The ZLB and the impending race into Swiss CHF1000 bank notes

Two things worth noting:

1. As many of you know by now, the Swiss National Bank (SNB), Switzerland's central bank, just reduced the rate that banks earn on deposits held at the SNB by half a percentage point to -0.75% (from -0.25%). The SNB had only recently instituted a negative deposit rate, having reduced it to -0.25% from 0% this December. The SNB will also be targeting a 3-month LIBOR rate of -1.25% to -0.25%, down from the previous range of -0.75% to +0.25%


2. The SNB issues the world's largest paper bearer note denomination, the hefty CHF 1000 note (pictured above). It's worth around US$1143.

The first is significant because as yet, no central bank has ever brought rates this deep into negative territory. The ECB's current deposit rate is set at -0.2% while Denmark's central bank, the Danmarks Nationalbank (DNB), applied a negative deposit rate of -0.2% on deposits that banks placed with the DNB in 2012. Neither of these top the SNB's ultra-low -0.75% rate.

The second point is significant because neither the ECB nor the DNB issue a note that approaches the real value of the CHF 1000.

Why is the conjunction of these two observations important? In short, we get to observe in real time how tightly the so-called zero-lower bound (ZLB) binds. When a central bank reduces the rate it pays on central bank deposits below 0%, arbitrage dictates that all other short term interest rates will follow along, including rates on government t-bills and insured bank deposits. However, one asset interferes with this adjustment: cash. Cash carries an implicit yield of 0%. If deposits or t-bills are being penalized at a rate of 0.25% per year, there are significant incentives for everyone to convert these assets into zero-yielding paper equivalents in order to avoid the 0.25% penalty. Not only will commercial banks all convert their deposits at the central bank to cash, but the public will clear out their bank accounts in order to hold paper. The upshot is that interest rates can't fall below 0% lest the  entire country turn into a 100% cash economy.

In practice, the 0% bound isn't a tight one since paper currency incurs storage and transportation costs whereas electronic deposits don't. What this means is that a depositor will grudgingly accept a slightly negative deposit rate in order to avoid having to bear the inconveniences of ungainly cash. So the zero lower bound actually lies a bit lower than 0%, let's say -0.4%. However, reduce rates far enough below that and the dash to cash beings.

This is where the CHF 1,000 note comes into the picture. The larger the denomination of paper currency issued by a central bank, the lower the storage and transportation costs. Take CHF 1,000,000 worth of CHF 20 notes. That's 50,000 paper notes. The costs incurred in counting, double counting, checking for counterfeits, packaging, loading into an armoured car, unloading into a vault, paying storage costs on that vault, and finally insuring the hoard will be quite high. Now imagine CHF 1,000,000 worth of CHF 1000 notes. That amount to just 1,000 slim paper notes, a fiftieth of the amount. Handling and storage costs come out to much less. The point being that thanks to the CHF 1,000 note, the zero lower bound binds a bit more tightly in Switzerland than anywhere else in the world.

What I'd expect over the next few months is a mad dash out of deposits into these colourful bits of paper. Luckily, the SNB provides data on its note denominations, which I've charted below going back to 1990.

The value of CHF 1000 denomination notes in circulation. Source: SNB

You can see that in general, the value of CHF 1,000 notes outstanding has grown quite quickly since 1990 and now comprises around 61% of the entire value of the Swiss note circulation. While that tally retreated a bit in 2014, it should start to grow at an above-trend rate in 2015 now that negative rates are in effect. The actual process will go something like this; the Swiss public will ask to convert their bank deposits into CHF 1000 notes, the banks being obliged to provide these notes by going to the SNB and converting their SNB deposits into cash.

If this process doesn't occur, the implication is that the costs of holding 1000 notes are even higher than 0.75% a year, thus giving the SNB even more breathing room to reduce rates.

I'd expect ongoing conversion into 1000 notes to impose a significant burden on the SNB, threatening both the banking system's deposit base and the effectiveness of monetary policy. There are a number of fixes that the Swiss might consider to offset this burden. First, the SNB can bump interest rates back up in order to stem the mania for 1000 notes, hardly an alternative if it is trying to get inflation back up to  its target. Alternatively, the Bank may decide to call in and demonetize the CHF 1000 notes, forcing everyone to accept five CHF 200 notes in its place (an idea discussed here). Since the 200 incurs more carrying costs than the 1000, the conversion into cash will be forestalled and the lower bound will have effectively been loosened downwards. Lastly, the Swiss might consider adopting a crawling peg between cash and deposits, as advocated by Miles Kimball.

The next and last option is the most interesting. When the public asks the banks for CHF 1000s, and the banks ask the SNB for 1000s, the SNB can just say no. In doing so, the SNB will have frozen the quantity of 1000s in circulation.

What will happen next will amount to an instance of Gresham's law. Since a CHF 1000 note is better than five CHF 200 notes due to its lower carrying costs, and 200s can no longer be converted on demand into 1000s thanks to the SNB's freeze, the 1000 should trade in the market at a premium to its face value, say CHF 1012 or 1013. However, legal tender laws typically stipulate that a note cannot discharge debts at more than its face value, thereby resulting in the forced undervalution of the 1000 note in trade. As a result, the Swiss public and its banks will hoard their 1000s rather than spending them, preferring instead to make payments and settle debts with lower denominations notes. Thus we get a modern version of Gresham's law, whereby 'good' CHF 1000 notes are driven out of circulation by 'bad' lower-denomination CHF notes. Think of it as an unofficial demonetization of the 1000.

Ultimately, I think that this last solution is the easiest and lowest cost alternative for the Swiss to fix their impending problem of mass paper storage at the negative interest rates. It's a temporary fix, however. A permanent solution will require outright demonetization of large denomination notes, or something like Miles Kimball's plan.

Is legal tender an imposition on free markets or a free market institution?

Robert the Bruce: Scottish  £20 issued by Clydesdale Bank. Not legal tender

This is my last post on legal tender. It builds on my initial posts on legal tender, various comments, and discussion at Bob Murphy's blog. If you're getting to the debate a bit late, here are the first two posts.

1. Legal Tender 101
2. How do legal tender laws affect purchasing power?

Are today's legal tender laws an imposition on monetary freedom?

My short answer: not really. In the US, legal tender is comprised of Federal Reserve notes and United States coin. That means that all debts can be discharged with government coins and notes. It might seem that this would impose the circulation of coins and notes on the marketplace. But as I pointed out in my initial post, debtor and creditor can easily get around legal tender rules by negotiating their own settlement media into the terms of a debt contract.

As commenter MF points out, there is one debt obligation that's tough to negotiate around: the government's tax obligation. Since citizens must pay taxes, and the government sets legal tender, surely notes and coin are forced upon the populace. In theory yes, but in practice no. The IRS asks that people do not send notes or coin to discharge their tax obligation. As a result, most taxes are paid with non-legal tender like cheques, direct deposit etc. Legal tender laws, it would seem, have no bite since the IRS itself ignores them.

But let's assume the government did indeed require tax payments in legal tender coin and notes. Let's return to my favorite McDonald's analogy (see here and here). Imagine that McDonald's Corporation forces customers to pay their "Big Mac tax" with McDonald-issued coupons. This is equivalent to a government that requires people to submit legal tender in order to discharge a tax obligation.

As I pointed out, people don't have to submit to McDonald's tax requirements, insofar as they are willing to eat at Burger King which (let's say) doesn't require coupons to pay for Whoppers. The same goes for US legal tender. If the US government requires citizens to settle their taxes with US legal tender (which, as I've pointed out above, is not the case in practice), then people can avoid this imposition by no longer doing business with the US. Go live in Scotland, which like Burger King, has no legal tender rules. Or find some other nation that doesn't have legal tender. You'll still have to pay taxes, of course, but settlement media won't be dictated to you.

As we know from Lawrence White's Free Banking in Britain, Scotland has a long history of free banking. Even today the majority of bank notes that circulate in Scotland are issued by three private banks—The Bank of Scotland, the Royal Bank of Scotland, and the Clydesdale Bank. These notes aren't legal tender. Nor are Bank of England notes, which also circulate in Scotland. For a brief time between 1954 and 1988, Bank of England notes with denominations below £5 were legal tender. But the withdrawal of the £1 notes from circulation in 1988 left Scotland with no paper legal tender. Scots accept both local Scottish notes and Bank of England notes as settlement media not because they must, but because it's convenient.

Legal tender as a free market institution?

Having shown that modern legal tender laws aren't necessarily a huge imposition on the free choice of payment media, I'll go one further and say that in a world characterized by free banking and governed by lex mercatoria (i.e. private merchant law) legal tender laws might evolve naturally as the result of market choice.

Huge amounts of debts are created in a day’s worth of business. Negotiating settlement media into each and every contract takes time, so transactors may choose to omit that bit. If so, a subsequent situation may arise in which a debtor arrives to pay a creditor, but the creditor refuses to accept the proffered settlement media, thereby forcing the debtor into unnecessary default. To avoid having court rooms being swamped by frivolous default cases, I could imagine merchant law evolving a list of common media that must always be accepted in the settlement of those debts for which a settlement medium was not already specified. If the marketplace were to accept these laws, then legal tender rules would arise in the same way that VHS beat Beta—they provide a cheap and useful set of standards around which everyone can coordinate their plans and actions.

Naturally, all sorts of interested parties would lobby jurists to have that list include their preferred asset. Nevertheless, there seems to me to be a certain “market” logic to legal tender. The real barriers to monetary freedom are not legal tender laws, but laws that restrict the issuance of notes to a monopoly issuer, and laws that force private banks to join a monopoly clearing house. But that's a different post.

How do legal tender laws affect purchasing power?

We discussed the definition of legal tender last week. Legal tender, in short, is any medium that can always be relied on to discharge a debt. Here's the next question—how does the conferral of legal tender status on an item affect that item's value? Here are my rough thoughts.

As I did in an older post on chartal coupon money, I'm going to make use of McDonald's Corporation to illustrate monetary phenomena. Let's say McDonald's wants to create its own form of legal tender: frozen meat patties. It does so by setting the 4 inch wide, 1/4 inch thick frozen beef patty as legal tender for all its receivables. This means that anyone indebted to McDonald's has to settle their debt with legal tender patties. If they owe $1000, they have to pay with $1000 worth of beef.

Next, McDonald's requires its suppliers, many of whom are entirely dependent on McDonald's for survival, to abide by its legal tender rules. Rather than give up their relationship with McDonald's, they accept. As a result, not only can debts due to McDonald's be settled in patties—so can debts due to a number of ranchers, bakeries, farmers, wholesalers, etc who are part of the McDonald's supply chain.

These developments will immediately increase the market price of 1/4 inch frozen beef patties. Why? Given the patty's new capacity to discharge all debts due to both McDonald's and its suppliers, it will be regarded as more liquid than if it didn't have this status. Instead of storing just one box of hamburger patties for future consumption or sale, a household or restaurant might keep a second in reserve for potential debt repayments. Since it provides an extra range of liquidity services, a 1/4 inch frozen patty will thereby gain a premium over its pre-legal tender market value.

Let's say that instead of beef patties, McDonald's declares that a new intrinsically worthless issue of yellow McDonald's certificates is to be made legal tender for $100 worth of debt. Anyone can buy the certificates at McDonald's, either with cash or in kind (say by selling supplies) and use them to pay off their debts to McDonald's or its suppliers. As debts are paid off, suppliers who accumulate unneeded certificates can offload them in the secondary market where debtors who need to settle debts can buy them.

Because McDonald's and its suppliers will always accept 1 certificate to settle each $100 worth of debt, arbitrage dictates that certificates will trade near parity. After all, if the market price of certificates falls to $90, all one need do go into debt to either McDonald's or one of its suppliers to the tune of $100, purchase a $90 certificate with the proceeds, use the certificate to repay the $100 debt, and enjoy the remaining risk-free earnings of $10. Of course, if McDonald's and its suppliers limit the market's ability to borrow from them, then this limitation might reduce the effectiveness of arbitrage and cause certificates to trade at a discount.

On the other hand, if the market price of certificates rises to $110, all one need do is buy certificates from McDonald's for $100 and sell them for $110 until the gap has been closed.

In any case, what is interesting here is that legal tender laws can add a liquidity premium to an already valuable commodity, or bestow market value on worthless bits of paper. That's not to say these certificates are pure fiat. After all, what makes them valuable is that they represent a liability of sorts, acceptance of which is backed up by power. Pure fiat objects, on the other hand, are items that circulate despite being no the liability of no one and having no intrinsic usefulness whatsoever.

As long as there are unredeemed certificates, or float, McDonald's earns seigniorage profits. After all, if $1000 worth of certificates are in circulation, the company pays no interest these certificates but can invest the proceeds in interest yielding bonds. The wider the circulation of McDonald's certificates, the larger the float and juicier the profits. Other large companies will of course be interested in enjoying seigniorage, and one can imagine them also trying to exert market power over their supply chains with legal tender rules. Their ability to do so will always be counterbalanced by competition, for if seigniorage gets too onerous, McDonalds' suppliers might flee to competitor Burger King, which may have less onerous seigniorage or no legal tender rules at all.

Extreme abuse of seigniorage would eventually result in certificates being worthless. Say McDonald's gets greedy and starts to sell certificates for $110. Anyone indebted to McDonald's or one of its suppliers is thus forced into the perverse position of having to acquire a certificate for $110 in order to settle a $100 debt, giving the debtor an immediate $10 loss. As a result, no one will choose to ever indebt themselves to either McDonald's or its suppliers. Soon, all debt in the McDonald's supply chain will have expired. Certificates will be worthless since their only source of value was their ability to discharge debts—and there is no more debt to discharge.

So is modern central bank money akin to meat patties or to yellow certificates? If the former, then a $100 bill is already valuable without legal tender laws, earning only a small premium when rules confer on it legal tender status. Removing legal tender status would do little to affect its purchasing power. If the latter, then central bank money would be entirely worthless without legal tender laws.

Legal tender 101

The trillion dollar coin debate has inspired a lot of chatter about legal tender, not all of it correct. The best source on the meaning of legal tender is Dror Goldberg (the same Dror Goldberg from my Yap Stone post). His paper, Legal Tender is short and concise. Give it a read. This post is largely based off his work.

First off. If someone offers to pay you in legal tender, say a US platinum coin, are you obligated to accept it? The answer is no.

When a medium-of-exchange is denoted as legal tender, that means that it must be accepted in the discharge of certain types of debt. If you are engaged in an exchange with someone that doesn't involve the settling of debts, then legal tender laws don't apply. For example, say you walk into a corner store and offer to pay for cigarettes using legal tender platinum coins. The store owner can legally refuse to accept the coins. After all, the two of you are not settling debts—you're engaging in a spot transaction. The owner is on the right side of the law in requiring payment in, say, peanuts. Either pay him in peanuts or walk out of the store without your smokes.

According to Goldberg, legal tender laws start with non-spot transaction—those transactions in which goods & services are provided prior to final settlement, thereby creating a debt. Legal tender laws require that a creditor accept legal tender as settlement for most types of debt contracts (not all, see next paragraph). What qualifies as legal tender? In the US this includes all United States coins and currency, as well as Federal Reserve notes. In Canada, coins produced by the Royal Mint and notes issued by the Bank of Canada are legal tender (see the Currency Act). Private bank deposits are not legal tender in the US or Canada, nor are traveler's cheques or credit cards. Creditors needn't accept cheques or credit cards.

Creditors can structure contracts to avoid the obligation of accepting legal tender. All it takes is that both parties to a debt contract agree ahead of time that some alternative medium will be used to settle the debt. Say a debtor and creditor have agreed to settle three months from now in bitcoin. If after three months have passed the debtor offers to settle with a legal tender platinum coin, the creditor can refuse to accept the coin since the contract specifies BTC. Private agreement trumps legal tender laws.

Even if no alternative media has been chosen to discharge a debt, in certain situations a creditor can still refuse legal tender. In Canada, for instance, the Currency Act specifies that while $2 coins (toonies) are legal tender, they need not be accepted in the settlement of debts over $40. If a debt is larger than $25, the creditor can refuse twenty-five $1 coins (loonies). In India, a half rupee coin is only legal tender for debts less than ten rupees, which means that a creditor can refuse to accept more than twenty half-rupee coins. (See this RBI page.)

Over the years, governments have set some odd commodities to serve as legal tender. In his book Legal Tender (1903) Samuel Breckenridge notes that in 1631, the governor of Massachusetts declared that corn was to pass in payment for all debts at the market rate, unless money or beaver had been stipulated in the contract. Breckenridge goes on to write:

A little later bullets were ordered to be taken, being rated as equal each to a farthing, though no man was to be forced to take more than 12d in any one payment in this form. In 1643, likewise in Massachusetts, wampum [shell money] was given the debt-paying quality within the value of 40s at the rate of four pieces of black or eight pieces of white to a penny. Similar legislation was enacted in Connecticut and Rhode Island. In Virgina and Maryland tobacco was the commodity most universally desired, and so, in 1633, Virginia enacted that, while contracts, judgements, etc., should be reckoned in English money, they should be paid in tobacco. And a century later Maryland made tobacco a legal tender at a penny a pound, and corn at twenty cents a bushel. In North Carolina corn, pitch, tar, pork were also used at specified rates. Thus, in 1715 any one of seventeen commodities named might be used as a legal tender or in payment of taxes. (Pg 53).

Here I'm obligated to present the alternative view to Goldberg, of which Breckenridge himself provides a decent example. In his book, Breckenridge adopts the common view that legal tender laws applies to all transactions, whether these be time (credit) or cash (spot) transactions. Writes Breckenridge:

in general, it may be said that both gold and silver coins were a lawful tender; that in cash transactions the buyer, in time transactions the debtor, had the right to select the form of money to be employed. In the case of cash transactions it was found necessary to supplement this law by penal legislation and by legislation regulating prices. But in the case of time transactions, the civil power of the courts was an adequate sanction.

Who is right? Here's a quote from the Richmond Fed that settles the matter, at least in its modern US context:

However, no federal law mandates that a person or an organization must accept currency or coins as payment for goods or services not yet provided. For example, a bus line may prohibit payment of fares in pennies or dollar bills. Some movie theaters, convenience stores and gas stations as a matter of policy may refuse to accept currency of a large denomination, such as notes above $20, and as long as notice is posted and a transaction giving rise to a debt has not already been completed, these organizations have not violated the legal tender law.

It would seem that Goldberg is correct. In spot transactions—those in which a debt hasn't been created—legal tender laws don't apply. No one needs to accept your trillion dollar coin or Federal Reserve note. At least not over the counter.

Would Bernanke accept a trillion dollar platinum coin?

The idea behind the trillion dollar platinum coin goes something like this. According to law, President Obama is permitted to take an ounce of platinum, which is worth around $1,500 in the market, and mint it into a collector's coin that says $1 trillion on its face. Obama then heads off to the Federal Reserve and deposits the coin at face value, his $1,500 worth of platinum having been exchanged for $1 trillion worth of fresh Fed deposits.

What is being exploited here is the difference between a collector coin's intrinsic value and its legal tender face value. Anyone who has collected American Eagle's will be aware of this difference. On its face, an Eagle is worth $50. But the coin's intrinsic value due to its gold content is well over $1600.

Do Eagle's pass at their face value or at intrinsic value? Head on over to the US Mint and you'll see that the Mint is selling $50 Eagles at their intrinsic price of $1,900 or so. Coin dealer American Gold Exchange is hocking 1 oz Eagles for $1750.  Aren't the Mint and and American Gold Exchange breaking the law in selling coins so far from face value? Not really. Legal tender laws stipulate the sorts of payment media required in the discharge of debt obligations. In selling collectors coins in retail spot transactions, the Mint isn't engaged in the activity of discharging debts. Nor is American Gold Exchange.

Think about the implications of requiring coin dealers and the US Mint to sell Eagles at face value to all comers. Both would be providing the world with the a great risk-free arbitrage opportunity—and destroying their balance sheet in the process.

Here's another interesting anecdote about collector's coins circulating (or not) at face value. From 1997 to 2003 Robert Kahre, a resident of Las Vegas and owner of 6 construction companies, ran a scheme in which he paid wages with gold eagles at their legal tender face value. Rather than hiring someone for say $50,000 a year payable by check, Kahre paid with 45 ounces of  Eagles with a total face value of $2,250 or so. Their declared income of $2,250 was so low that Kahre's workers didn't have to report their income to the IRS. At the same time, Kahre saved on payroll tax. Win-win. Except for the IRS. In May 2003, Kahre's businesses were raided by the tax authorities. Kahre was at first acquitted in 2007, but in 2009 he was found guilty of tax evasion and sent to prison.

The implications of the Kahre case are that despite what's said on their face, collectors coins pass at intrinsic value in the US.

The ability, indeed requirement, to ignore a collector coin's face value when engaging in transactions with these coins is a matter of common-sense self-preservation. If private coin shops like American Gold Exchange, the US Mint, or the IRS were required to let eagles pass at face value they would all suffer tremendous losses. Likewise, if the market price of an ounce of gold fell to $2, those obliged to accept Eagles at their $50 face value would quickly go bankrupt. Face value on collectors coins is merely symbolic, not obligatory.

With the rest of the US already passing collector coins at their intrinsic value, why would Ben Bernanke be expected to accept a platinum collector coin worth $1,500 at its face value of $1 trillion? He has no obligation to do so. As I pointed out, legal tender refers to the types of media that can be used to discharge debts, and Bernanke is not indebted to Obama in any way. All he does is administer the Treasury's account at the Fed.

Nor can Bernanke choose to forgo self-preservation. Section 16.2 of the Federal Reserve Act obligates him to protect the Fed's balance sheet by stipulating the rules concerning Federal Reserve note collateralization. The Act requires that all notes must be backed by

collateral in amount equal to the sum of the Federal Reserve notes thus applied for and issued pursuant to such application... In no event shall such collateral security be less than the amount of Federal Reserve notes applied for.

This means that notes cannot be backed by an insufficient amount of collateral security. There is a long history behind section 16.2. I've discussed it before here and here. 16.2 has been liberalized over the decades. In the old days, only a small range of assets could stand as collateral, but now almost any asset can back the note issue. Nevertheless, the 16.2 requirement for sufficient quantity of security remains. If a collector coin's market value is only $1,500, then Section 16.2 presumably prevents Bernanke from depositing the coin in exchange for anything over $1,500 in Fed notes and deposits. Any larger amount of notes and deposits applied for and the coin fails the collateral test.

The case could be made that Bernanke would accept the trillion dollar coin if it were to represent a binding debt of the government to repay the $1 trillion loan. But in this form the coin is no more than a bond or promissory note. Instead of being written on paper, the promise is embossed on platinum. Bernanke can't directly accept government debt, no matter if its inscribed on platinum, paper, or a mere digital entry. He can only bring government debt onto his balance sheet after the market has already purchased it. These limits can be found in sections 13 and 14 of the act. Section 13, which governs the Fed's lending powers, does not give the Fed power to lend to the government, while section 14, which governs open market purchases, only allows the Fed to purchase government bonds on the open market.

Of course, we can speculate about the possibility of Bernanke accepting the trillion dollar coin until we turn blue. We only really know what he'd do when the time actually comes. Bernanke might accept the trillion dollar coin at face value, but he'd surely have both tradition and law on his side in questioning his obligation to do so. However, laws and conventions often bend and morph when circumstances dictate. The Bear Stearns transaction via Maiden Lane I and the AIG bailout via Maiden Lane II and III somehow went through, despite what would seem to be explicit warnings against such actions in the Federal Reserve Act. Until it gets minted, I've got to hand it to the Beowulf, the originator of the trillion dollar coin idea, in having created what seems to be the econ blogosphere's most influential idea of the New Year.

[Update: In the comments with Bill W., I mentioned another bit of legalese indicating that the Fed needn't accept coin from either the government or a member bank. See section 13.1 of the Federal Reserve Act: “Any Federal reserve bank may receive from any of its member banks, or other depository institutions, and from the United States, deposits of current funds in lawful money, national-bank notes, Federal reserve notes, or checks.”  More evidence that Bernanke can say no to a government deposit request. May≠must.]