notes still get to use them; they don't under Rogoff's abolition.

Unfortunately, an aggressive demonetization can only be effective for a little while. It's hard to see why people won't quickly re-adopt the highest denomination note as a medium for evading taxes and engaging in illicit activity. In response, the central bank will have to enact an followup demonetizations every few years, but of course the underground economy will do its best to anticipate these by moving into low-denomination notes or foreign paper whenever it suspects something is afoot.

To create a logistical nightmare for money launderers, maybe Peter Garber's idea beats Rogoff's abolition and Modi's demonetization?:

"Why not simply increase the physical dimensions of high-denomination notes without jumping through the flaming hoop of elimination? Before 1929, U.S. currency was 40 percent physically larger than it is now. Restoring that size or making it even larger would instantly work the wonders of decades of inflation. The iron law for subverting illicit economies: a percentage increase in physical note size is equivalent to the same percentage increase in the price level."

Don't kill the $100 bill

Last week I asked whether the Federal Reserve could get rid of the $100 bill. This week let's discuss whether it should get rid of the $100. I don't think so. The U.S. provides the world with a universal backup monetary system. Removing the $100 would reduce the effectiveness of this backup.

Earlier this week the New York Times took up the knell for eliminating high value bank notes, echoing Larry Summers' earlier call to kill the $100 in order to reduce crime which in turn was a follow up on this piece from Peter Sands. More specifically, Summers says that "removing existing notes is a step too far. But a moratorium on printing new high denomination notes would make the world a better place."

As an aside, I just want to point out that Summers' moratorium is an odd remedy since it doesn't move society any closer to his better place, a world with less crime. A moratorium simply means that the stock of $100 bills is fixed while their price is free to float. As population growth boosts the demand for the limited supply of $100 notes, their price will rise to a premium to face value, say to $120 or $150. In other words, the value of the stock of $100 bills will simply expand to meet criminals' demands. Another problem with a moratorium is that when a $100 bill is worth $150, it takes even less suitcases of cash to make large cocaine deals, making life easier—not harder—for criminals. To hurt criminals, the $100 needs to be withdrawn entirely from circulation, a classic demonetizaiton.

With that distinction out of the way, let's deal with three of the motivations for demonetizing high denomination notes: to reduce criminality, to cut down on tax evasion, and to help remove the effective lower bound.

Criminality

Summer's idea is to kill the $100 bill so that criminals have to rely on smaller denominations like $20s. Force criminals to conduct trade with a few suitcases filled with $20 bills rather than one suitcase filled with $100 bills and they'll only be able to jog away from authorities, not sprint. What sorts of criminals would be affected? The chart below (from this article by Peter Sands) builds a picture of cash usage across the different types of crime.

As the chart illustrates, the largest illegal user of cash is the narcotics industry. So presumably the main effect of a ban of $100s will be to raise the operating costs of drug producers, dealers, and their clients.

But should we be sacrificing the benefits of the $100 bill in the name of what has always been a very dubious enterprise; the war on drugs? An alternative way to reduce crime would be to redefine the bounds of punishable offences to exclude the narcotics trade, or at least certain types of drugs like marijuana. Law enforcement officers could be re-tasked to focus on the cash intensive crimes that remain, like human trafficking and corruption. In that way crime gets more costly and we get to keep the $100 to boot, which (as I'll show) has some very important redeeming qualities.

Tax Evasion

Cash is certainly one of the best ways to evade taxes, but there are other methods to reduce tax evasion. For instance, Martin Enlund draws my attention to a tax deduction implemented by Sweden in 2007 for the purchase of household related services, or hushållstjänster, including the hiring of gardeners, nannies, cooks, and cleaners. In order to qualify the services must be performed in the taxpayer’s home and the tax credit cannot exceed 50,000 SEK per year per person. 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.*

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 get their tax credits, many of these transactions would have been pulled into the open.

We can evidence of this in the incredible decline in Swedish cash demand ever since:

@t0nyyates @jp_koning Starting in July 2007 it became 50% cheaper to buy services (cleaning, ironing, baby-sitting) pic.twitter.com/4EHshRAHWR

— Martin Enlund (@enlundm) February 18, 2016

Sweden has the distinction of being the only country in the world with declining cash usage. The lesson here is that it isn't necessary to sacrifice the $100 in order to reduce tax evasion. Just design the tax system to be more lenient on those market activities that can most easily be replaced by underground production.

Escaping the lower bound

Yep, those advocating a removal of $100s are right. Central banks can evade the effective lower bound on interest rates and go deeply negative if they kill cash, starting with high denomination notes.

But as economists such as David Beckworth have pointed out, you can keep cash and still go deeply negative. All a central banker needs to do is adopt Miles Kimball's proposal to institute a crawling peg between cash and central bank deposits. This effectively puts a penalty on cash such that the public will be indifferent on the margin between holding $100 bills or $100 in negative yielding deposits.

Another way to fix the lower bound problem is a large value note embargo whereby the Fed allows its existing stock of $100 bills to stay in circulation but doesn't print new ones (much like Summers' moratorium). This means that if Yellen were to cut deposit rates to -2% or so, the price of the $100 would quickly jump to its market-clearing level, cutting off the $100 as a profitable escape route. As for the lower denominations, the public wouldn't resort to them since $20s are at least as costly to hold as the negative rate on deposits. Unlike Miles' proposal a large value note embargo doesn't allow for a full escape from the lower bound, but it does ratchet the bound downwards a bit, and it keeps the $100 in circulation.

Why should we keep it?

The $100 bill is the monetary universe's Statue of Liberty. In the same way that foreigners have always been able to sleep a little easier knowing that Ellis Island beckons should things go bad at home, they have also found comfort in the fact that if the domestic monetary authority goes rotten, at least they can resort to the $100 bill.

The dollar is categorically different from the yen, pound or euro in that it is the world's back-up medium of exchange and unit of account. The citizens of a dozen or so countries rely on it entirely, many more use it in a partial manner along with their domestic currency, and I can guarantee you that future citizens of other nations will turn to the dollar in their most desperate hour. The very real threat of dollarization has made the world a better place. Think of all the would-be Robert Mugabe's who were prevented from hurting their nations because of the ever present threat that if they did so, their citizens would turn to the dollar.    

I should point out that the U.S. gets compensation for the unique role it performs in the form of seigniorage. Each $100 is backed by $100 in bonds, the interest on which the U.S. gets to keep. So don't complain that the U.S. is providing its services as backup monetary system for free.

Foreigners who are being subjected to high rates of domestic inflation will find it harder to get U.S dollar shelter if the $100 is killed off; after all, it costs much more to get a few suitcases of $20 overseas than one case of $100. This delayed onset of the appearance of U.S. dollars as a medium of exchange will also push back the timing of a unit of account switch from local units to the dollar. As Larry White has written, money's dual role as unit of account and medium of exchange are inextricably linked. People will only adopt something as a unit of account after it is has already been circulating as a medium of exchange. A switch in the economy's pricing unit is a vital remedy for the nasty calculational burden imposed on individuals and businesses by high inflation. The quicker this tipping point can be reached, the less hardship a country's citizens must bear. The $20 doesn't get us there as quick as the $100.

So contrary to Summers, I think we should think twice before killing the $100. The U.S. has a very special to role to play as provider of the world's backup monetary system; it should not take a step back from that role. Criminals, tax evaders, and the lower bound can be punished via alternative means. I'd be less concerned about killing other high denomination notes such as the €500, 1000 Swiss franc, or ¥10,000. That's because inflation-prone economies don't euroize or yenify—they dollarize.


Addendum: If Summers is genuinely interested in combing the world of coins and bills for what he refers to as a 'cheap lunch', then there's nothing better the U.S. can do than stop making the 1 cent coin, which is little more than monetary trash/financial kipple. Secondly, replace the $1 bill, which is made out of cotton and supported by the cotton lobby, with a $1 coin. The U.S. lags far behind the rest of the world in enacting these simple cost cutting efforts.


*See here and here for more details on RUT and ROT avdrag,
** Martin Enlund has a great post here on Sweden's cash policies.

Can a central bank eliminate its highest value banknote?

Singapore's $10,000 bill, worth around US$7500, shares title to world's largest value banknote with Brunei's $10,000

Peter Sands has adeptly made the case for eliminating high denomination banknotes. The rough idea is that if all central banks were to eliminate their highest value banknotes, then criminals would have to fall back on smaller denominations or more volatile media of exchange like gold. Since both of these options are more cumbersome than large denomination notes, storage and handling expenses will grow. This means the costs of running a criminal enterprise increases as does the odds of being apprehended.

Elimination of cash is a polarizing topic. For now I'm going to sidestep that debate because I think there's a more interesting topic to chew on: might a central bank be unsuccessful in its attempt to withdraw its own high denomination notes? Put differently, what happens if everyone just ignores a central banker's demands to retire the biggest bill?

Take the most popular high denomination banknote in the world, the US$100 bill. According to the Federal Reserve, there are 10.8 billion of these in circulation, or around $1 trillion in nominal value terms. Popular not only with criminals, the $100 bill circulates in many dollarized or semi-dollarized nations as a legitimate means of exchange in the absence of decent local alternatives. Say that the Federal Reserves wants to hobble criminals by cancelling all 10.8 billion notes. It announces that everyone holding $100s has until January 1, 2018 to trade them in for two $50s (or five $20s). After that date any $100 notes that remain in circulation will no longer be considered money. Specifically, they will cease to be recognized by the Fed as a liability.

Will this demonetization work? Consider what happens if everyone simply ignores the proclamation and continues to use $100s in trade. Say that by the January 1, 2018 expiry date, only $300 billion of the $1 trillion in $100 bills in circulation have been tendered leaving the remaining $700 billion (or 7 billion individual notes) in peoples' pockets.

So much for hurting criminals by removing the $100, right? We'd say that the central bank's demonetization campaign has failed. But not so fast.

Even though 7 billion $100 bills remain in circulation, the nature of $100 bill will have changed. Prior to January 1, 2018, the Fed maintained a peg between the $100 bill and all other denomination ($50, $20, $10, $5, and $1). This peg was enforced by the Fed's promise to convert any quantity of $100 bills into lower denominated notes and vice versa. After the expiry date, the Fed will no longer include the $100 in these pegging arrangements.

In addition to maintaining a fixed rate between the various denomination, the Fed also promises to peg the value of a dollar to a slowly-declining bundle of consumer goods (put differently, it set a 3% 2% inflation target). It does so by injecting an appropriate quantity of new currency into the economy via open market purchases or withdrawing sufficient currency by selling assets. When the Fed demonetizes the $100 note, it ceases to include the $100 in its consumer goods peg. This means it will no longer dedicate any of its assets to protecting the purchasing power of the $100 bill.

Given this new setup, as demand for $100 bills varies their value will float relative to both Fed dollars and the slowly declining consumer good bundle. Like bitcoin, which also has a fixed supply, fluctuations in the purchasing power of the $100 could be quite volatile. One day the $100 might be worth $110, the next it could be worth just $90. So even if the Fed has failed in withdrawing the $100, it will still have succeeded in imposing purchasing power volatility on criminals and other users of the $100. Volatile assets make for unpleasant and costly media of exchange and criminals will not be happy with these change.

By forswearing the $100, the Fed also ceases to act as a guardian of the quality of its issue of $100 bills against counterfeiters. The abdication of this function is especially important given that the marginal cost of printing a decent knock off of the $100 is probably just a few cents. Absent the threat of imprisonment, entrepreneurs will swarm to duplicate the $100, spending counterfeits into circulation and steadily reducing the purchasing power of the $100. After a few years of constant counterfeiting the $100 bill won't be worth much more than a few cents or so; the marginal cost of paper, ink, and printing. This hyperinflation will bring the nominal value of the original 7 billion in notes to just $700 million, down from $1 trillion.

Highest denomination note in various counties, sorted by US$ equivalent

Incidentally, we know this is a likely situation because of what has happened in Somalia. When Somalia's central bank was dismantled in the early 1990s, Somali shillings continued to circulate (see my blog post here). Over the next few years, warlords issued their own counterfeits which eventually drove the value of the shilling down to the cost of paper and transportation. William Luther has described this process here.

Along the way to hitting a terminal value of just a few cents, the $100 will lose any advantage it had previously enjoyed in terms of storage costs and handling. The moment a $100 falls to $49, the Fed's own $50 note becomes a cheaper note for criminals to use. And as the hyperinflation continues and the $100 falls to $19, the Fed's own $20 note will become preferred. The upshot is this: even if the Fed's January 1, 2018 expiry date fails to attract any $100s for redemption, competitive counterfeiting means that the $100 will inevitably cease to be used as the criminal economy's preferred medium of exchange.

Since criminals are rational and can anticipate that this sort of hyperinflation will ensue, they are more likely to tender their notes for cancellation prior to the original January 1, 2018 deadline. Better to get full restitution rather than lose all one's wealth.

Could criminals somehow police against hyperinflation by rejecting counterfeits? Militating against this would be the constant degradation of the note issue's quality due to normal passage of paper from hand to hand. In normal times, the Fed works behind the scenes to keep its note issue up to snuff, replacing worn out specimens with fresh new greenbacks. Once the Fed abdicates this role, $100 bills will quickly start to deteriorate. Picking the counterfeits out from a stack of bills will become more difficult, only making the job of counterfeiting easier.

In the face of this deterioration the mass of $100 bills may begin to fragment and lose fungibility. Fungibility is the idea that all members of a population are perfect substitutes. Well-preserved $100s that are easily identifiable as non-counterfeits may pass at a higher value than a slightly worn out $100, with well-worn and less identifiable $100 bills trading at an even larger discount. Without fungibility, it becomes far more difficult for a medium of exchange to do its job. Where a transaction with fungible $100 notes might be consummated in a few moments, it may take hours to grade a small stack of heterogeneous bills. The costs arising from non-fungibility may be so high that criminals will prefer to use relatively bulky $50 bills which, though possessing higher storage costs, will not be plagued by the requirement that each note be closely analyzed for quality.

So in the end, even if criminals ignore a central bank's deadline to tender notes for cancellation, they will eventually cease using the highest denomination notes through a more roundabout route. A central bank's renouncement of both its role as enforcer of the largest denomination's peg to other notes as well as its commitment to tend to that note's quality will set off forces that drive the purchasing power of those notes down to the cost of paper and ink, at which point they will be as good as demonetized.

Having settled whether a central bank can demonetize its highest value note, should it? That's an entirely different post. Or we can hash it out in the comments.

---

PS. An alternative story to a Somali-style hyperinflation is an Iraqi-style deflation. See Tony Yates on Twitter. I've written about the odd case of the Iraqi Swiss dinar here. How likely is an Iraqi scenario? Criminals would have to assume that a future monetary authority, maybe even the Fed itself, reverts its decision and undertakes to adopt orphan $100 bills as a liability at a price consistent with their previous purchasing power. This would give $100 bills a fixed value in the present.

PPS. On the topic of altering the relationship between high denomination notes and other notes, see my posts on high value note embargoes. 

Zimbabwe's new bond coins and the demonetization of the rand

Issued a little less than a year ago, Zimbabwe's bond coin is one of the world's newest monetary units. The bond coin is designed to solve one of the most venerable problems in the pantheon of monetary conundrums; the big problem of small change—a nice turn of phrase coined by economists Tom Sargent and François Velde (excuse the pun).

Some background first. When Zimbabweans spontaneously ceased to use worthless Zimbabwe dollars in 2009 they simultaneously adopted a ragtag collection of currencies including the South African rand and U.S. dollar. Unlike cash, coins are heavy—shipping them over to Zimbabwe from the U.S. is prohibitively expensive. So while Federal Reserve banknotes have tended to be used in large value transactions, rand coinage from neighbouring South Africa has been recruited for use in smaller transactions. Unfortunately, there has never been enough coins to conduct trade. The demand for small change is so large that items like gum or candies or IOUs have often been used as coin-substitutes.

The bond coin is a brave attempt by the Reserve Bank of Zimbabwe's (RBZ) incoming Governor John Mangudya to fix the small change problem. Issued in denominations of 1, 50, 10, 25, and 50 cents, each bond coin is worth an equivalent amount of U.S. cents. Issuing small change is an entirely sensible goal for a central banker to pursue. It's low hanging fruit—a cheap solution to a significant problem that disproportionately hurts those who rely on coins the most, the poor.

But how can an institution that has lost all credibility—and deservedly so—successfully float a new monetary unit? Only with a little bit of help, it seems. The RBZ's FAQ on bond coins says that the new issue is backed by a "bond facility." What does this mean? Unfortunately the RBZ forgot to answer that question in its FAQ, as the screenshot below indicates (ht Twitter finance's @guan).

Oh dear.

Reading through some earlier news reports, let me try and answer on their behalf. We know that the African Export-Import Bank (Afreximbank), based in Cairo, opened up a US$200 million line of credit with the RBZ last year. Presumably some portion of this line of credit will be used to ensure that bond coins stay pegged to the U.S. dollar. Should the bond coin fall below the dollar, for instance, the RBZ will have to draw down on its bond facility with Afreximbank to repurchase the coins. Thus the moniker "bond coin." At least, that's the story that the RBZ Governor John Mangudya has been providing. So far the value of bond coins has held, so Zimbabweans see Afreximbank backing as credible.

The minting of U.S. dollar tokens isn't a novel idea. Other dollarized nations have introduced coins to make up for the lack of U.S. change. Panama, for instance, has the balboa while Ecuador and East Timor have the centavo. Zimbabwe's is a well-trodden path.

The RBZ's new coins were initially greeted with a large amount of skepticism. No wonder. This is an institution that generated an inflation rate of 79.6 billion percent (with the help of Robert Mugabe's insane fiscal policy). However, a sudden glut of news articles say that Zimbabweans have begun to embrace bond coins in earnest. At the same time, no one wants South African currency anymore, with retailers and banks increasingly refusing rand coins.

Why is that? Zimbabweans have been transacting with both rand and dollars since 2009 but they have been setting prices in the latter. The dollar, not the rand, is the unit of account. This means that any transaction involving rand is inconvenient as it requires a foreign exchange conversion back into dollars prior to consummation. Over the last few years, Zimbabweans have solved this problem by the informal adoption of a "street" rate of ten rand-to-the dollar.  They use this rate as a rule of thumb even though the market exchange rate has deviated quite far from it. The advantage of a nice round number is that it reduces the calculational burden of a two currency system.

For instance, one of the more ubiquitous commercial experiences in Zimbabwe, a ride on a privately operated bus, or kombi, has been priced at $0.50, or five rand, for many years now. It's interesting that this price has undervalued the rand relative to its actual market rate. In 2012-2013 the U.S. dollar was worth around eight rand, so a kombi ride should have only cost commuters four rand, not five. But convenience seems to have trumped exactitude, especially with small change being so hard to come by.

With the greenback having spiked in late 2014 and 2015, the U.S. dollar is now worth around fourteen rand. In this context, the old informal ten-to-one exchange rate no longer makes much sense. A massive coordination problem seems to have developed. While kombi drivers still charge fifty U.S. cents per ride, they have reportedly begun to charge as much as seven rand for a trip, or a 14-to-one exchange rate, thus breaking with the traditional ten-to-one street rate. Customers are not happy. When they pay with US$1, they are now asking for a 50 cent bond coin as change. After all, if they get five rand in change, that won't be enough to afford the new seven rand price on their next ride.

The period of economy-wide haggling necessary to settle on a new generally accepted "street price" for the rand no doubt imposes significant costs on Zimbabwean society. Thorny issues of fairness come to the forefront. And if the new rate isn't a nice round number, payment calculations becomes a burden. Before the bond coin's appearance on the scene, Zimbabwe would simply have endured this period of rand-induced calculational turmoil as it slowly groped to a new equilibrium. But this time there's a small change alternative to the rand. The sudden adoption of the once unpopular bond coin by Zimbabwean society may be a convenient hack for getting around the complexity of adjusting to rand volatility. If so, all that the bond coin needed for mass adoption was either a sharp rise or fall in the rand. Without that volatility—i.e. if the rand exchange rate had stayed near ten-to-one forever—then the requisite chaos for bond coin acceptance would never have appeared.

Monetary economists have long debated the idea of a divorce between a nation's unit-of-account and its medium-of-exchange. (See Tyler Cowen, for instance, on New Monetary Economics). This is the notion that a nation's prices can be set in terms of one unit and its transactions carried out in another; a notion exemplified in Zimbabwe where prices are set in dollars but rand trades hands. I think Zimbabwe's recent adoption of the bond coin bears out economist and blogger Larry White's stance on the subject. White, who wrote a skeptical paper on the prospects for medium-unit divergence, maintains that the practice of harmonizing the unit in which we transact with the unit for posting prices is an evolutionary inevitability. A divorce is simply not in the self interest of economic actors. Harmonization-

...economizes on time spent in negotiation over what commodities are acceptable in payment and at what rate of exchange. More importantly, it economizes on the information necessary for the buyer's and the seller's economic calculation.

For these reasons, a unit of account is typically "wedded" to a general medium of exchange, says White. In Zimbabwe, the convenience of wedding the medium-of-exchange with the unit-of-account is playing out in the mass disgorgement of rand and adoption of US$-denominated bond coins. This is just another chapter in Zimbabwe's ongoing game of monetary musical chairs. Having spontaneously demonetized the Zimbabwe dollar in 2009 for the rand, they are now demonetizing the rand in favour of Zimbabwean U.S. dollars. If White is correct, expect this new evolution to be a permanent one.

The final chapter in the Zimbabwe dollar saga?

Here's an interesting fact. Remember all those worthless Zimbabwe paper banknotes? The Reserve Bank of Zimbabwe (RBZ), Zimbabwe's central bank, is officially buying them back for cancellation. According to its recent monetary policy statement, the RBZ will be demonetizing old banknotes at the "United Nations rate," that is, at a rate of Z$35 quadrillion to US$1. Stranded Zimbabwe dollar-denominated bank deposits will also be repurchased.

As a reminder, Zimbabwe endured a hyperinflation that met its demise in late 2008 when Zimbabweans spontaneously stopped using the Zimbabwe dollar as either a unit of account or medium of exchange, U.S. dollars and South African rand being substituted in their place. Along the way, the RBZ was used by corrupt authorities to subsidize all sorts of crazy schemes, including farm mechanization programs and tourism development facilities.

Upon hearing about the RBZ's buyback, entrepreneurial readers may be thinking about an arbitrage. Buy up Zimbabwe bank notes and fly them back to Zimbabwe for redemption at the RBZ's new official rate, making a quick buck in the process. But don't get too excited. The highest denomination note ever printed by the RBZ is the $100 trillion note. At the RBZ's demonetization rate, one $100 trillion will get you... US$0.003. With these notes selling for US$10 to $20 as collectors items on eBay, forget it—there's no money to be made on this trade. If you've already got a few $100 trillion Zimbabwean notes sitting in your cupboard, you're way better off hoarding them than submitting them to the RBZ's buyback campaign.

But this does give us some interesting data points about the nature of money. Last year I wrote two posts on the topic of whether money constituted an IOU or not. With the gold standard days long gone, central banks no longer offer immediate redemption into some underlying asset. But do they offer ultimate redemption into an asset? A number of central banks—including the Bank of Canada and the Federal Reserve—make an explicit promise that notes constitute a first claim or paramount lien on the assets of the central bank. This language implies that banknotes are like any other security, say a bond or equity, since each provides their owner with eventual access to firm assets upon liquidation or windup of the firm.

George Selgin is skeptical of the banknotes-as-security theory, replying that a note's guarantee of a first claim on assets is a mere relic of the gold standard. However, the Bank of Canada was formed after Canada had ceased gold convertibility. Furthermore, modern legislation governing central banks like the 2004 Central Bank of Iraq (CBI) Law declares that banknotes "shall be a first charge on the assets of the CBI." [See pdf]. So these promises certainly aren't relics of a bygone age. The Zimbabwean example provides even more evidence that a banknote constitutes a terminal IOU of sorts. After all, Zimbabwean authorities could have left legacy Zimbabwe dollar banknotes to flap in the wind. But for some reason, they've decided to provide an offer to buy them back, even if it is just a stink bid.

Given that banknotes are a type of security or IOU, how far can we take this idea? For instance, analysts often value a non-dividend paying stock by calculating how much a firm's assets will be worth upon break up. Likewise, we might say that the value of Zimbabwean banknotes, or any other banknote, is valued relative to the central bank's liquidation value, or the quantity of central bank assets upon which those notes are claim when they are finally canceled. If so, then the precise quantity of assets that back a currency are very important, since any impairment of assets will cause inflation. This is a pure form of the backing theory of money.

I'm not quite willing to take this idea that far. While banknotes do appear to constitute a first claim on a central bank's assets, the central bank documents that I'm familiar with give no indication of the nominal quantity of central bank assets to which a banknote is entitled come liquidation. So while it is realistic to say that the Reserve Bank of Zimbabwe always had a terminal offer to buy back Zimbabwe dollars, even during the awful hyper-inflationary period of 2007 and 2008, the lack of a set nominal offer price meant that the value of that promise would have been very difficult to calculate. More explicitly, on September 30, 2007, no Zimbabwean could have possibly know that, when all was said and done, their $100 trillion Zimbabwe note would be redeemable for only US$0.003. The difficulty of calculating this terminal value is an idea I outlined here, via an earlier Mike Friemuth blog post.

While the final chapter of the Zimbabwe dollar saga is over, the first chapter of Zimbabwe's U.S. dollar standard has just begun. Gone are the days of 79,600,000,000% hyperinflation. Instead, Zimbabweans are experiencing something entirely new, deflation. Consumer prices have fallen by 1.3% year-over-year, one of the deepest deflation rates in the world and the most in Africa. With prices being set in terms of the U.S. dollar unit of account, Zimbabwean monetary policy is effectively held hostage to the U.S. Federal Reserve's 12 member Federal Open Market Committee. Most analysts expect the Fed to start hiking rates this year, so I have troubles seeing how Zimbabwean prices will pull out of their deflationary trend. Few people have experienced as many monetary outliers as the citizens of Zimbabwe over such a short period of time. I wish them the best.